Macro Economics Lesson-1 PDF

Subject: Macro Economics Author: Ms. Chand Kiran Subject Code: BC 202 Vetter: Prof. Anil Kumar LESSON-1 Introduction to Macroeconomics STRUCTURE 1.0 Learning Objectives 1.1 In...

Subject: Macro Economics Author: Ms. Chand Kiran Subject Code: BC 202 Vetter: Prof. Anil Kumar LESSON-1 Introduction to Macroeconomics STRUCTURE 1.0 Learning Objectives 1.1 Introduction to Macroeconomics 1.1.1 Scope of Macroeconomics 1.1.2 Importance of Macroeconomics 1.1.3 Types of Macroeconomics 1.1.4 Variables of Macroeconomics 1.1.5 Difference between Macroeconomics and Microeconomics 1.1.6 Interdependence of Macroeconomics and Microeconomics 1.1.7 Limitations of the Macroeconomics 1.2 Evolution of Macroeconomics 1.3 Check Your Progress 1.4 Summary 1.5 Keywords 1.6 Self-assessment Test 1.7 Answers to Check Your Progress 1.8 References/Suggested Readings 1 1.0 Learning Objectives After reading this chapter you will be able to understand the concept of macroeconomics, its importance and areas in which macroeconomics works. Through this lesson knowledge will be imparted to you about the interrelationship of microeconomics and macroeconomics. This lesson will be helpful for you to understand the needs to study macroeconomics. 1.1 Introduction to Macroeconomics Macroeconomics is formed with the help of two words i.e. Macroplus Economics. The term Macro is taken from a Greek word ‘Uakpo’ which means large and Economics refers to branch of social science concerned with the production, consumption and distribution of goods and services. So, macroeconomics is concerned with total production, total consumption and total distribution at large. Macroeconomics is concerned with economy as a whole. Adam Smith, the father of modern economics, suggested that if every buyer and seller start thinking about their self-interest only rather than the whole economy then there will be no need to think about the wealth, national income and welfare of a country or economy.At the early stage economists thinks that market did not exists in the economy. Then, it is believed that market exists but equilibrium cannot be determined through demand and supply of the products. Later, at the end economist think that there is effect of microeconomic variables on the whole society and country and it is necessary to study the whole economy. Macroeconomics coined in the 16th and the 17thcenturies with the Mercantilists. After that many economists like Cassel, Marshall, Pigou and Hayek developed theory of money and general prices. Later on Keynes developed a book on general theory of Income, Output and employment at the time of great depression. Thus, Keynes provides a new direction to the macroeconomics through the development of general theory in 1936. After this, due to depression in the economy, demand for goods and services starts declining in the economy. These prevailing situations in the economy lead to unemployment and low GDP rate. Thus, it becomes necessary for economists to think about functioning of the economy in a new direction. Keynes tries to explain all these facts in his book and explain these concepts very well for the economy as a whole. The theory provided by Keynes is also termed as thoughts of Keynes. After this many other economics tries to explain macroeconomics in different sense of economics. 2  Macroeconomics study all the factors related with economic aggregates like output, employment, National income and prices in the economy. Macroeconomics does not study the individual activities like a firm, a household or an industry. Definitions of Macroeconomics, According to R.G.D. Allen,“The term Macroeconomics applies to the study of relations between broad economics aggregates.” According to Edward Shapiro, “The major task of macroeconomics is the explanation of what determines the economy’s aggregate output of goods and services. It deals with the functioning of the economy as a whole”. According to Ackley Gardner, "Macroeconomics concerns with such variables as the aggregate volume of the output of an economy, with the extent to which its resources are employed, with the size of national income and with the general price level" 1.1.1 Scope of Macroeconomics I. Theory of National Income Macroeconomics studies the measurement and methods of calculating national income. This measurement involves aggregate saving, aggregate consumption and aggregate investment. II. Theory of International Trade International trade refers to the exchange of goods and services among different countries which affect the whole economy. Thus, international trade is studied under macroeconomics. III. Theory of Employment Study of employment level, types of unemployment and cause behind unemployment is studied under the scope of macroeconomics. IV. Theory of General Price Level General Price level is affected through the business cycles. Inflation and deflation are two major factors studied for general price level in macroeconomics. V. Theory of Money In macroeconomics, various theories of money, role of money, effect of government expenditure and effect of government income in the economy are discussed. 3  VI. Theory of Trade Cycles Trade cycle represents the ups and downs in the market. These ups and downs may be positive or negative. Study of trade cycle is included in macroeconomics as this is based on the whole economy. VII. Theory of Economic Growth Macroeconomics theories are studied and applied for balanced economic growth. It is the major objective behind any economic policy formulation. 1.1.2 Importance of Macroeconomics I. Helpful in formulation of economic policies Macroeconomics deals with the economy as a whole. It includes aggregates of all economic factors. Economic policies of the government are related with the whole economy. For example during depression, it is necessary to analyze the cause behind depression and unemployment in economy. At that time macroeconomics helps to understand these causes and provide guidance for policy formulation. Thus, macroeconomics helps to study the economic factors and formulation of economic policies. II. Helpful in understanding the functioning of an economy Macroeconomic study the problems related with behaviour of total output, income, employment and general price level. It is necessary to have proper and adequate knowledge to understand the behaviour of the aggregate variables. Every country wants proper working on these problems for the smooth running of that country. Through macroeconomics these complex problems can be understood and solved. Thus, Macroeconomics is helpful to understand the functioning of an economy. III. Useful for determining National Income The concept of National income is studied under the scope of macroeconomics. As overall performance of any nation can only be determined through its national income. For solving the problems related with overproduction and unemployment it is necessary to prepare data on national income. These data on national income are helpful in forecasting the level of economic activity and to understand the distribution of income among different sectors of the economy. 4 IV. Important for Economic growth As we had discussed earlier that macroeconomics helps in formulation of economic policies, these policies are formed for the future growth of an economy. These policies form basis for the stable and long run growth of an economy. There are various theories on unemployment, general prices and national income in macroeconomics which are helpful to solve the problems related with these issues. Thus, macroeconomics is helpful for the economic growth. V. Useful for the development of Micro economics Macroeconomic is helpful to understand microeconomics. Without proper understanding of aggregates of facts no microeconomics law can be formed. For example behaviour of single firm cannot form the behaviour pattern for all firms. As behaviour of single firm can be used for single entity but it is not useful in case of economy as a whole. The theory was formed after considering the behaviour pattern of aggregate firms. Thus, macroeconomics is helpful for the development of microeconomics. VI. Helpful in Economic planning Economic planning is formed for balanced economic development and economic solution to different problems. Economics planning requires special knowledge and skills as future of a nation is somewhere based in its economic planning. Formulation of economic plans require necessary knowledge about macroeconomics concepts like mutual dependence of different sectors, composition of national income, level of employment, etc. Thus, macroeconomics is helpful in economic planning. VII. Helpful to study Trade cycles Trade cycles indicate the economic fluctuations in the economy. These fluctuations can be understood and analyzed with the help of macroeconomics. The factors like boom, depression and recovery cannot be studied without the adequate knowledge about macroeconomics. To understand the trade cycles it is important to study the aggregate demand, aggregate consumption and aggregate production which are studied through macroeconomics. Thus, macroeconomics is helpful to provide the solutions to these fluctuations in the trade. It has been possible to form policies for controlling the effect of inflation and deflation on business through detailed study of macroeconomics. 5  VIII. Helpful to understand monetary problems Macroeconomics includes the concept like money, theories of money, banking and credit system in a country. Macroeconomics provides the direction to economists to understand these concepts and provide remedies to the monetary problems. Regular changes in the monetary system of a country effect adversely and this adverse effect can be counteracted by adopting the monetary measures with the help of macroeconomics. Thus, macroeconomics helps to understand the monetary problems. IX. Useful to analysis Unemployment Unemployment is a major problem in developing countries. At the time of depression in the economy it becomes necessary to understand the need and requirement of the labour. To understand this concept economists develop general theory of employment. Macroeconomics provides the knowledge and understanding about this concept through Keynesian theory of employment. This concept can be studied through aggregate demand, aggregate supply of labour. Thus, macroeconomics provides knowledge about the cause, effect and remedies of general employment. 