Introductory Macroeconomics PDF

Department of Distance and Continuing Education University of Delhi nwjLFk ,oa lrr~ f'k{kk foHkkx fnYyh fo'ofo|ky; B.A.(Hons.) Economics - DSC-4 B.A. (Programme) - DSC-3 (Minor) Semester-II...

Department of Distance and Continuing Education University of Delhi nwjLFk ,oa lrr~ f'k{kk foHkkx fnYyh fo'ofo|ky; B.A.(Hons.) Economics - DSC-4 B.A. (Programme) - DSC-3 (Minor) Semester-II Course Credit-4 INTRODUCTORY MACROECONOMICS (Department of Economics) As per the UGCF - 2022 and National Education Policy 2020 Introductory Macroeconomics Editorial Board Prof. J. Khuntia, Devender Content Writers Devender Academic Coordinator Deekshant Awasthi © Department of Distance and Continuing Education ISBN : 978-81-19169-62-7 1st edition: 2023 E-mail: [email protected] [email protected] Published by: Department of Distance and Continuing Education under the aegis of Campus of Open Learning/School of Open Learning, University of Delhi, Delhi-110 007 Printed by: School of Open Learning, University of Delhi © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics Corrections/Modifications/Suggestions proposed by Statutory Body, DU/Stakeholder/s in the Self Learning Material (SLM) will be incorporated in the next edition. However, these corrections/modifications/suggestions will be uploaded on the website https://sol.du.ac.in. Any feedback or suggestions can be sent to the email- [email protected] © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi Introductory Macroeconomics INTRODUCTORY MACROECONOMICS Study Material : Lesson 1-14 TABLE OF CONTENTS Name of Lesson Page No LESSON 1 Introduction to Macroeconomics 1-11 LESSON 2 Introduction to National Income Accounting 12-36 LESSON 3 National Product/National Income 37-75 LESSON 4 Balance of Payments 76-80 LESSON 5 Money 81-90 LESSON 6 Measures of Money Supply 91-96 LESSON 7 Money and Price 97-103 LESSON 8 Credit Creation 104-110 LESSON 9 Demand for Money and its Determinants 111-125 LESSON 10 Tool of Monetary Policy 126-129 LESSON 11 Classical Macroeconomics: Equilibrium Output and Employment 130-148 LESSON 12 Keynesian Macroeconomics: Equilibrium Determination a 149-164 Multiplier LESSON 13 IS-LM Determination 165-178 LESSON 14 Fiscal and Monetary Multiplies 179-188 © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics LESSON-1 INTRODUCTION TO MACROECONOMICS STRUCTURE 1.1 Introduction 1.1.1 What is Economics? 1.1.2 Scope of Economics: Micro and Macro Economics 1.1.3 Major Macroeconomic Issues 1.2 Concepts 1.2.1 Stocks and Flows 1.2.2 Equilibrium and Disequilibrium 1.2.3 Partial and General Equilibrium Analysis 1.3 Methods of Macroeconomic Analysis 1.3.1 Static Analysis 1.3.2 Dynamic Analysis 1.3.3 Comparative Statics Analysis 1.4 Self-Assessment Questions 1.1 INTRODUCTION 1.1.1 What is Economics? The science of economics was born with the publication of Adam Smith’s “An Inquiry into the Nature & Causes of Wealth of Nations” in the year 1776. Before Adam Smith, there were other writers who expressed significant economic ideas. But economics as a separate branch of knowledge started with Adam Smith’s book. The word ‘ECONOMICS has been derived from two Greek word oikos (meaning a house) and nemein (meaning to manage). Hence economics meant managing a household in an economical manner. Economics is concerned with the allocative decisions of individual, households, business and other economic agents operating in the society and how the society itself (as a whole) allocates its resources. Alternatively, it is the study of how a society chooses to use its limited resources to produce, exchange and consume goods and services. Economics has been variously defined. For example, Prof. Alfred Marshall defined it as “a study of mankind in the ordinary business of life; it examines that part of individual and 1|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) social action which is more closely connected with the attainment and use of material requisites of well-being”. It is thus “on one side the study of wealth, and on the other and more important side, the study of man”. 1.1.2 Scope of Economics: Micro and Macro Economics Modern economics has two major branches—Microeconomics and Macroeconomics. Before 1930’s most economists concentrated their attention almost exclusively on microeconomics. Macroeconomics was the junior partner. But after 1936, the year John Maynard Keynes published “The General theory of Employment, Interest & Money”, a new interest in macroeconomics arose. Some chose to call it the “Keynesian Revolution” (Late 1930’s – mid 1960’s). Under the influence of Keynes, a whole new branch of economic theory has been developed called macroeconomics. In fact, both the branches study economic phenomenon, investigate economic issues and provide a logical solution to economic problems at two different levels. Microeconomics analysis is the behaviour of individual decision-making units, such as consumers, resource owners’ firms. It studies economic problems such as what, how and for whom to produce at individual level. The unit of study is the part rather than the whole. Fig. 1.1 Scope of Microeconomics However, microeconomics fails to explain the functioning of an economy as a whole. It cannot explain unemployment, poverty, illiteracy and other problems prevailing at the country level. 