Looking for a Tutor Near You?

Post Learning Requirement »
x

Choose Country Code

x

Direction

x

Ask a Question

x

x
x
For better view click here
x
Hire a Tutor
DISCOVER

Notes On Macro Economic

Loading...

Published in: Economics
4,380 Views

Macro economic for class 12th

Online B / Gaya

year of teaching experience

Qualification:

Teaches: Business Studies, Chemistry, Economics, Hindi, Mathematics, Physics, Algebra, Social Studies, Bank PO, Defence Exams, Railways Exams, SSC CGL Exams, SSC Exams, SSC JE, CLAT, Constitutional Law, Law Entrance

Contact this Institute
  1. UNIT 1 MACRO ECONOMICS AND NATIONAL INCOME Syllabus: Macro Economics Micro Macro Paradox, Importance and uses of macroeconomics Circular flow of income and wealth National Income — concepts, methods of calculating national income, problems in the estimation of national income. Macro Economics It is that part of economic theory which studies the economy in its totality or as a whole. It studies not individual economic units like a household, a firm or an industry but the whole economic system. Macroeconomics is the study of aggregates and averages of the entire economy. Such aggregates are national income, total employment, aggregate savings and investment, aggregate demand, aggregate supply general price level, etc. Here, we study how these aggregates and averages of the economy as a whole are determined and what causes fluctuations in them. Having understood the determinants, the aim is how to ensure the maximum level of income and employment in a country. In short, macroeconomics is the study of national aggregates or economy-wide aggregates. In a way it is like study of economic forest as distinguished from trees that comprise the forest. Main tools of its analysis are aggregate demand and aggregate supply. Since the subject matter of macroeconomics revolves around determination of the level of income and employment, therefore, it is also known as 'Theory of Income and Employment. These days when the study of lakhs of individual units has become almost impossible and when government's participation through monetary and fiscal measures in the economy has increased very much, use of macro analysis has become indispensable. Correct economic policies formulated at macro level have made it possible to control business cycles (inflation and deflation) and as a result violent booms and depressions have become things of the past. In a suitably modified form, macroeconomics is the basis of all plans of economic development of underdeveloped economies. Economists are now confidently exploring the possibilities and ways of maintaining economic growth and full employment. More than anything else, macroeconomic thought has enabled us to properly organise, collect and analyse the data about national income and coordinate international economic policies. Scope and Importance of Macroeconomics: 1
  2. As a method of economic analysis macroeconomics is of much theoretical and practical importance. (1) To Understand the Working of the Economy: The study of macroeconomic variables is indispensable for understanding the working of the economy. Our main economic problems are related to the behaviour of total income, output, employment and the general price level in the economy. These variables are statistically measurable, thereby facilitating the possibilities of analysing the effects on the functioning of the economy. As Tinbergen observes, macroeconomic concepts help in "making the elimination process understandable and transparent". For instance, one may not agree on the best method of measuring different prices, but the general price level is helpful in understanding the nature of the economy. (2) In Economic Policies: Macroeconomics is extremely useful from the point of view of economic policy. Modern governments, especially of the underdeveloped economies, are confronted with innumerable national problems. They are the problems of overpopulation, inflation, balance of payments, general underproduction, etc. The main responsibility of these governments rests in the regulation and control of overpopulation, general prices, general volume of trade, general outputs, etc. Tinbergen says: "Working with macroeconomic concepts is a bare necessity in order to contribute to the solutions of the great problems of our times. " No government can solve these problems in terms of individual behaviour. Let us analyse the use of macroeconomic study in the solution of certain complex economic problems. (i) In General Unemployment: The Keynesian theory of employment is an exercise in macroeconomics. The general level of employment in an economy depends upon effective demand which in turn depends on aggregate demand and aggregate supply functions. Unemployment is thus caused by deficiency of effective demand. In order to eliminate it, effective demand should be raised by increasing total investment, total output, total income and total consumption. Thus, macroeconomics has special significance in studying the causes, effects and remedies of general unemployment. (ii) In National Income: The study of macroeconomics is very important for evaluating the overall performance of the economy in terms of national income. With the advent of the Great Depression of the 1930s, it became necessary to analyse the causes of general overproduction and general unemployment. This led to the construction of the data on national income. National income data help in forecasting the level of economic activity and to understand the distribution of income among different groups of people in the economy. 2
  3. (iii) In Economic Growth: The economics of growth is also a study in macroeconomics. It is on the basis of macroeconomics that the resources and capabilities of an economy are evaluated. Plans for the overall increase in national income, output, and employment are framed and implemented so as to raise the level of economic development of the economy as a whole. (iv) In Monetary Problems: It is in terms of macroeconomics that monetary problems can be analysed and understood properly. Frequent changes in the value of money, inflation or deflation, affect the economy adversely. They can be counteracted by adopting monetary, fiscal and direct control measures for the economy as a whole. (v) In Business Cycles: Further macroeconomics as an approach to economic problems started after the Great Depression. Thus its importance lies in analysing the causes of economic fluctuations and in providing remedies. (3) For Understanding the Behaviour of Individual Units: For understanding the behaviour of individual units, the study of macroeconomics is imperative. Demand for individual products depends upon aggregate demand in the economy. Unless the causes of deficiency in aggregate demand are analysed, it is not possible