1.1.3 Types of Macroeconomics Types of Macroeconomics Macro Static Macro Comparative Macro Dynamic Analysis Static Analysis Analysis Figure 1-Types of Macroeconomics I. Macro static analysis 6 Meaningof static is different in different subject of study. In Economics, static refers to a state of movement at a particular level without any change. According to Clark, “It is a state where five kinds of changes are conspicuous by their absence. The size of population, the supply of capital, methods of production, forms of business organization and wants of the people remain constant, but the economy continues to work at a steady pace”. There is certainty in static state as the other variables are constant.Macro static is best explained by Prof. Kurihara as they present macro static as a still picture of economy.Macro static represents the static equilibrium position of the economy. Whenever an economy is working at equilibrium point E and it is producing at a constant rate without any change in the other variables, it is known as static state of economy at a point of time. This equilibrium is shown through a timeless identity equation without any adjusting mechanism: Y=C+I Here, Y= Total Income C= Total Consumption I= Total Investment According to static Keynesian model, the interaction of aggregate supply function and the aggregate demand function are helpful to determine the level of National Income. This model includes the above identity equation to represent the equilibrium in the economy. This model is shown in figure 2 as under: 7  Figure-2 Here, 450 line represents the aggregate supply function, C+I+G line represent the aggregate demand function E the intersection point represents point of effective demand through which level of National income (OY) is shown. Thus, macro static refers to timeless economy. It cannot be formed or destroyed. This is an equilibrium situation. This situation cannot be changed whether the previous position and subsequent position of the economy change or not. II. Macro dynamic analysis Macro dynamic analysis studies the cause of change in two equilibrium points. It analyses the process of change which continues over a period of time. An economy may change over a period of time in two major ways: (a) Without changing its pattern (b) By changing its pattern Macro dynamic analysis is related with second type of change. This change in pattern occurs due to change in population, capital, techniques of production, forms of business organization and taste of the people. Macro dynamic analysis explains the forces which brought these change in the economy.It is based on time lags, rate of change, past and expected values of the variables. In the words of Kurihara, “Macro-dynamics treats discrete movements or rates of change of macro-variables. It enables one to see a ‘motion-picture’ of the functioning of the economy as a progressive whole.” The following diagram shows the operation of analysis: 8  Figure-3 This diagram represents the change of equilibrium from point E to E1 which shows change in government expenditure. This is not a sudden change but it has been arise by a process and time-lag. This process can be understood as the government increase investment which might have result in more employment, high productivity and high level of income. Thus, macro dynamic analysis is a method to describe the causes behind the change in economy due to change in other variables over a period of time. III. Macro comparative static analysis Macro comparative static analysis was first used by a German Economist F. Oppenheimer, in 1916. It is a method of economic analysis. According to Schumpeter, “Wheneverwe deal with disturbance of a given state by trying to indicate the static relations obtaining before a given disturbance impinged upon the system and after it, had time to work it out. This method of procedure is known as Comparative statics”. It means comparative statics analysis is a method where different equilibrium situation are compared. Under Macro Static analysis, equilibrium is shown at a point E and it remains constant at a point of time. In Macro Dynamic analysis, the point of equilibrium shift from point E to point to E1. Macro Comparative Static studies the variations in the positions of equilibrium from point E to E1 due to some specific changes in other variables. Detailed analysis of macro comparative analysis is shown through a figure as under: 9  Figure-4 The initial point of equilibrium is at point E where Y (Total income) and C+I+G (total consumption, total investment and government expenditure) intersect each other. But after the inducement of government expenditure the equilibrium point shift from E to E1. New equilibrium point E1 is situated at the intersection of Y and C+I+G+∆G. At this level total income shifts from OY1 to OY2. Thus, the study between two equilibrium points is known as Macro Comparative Static Analysis. Macro comparative static analysis has some drawbacks also. These are discussed as under: (a) It ignores the problems related with economic fluctuations. (b) This method explains only the process of change from one position to another position of equilibrium. Complete reasons behind this change are not cleared under this method. (c) This method neglects the transitional period. 1.1.4 Variables of Macroeconomics I. Aggregate Demand Demand refers to that quantity of goods and services for which consumer is ready to pay and have willingness to purchase that goods and services at different price level over a period of time. But, Aggregate demand refers to the total expenditure incurred on the purchase of all the finished goods and services in the economy during the period 10  of an accounting year. It can be defined as the total monetary expenditure incurred on the purchase of goods and services at a specified price level on a point of time. II. Aggregate Supply Supply refers to production of that goods and services which a producer is willing to sell at different prices during a period of time, when all the other factors remain constant. Aggregate supply is the total supply or total production of goods and services in the economy during an accounting period. III. Aggregate Consumption Total consumption of all goods and services in the economy during an accounting period is known as aggregate consumption. IV. Aggregate Investment Investment refers to that asset which results into appreciation of income over a period of time. In economics, it can be defined as expenditure incurred by producers to purchase raw material so that this can be add to their capital in that year. And aggregate investment refers to the total expenditure incurred by all the producers for purchasing raw material in the economy to add their capital during that year. Inflation Aggregat Business e Cycle Demand Economic Unemploy Policies -ment Interest Rate Aggregate Macro- Supply economic Variables General Price GDP & Level National Income Aggregate Investment Exchange Rate Govt. Aggregate Spending Consumption 11  Figure-5 V. Unemployment Unemployment occurs when a person wants to do job but he is unable to find a job. Unemployment can be computed on the basis of unemployment rate. It is the rate through which the percentage of the current unemployed labour force and actively seeking employment can be measured. High rate of unemployment leads to unfavorable indicators of macroeconomics. High rate of unemployment leads to maximum number of workforce who is not engaged in any work and job. This represents negative signs for an economy. VI. General Price level General Price level refers to index of prices of all goods and services in the economy at the end of a specified period of time. VII. Exchange Rate Exchange rate is an important macroeconomic variable as it is helpful for international trade. Import and export among different countries is possible due to exchange rate, as this becomes consideration for exchange of goods and services. Exchange rate refers to that rate at which currency of one country is exchange with the currency of other country. It can provide answer to the question that for one unit of a currency of country A how many units of currency of country B can be obtained. VIII. Interest Rate Interest rate refers the cost of borrowed money. This rate is defined by monetary authorities by using various regulations and interventions in the money market. Interest rate is the rate which interest is paid by the borrower for use of money to lender. There is various interest rates prevails in the economy. Interest rates can vary according to variation in the degree of risk. IX. Government Spending Government spending refers to the government consumption, government investment and transfer payments. Government spending describes the size of the public sectors in the economy. Government spending can also be described as the expenditure incurred by public sectors in education sector, health sector, transportation, social protection, 12  defense, etc. This spending is based on major two factors i.e. tax collection and borrowing from public. X. GDP & National Income Gross domestic product is the total monetary value of the final goods and services produced within national boundaries of a country during an accounting year. GDP is a macroeconomic indicator of health of an economy. High GDP represents the increase in output and this will leads to economic growth. Generally, GDP is also known as measurement of national income. National income provides an idea of purchasing power of people of a country. XI. Inflation Inflation refers to hike in general price level of goods and services in an economy over a period of time. Inflation results into loss to value of money as hike in general prices leads to pay more units of money for purchasing goods and services. When demand for goods and services increases consequently their prices also rise and this will leads to inflation. It means consumer is willing to pay high prices for purchasing goods and services they want. Inflation is an important macroeconomic variable as it is interlinked with the other variables of the macroeconomics. Like high rate of unemployment leads to low rate of economic growth which ultimately results into risk of high inflation. XII. Economic Policies Economic policies are also defined as the macroeconomic indicators. There are two major economic policies i.e. monetary policy and fiscal policy. Monetary policy is the policy which is formed to control money supply in the economy. Fiscal policy is the policy of government expenditure and government revenue. These policies are formed by monetary authority and government of the country. XIII. Business Cycle Business cycle refers to the upward and downward movements in the gross domestic product. Business cycle defines the fluctuations in the aggregate production, trade and activity in an economy. Business cycles involve the situation of recession and depression. Recession means that period during which aggregate output declines. A prolonged and deep recession is termed as depression. Thus, business cycle is an important indicator of macroeconomics. 