2|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics The word Macroeconomics was coined by Ragnar Frisch in 1933. It deals with the functioning of the economy as a whole. It is concerned with the behaviour and performance of the aggregates or the “wholes”—such as aggregate output, general price level, size of national income, level of total employment, aggregate savings, aggregate investment, economic growth etc. Macroeconomics studies not only the nature and behaviour of the above variables but also the inter-relationships that exist between the above variables. It is also known as Theory of Income and Employment since its major subject matter deals with the determination of income and employment. The scope of macroeconomics in the words of Dornbusch & Fischer: “Macroeconomics is concerned will the behaviour of the economy as a whole - with booms and recessions, the economy’s total output of goods and services and the growth of output, the rates of inflation and employment, the balance of payments, and exchange rates.” To conclude we can say: Macroeconomics focus on big picture view of the economy. It attempts to deal with the big issues of economic life at aggregate level, such as: a) Why growth rate is less than expected growth rate? b) Why are jobs plentiful in some years and not in others? c) Why the prices go up rapidly at some times? d) Why high rate of inflation persists so long? e) Why India’s BOP always in deficit? f) Why fiscal and monetary policies of India failed to achieve their goals? The scope of macroeconomics includes the following topics as shown in Fig. 1.2. Fig. 1.2 Scope of Macroeconomics Macroeconomics has emerged as the most challenging branch of economics. It has both theoretical and policy orientations. 3|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) 1. Macroeconomics theories use macroeconomic models to explain the behaviour of macroeconomic variable and specify the nature of the relationship between them. 2. Study of the inter-relationships between aggregate economic variables assists the economic policy makers (the Government) to devise appropriate economic policies. 3. Macroeconomics analyses the working and effects of government policies (especially monetary and fiscal policy) on the economy. 4. It explores the consequences of government policies intended to reduce unemployment, smooth output fluctuations and maintain stable prices. 5. Macroeconomics provides a framework for controlling and guiding the economy to achieve desired goals of growth and stability. 6. Macroeconomic policies formulated and implemented by the Government are directed towards improving the long-run competitiveness of the economy. The combinations of wages, prices and exchange rates and productivity are “in-line” so that firms can market their products profitably to the rest of the world. 7. The study of macroeconomics is used to solve many problems of an economy like monetary problems, economic fluctuations, general unemployment, inflation, disequilibrium in the balance of payments position, etc. 8. We use this tool to understand why the economy deviates from a path of smooth growth over time. 9. Macroeconomic policies bring balance in the economic relations with the rest of the world. In conclusion, we may say that in a sense, Microeconomic theory has a foundation in macroeconomics and Macroeconomic theory has a foundation in microeconomics. Microeconomic point of view is—optimum allocation of its resources and macroeconomics point of view is full utilization of its resources. 1.1.3 Major Macroeconomic Issues Macro Economics deals with whole units of the economy like Aggregate demand, Aggregate supply, total saving, total investment, national Income, Theory of employment, Balance of Payment, foreign exchange rate, inflation, Long run Economic growth, overall living standard, fiscal imbalances & Interest rates are the major issues of macro-Economics. 4|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics Some Major issues of Macro Economics 1. Business Cycles – Business cycles are the wave like fluctuations. According to Schumpeter Business cycles have four stages: - Boom, Recession, Depression & Recovery, which occur time to time and controlling these stages of business cycle is another important task of the macro economics. 2. Long run Economic growth- Economic growth is a continuous process in which National income & per capita income increases. Each and Every country want to achieve high growth rate of the economy for raising the level of standard of living of their country people and it is the major issue of macro economics because macro economics knowledge helps in the achievement of this goal. 3. Overall living standard – Economic Development depends upon social welfare of the country people. If country people are able to buy their required or living things, then their standard of living can rise and it will help in the achievement of higher growth rate of the economy. 