to understand fully the reasons for a fall in the demand of individual products. The reasons for increase in costs of a particular firm or industry cannot be analysed without knowing the average cost conditions of the whole economy. Thus, the study of individual units is not possible without macroeconomics. Conclusion: We may conclude that macroeconomics enriches our knowledge of the functioning of an economy by studying the behaviour of national income, output, investment, saving and consumption. Moreover, it throws much light in solving the problems of unemployment, inflation, economic instability and economic growth. Limitations of Macroeconomics: There are, however, certain limitations of macroeconomic analysis. Mostly, these stem from attempts to yield macroeconomic generalisations from individual experiences. (1) Fallacy of Composition: In Macroeconomic analysis the "fallacy of composition" is involved, i.e., aggregate economic behaviour is the sum total of individual activities. But what is true of individuals is not necessarily true of the economy as a whole. 3
  4. For instance, savings are a private virtue but a public vice. If total savings in the economy increase, they may initiate a depression unless they are invested. Again, if an individual depositor withdraws his money from the bank there is no ganger. But if all depositors do this simultaneously, there will be a run on the banks and the banking system will be adversely affected. (2) To Regard the Aggregates as Homogeneous: The main defect in macro analysis is that it regards the aggregates as homogeneous without caring about their internal composition and structure. The average wage in a country is the sum total of wages in all occupations, i.e., wages of clerks, typists, teachers, nurses, etc. But the volume of aggregate employment depends on the relative structure of wages rather than on the average wage. If, for instance, wages of nurses increase but of typists fall, the average may remain unchanged. But if the employment of nurses falls a little and of typists rises much, aggregate employment would increase. (3) Aggregate Variables may not be Important Necessarily: The aggregate variables which form the economic system may not be of much significance. For instance, the national income of a country is the total of all individual incomes. A rise in national income does not mean that individual incomes have risen. The increase in national income might be the result of the increase in the incomes of a few rich people in the country. Thus a rise in the national income of this type has little significance from the point of view of the community. Prof. Boulding calls these three difficulties as "macroeconomic paradoxes" which are true when applied to a single individual but which are untrue when applied to the economic system as a whole. (4) Indiscriminate Use of Macroeconomics Misleading: An indiscriminate and uncritical use of macroeconomics in analysing the problems of the real world can often be misleading. For instance, if the policy measures needed to achieve and maintain full employment in the economy are applied to structural unemployment in individual firms and industries, they become irrelevant. Similarly, measures aimed at controlling general prices cannot be applied with much advantage for controlling prices of individual products. (5) Statistical and Conceptual Difficulties: The measurement of macroeconomic concepts involves a number of statistical and conceptual difficulties. These problems relate to the aggregation of microeconomic variables. If individual units are almost similar, aggregation does not present much difficulty. But if microeconomic variables relate to dissimilar individual units, their aggregation into one macroeconomic variable may be wrong and dangerous. Importance of Macroeconomics: 4
  5. 1. It helps to understand the functioning of a complicated modern economic system. It describes how the economy as a whole functions and how the level of national income and employment is determined on the basis of aggregate demand and aggregate supply. 2. It helps to achieve the goal of economic growth, higher level of GDP and higher level of employment. It analyses the forces which determine economic growth of a country and explains how to reach the highest state of economic growth and sustain it. 3. It helps to bring stability in price level and analyses fluctuations in business activities. It suggests policy measures to control Inflation and deflation. 4. It explains factors which determine balance of payment. At the same time, it identifies causes of deficit in balance of payment and suggests remedial measures. 5. It helps to solve economic problems like poverty, unemployment, business cycles, etc., whose solution is possible at macro level only, i.e., at the level of whole economy. 6. With detailed knowledge of functioning of an economy at macro level, it has been possible to formulate correct economic policies and also coordinate international economic policies. 7. Last but not the least, is that macroeconomic theory has saved us from the dangers of application of microeconomic theory to the problems of the economy as a whole. Circular Flow of Income: 2 Sector, 3 Sector and 4 Sector Economy Circular Income Flow in a Two Sector Economy: Real flows of resources, goods and services have been shown in Fig. 6.1. In the upper loop of this figure, the resources such as land, capital and entrepreneurial ability flow from households to business firms as indicated by the arrow mark. In opposite direction to this, money flows from business firms to the households as factor payments such as wages, rent, interest and profits. 5
  6. EntetDe. Exposu.ge 00 GaxS Fig. 6.1. Circular Flow of Income in a Simple Sector Economy In the lower part of the figure, money flows from households to firms as consumption expenditure made by the households on the goods and services produced by the firms, while the flow of goods and services is in opposite direction from business firms to households. Thus we see that money flows from business firms to households as factor payments and then it flows from households to firms. Thus there is, in fact, a circular flow of money or income. This circular flow of money will continue indefinitely week by week and year by year. This is how the economy functions. It may, however, be pointed out that this flow of money income will not always remain the same in volume. In other words, the flow of money income will not always continue at a constant level. In year of depression, the circular flow of money income will contract, i.e., will become lesser in volume, and in years of prosperity it will expand, i.e., will become greater in volume. This is so because the flow of money is a measure of national income and will, therefore, change with changes in the national income. In year of depression, when national income is low, the volume of the flow of money will be small and in years of prosperity when the level of national income is quite high, the flow of money will be large. In order to make our analysis simple and to explain the central issues involved, we take many assumptions. In the first place, we assume that neither the households save from their incomes, nor the firms save from their profits. We further assume that the government does not play any part in the national economy. In other words, the government does not receive any money from the people by way of taxes, nor does the government spend any money on the goods and services produced by the firms or on the resources and services supplied by the households. Thirdly, we assume that the economy neither imports goods and services, nor exports anything. In other words, in our above analysis we have 6