13 1.1.5 Difference between Macroeconomics and Microeconomics Economics refers to the branch of knowledge concerned with production, consumption and transfer of wealth. Economics can be further classified into two parts: microeconomics and macroeconomics. Microeconomics is concerned with individual and business decision making while macroeconomics is concerned with the decisions of government and business. Although in next section we will discussed that both microeconomics and macroeconomics depends on each other and it is not possible to study one without the knowledge of other. Still there exists some different among microeconomics and macroeconomics. These differences among microeconomics and macroeconomics are not rigid because parts affect the whole economy and whole economy affects the parts in the economy. These are discussed as follows: Table No. 1- Difference between microeconomics and macroeconomics Sr. No. Microeconomics Macroeconomics 1. Microeconomics deals with the Macroeconomics deals with the aggregate of individual units of an economy. individual units or the whole economy. 2. It includes individual price, individual It includes general prices, aggregate demand, demand, individual income, etc. National income, etc. 3. Price determination and allocation of Determination of income and unemployment resources are the major problem studied are the major problem studied under under microeconomics. macroeconomics. 4. Two major tools i.e. demand and supply Two major tools i.e. aggregate demand (AD) of a particular commodity is used in and aggregate supply (AS) of a particular microeconomics. commodity is used in macroeconomics. 5. Microeconomics solves the central Macroeconomics solves the central problem of problem of what to produce, how to full employment of resources in the economy. produce and for whom to produce. 6. It is concerned with the equilibrium of a It is concerned with the equilibrium of level of consumer, a producer and an industry. income and employment in an economy. 7. Microeconomics uses bottom-top Macroeconomics uses top-bottom approach for approach for analyzing the economy. analyzing the economy. 14  8. It assumes that all macroeconomic It assumes that all microeconomic variables variables like aggregate demand, like individual demand, individual income, etc. national income and price are constant. are constant. 9. It is also known as price theory. It is also known as income theory or employment theory. 10. It believes in Laissez-faire economy. It believes in command economy. 11. It is simple to study microeconomics. It is complex process to understand macroeconomic due to inclusion of large numbers. 1.1.6 Interdependence of Macroeconomics and Microeconomics Theory Both macroeconomics and microeconomics are dependent on each other. As a small change in microeconomic leads to change in macroeconomics and a little change in macroeconomics leads to change in macroeconomics. For instance, when aggregate demand rises it leads to an increase in individual demand for product. This increase in demand may be due to a macroeconomic factor i.e. interest rate. Whenever there is reduction in interest rate people borrow money from financial institutions and this increased supply of money results into increase in demand for individual product. Due to increase in demand for product, demand for labour in particular industry also increases consequently wage rate also increases for a particular industry. This increased wage rate can be made possible only when there are increased profits. Again it will be ultimately duty to increase in demand. Thus, a macroeconomic change becomes cause for change in microeconomic variables. This represents that there is dependence of microeconomics theory on macroeconomics theory. Some other examples for explaining dependence of microeconomics on macroeconomics: a. Payment made for means of production cannot be decided by an individual firm rather than these are dependent on the demand for means of production in the whole economy. b. Sale of an individual firm is based on the purchasing power of consumer in the whole society. c. For determining the demand for a product in an individual firm, it is necessary to study the demand of society, income and employment level in the economy. 15  Not only microeconomics theory is dependent on macroeconomics theory but macroeconomics theory is also dependent on microeconomics theory. Macroeconomics is the aggregate of the entire microeconomics variable. It means macroeconomics is formed from the different parts of microeconomics. National income is made up of income of individuals, firms, households and industries. Every indicator of macroeconomic aggregate consumption, aggregate investment, aggregate saving is made from microeconomic variables consumption, investment and saving. Thus, aggregate of macroeconomics is formed by averages of the individual quantities of microeconomic variables. For example, if an economy concentrates all its resources for production of capital goods only, then total output of the economy will decline. After this other sectors of the economy starts declining. Due to this activity total output, total income and employment will be affected adversely. This adverse effect results into unequal distribution of income. As a result, unemployment will increase and all of these factor cause depression in the economy. Thus, any change in microeconomic variable will results into change in macroeconomic variables. Some other examples for explaining dependence of macroeconomics on microeconomics: a. National income is computed with the help of individual expenditure obtained from microeconomics. b. Aggregate demand in the economy is computed with the help of demand of an individual firm. According to Gardner Ackley, “Actually, the line between macroeconomics and micro economics theory cannot be precisely drawn. A true general theory of the economy would clearly embrace both. It would explain individual behavior, individual I outputs, incomes and prices and the sums or averages of individual results I would constitute the aggregates which macroeconomics is concerned”. The same thing is suggested by Samuelson that “There is really no opposition between Micro and Macro Economics. Both are absolutely vital and you are only half-educated if you understand the one while being ignored or the other”. Thus, we can conclude that both micro and macro approaches are interrelated and interdependent on each other. Both approaches are helpful to analyze the economy. 1.1.7 Limitations of the Macroeconomics 16  I. Macroeconomics is based on the aggregate of facts or aggregate behaviour but an individual behaviour is may not be true for the whole economy. For example, increase in total saving may leads to depression if these savings are not invested. Same can be seen in case of deposits in a bank. If all the depositors withdraw money simultaneously then this will adversely affect the banking system in the economy. II. Macroeconomics considers all the aggregates homogenous under aggregation. But, all the aggregates cannot be homogenous. For example, aggregate wages are computed with the help of wages in all the occupations. If wages of teachers’ increases and wages of clerks decreases then aggregate wages will remain unchanged. Thus, this increase and decrease cannot be measured due to homogeneity of aggregates. III. Sometimes aggregate variables are not taken as important in macroeconomics. National income is calculated with the help aggregate of individual income. But, increase in National income does not mean that income of every individual person increase. Sometimes, income of rich person may increase and this affects the national income. Thus, this type of increase in income has little significance in the economy. IV. Uncritical use of macroeconomics also becomes problem for the real word as the same theory cannot be applied on different situations. For instance, if a policy is formed to achieve full employment in the economy by applying structural unemployment in individual firm and industry, then it is irrelevant for the whole economy. This can be results into misleading information. V. It is difficult to compute macroeconomics variables by using statistical methods. Macroeconomics is aggregate of microeconomic variables. So, first of all microeconomic variables are computed statistically, then these are converted into microeconomic variables through average. This conversion is very difficult and complex process. The conversion of results into one macroeconomic variable may be dangerous and faulty. Thus, measurement of macroeconomics variable is a very difficult and tough process. VI. Macroeconomics also ignores the welfare of individual. If aggregate saving is increased at the cost of individual welfare then it is not considered as wise decision regarding the individual. 17  VII. One major problem is with macroeconomic models. These models are designed only for developed countries of the world. Developing countries cannot take benefit of macroeconomic models due to some difficulties. 1.2 Evolution of Macroeconomics Macroeconomics is not formed in only one day rather it takes many years for development. Different economists provide their own different views in their own analysis basis. These schools of thoughts may be defined as under: I. Adam Smith, Ricardo and J.C.B. are well known economists for classical or tradition thoughts. These economists try to study the economic problems for the whole economy. Thus, they are in favour of macroeconomics. Classical thoughts were based on Say’s Law of Market and Flexibility of Wages, Rate of Interest and Prices. According to classical thoughts full employment prevails in the economy and if there is any situation of unemployment it prevails for short term only. At last, tradition thoughts concerned with the auto adjustment of macroeconomics variables in the economy. II. After classical thoughts, a book “The General Theory of Employment, Interest and Money” was written by the famous economist Keynes in 1936. Keynes point out the limitations of classical thoughts and worked on modern thoughts of macroeconomics. Keynes was against the say’s law as they did not believe that supply automatically adjusts demand and unemployment prevails only for short term. Keynes suggested that aggregate demand is the main cause behind unemployment and it can be reduced through increase in aggregate demand. III. Then, Keynes thoughts were opposed by famous economist Milton Friedman. He came with the new-classical thoughts of macroeconomics. This school of thought suggested that unemployment cannot be reduced by government intervention or fiscal policy. New-classical thoughts were based on monetary measures thus it is also known as monetarism. Friedman believed that full employment can be achieved through variations in money supply. Supply of money directly affects the demand for product and increase in demand leads to full employment in the economy. IV. After this many other economists works for changes in macroeconomic thoughts. After 1960 a new theory named as Rational Expectation Theory was propounded by 18  Prof. Muth, Prof. Lucas and some other economists. Onward this many other changes were also propounded in macroeconomics thoughts. 