4. Inflation – When Price rises continuously or persistently that will be called inflation. Inflation is the main problem which occurs from time to time. It is also the main issue of macro economics. To control inflation Govt. can use both policies (Monetary Policy and Fiscal Policy). 5. Unemployment – This is the main and most important issue of macro economics because Macro Economics introduced by Keynes at that time when US economy & U.K. were suffering from the problem of depression. During depression period of 1930’s unemployment rate was rise from 17 to 20%. The solution of this problem was the interference of the government in economic activities. 5|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) 6. Fiscal Imbalances – Fiscal Imbalance is a situation which occurs when Govt. Revenue is less than Govt. Expenditure. Govt. make budget which may be in surplus or in deficit. But generally, it remains deficit and creates the problem of fiscal imbalance. To solve it Govt. makes fiscal policy in which Govt. can raise their source of revenue and cut their expenditure & external borrowings. 1.2 CONCEPTS 1.2.1 Stocks and Flows Macroeconomics uses certain economic aggregates called macro-economic variables, to assess the performance and to analyse the behaviour of an economy. Macroeconomic variables that figure in macroeconomic studies are generally grouped under this category stock variables and flow variables. The twin concepts of stocks and flows are not difficult to understand but they can cause great difficulty if misunderstood or misused. To begin with, both are variables, quantities that may increase or decrease over time and are often related though measured in different units. A stock is a quantity measured at a given point in time i.e. as on date, whereas a flow is a quantity measured per unit of time i.e. per hour, per week etc. For example, the amount of water in a tub is a stock because it is a quantity measured at a given moment in time and the amount of water coming out of tap is a flow as it is a quantity measured per unit of time. GDP is probably the most important flow variable in economics which tells us about the rupees flowing in an economy's circular flow per unit of time. 6|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics Some examples: Stock Variables Flow Variables Person’s Wealth Person’s income and expenditure Balance sheet of a firm Profit and loss account Supply of money Spending of money Fixed deposit in a bank Interest earned on the deposit Inventories Change in inventories Accumulated savings Savings Total stock of capital Investments Foreign exchange reserve Balance of payment Total employment Addition to employment Government tax revenues Government expenditures Exports and imports Wages and salaries Hint: Any component with which change is associated becomes a Flow concept. Some flow variables have direct counterpart stock variables, e.g., ‘investment’ is a flow variable having counterpart of stock of capital. But some variables are only flows and have no direct stock counterpart e.g., imports and exports, wages and salaries, etc. These flow variables indirectly affect the size of other stocks. A stock can change only as a result of flow. For those flow variables which have a stock variable, a change in the magnitude of the stock variable between two specified points in time will depend on the magnitude of the flow variables themselves may be determined in part by changes in the stock. The best example of this is the relationship between the stock of capital and the flow of investment (both of these two depend on each other). The stock of capital can increase only as a result of an excess of the flow of investment or of new capital goods produced. However, the flow of investment itself depends on other things on the size of the capital stock 7|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) With respect to this relationship between the flow of investment and the stock of capital, we may define the short-run period and the long-run period. Short-run period - as one in which changes in the stock of capital are too small to influence the flow of investment (stock may be assumed to be constant in that period). Long-run period - is one in which such changes are large enough to influence the flow of investment. So, we can conclude: Although flows may be influenced by changes in stocks, they will not be so influenced by changes in stocks in the short run. Stocks can exert an influence on flow only in the long run. In this sense, elementary macroeconomics theory is primarily short-run, it is essentially a study of relationships among flows in which size of each flow in any time period is determined slowly by the size of the other flows. 