  7. not taken into account the role of foreign trade. In fact we have explained above the flow of money that occurs in the functioning of a closed economy with no savings and no role of government. Circular Income Flow with Saving and Investment: In our above analysis of the circular flow of income we have assumed that all income which the households receive, they spend it on consumer goods and services. A result, circular flow of money speeding and income remains undiminished. We will now explain if households save a part of their income, how their savings will affect money flows in the economy. When households save, their expenditure on goods and services will decline to that extent and as a result money flow to the business firms will contract. With reduced money receipts, firms will hire fewer workers (or lay off some workers) or reduce the factor payments they make to the suppliers of factors such as workers. This will lead to the fall in total incomes of the households. Thus, savings reduce the flow of money expenditure to the business firms and will cause a fall in economy's total income. Economists therefore call savings a leakage from the money expenditure flow. But savings by households need not lead to reduced aggregate spending and income if they find their way back into flow of expenditure. In free market economies there exists a set of institutions such as banks, insurance companies, financial houses, stock markets where households deposit their savings. All these institutions together are called financial institutions or financial market. We assume that all the savings of households come in the financial market. We further assume that there are no inter-households borrowings. It is business firms who borrow from the financial market for investment in capital goods such as machines, factories, tools and instruments, trucks. Firms spend on investment in order to expand their productive capacity in future. Thus, through investment expenditure by borrowing the savings of the households deposited in financial market, are again brought into the expenditure stream and as a result total flow of spending does not decrease. Circular money flow with saving and investment is illustrated in Fig. 6.2 where in the middle part a box representing financial market is drawn. Money flow of savings is shown from the households towards the financial market. Then flow of investment expenditure is shown as borrowing by business firms from the financial market. 7
  8. Savtng Investment Finare em Fig. 6.2. Circular Money Flow with Saving and Investment Condition for the Constancy of Circular Income Flow: Now the question arises what is the condition for the flow of money income to continue at a steady level so that it makes possible the production and subsequent flow of a given volume of goods and services at constant prices. To explain this we have to introduce saving and investment in the analysis of circular flow of income. Saving a part of income means it is not spent on consumer goods and services. In other words, saving is withdrawal of some money from the income flow. On the other hand, investment means some money is spent on buying new capital goods to expand production capacity. In other words, investment is injection of some money in circular flow of income. For the circular flow of income to continue unabated, the withdrawal of money from the income stream by way of saving must equal injection of money by way of investment expenditure. Therefore, planned savings must be equal to planned investment if the constant money income flow in an economy is to be obtained. Now, what will happen if planned investment expenditure falls short of the planned savings? As a result of fall in planned investment expenditure, income, output and employment will fall and therefore the flow of money will contract. If the equality between planned savings and planned investment is disturbed by increase in savings, then the immediate effect will be that the stocks of goods lying in the shelves of the shops will increase (as some of the goods will not be sold due to the fall in consumption i.e., increase in savings). Owing to the deficiency of demand for goods and the accumulation of stocks, retailers will place small orders with the wholesalers. Consequently, smaller amount of goods will be produced and therefore fewer capital goods like machinery will be indeed with the result that fixed investment will tend to fall. 8
  9. Thus the ultimate effect of either the fall in planned investment or the increase in planned savings is the same, namely, the fall in income, output, employment and prices with the result that the flow of money will contract. On the other hand, if the equality between planned savings and planned investment is disturbed by the increase in investment demand, the result will be increase in income, output and employment. Consequently, the flow of money income will expand. It is thus clear from the above analysis that the flow of money income will continue at a constant level only when the condition of equality between planned saving and investment is satisfied. It was believed by classical economists that financial market provides a mechanism which coordinates the savings of households and the investment expenditure, by the firms. Rate of interest, which is the price for the use of savings, is determined by saving and investment. If savings exceed investment expenditure, rate of interest falls so that, at a lower rate of interest, investment increases and both become equal. On the contrary, if investment expenditure is greater than savings, rate of interest will rise so that at a higher rate of interest savings increase and become equal to planned investment expenditure. However, an eminent British economist J.M. Keynes refuted the above argument that changes in rate of interest will cause saving and investment to become