1.3 Check Your Progress 1. is father of modern economics. 2. Concept of National Income is studied under Economics. 3. Macroeconomics deals with. 4. Microeconomics concentrates on. 5. wrote the book “General Theory of Employment, Interest and Money”. 1.4 Summary Microeconomics deals with aggregates of microeconomics variables. It is concerned with economy as a whole. Although both macroeconomics and microeconomics depends on each other still there are various differences among both. Major difference of microeconomics and macroeconomics is that former is based on the study of individuals and firms decisions making regarding scarce resources and the latter is based on study of aggregate of microeconomics variables. Macroeconomics is further divided into three parts i.e. Macro static analysis, macro comparative analysis and macro dynamic analysis. There are various variables of macroeconomics which affect the whole economy. Study of macroeconomics is as important as microeconomics. Scope of macroeconomics is very wide as it included theory of money, theory of employment, theory of national income, etc. In the last section of some schools of thoughts of macroeconomics are also described. These schools of thoughts represent the evaluation and changes in macroeconomics analysis from time to time. Macroeconomics has also limited applications due to its limitations but still it is a powerful source of knowledge to understand economy. Thus, one can conclude that macroeconomics study is an important aspect to know the whole economy. Without macroeconomics it is not possible to measure the national income, growth rate in the economy, unemployment rate, etc. 1.5 Keywords Microeconomics: Microeconomics refers to that branch of economics which studies the behaviour of individuals and firms for decision making regarding allocation of scarce resources. 19  Macroeconomics:Macroeconomics refers to that branch of economics which study the economy as a whole. It is concerned with the study of aggregates of microeconomics. National Income: National income refers to the total value of goods and services produced in an accounting year within the boundaries of a country. Aggregate Demand: Aggregate demand refers to average of the total demand by consumers for all the goods and services in a country within a year. Aggregate Supply: Aggregate supply refers to the average of the total production of all the goods and services produced within a year in a country. Trade Cycles: Trade cycles are also known as business cycles. A trade cycle refers to the fluctuation in the Gross Domestic Product of an economy. These fluctuations may be upward or downward according to the prevailing conditions in the economy. Aggregate Consumption: Aggregate consumption refers to the total spending of individuals and firms in the economy. It is directly related with aggregate saving because aggregate saving is total of that portion of income which is not consumed. Aggregate Expenditure: Aggregate expenditure refers to the sum of total consumption, total investment, total government expenditure and total difference among exports and imports in the economy. It can be shown as AE= C+I+G+ (E-I). Unemployment: Unemployment refers to a situation where able people want to do job but are not able to get work or job. 1.6 Self-assessment Test Q.1 What do you mean by macroeconomics? How it is different from microeconomics? Q.2 Explain the scope and importance of macroeconomics in detail. Q.3 Define macroeconomics. Why do we need macroeconomics? Q.4 Explain the role of macroeconomics in real world. Is macroeconomics can really be a solution to economic problems in the economy? Q.5 How macroeconomics is different from microeconomics? Is there any relationship exists among these two concepts? Q.6 Explain the different types of macroeconomics in detail. Q.7 Explain the different macroeconomics variables affecting the economy. Also explain the importance of macro analysis in detail. 20  Q.8 Explain the major issues macroeconomic issues. What are major issues arising in the study of macroeconomics? Q.9 How can you say that macroeconomics and microeconomics are dependent on each other? What are the major forces behind this dependence? Q.10 How does macro static analysis is different from macro dynamic analysis? How does Macro comparative analysis is related with static analysis and dynamic analysis? 1.7 Answer to Check Your Progress 1. Adam Smith 2. Macroeconomics 3. Aggregate Economic Activity 4. Individual Economic Activity 5. Prof. J. M. Keynes 1.8 References/Suggested Readings 1. Jain et al. 2019. Macroeconomics, pages 3-14, VK Global Publication Pvt. Ltd., New Delhi. 2. Bhaduri, A., 1990. Macroeconomics: The Dynamics of Commodity Production, pages 1 – 27, Macmillan India Limited, New Delhi. 3. Mankiw, N. G., 2000. Macroeconomics, pages 2 – 14, Macmillan Worth Publishers, New York. 4. Jain & Ohri, 2014. Introductory Macroeconomics, pages 1-30, VK Global Publication Pvt. Ltd., New Delhi. 5. Jhingan, 2012. Macro Economic Theory, pages 3-16, Vrinda Publication (P) Ltd., Delhi. 6. Case et al., 2018. Principles of Economics, pages 445-455, Pearson Education Limited, Uttar Pradesh. 7. Shapiro, E. (1978). Macroeconomic analysis, 4th Edition, Chapter 1st, New York. 21 Subject: Macro Economics Author: Ms. Chand Kiran Subject Code: BC 202 Vetter: Prof. Anil Kumar LESSON-2 National Income Structure 2.0 Learning Objectives 2.1 Introduction 2.2 Concepts or Aggregates of National Income 2.2.1 Circular Flow of Income 2.2.1.1 Two Sector Model of Circular Flow of Income 2.2.1.2 Three Sector Model of Circular Flow of Income 2.2.1.3 Four Sector Model of Circular Flow of Income 2.2.2 Importance of National Income Analysis 2.2.3 Measurement of National Income 2.2.4 Difficulties in Measurement of National Income 2.3 Some Practical Questions on National Income 2.4 Check Your Progress 2.5 Summary 2.6 Keywords 2.7 Self-assessment Test 2.8 Answers to Check Your Progress 22 2.9 References/Suggested Readings 2.0 Learning Objectives After reading this chapter you will be able to understand the concept on National Income. You will find different methods of measurement of National income. You will learn about the circular flow of National Income in the economy. At the end you will also find difficulties to measure National Income. All these concepts will be useful for you to understand the role of National Income in an economy. 2.1 Introduction In previous chapter, we have discussed about macroeconomics; National Income is a major concept which is studied under macroeconomics. National income and wealth of England was estimated by Sir William Petty in 1665 for the first time. Then, Gregory King also tries to estimate national income in 1696. And Gregory King is also known as Father of Modern National Income Accounting. During First World War Prof. Bowley and Sir Joshia Stamp collected data for national income. After this, many economists like Prof. Stone, Meade, Gilbert and Kuznets also worked in this direction. In India, National Income Committee was formed to collect data for National Income in 1949. After 1952, this work was allotted to Central Statistical Organisation (CSO) and currently this organisation published data on national income in National Accounting Statistics. National income may be defined as the total sum of factor incomes earned by normal residents of a country during an accounting year. National income involves two major terms i.e. Factor income and Normal residents of a country. Factor income refers to the income earned by households from factor of production (land, labour, capital, entrepreneurship. Normal resident of a country may be defined as the resident who normally resides in the country and his economic interest lies in that country. National Income can be defined as the total value of goods and services produced within a country during an accounting year. We can also conclude that national income is the total outcome of all the economic activity of a country in an accounting year. 23  Traditional definitions of National Income 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.” According to A.C. Pigou, “National income is that part of the objective income of the community, including, of course, income derived from abroad which can be measured in money.” Modern definitions of National Income Profs Lipsey and Chrystral defined National Income as, “the value of the nation’s total output and the value of the income generated by the production of that output.” Gardner Ackley defines “National income is the sum of all (a) wages, salaries, commissions, bonuses and other form of incomes, (b) net income from rentals and royalties, (c) interest, (d) profit.” So, we a large number of definition of national income and we can use the one which is easy to understand and included every aspect of national income. In practical life, we can use any definition because we will get same results if we use correct values and measures for calculating national income. 