1.2.2 Equilibrium and Disequilibrium Equilibrium: refer to a position in which forces working in opposite directions are in balance and there is no in-built tendency to deviate from this position. In other words, it is expressed as a state of no change over time. This is not to say that economics equilibrium is a motion-less state in which no action takes place whether it is a state of action of repetitive nature. Disequilibrium: is the state in which the opposite forces produce imbalance or simply it can be stated as the absence of a state of balance. The factor causing disequilibrium arise of the working process of the economy. The economic activities are undertaken by million of decision makers, consumers, producers, workers and others and their decision need not always coincide and the result is the disequilibrium. 1.2.3 Partial and General Equilibrium Analysis Partial and general equilibrium analysis are two other concepts which are often used in macroeconomic analysis. Partial equilibrium: The analysis of a part of an economy isolated and insulated through assumptions from the influence of the changes in the rest of the economy. In simple words, when a part of economic system or an economic phenomenon is analysed in isolation of the economic system, it is called partial equilibrium analysis. It is based on ceteris peribus, i.e., all other related variables are constant. 8|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics It is widely used in microeconomics analysis, but in macroeconomics partial equilibrium analysis is applicable when macroeconomic analysis is confined either to the product sector or to the monetary sector. General equilibrium: General equilibrium analysis is carried out when the objective is to analyse the economic system as a whole. It takes into account the inter-relationships and inter-dependence between the various elements of an economy. General equilibrium analysis takes a comprehensive and realistic view of the economic system and focuses on the simultaneous determination of equilibrium of all the markets. Macroeconomic analysis is largely of general equilibrium nature as it helps in formulation of macroeconomics policies and identifies and explain the causes and effects of economic disturbances. 1.3 METHODS OF MACROECONOMIC ANALYSIS Three methods/approaches are employed in construction and analysis of economic model in macroeconomics. 1.3.1 Static Analysis When an economic phenomenon is studied under static conditions. It is called static analysis. In this method, it is assumed that macroeconomic variables like the size of the economy, national income, national consumption, savings, investments, employment, etc. all pertain to same period of time and remain unchanged over the reference period because static ignore the passage of time. It cannot explain the process of change in a model so the entire economic process in a static economy reproduced itself year after year at the same level of output and employment. Such an economy is said to be in a state of static equilibrium. In this method, our analysis is limited to a single position of equilibrium only. Importance: This kind of approach to the study of an economic phenomenon is essentially a theoretical approach. The primary objective of constructing a static model is to make generalizations or theoretical prepositions regarding the relationship between the related variables under static conditions. Static analysis can identify the equilibrium positions and describe in general terms how the system will move to this position. It can indicate the position of the model for a but cannot explain the actual process step-by-step or period-by-period, that the system follows over time to reach that equilibrium position and also cannot reveal exactly what the position will be in any other period. 9|Page © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) 1.3.2 Dynamic Analysis When a macroeconomic phenomenon is analyzed under dynamic conditions, it is called dynamic analysis. Dynamic analysis is able to trace the changes in the value of macroeconomic variables as they moved through successive disequilibrium position towards the single equilibrium position over time. It takes into account the time lag involved in the process of adjustment. It studies the nature and the magnitude of change. Importance: For a realistic study of economic movements and for policy recommendations, we require information regarding the whole path of progress, i.e., ‘how’ an economy moves from one position of equilibrium to the other. It unfolds the changes which occur during the course of movement of the economy from one position to another. Moreover, a dynamic economy raises certain issues which cannot be handled through static or comparative - static approaches. 