equal. According to him, since in a free market capitalist economy, investment is made by business enterprises and savings are mostly done by households and for different reasons, there is no guarantee that planned investment will be equal to planned savings and thus fluctuations in income, output and employment are inevitable. As a result, circular flow of income does not continue at a steady level in a free-enterprise capitalist economy unless certain corrective and preventive steps are taken by the government to maintain stability in the economy. Saving-Investment Identity in National Income Accounts in a Two Sector Economy: Despite the fact that people who save are different from the business firms which primarily invest, in national income accounts savings are identical or always equal to investment in a simple two sector economy having no roles of Government and foreign trade. This is a basic identity in national income accounts which needs to be carefully understood. Of course, in our above analysis of circular flow of income, we explained that planned investment by business firms can differ from savings by household. But in that analysis we referred to planned or intended investment and savings which often differ and affect the flow of national income. However, in national income accounts we are concerned with actual saving and actual investment. It is these actual or realised saving and investment that are identical in national income accounts. We can prove their identity in the following way. In a simple economy which has neither government, nor foreign trade, the value of output produced which we denote by Y is equal to the value of output sold. Since the value of output sold in a simple two sector economy is equal to the sum of consumption expenditure and investment 9
  10. expenditure we have y= C+ I where Y = Value of aggregate output, C = Consumption expenditure and I = Investment expenditure. A pertinent question which arises here is what happens to the unsold output. The unsold output leads to the increase in the inventories of goods and in national income accounting increase in inventories of goods is treated as a part of actual investment. This may be considered as the firms selling the goods to themselves to add to their inventories. Thus, gross national product (GNP) produced is used either for consumption or for investment. Now, look at the gross national product or income in the simple economy from the viewpoint of its allocation between consumption and saving. Since national income (which is equal to GNP) can be either consumed or saved,. We have Y E C+ S From the identities (i) and (ii) we get C+IEYE S The left hand side of the identity (iii), namely C + I = Y shows the components of aggregate demand (that is, aggregate expenditure on goods and services produced) and the right-hand side of the identity (iii) namely Y = C + S shows the allocation of national income to either consumption or saving. Thus, the identity (iii) shows that the value of output produced or sold is equal to the total income received. It is income received that is spent on goods and services produced. Now subtracting the consumption (C) from both sides of the identity (iii) we have 1 EYES Thus, in our two sector simple economy with neither government, nor foreign trade, investment is identically equal to saving. Circular Income Flow in a Three Sector Economy with Government: In our above analysis of money flow, we have ignored the existence of government for the sake of making our circular flow model simple. This is quite unrealistic because government absorbs a good part of the incomes earned by households. Government affects the economy in a number of ways. Here we will concentrate on its taxing, spending and borrowing roles. Government purchases goods and services just as households and firms do. Government expenditure takes many forms including spending on capital goods and infrastructure (highways, power, communication), on defence goods, and on education and public health and so on. These add to the money flows which are shown in Fig. 6.3 where a box representing Government has been drawn. It will be seen that government purchases of goods and services from firms and households are shown as flow of money spending on goods and services. 10
  11. Fhancial Market Fig. 6.3. Circ•ular Income Flow Model with Government Government expenditure may be financed through taxes, out of assets or by borrowing. The money flow from households and business firms to the government is labelled as tax payments in Fig. 6.3 This money flow includes all the tax payments made by households less transfer payments received from the Government. Transfer payments are treated as negative tax payments. Another method of financing Government expenditure is borrowing from the financial market. This can be represented by the money flow from the financial market to the Government and is labelled as Government borrowing (To avoid confusion we have not drawn this money flow from financial market to the Government). Government borrowing increases the demand for credit which causes rate of interest to rise. The government borrowing through its effect on the rate of interest affects the behaviour of firms and households. Business firms consider the interest rate as cost of borrowing and the rise in the interest rate as a result of borrowing by the Government lowers private investment. However, households who view the rate of interest as return on savings feel encouraged to save more. It follows from above that the inclusion of the Government sector significantly affects the overall economic situation. Total expenditure flow in the economy is now the sum of consumption expenditure (denoted by C), investment expenditure (I) and Government expenditure (denoted by G). Thus Total expenditure (E) — C + I + G ... ..(i) Total income (K) received is allocated to consumption (C), savings (S) and taxes (T). Thus Y C+S+T ... (ii) Since expenditure) made must be equal to the income received (Y), from equations (i) and (ii) above we have C +1 + G C + S + T ... (iii) Since C occurs on both sides of the equation (iii) and will therefore be cancelled out, we have 11