2.2 Concepts or Aggregates of National Income National income is not just a term rather than it is a complete conception which is further classified into different concepts. National income is formed with help of many concepts which are discussed below: I. Gross Domestic Product Gross domestic product (GDP) is the monetary value of total sum of all goods and services produced within domestic territory of a country in an accounting period. It is also known as GDP at market price because it is calculated on market price. It is a monetary measure. Dernberg defines GDP at market price as “the market value of the output of final goods and services produced in the domestic territory of a country 24  during an accounting year.” Gross Domestic Product is shown as GDPMP and depreciation is included in it. GDP = Market value of goods and services produced in the country + incomes earned in the country by foreigners – incomes received by resident nationals from abroad GDP at market price is calculated on market price of goods and services which includes the indirect taxes like sales tax and excise duty. The grants or subsidy received from government also reduce the market price. II. Gross Domestic Product at Factor Cost GDP can be computed at both market prices as well as factor cost. It is shown as GDPFC. GDPFC refers to total value of goods and services produced during an accounting year at the cost of production. GDPFC is dependent on gross domestic product at market price. So, first of all we have to calculate GDP at market price then indirect taxes are deduced and subsidies are added into GDP at market price. GDPFC= GDPMP – Indirect Taxes + Subsidies OR GDPFC= Factor Income (Rent + Compensation + Interest + Profit) + Depreciation (due to consumption of fixed capital) GDP at factor cost may be defined as sum total of factor incomes generated in an accounting year within the domestic territory of a country. III. Net Domestic Product Gross domestic product includes depreciation charges incurred due to consumption of fixed capital. When these charges depreciation are deducted from GDP, it becomes Net Domestic Product or NDP. It is also known as net output of a country in an accounting year. It can be calculated as follows: NDP = GDP – Depreciation; it is also calculated on both market price and factor cost. NDPMP = GDPMP – Depreciation NDPFC = NDPMP – Indirect taxes + Subsidies IV. Nominal and Real Gross Domestic Product GDP can be calculated on the basis of two type of prices i.e. current price and fixed price. When GDP is calculated on current price, it is known as nominal GDP and when 25  GDP is calculated on fixed price in some year, it is known as real GDP. In case of nominal GDP it becomes very difficult to compare one year GDP with another year GDP because prices fluctuates over a period of time. And one more thing about rupee is that it is not a stable measure of purchasing power. Due to these problems GDP may raise or fall without growth in the economy. Thus, actual GDP cannot be determined. These are major reasons which force us to use real GDP because here we use constant price to calculate GDP. For this purpose, price of a base year is selected where prices are general; means these are neither high nor low. It can be calculated as follows: Nominal GDP = Quantity of final goods and services produced during an accounting year × Current prices prevailing during the accounting year 𝐁𝐚𝐬𝐞 𝐘𝐞𝐚𝐫 Real GDP = GDP for the current year× 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐘𝐞𝐚𝐫 𝐈𝐧𝐝𝐞𝐱 V. Gross Domestic Product Deflator GDP inflator is a price index which shows price changes of goods and services included in GDP. It can be calculated as follows: 𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷 GDP Deflator = × 𝟏𝟎𝟎 𝑹𝒆𝒂𝒍 𝑮𝑫𝑷 VI. Gross National Product GNP refers to the gross national product which is total value of goods and services produced by normal residents and non-residents in the domestic territory of a country. Net income from abroad is the major difference among GDP and GNP because GDP does not include factor income from abroad. This can be calculated as follows: GNP = GDP + Net factor income from abroad OR GNP = money value of goods and services + Income earned by national residents from abroad – Income earned locally but accruing to foreigners GNP is also calculated at factor cost and market price. 26  GNPMP = GDPMP + Net factor income from abroad GNPFC = GNPMP – Indirect Taxes + Subsidies VII. Net National Product Net National Product is the total value of goods and services produced in the domestic territory of a country in an accounting year after deducting depreciation and by adding net income from abroad. It is calculated through following equation: NNP = GNP – Depreciation NNPMP = GNPMP – Depreciation NNPFC = NNPMP – Indirect Taxes + Subsidies VIII. Domestic Income Domestic income is the total factor income generated by producing goods and services in the domestic territory of a country in an accounting year. This income is generated with the help of own resources of a country. Domestic income includes rent, wages, interest, dividend, direct taxes and undistributed profits. Domestic income does not include the income generated from abroad. If we add income from abroad into domestic income then domestic income will become national income. Net income from abroad may be positive or negative as it is the difference among exports and imports. If exports exceed imports then net income from abroad will be positive or vice-versa. Domestic Income = National Income – Net Income from Abroad IX. Private Income Private may be defined as the income which is generated by private sector from any source; which may be productive or other. It also includes retained earnings of the corporations. According to Central Statistical Organisation, private income is total factor income from all sources and the current transfers from the government and the rest of the world accruing to private sector. Private Income = Income from Net Domestic Product accruing to the Private Sector + Net Factor Income from Abroad + Net Transfer Payments from the Government + Net Current Transfer Payments from Rest of the World + Interest on National Debt X. Personal Income 27  Personal income refers to the total income received by households from all sources in the form of current transfer payments and factor incomes in an accounting year. It includes wages, salaries, fees, commission, bonus, dividends and earnings from self- employment. Other transfer incomes like pension, social security benefits, sickness allowances, etc. are also included in personal income. Personal income can never be equal to national income because personal income includes transfer payments also. Personal Income = Private Income – Undistributed Profits – Corporate Taxes XI. Personal Disposable Income Personal Disposal Income is that part of income which is obtained after deducting direct taxes, fines and fees to the government from personal income. This income can be used by individual for any purpose which may be saving or consumption. Personal Disposable Income = Personal Income – Personal Taxes OR Personal Disposable Income = Consumption + Saving XII. Real Income It can be defined as the national income which is calculated on the basis of general price level in a particular year where general price is taken from that base year. It is calculated on general prices because current prices do not provide a real estimation of national income. 𝐵𝑎𝑠𝑒 𝑌𝑒𝑎𝑟 𝐼𝑛𝑑𝑒𝑥 Real Income = 𝑁𝑁𝑃 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑒𝑎𝑟 × 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑒𝑎𝑟 𝐼𝑛𝑑𝑒𝑥 XIII. Per Capita Income Per capita income refers to average income of the people of a country in a particular year. It can be also known as measurement of national income at current prices and constant prices. Per capita income can be computed as follows: 𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 Per capita income = 𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛 Per capita income indicates the average availability of goods and services per individual during an accounting year. 2.2.1 Circular Flow of Income 28 Everyday economic transactions and exchange take place in the economy. These transactions go through a particular path. First of all, producer produces the goods and services and consumer purchase these products. Money is used for this exchange. Earlier there was barter system which has many drawbacks, but money reduces all these difficulties and become basis for exchange. Economy runs in a particular manner as consumer provides factor of productions to producer and producer produces goods and services for the customers. Then, customer exchange through money and this process goes on. Money changes hands and thus this formed a circle known as circular flow of income. Circular flow of income increases over a period of time due to growth of population and higher level of production-distribution-expenditure. Income and expenditure are in opposite direction in the circular flow. This flow of income and expenditure can be shown in different sectors. These sectors are defined as follows: 2.2.1.1 Two Sector Model of Circular Flow of Income Two sector model consist major two sector i.e. Household Sector and Government Sector. This model is based on some assumptions discussed as follows: (a) Government Expenditure does not exists in the economy (b) Foreign Trade does not exists in the economy (c) Taxes do not exist in the economy. (d) Households saving do not exist in the economy. Figure.1 Two Sector Model of Circular Flow of Income 29  Although this model is unrealistic but it can provides us a basic idea about circular flow of income. This model defines that households are the owners of factor of productions (Land, Labour, Capital, and Entrepreneurship) and they provides these factor of production to producer as shown in the figure. Producer offers factor payments (Rent, Wages, Interest and Profit) for use of these factors of production. After this producer produces goods and services and rendered these products to consumer in exchange with money. When goods are transferred from producer to consumer, it is known as real flow. This real flow is shown through the upper circle of the diagram. The inner circle of the diagram presents the money flow from producer to consumer and consumer to producer. Real flow and money flow are in opposite direction. One part of diagram is known as factor market in which factor of production are exchanged with factor payments. And another part of diagram is known as commodity market where goods and services are supplied to consumer in exchange for money. Factor of production get payment as rent for land, wages for labour, interest for capital and profit for entrepreneurship. Due to this payment system under each head, there will be no chance for undistributed profits. Total output of the producer will be equal to total income of households. Here, gross income will be equal to total disposable income and there will be equilibrium situation in the economy. This situation does not prevail in the real economy because in real life, households save money and invest it into capital market which is again invested for production. Through circulation of saving and investment, equilibrium can be situated again in the economy. 