  12. I + G S + T ... (iv) By rearranging we obtain G-T=S-I. . (v) Equation (v) is very significant as it depicts what would be the consequences if government budget is not balanced, that is, if Government expenditure (G) is greater than the tax revenue (7), that is, G > T, the government will have a deficit budget. To finance the deficit budget, the Government will borrow from the financial market. For this purpose, then private investment by business firms must be less than the savings of the households. Thus Government borrowing reduces private investment in the economy. In other words, Government borrowing crowds out private investment. Money Income Flows in the Four Sector Open Economy: Adding Foreign Sector: We now turn to explain the money flows that are generated in an open economy, that is, economy which have trade relations with foreign countries. Thus, the inclusion of the foreign sector will reveal to us the interaction of the domestic economy with foreign countries. Foreigners interact with the domestic firms and households through exports and imports of goods and services as well as through borrowing and lending operations through financial market. Goods and services produced within the domestic territory which are sold to the foreigners are called exports. On the other hand, purchases of foreign-made goods and services by domestic households are called imports. Figure 6.4 illustrates additional money flows that occur in the open economy when exports and imports also exist in the economy. In our analysis, we assume it is only the business firms of the domestic economy that interact with foreign countries and therefore export and import goods and services. Botro•mng investment Market F«cign e, Business Firms fig. 6.4. Circular Flow of Income in an Open Economy With Government and Fon•tgn Sector 12
  13. A flow of money spending on imports have been shown to be occurring from the domestic business firms to the foreign countries (i.e., rest of the world). On the contrary, flow of money expenditure on exports of a domestic economy has been shown to be taking place from foreign countries to the business firms of the domestic economy. If exports are equal to the imports, then there exists a balance of trade. Generally, exports and imports are not equal to each other. If value of exports exceeds the value of imports, trade surplus occurs. On the other hand if value of imports exceeds value of exports of a country, trade deficit occurs. In the open economy there is interaction between countries not only through exports and imports of goods and services but also through borrowing and lending funds or what is also called financial market. These days financial markets around the world have become well integrated. When there is a trade surplus in the economy, that is, when exports (X) exceed imports (M), net capital inflow will take place. By net capital inflow we mean foreigners will borrow from domestic savers to finance their purchases of domestic exports. In this way as a result of net capital inflow domestic savers will lend to foreigners, that is, acquire foreign financial assets. On the contrary, in case of import surplus, that is, when imports are greater than exports, trade deficit will occur. Therefore, in case of trade deficit, domestic consumer households and business firms will borrow from abroad to finance their excess of imports over exports. As a result, foreigners will acquire domestic financial assets. From the circular flows that occur in the open economy the national income must be measured by aggregate expenditure that includes net exports, that is, X-M where X represents exports and M represents imports. Imports must be subtracted from the total expenditure on foreign produced goods and services to get the value of net exports. Thus, in the open economy National Income = C + 1 + G + NX where NX represents net exports, X-M. Since national income can be either consumed, saved or paid as taxes to the Government we have C+I+G+NX = C + S + T National Income: Meaning and Definitions In common parlance, national income means the total value of goods and services produced annually in a country. In other words, the total amount of income, accruing to a country from economic activities in a year's time, is known as national income. It includes payments made to all resources in the form of wages, interest, rent and profits. National income may be defined as the aggregate factor income (i.e. earnings of the factors of production) which arises from the current year's production of goods and services by the nation' s economy. 13
  14. Definitions The definitions of national income can be grouped into two classes: one, the traditional definitions advanced by Marshall, Pigou and Fisher; and two modern definitions. The Marshallian Definition. According to Marshall: 'the labour and capital of a country acting on its natural resources produce annually a certain net aggregate of commodities, material and immaterial including services of all kinds... This is the true net annual income or revenue of the country or national dividend." In this definition, the word 'net' refers to deductions from gross national income in respect of depreciation and wearing out of machines. And to this must be added the income from abroad. Its defects. Though the definition advanced by Marshall is simple and comprehensive, yet it suffers from a number of limitations. 1. 2. 3. In the present day world, so varied and numerous are the goods and services produced that it is very difficult to have a correct estimation of them and consequently the national income cannot be calculated correctly. There always exists the fear of the mistake of double counting and hence NI cannot be correctly estimated. Double counting means that a particular commodity or service like raw material or labour etc. might get included in the NI twice or more than twice. It is again not possible to have a correct estimation of NI because many of the commodities produced are not marketed and the producer either keeps the produce for self-consumption or exchanges it for other commodities. It generally happens in an agriculture-oriented country like India. Thus the volume of NI is underestimated. The Pigouvian definition. Marshall's follower, A.C. Pigou has, in his definition of national income included that income which can be measured in terms of money. In the words of Pigou, 'NI is that part of objective income of the community, including of course income derived from abroad, which can be measured in terms of money." This definition is better than that of Marshall. It has proved to be more practical also. While calculating the NI nowadays, estimates are prepared in accordance with the two criteria laid down in this definition. First, avoiding double counting, the goods and services which can be measured in money are included in NI. Second, income received on account of investment in foreign countries is included in NI. Its defects. The Pigouvian definition is precise, simple and practical but it is not free from criticism. 1. 2. In the light if this definition, we have to unnecessarily differentiate between commodities which can and which cannot be exchanged for money. When only such commodities which can be exchanged for money are included in the estimation of national income, the NI cannot be estimated correctly. According to Pigou, a woman's services as nurse would be included in NI but excluded when she work at home looking after the children because she does not get any salary for it. Thus this definition gives rise to many paradoxes. 14
  15. 3. This definition is only applicable to the developed countries where goods and services are exchanged for money in the market. In the less developed countries, where a major portion of the produce is simply bartered, correct estimate of NI will not be possible, because it will always work out to be less than the actual level. Fisher's Definition. Fisher adopted Consumption as the criterion of NI whereas Marshall and Pigou regarded it to be production. According to Fisher, "the national dividend or income consists solely of services as received by ultimate consumers, whether from their material or from their human environments. Thus a piano or an overcoat made to me this year is not an income but an addition to capital. Only the services rendered to me during this year by these things are income.' Fisher's definition is considered to be better than that of Marshall or Pigou, because Fisher's definition provides an adequate concept of economic welfare which is dependent on consumption and consumption represents our standard of living. Its defects. But from practical point of view, this definition is less useful. 1. 2. 3. It is more difficult to estimate the money value of net consumption than that of net production. In one country there are several individuals who consume a particular good and that too at different places and, therefore it is very difficult to estimate their total consumption in terms of money. Certain consumption goods are durable and last for many years. If we consider the example of piano or overcoat, as given by Fisher, only the services rendered to use during one year by them will be included in NI. If an overcoat costs Rs. 100 and lasts for 10 years, Fisher will take into account only Rs. 10 as NI during one year whereas Marshall and Pigou will include Rs.100 in the NI for the year when it is produced. Besides it cannot be said with certainty that the overcoat will last only for 10 years. It may last longer or for a shorter period. Durable goods generally keep changing hands leading to a change in their ownership and value too. From the modern point of view, Simon Kuznets has defined NI as "the net output of commodities and services flowing during the year from the country's productive system in the hands of ultimate consumers.' In one of the reports of United Nations, NI has been defined on the basis of the systems of estimating NI, as net national product, as addition to the shares of different factors and as net national expenditure in a country in a year' s time. In practice, while estimating NI, any of these three definitions may be adopted, because the same NI would be derived, if different items were correctly included in the estimate. Concepts of National Income 15
  16. There are various concepts of National Income. The main concepts of NI are: GDP, GNP, NNP, NI, PI, DI, and PCI. These different concepts explain about the phenomenon of economic activities of the various sectors of the economy. 1. Gross Domestic Product (GDP) The most important concept of national income is Gross Domestic Product. Gross domestic product is the money value of all final goods and services produced within the domestic territory of a country during a year. Algebraic expression under product method is, GDP= (P*Q) Where, GDP-Gross Domestic Product P=Price of goods and service Q=Quantity of goods and service *denotes the summation of all values. According to expenditure approach, GDP is the sum of consumption, investment, government expenditure, net foreign exports of a country during a year. Algebraic expression under expenditure approach is, Where, C=Consumption 1=1nvestment G=Government expenditure (X-M)=Export minus import GDP includes the following types of final goods and services. They are: 1. Consumer goods and services. 2. Gross private domestic investment in capital goods. 3. Government expenditure. 4. Exports and imports. 2. Gross National Product (GNP) Gross National Product is the total market value of all final goods and services produced annually in a country plus net factor income from abroad. Thus, GNP is the total measure of the flow of goods and services at market value resulting from current production during a year in a country including net factor income from abroad. The GNP can be expressed as the following equation: 16
  17. GNP=GDP+NFIA (Net Factor Income from Abroad) or, Hence, GNP includes the following: 1. 2. 3. 4. 5. Consumer goods and services. Gross private domestic investment in capital goods. Government expenditure. Net exports (exports-imports). Net factor income from abroad. 3. GNP at Factor Cost GNP at factor cost is the sum of the money value of the income produced by and accruing to the various factors of production in one year in a country. In order to arrive at GNP at Factor Cost, we deduct indirect taxes from GNP at Market prices and we add subsidies to it. Thus, GNP at Factor Cost = GNP at market prices — indirect taxes + subsidy 4. Net National Product (NNP) . Net National Product is the market value of all final goods and services after allowing for depreciation. When charges for depreciation are deducted from the gross national product, we get it. Thus, NNP at market prices = GNP — Depreciation or, NNP = 5. NNP at Market Prices. NNP at MP is the net value of final goods and services evaluated at market prices in the course of one year in a country. NNP at Market Prices = GNP at market prices - depreciation 6. Net National Product (NNP) at Factor cost. Net National Product at factor cost is also known as National Income. NNP at factor cost means the sum of all incomes earned by resources suppliers for their contribution of land, labour, capital and organizational ability which go into the year's net production. Hence, the sum of the income received by factors of production in the form of rent, wages, interest and profit is called National Income. Symbolically, NNP at Factor Cost = NNP at market prices + Subsidies - Indirect Taxes or, GNP at market prices - Depreciation + Subsidies - Indirect Taxes or, NNP at FC = - Depreciation - Indirect Taxes + Subsidies 17