2.2.1.2 Three Sector Model of Circular Flow of Income This model is more realistic than two sector model. Here, we have three sectors i.e. Household sector, Production sector and Government sector. This model involves the government intervention in the economy but still it is based on closed economy. Closed economy means there is non-involvement of foreign trade in the economy. This model discard a major limitation of taxes of two sector model which means taxes exists in three sector model. Major three variables are included here: (a) Direct Taxes 30 (b) Government Expenditure (c) Transfer payment Figure.2 Three Sector Model of Circular Flow of Income Direct tax reduces personal disposable income which results into reduction of consumption expenditure as well as savings. Then, the second variable government expenditureprovides an inducement to purchasing power of households and this will increase demand for goods and services. This increase in demand leads to more production from producer sector. Further the next variable, transfer payments by the government are also work as injections in the circular flow of income in three sector model. In two sector model government sector was absent and money flow was among business sector and producer sector. Due to government sector money flow from household gets reduced. Household sector has to pay direct taxes to government sector and producer sector has to corporate taxes to government sector. This amount of taxes is used for providing transfer payment to households, for purchasing goods and services from firms and for providing subsidies. Ultimately, these will results into circular flow because firm and household pay taxes to government and government provide these taxes in the form of subsidies and financial aid. This situation is possible when government has a balanced budget. If government has some deficit then it takes 31  loans from capital market and in case of surplus with government then it will be invested in capital market. 2.2.1.3 Four Sector Model of Circular Flow of Income It is an advanced form of three sector model as it included foreign trade as well as the other three sectors. Every economy is dependent on the other economy for some or the other products. This is also known as open economy as the economy is opened for the rest of the world. Four sectors are as follows: (a) Household sector (b) Producing sector (c) Government sector (d) Rest of the World Figure.3 Four Sector Model of Circular Flow of Income Household sector provide factor of production to firms, pay taxes to government sector and import payment to rest of the world. Household sector obtain factor payment from firms, export receipts and transfer payments from government. Similarly government receives taxes from households and firms and borrowing from capital market in case 32  of deficit. Firms have to pay taxes to government, factor payment to household and import payment to rest of the world. Firms obtain subsidies from government, factor of production from households and export receipts from rest of the world. Capital market got savings from producing sector, government sector and household sector. It provides borrowings producing sector and government sector. Thus, four sector model is provides a complete circular flow of income and expenditure. 2.2.2 Importance of National Income Analysis National income analysis is very important for a Nation. It gives answer to various economic questions and problems. Every country faces some problem regarding their economy and these problems are identified through national income analysis. It is a macroeconomic factor which study the Net National Income. Importance of national income analysis is discussed in detail as under: I. National income is an important indicator for economic planning in a country. National income gives estimation about the health of an economy and economic planning the different ways to improve economic health of a country. So, national income is helpful for the development of economic planning. II. Economic planning is based on the estimation of national income and economic policy is based on economic planning. Economic policies are formed for the development of a nation. National income provides information about the various indicators affecting any nation. These indicators are helpful for economic decisions and formation of economic policies. Thus, national income is helpful in formation of Economic policies. III. National income is also helpful to provide information about the major economic problems. As national income analysis indicates what to produce, how to produce and for whom to produce. Thus, one can find the solutions for these problems in order to achieve economic development. IV. National income also involves contribution of different sectors of production. It includes primary sector, secondary sector and territory sector. Thus, national income provides us knowledge about all the sector of production. 33  V. Inflation and Deflation are the two major indicators of national health of a country. Both these situations are unfavorable for a country and every country tries to balance this situation. Solution to these problems can be obtained after knowledge of these indicators. Thus, national income analysis is important as Inflation and Deflation are depicted through national income analysis. VI. Every country wants to balance their country through various measures. For this purpose budgetary policies are also formed. Every nation wants to stay away from the fluctuations of business cycles. These fluctuations are controlled through various budgetary policies. Thus, national income is helpful for creation of budgetary policies. VII. National income is also helpful to provide knowledge about national expenditure. In calculation of national income we segregate the total expenditure in consumption expenditure and government expenditure. One important fact i.e. depreciation is also studied under national income analysis. This analysis also express that liberal policy may be dangerous for any economy. VIII. Through calculation of national income, we came to know about the government aids i.e. subsidies. National income analysis is helpful to balance the distribution of these subsidies in the economy. IX. National income analysis is also helpful for comparison among different nations. This comparison is based on Gross Domestic Product. Thus, it also becomes basis for comparison of standard of living of different countries. X. National income analysis also includes exports and imports with other countries. We also calculate foreign aids, receipts, payments and quota from other countries. It also includes contribution of IMF, WTO, UNO, etc. Thus, national income analysis provides knowledge about international sphere. XI. National income analysis is also helpful to distribute the total Gross National Product in consumer goods and defence products. If GNP is high then more income may be used for development and defence products and rest of the consumer products will not suffer. XII. National income analysis includes income of both public and private sector. If more contribution is done by public sector then there is dominance of public sector in the economy and vice-versa. 34  XIII. Data on national income are important for any economy. These data calculated on national income are called social accounts. Here, we calculate net national income and net national expenditure. XIV. All the short-run economic models and long-run economic models formed by economists are based on national income data. Thus, national income analysis is helpful for the development of economic models. XV. Economists try to find new theories and models in economics for development in existing literature and national development. These researches are based on national income data and analysis. Researchers also use various economic data about consumption, investment, production, etc. in their research for the development of new models and theories. 2.2.3 Measurement of National Income National income can be measured as addition of value of goods and services produced in an accounting year OR it can be expressed as total of income generated through producing goods and services during an accounting year OR it may also be calculated as the sum of expenditure incurred on producing goods and services in the economy. There are three major methods to calculate national income i.e. Value added method, Income method and Expenditure method. Thus, measurement of national income can be calculated using three different methods. These are as follows: Figure.4 Four Sector Model of Circular Flow of Income 35 I. Product Method Product method defines national income as total value of goods and services produced during an accounting year by all the firms in an economy. This value will also include products work-in-progress and production for personal use by producer. This method as also known as output method or value added method because it is addition of value to intermediate goods at different stages of production. Total value addition by each firm is calculated by the total output of firm minus value of the intermediate goods obtained from other firm as input for final product. This method can be understood with the help of an example. Like farmer sell wheat for ₹ 400, it is final output for farmer. Then, producer of wheat flour take wheat as an input and flour as final product. After this, flour is purchased by bakers for ₹ 800as raw material for preparing bread. Then, the bread is sold by baker for ₹1000 to customer. Hence, total output for baker is ₹1000. If we count total output it will be calculated as 400 + 800 + 1000 = 2200. But, this calculation is wrong in case of calculation of GDP. Here, we can see that total output for baker includes the total output of wheat flour. This becomes the reason for double counting. In case of calculation of GDP this problem of double counting is avoided. GDPMP = Ʃ GVAMP GDPMP is calculated by adding up value addition by all the producers in the economy. Value added = ₹400 + ₹(800-400) 400 + ₹(1000-800) 200 = ₹1000 National Income can be calculated as: GDPMP - Net Indirect Taxes = GDPFC GDPFC – Depreciation = NDPFC NDPFC + Net Factor Income from Abroad = NNPFC Precautions used in Expenditure method: (i) Value of final goods and services is included in National Income. (ii) Any product supplied at free of cost or at discount rate or sold at a profit margin, and then it will be included in it. (iii) Value of goods for self-consumption and imputed rent of self-occupied building is also included in National Income. 