  18. 7. Private Income. Private Income is the income obtained by private individuals from any source, productive or otherwise, and the retained income of corporations. It can be arrived at from NNP at Factor Cost by making certain additions and deductions. The additions include transfer payments such as pensions, unemployment allowances, sickness and other social security benefits etc. and interest on public debt. The deductions include income from government undertakings, and employees contributions to social security schemes like provident fund, life insurance, etc. Thus, private Income IS' Private Income = NNP at FC + transfer payments + interest on public debt — social security contributions — profits and surpluses of public undertakings. 8. Personal Income (PI) Personal Income is the total money income received by individuals and households of a country from all possible sources before direct taxes. Therefore, personal income can be expressed as follows: PI = NI — Undistributed Corporate Profits — Profit Taxes — Social Security Contributions + Transfer Payments + Interest on Public Debt. Or, PI = Private income — Undistributed Corporate Profits — Profit Taxes. 9. Disposable Income (DI) The income left after the payment of direct taxes from personal income is called Disposable Income. Disposable income means actual income which can be spent on consumption by individuals and families. Thus, it can be expressed as: DI = PI - Direct Taxes From consumption approach, DI=Consumption Expenditure + Savings 10. Real Income. Real Income is national income expressed in terms of a general level of prices of a particular year taken as a base. To find out the real income of a country, a particular year is taken as base year when the general price level is neither too high nor too low and the price level for that year is assumed to be 100. Now the general level of the prices of the given year for which the real national income is to be determined is assessed in accordance with the prices of the base year. Real NNP = NNP for the current year x Base year index (= 18 100)
  19. urren 11. Per Capita Income (PCI) ear n ex Per Capita Income of a country is derived by dividing the national income of the country by the total population of a country. Thus, PCI=Total National Income/Total National Population Real PCI = Real National Income/ Total National Population. These are the various concepts of national income. Methods of estimating National Income Primarily there are three methods of measuring/estimating national income. Which method is to be employed depends on the availability of data and purpose. The methods are product method, income method, expenditure method and value added method. Product method is given by Dr. Alfred Marshall, income method by A.C. Pigou and expenditure method by Dr. Irving Fisher. 1. Value Added Method Value added method is also named as Product method. This method is used to measure national income at the phases of 'production of each enterprise and each industrial sector during a year. In fact this method measures the contribution of each enterprise in the flow of goods and services in the economy. Under this method, the economy is- generally divided into three industrial classes namely (a) Primary sector (b) Industrial sector and (c) Service sector. The main enterprises included in these sectors are agriculture, fishing, forestry, mining, manufacturing, construction, transport and communication, trade and commerce insurance, banking etc. For computing national income, the values added by the above three sectors at each stage is worked out. The value of output at each enterprise is found by multiplying the physical output with the market prices of the goods produced. For example, firm A produces necessary raw material and sells it in market for Rs.2000 to firm B. The firm B manufactures raw material, into finished goods and sells it to firm C for Rs.4000. The firm C sells the finished goods to household for Rs.5000/=. The value added at each stage is Rs.2000 + 2000 + 1000 = Rs.5000. The total value added is Rs.5000. Precautions for this approach There are certain precautions which are to be taken to avoid miscalculation of national income using this method. These in brief are: 19
  20. 1 Problem of double counting: When we add up the value of output of various sectors, we should be careful to avoid double counting. This pitfall can be avoided by either counting the final value of the output or by including the extra value that each firm adds to an item. (ii) Value addition in particular year: While calculating national income, the values of goods added in the particular year in question are added up. The values which had previously been added to the stocks of raw material and goods have to be ignored. GDP thus includes only those goods and services that are newly produced within the current period. (iii) Stock appreciation: Stock appreciation, if any, must be deducted from value added. This is necessary as there is no real increase in output (iv) Production for self-consumption. The production of goods for self-consumption should be counted while measuring national income. In this method, the production of goods for self- consumption should be valued at the prevailing market prices. 2. The Expenditure Method: The expenditure approach measures national income as total spending on final goods and services produced within nation during an year: The expenditure approach to measuring national income is to add up all expenditures made for final goods and services at current market prices by households, firms and government during a year. Total aggregate final expenditure on final output thus is the sum of four broad categories of expenditures (i) consumption (ii) Investment (iii) government and (iv) net exports. (i) Consumption expenditure: Consumption expenditure is the largest component of national income. It includes expenditure on all goods and services produced and sold to the final consumer during the year. (ii) Investment expenditure: Investment is the use of today's resources to expand tomorrow's production or consumption. Investment expenditure is expenditure incurred on by business firms on(a) new plants, (b) adding to the stock of inventories and (c) on newly constructed houses. (iii) Government expenditure: (G) it is the second largest component of national income. It includes all government expenditure on currently produced goods and services but excludes transfer payments while computing national income. (iv) Net exports: Net exports are defined as total exports minus total imports. National income calculated from the expenditure side is the sum of final consumption expenditure, expenditure by business on plants, government spending and net exports. NI=C+ 1 +G+(X M) Precautions While estimating national income through expenditure method, the following precautions should be taken: 20
  21. (i) The expenditure on second hand goods should not be included as they do not contribute to the current year' s production of goods. (ii) Similarly, expenditure on purchase of old shares and bonds is not included as these also do not represent expenditure on currently produced goods and services. (iii) Expenditure on transfer payments by government such as unemployment benefit, old age pensions, interest on public debt should also not be included because no productive service is rendered in exchange by recipients of these payments. 3. The Income Approach: Income approach is another alternative way of computing national income. This method seeks to measure national income at the phase of distribution. In the production process of an economy, the factors of production are engaged by the enterprises. They are paid money incomes for their participation in the production. The payments received by the factors and paid by the enterprises are wages, rent, interest and profit. National income thus may be defined as the sum of wages, rent, interest and profit received or accrued to the factors of production in lieu of their services in the production of goods. Briefly, national income is the sum of all income, wages, rents, interest and profit paid to the four factors of production. The four categories of payments are briefly described below: (i) Wages: It is the largest component of national income. It consists of wages and salaries along with fringe benefits and unemployment insurance. (ii) Rents: Rents are the income from property received by households. (iii) Interest: Interest is the income private businesses pay to households who have lent the business money. (iv) Profits: Profits are normally divided into two categories (a) profits of incorporated businesses and (b) profits of unincorporated businesses (sole proprietorship, partnerships and producers cooperatives). Precautions While estimating national income through income method, the following precautions should be undertaken. (i) Transfer payments such as gifts, donations, scholarships, indirect taxes should not be included in the estimation of national income. (ii) Illegal money earned through smuggling and gambling should not be included. (iii) Windfall gains such as -prizes won, lotteries etc. is not be included in the estimation of national income. (iv) Receipts from the sale of financial assets such as shares, bonds should not be included in measuring national income as they are not related to generation of income in the current year production of goods. 21
  22. Difficulties in National Income measurement To calculate the national income of a country is a complicated problem and is beset with the following difficulties: 1. First there is the difficulty of defining a nation in national income. Every nation has its political boundaries, but in the national income is also included the income earned by the nationals of a country in a foreign country beyond the territorial boundaries of that country. 2. National income is always measured in terms of money, but there are a number of goods and services which are difficult to be assessed in terms of money, e.g., painting as a hobby of an individual, the bringing up of her children by a mother. 3. The greatest difficulty in calculating national income is of double counting, which arises from the failure to distinguish properly between a final and an intermediate product. To solve this problem, only final goods and services are taken into consideration. But it is not an easy task. 4. Income earned through illegal activities like gambling, illicit extraction of wine etc. are not included in the calculation of national income. Such goods and services do have value and meet the needs of the consumers. But by leaving them out, the national income works out to be less than the actual value. 5. Then there arises the difficulty of including transfer payments in the national income. Individuals get pension, unemployment allowance and interest on public loans; but whether these should be included in the national income is a difficult problem. On the one hand, these earnings are a part of individual income and on the other, they are government expenditure. To avoid this difficulty, they are deducted from national income. 6. All inventory changes whether negative or positive are included in the GNP. But inventory evaluation is a very difficult and cumbersome procedure. 7. When we deduct capital depreciation from GNP, the resulting measure is NNP. Depreciation is a charge on profits which lowers national income. Depreciation valuation is full of statistical difficulties, such as age-composition of the whole capital stock, and changes in prices of capital goods every year since the assets were bought. 8. Another difficulty in calculating national income is that of price-changes which fail to keep stable the measuring rod of money for national income. In order to solve this problem, the statisticians have brought the concept of real national income, according to which the prices of the year in question are assessed in terms of prices of the base year. 9. In calculating national income, a good number of public services are also taken which cannot be estimated correctly. For e.g., police and military. 22
  23. In a developing economy certain additional difficulties are to be faced while calculating national income. Complete and reliable information relating to the various methods of estimating national income are available due to the following problems: 1. 2. 3. 4. 5. Non-monetised sector. There is a large non-monetised sector in a developing economy. This is the subsistence sector in rural areas in which a large portion of production is partly exchanged for the other goods and is partly kept for personal consumption. Such production and consumption cannot be calculated in national income. Lack of occupational specialisation. There is a lack of occupational specialisation i such countries which makes calculation of national income by product method difficult. The crop farmers in such countries, besides crop farming might be also engaged in poultry farming dairy farming etc. Non-market transactions. People living in rural areas in a developing country are able to avoid expenses by building their own huts, tools, implements, and other essential commodities. All such productive activities do not enter the market transactions and hence are not included in the national income estimates. Illiteracy. The majority of people in such a country are illiterate and they do not keep any accounts about the production and sales of their products. Under such circumstances, the estimates of production and earned incomes are mere guesses. Non-availability of data. Adequate and correct production and cost data are not available in a developing country. Moreover there is no machinery for the collection of data in such countries. 23

Need a Tutor or Coaching Class?

Post an enquiry and get instant responses from qualified and experienced tutors.

Post Requirement

Related Study Notes

Upload Study Notes

If you have your own Study Notes which you think can benefit others, please upload on LearnPick. For each approved Study Note you will get 100 Credit Points and 100 Activity Score which will increase your profile visibility.

Upload Now
Home > Study Notes > Notes On Macro Economic