36  (iv) Value obtained from leisure time or illegal activity is excluded from National Income. (v) Service of housewives for their home and any voluntary work are not included in calculation of National Income. II. Income Method Income method refers to that method where national income is calculated from total factor income arising from different factors of production used in producing the national income. It is also known as Factor Share Method, Distributed Share Method and Factor Payment Method. In this method, the value of production should be equal to the value of income claims arising by that production. Factor Income from those households is included who are normal resident of a country. Factor Income refers to that income which is incurred by a person as a reward rendering factor services. Factor income includes rent for land, wages for labour, interest for capital and profit for entrepreneurs. National Income = Compensation to employees + Operating surplus + Mixed Income + Net Factor Income from Abroad Here, Compensation of employees = wages & salaries in cash + Payments in Kind + Employers’ contribution to social security + Pension on Retirement Operating Surplus = Rent + Interest + Profit (Dividend + Corporate Profit Tax + Undistributed Profit) Mixed Income = Mixed income refers to income earned by using own land, labour, capital and entrepreneurship. It includes rent, interest, wages and profit earned through own factors. NDPFC = Compensation to employees + Operating surplus + Mixed Income NNPFC = NDPFC +Net Factor Income from Abroad Precautions used in Expenditure method: (i) Income earned from sale of second hand goods is not included in calculation of National Income. 37  (ii) Any type of wealth tax, gift tax and estate duties are excluded from the National Income. (iii) Illegal incomes are not included in calculation of National Income. (iv) Any transfer payment is not included in National Income. (v) Value of production for self-consumption and imputed rent on self-occupied building is included in it. III. Expenditure Method According to Expenditure method, National income refers to total expenditure incurred on purchase of final goods and services produced in an economy during an accounting year. This method is also known as Consumption and Investment Method or Income Disposal Method. National Income can be computed as follows: National Income = Final Consumption Expenditure + Gross Domestic Capital Formation + Net Exports - Depreciation – Net Indirect Taxes + Net Factor Income from Abroad Here,Final Consumption Expenditure = Private Final consumption expenditure + Government final consumption expenditure Gross Domestic Capital Formation = Gross Domestic Fixed Capital Formation + the Expenditure on Change in Stock or Inventory Net Exports = Exports – Imports Precautions used in Expenditure method: (i) Expenditure on final goods is included and expenditure on intermediate goods or semi-finished goods is excluded. (ii) Expenditure on obtaining finance capital is not included in it. (iii) Any government expenditure on old age pension, scholarship, unemployment allowances, etc. is not included in this method. Thus, we can conclude that there are three major methods to calculate national income. These three methods include different factors and attributes. One method describes items related with value addition in final products; other method includes items related with income and the last method includes items related with expenditure. So, these 38  methods provide the complete knowledge of all the variables related with National Income. Estimation of National Income can be shown as follows through a diagram: PRODUCT METHOD INCOME METHOD EXPENDITURE METHOD Compensation of Gross Value Added in all Employees + Operating three Sectors at Market Surplus + Mixed Price Income of the Self- Private Final Consumption Expenditure + Government Final employed Consumption Expenditure + Gross Domestic Fixed Capital Formation + Change in Stock or Inventory Investment + Net Exports (Exports - Imports) GDP at Market Price Net Domestic Income Depreciation GDP at Market Price NDP at Market Price Depreciation Net Factor Income from Net Indirect Taxes Abroad NDP at Market Price NDP at Factor Cost Net Indirect Taxes National Income Net Factor Income from NDP at Factor Cost Abroad National Income Net Factor Income from Abroad National Income Figure.5 Four Sector Model of Circular Flow of Income 39 2.2.4 Difficulties in measurement of National Income There are various difficulties in calculation of national income. Some of these are related with concepts and some of these are related with statistics. These are described as: I. While measuring national income we exclude non-monetary transactions in the economy. Services of housewives and farm output used at home are not included in calculation of national income. Sometimes, services of housewives are excluded and farm output used at home is included in national income but this creates anomalies. II. Another major problem arises when foreign income is generated by a foreign firm in a country. It creates problems of inclusion of that income. This income may be included in national income of that country where the firm is situated or this will be included in national income of foreign country. Thus, foreign income is also creates problem in calculation of national income. III. It is difficult to determine the final goods and services included under calculation of national income because it creates problem of double counting. Thus, it is difficult to clear the difference of final goods and semi-finished goods. IV. National income calculation is based on national income data which may be false. Calculation of national income requires proper accounts and data on production, investment, consumption, etc. V. When accounts are prepared, prices are different and when national income is calculated prices changes. This change in price creates problem in calculation of national income. 2.3 Some practical questions on National Income: Q.1From the following data calculate National Income: Items (in crore) (i) Private income 1,200 (ii) National debt interest 40 (iii) Current transfers from the government administrative departments 40 (iv) Other current transfers from rest of the world 12 (v) Income from property and entrepreneurship accruing to government departments 16 (vi) Savings of government departmental enterprises 8. 40 Sol. National Income = Private income – National debt interest – Current transfers from the government administrative departments – Other current transfers from rest of the world + Income from property and entrepreneurship accruing to government departments + Savings of government departmental enterprises National Income = 1,200 crore – 40 crore – 40 crore – 12 crore + 16 crore + 8 crore = 1,132 crore = 1,132 crore. Q.2 Calculate GDPMP and NDPMP with the help of expenditure method from the data give below: Items (in crore) (i) Personal disposable income 8,600 (ii) Personal savings 1,500 (iii) Fixed capital formation 3,000 (iv) Net exports (–)300 (v) Net factor income from abroad (–)500 (vi) Net indirect taxes 600 (vii) Government final consumption expenditure 2,200 (viii) Change in stock 800 (ix) Consumption of fixed capital 450 Sol. GDPMP = Personal disposable income – Personal savings + Net exports + Fixed capital formation + Change in stock + Government final consumption expenditure GDPMP= 8,600 crore – 1,500 crore + (–) 300 crore + 3,000 crore + 800 crore + 2,200 crore GDPMP = 12,800 crore NDPMP = GDPMP – Consumption of fixed capital NDPMP= 12,800 crore – 450 crore NDPMP= 12,350 crore Q.3From the following data, calculate National Income by (a) income method, and (b) expenditure method: Items (in crore) (i) Private final consumption expenditure 2,000 (ii) Net capital formation 400 (iii) Change in stock 50 (iv) Compensation of employees 1,900 (v) Rent 200 (vi) Interest 150 (vii) Operating surplus 720 (viii) Net indirect tax 400 (ix) Employers’ contribution to social security schemes 100 (x) Net exports 20 (xi) Net factor income from abroad (-)20 (xii) Government final consumption expenditure 600 (xiii) Consumption of fixed capital 100 Sol. (a) Income Method: 41 National Income = Compensation of employees + Operating surplus + Net factor Income from abroad National Income = 1,900 crore + 720 crore + (–) 20 crore = 2,600 crore (b) Expenditure Method: National Income = Private final consumption expenditure + Government final consumption expenditure + Net capital formation + Net exports + Net factor income from abroad - Net indirect taxes National Income = 2,000 crore + 600 crore + 400 crore + 20 crore + (-) 20 crore - 400 crore = 2,600 crore Q.4Calculate from the following data: (a) Private Income, (b) Personal Disposable Income, and (c) Net National Disposable Income: Items (in crore) (i) National income 3,000 (ii) Savings of private corporate sector 30 (iii) Corporation tax 80 (iv) Current transfers from government administrative departments 60 (v) Income from property and entrepreneurship accruing to government administrative departments 150 (vi) Current transfers from rest of the world 50 (vii) Savings of non-departmental governments enterprises 40 Introductory Macroeconomics (iii) Economics–XII (viii) Net indirect taxes 250 (ix) Direct taxes paid by households 100 (x) Net factor income from abroad (–)10 Sol.(a) Private Income = National income + Current transfers from government administrative departments + Current transfers from rest of the world – Income from property and entrepreneurship accruing to government administrative departments – Saving of non-departmental governments enterprises PI = 3,000 crore + 60 crore + 50 crore – 150 crore – 40 crore = 2,920 crore (b) Personal Disposable Income = Private income – Savings of private corporate sector – Corporation tax – Direct taxes paid by households Personal Disposable Income = 2,920 crore – 30 crore – 80 crore – 100 crore 42  = 2,710 crore (c) Net National Disposable Income = National income + Net indirect taxes + Current transfers from the rest of the world Net National Disposable Income = 3,000 crore + 250 crore + 50 crore = 3,300 crore 2.4Check Your Progress 1. is known as National Income. 2. Product method of calculating National Income is also known as. 3. Four factors of products are. 4. There are methods to measure National Income. 5. GDP stands for. 2.5 Summary National income is not only a term rather than it includes various concepts related to national income. National income is an indicator of economic health of a country. National income is calculated with the help of three methods i.e. Income Method, Product Method and Expenditure Method. Every method is important in its own way and includes different terms under each method. National income analysis is very important for every country because it becomes a basis for comparison among different nations. No doubt national income analysis plays an important role in the economy. Still this analysis has many drawbacks which create problems in calculation of national income. But, National income is an estimation of Net National Income, so these problems can be removed and ignored through some measures. 2.6 Keywords National Income- National income may be defined as the total sum of factor incomes earned by normal residents of a country during an accounting year. Gross Domestic Product- Gross domestic product (GDP) is the monetary value of total sum of all goods and services produced within domestic territory of a country in an accounting period. 43  Double Counting- Double counting arises when total output of the entire producer is added up without considering that output of one producer may be input for the other producer. Product Method- Product method defines national income as total value of goods and services produced during an accounting year by all the firms in an economy. Income Method- Income method refers to that method where national income is calculated from total factor income arising from different factors of production used in producing the national income. Expenditure Method- According to Expenditure method, National income refers to total expenditure incurred on purchase of final goods and services produced in an economy during an accounting year. 2.7Self-assessment Test Q.1 Explain the following concepts: (a) Domestic Income (b) GDP (c) GDP deflator (d) Private Income Q.2 What do you mean by NNPMP? How does it can be calculated from GDP? Q.3 Distinguish domestic income and national income with the help of suitable example. 44  Q.4 Explain the different methods of measuring National Income in detail. Q.5 What do you mean by National Income Analysis? Explain the major importance of National Income Analysis. Q.6 Differentiate between product method and expenditure method of calculating national income. Q.7 Elaborate income method of measuring national income. Also explain the various precautions taken under income method. Q.8 You are given the following information about an economy: Gross Investment = 40, Govt. purchases of goods & service = 30, GNP = 200, X – M = - 20, Personal Tax = 60, Govt. transfer = 25, Interest payments from the Govt. to domestic Pvt. Sector = 15, Factor income received from the rest of the world = 7, Factor payment made to rest of would = 9. Calculate: a) Consumption b) GDP c) Net factor payment from abroad d) Pvt. Saving e) Public Saving. Q.9 The following is the information from the national income accounts for a hypothetical country: GNP = 5000.00, Personal Disposable Income = 4100.00, Consumption = 3800.00, X- M = 50.00, Govt. Budget Deficit = 200.00, Calculate Gross Investment and Government Expenditure. Q.10 What is the difference between gross domestic product and gross national product? Which of these two is best measure of income and why? 2.8Answers to Check Your Progress 1. Total income earned in producing the national product 2. Value Added Method 3. Wages, Rent, Interest, Profit 4. Three 5. GDP 2.9 References/Suggested Readings 1. Jain & Ohri, 2014. Introductory Macroeconomics, pages 31-61, VK Global Publication Pvt. Ltd., New Delhi. 45 2. Jhingan, 2012. Macro Economic Theory, pages 19-72, Vrinda Publication (P) Ltd., Delhi. 3. Jain et al., 2019. Macro Economics, pages 15-27, VK Global Publication Pvt. Ltd., New Delhi. 4. Chaturvedi & Mittal, 2013. Macro Economics, pages 13-34, International Book House Pvt. Ltd., New Delhi. 5. Ahuja, 2013. Macroeconomics Theory and Policy, pages 20-52, S. Chand Publishing, New Delhi. 46 Subject: Macro Economics Author: Ms. Chand Kiran Subject Code: BC 202 Vetter: Prof. Anil Kumar LESSON-3 Consumption Function Structure 3.0 Learning Objectives 3.1 Introduction to Consumption Function 3.1.1 Properties of consumption function 3.1.2 Psychological law of consumption 3.1.3 Importance of Consumption Function 3.1.4 Theories of Consumption Function 3.1.5 Determinants of Consumption Function 3.2 Measures to raise the Propensity to Consume 3.3 Criticism of Propensity to Consume 3.4 Check Your Progress 3.5 Summary 3.6 Keywords 3.7 Self-Assessment Test 3.8 Answers to Check Your Progress 3.9 References/Suggested Readings 3.0 Learning Objective After reading this chapter you will be able to understand the concept of consumption function, its importance and emergence as the topic of study under macroeconomics. Consumption function concepts will provide you knowledge about types of consumption function. You will also be able to realize different theories and determinants of consumption 47  function. Propensity to consume and its measures are also important factor to know about consumption function and this can be understood by this chapter. 3.1 Introduction to Consumption Function In 1936, J. M. Keynes developed the term ‘consumption function’ to describe the relationship between household’s planned consumption expenditure and total income. As we know that demand for a product is depend on price of that product, similarly consumption of a community depends on the level of income. Consumption refers to total amount of money spend by people on purchase of goods and services. Consumption function is related with income-consumption relationship. Consumption function may also be known as propensity to consume. Consumption function may be defined as functional relationship among total consumption and gross national income. This relationship may be represented as C = f (Y), where C is the total consumption, Y is the total Income and f represents the functional relationship of both the factors. Y is an independent variable and C is dependent variable which means consumption is dependent on national income. This relationship is based on a major assumption i.e. all the factors influencing consumption will be held constant. Whenever level of income increases in the community it will result into increase in consumption level. But how much consumption will increase it is measured through marginal propensity to consume. Consumption function is different from amount of consumption. Consumption function shows through a schedule which represents consumption at various levels of income, whereas amount of consumption represents the amount consumed at a specific level of income. The table 3.1 represents the schedule of consumption function which shows the amount of consumption changes due to change in national income. Table 3.1 Income and Consumption Level Income Consumption 1000 550 1200 600 1400 750 1800 1000 48  2000 1130 2300 1300 2600 1420 This table shows that at the level of income 1000 rupees, the total consumption is 550 rupees. As the national income increases to rupees 1400, the amount of consumption rises to rupees 750. Thus, we can say that whenever level of national income changes it cause change in consumption level. As national income increase consumption will also increase but this increase in consumption will not at same pace as increase in national income. 3.1.1Properties of the Consumption Function Consumption function is based on two major properties i.e. Average Propensity to Consume and Marginal propensity to consume. These two properties are also known as technical attributes of consumption function. Both properties are important to study for better understanding of consumption function. Propensity to consume refers to that portion of total income which consumers tend to spend on goods and services. These properties are discussed in detail here: (I) Average Propensity to Consume Average propensity to consume refers to the ration between total consumption expenditure to total income. Or this may be defined as the ratio of consumption expenditure to personal disposable income. It can be shown as: 𝑻𝒐𝒕𝒂𝒍 𝑪𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 𝑬𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆 Average Propensity to consume = 𝑻𝒐𝒕𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆 OR 𝑪 APC = 𝒀 For example, if total consumption expenditure is 8,000 rupee and personal disposable 𝟖𝟎𝟎𝟎 income is 20,000 rupee, then APC = = 0.4or 40%. It means 40% of the total 𝟐𝟎𝟎𝟎𝟎 income is used for consumption purpose in an economy. This can be calculated for individual consumer using personal disposable income. APC can be presented through Table No. 3.2. 49 This table represents that when income level is zero, consumption expenditure is 40 crores. This is due to expenditure on necessity goods even when national income is 0. When national income increases consumption expenditure will increase simultaneously. But APC starts declining from 1.20 to 0.90. Table No. 3.2 Average Propensity to Consume Further this can presented through a diagram, where consumption is shown on OY axis and income is represented on OX axis. In Fig. 3.1, CC is the consumption curve. At ON consumption level and OY1 income level, APC situated at point A which can be 𝑂𝑁 calculated by, APC = OY1. Fig. 3.1 Average Propensity to Consume Some important points about APC: (i) APC > 1, when consumption is more than national income. (ii) APC < 1, when consumption is less than national income. (iii) APC = 1, when consumption is equal to national income. (iv) APC ≠ 0, because consumption cannot be zero at any level of income. 50  (v) APC falls continuously with the increase in national income because the portion spent on consumption starts declining. (II) Marginal Propensity to Consume Marginal propensity to consume refers to measurement of change in total consumption and total income. It may be described as the ratio of change in consumption expenditure due to change in personal disposable income. It can be represented as, 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑪𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏 𝑬𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆 Marginal Propensity to Consume = 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑻𝒐𝒕𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆 OR ∆𝑪 MPC = ∆𝒀 For example, if total consumption expenditure increases from 8,000 to 10,000 rupee 𝟏𝟎𝟎𝟎𝟎 and personal disposable income increases 30,000 rupee, then MPC = = 0.33 or 𝟑𝟎𝟎𝟎𝟎 33%. It means 33% of the total income is used for consumption purpose in an economy. This can be calculated as additional consumption out of additional income. MPC can be presented through Table No. 3.3. Table No. 3.3 Marginal Propensity to Consume Income ConsumptionCrores Change in Change in Marginal Propensity (Y) Income Consumption ∆𝐶