1.3.3 Comparative Statics Analysis As it is clear by its name itself, it is a comparative study of economic conditions at two equilibrium positions at two different points of time. In other words, it refers to the technique of analysis which economists employ for comparing positions of economic variables and their relationship under equilibrium conditions at different points of time. The economic forces that determine the equilibrium position for a model may be expected to change over time so as to displace the original equilibrium and lead to the establishment of a new equilibrium. So, one can compare the two equilibrium positions and explain the change between the two in terms of the changes in forces. The analysis of this kind of change from one equilibrium to another may be handled by the method of comparative statics. Importance: It assumes great significance where the object is to predict the future course of an economy on the basis of the past experience. Through method of comparative statics, we can show the direction and magnitude of the change in equilibrium price and quantity that follows from changes in the underlying forces that causes the shifts in the supply and demand curve. CONCLUSION: Comparative statics bridges the gap between equilibrium positions in one instantaneous jump. But it reveals nothing about how we got from one position of equilibrium to the other. In reality, we are more interested in the path followed between positions of equilibrium than in the positions themselves and only dynamic analysis can handle this task. 10 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics Hence, in short we can conclude that change from one equilibrium position to the next can be analyzed by method of comparative statics, but actual path followed between equilibrium positions can be explained only by macro dynamic analysis. Summary The origin of economics can be traced to Adam Smith's book “An Inquiry into the Nature & Causes of Wealth of Nations” published in the year 1776. Microeconomics deals with behaviour of individual decision-making units such as consumers, resource owners, etc. Macroeconomics deals with aggregates such as national income, aggregate consumption, etc. A stock is a quantity measured at a given point in time. A flow is a quantity measured per unit of time. Equilibrium refers to a position in which forces working in opposite direction are in balance. Disequilibrium is a state in which opposite forces produce imbalance. When a part of an economy is studied in isolation is called partial equilibrium analysis. A comprehensive study of an economic system is referred as General Equilibrium Analysis. Static. Dynamic and Comparative-Static Analysis are three methods of Macroeconomic Analysis. 1.4 SELF-ASSESSMENT QUESTIONS 1. What is macroeconomics? Distinguish it from microeconomics. 2. Explain the difference between stock and flow. 3. What methods are employed by economists for analytical purposes in macroeconomic theory? 4. Write a short note on: Major issues of Macro Economics 11 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) LESSON-2 INTRODUCTION TO NATIONAL INCOME ACCOUNTING STRUCTURE 2.1 Introduction 2.2 Gross Domestic Product (GDP) 2.2.1 Rules for Computing GDP 2.2.2 Real GDP versus Nominal GDP 2.2.3 The GDP Deflator 2.2.4 Consumer Price Index 2.3 Other Measures of Income 2.3.1 Gross National Product (GNP) 2.3.2 Net National Product (NNP) 2.3.3 National Income (NI) 2.3.4 Personal Income (PI) 2.3.5 Personal Disposable Income (DI) 2.3.6 Private Saving 2.3.7 Public Saving 2.3.8 National Saving 2.3.9 Distinguish between National Income, National Capital & National Wealth 2.3.10 Interest Rate 2.4 The Components of Expenditure (GDP) 2.4.1 Consumption (C) 2.4.2 Investment (I) 2.4.3 Government Purchases (G) 2.4.4 Net Exports (NX) 2.5 Income Expenditure and The Circular Flow 2.5.1 The Circular Flow in 2-Sector Model 2.5.2 Computation or GDP from the Circular Flow 2.5.3 The Circular Flow in a Three-Sector Model 2.6 Self-Assessment Questions 12 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics 2.1 INTRODUCTION Economists want to figure out what's going on in the world around them. To do this, they rely on both theory and observation. Casual observation is one source of information about what's happening in the economy. They build theories in attempt to make sense of what they see happening. Then they turn to use statistics to study the economy. Study of national income and related concepts like Gross Domestic Product (GDP), Gross National Product (GNP), Net National Product (NNP), Net Domestic Product (NDP), etc. enables the government to judge whether the economy is contracting or expanding, whether it needs a boost or should be controlled or rained in a bit, or whether severe inflationary or deflationary pressure are round the corner. The data from National income accounts serve like beacons to help economic policy makers in achieving their objectives, Paul. A. Samuelson and William D. Nordhaus have succinctly remarked, “Without measures of national economic aggregates like GDP, Policy Makers would be adrift in a sea of unorganized data”. The three statistics that economists and the policy makers use most often to qualify the performance of the economy are: 1. Gross Domestic Product (GDP)—It tells us the nation's total income and total expenditure on its outputs of goods and services. 2. Consumer Price Index (CPI)—It measures the level of prices. 3. Unemployment Rate—It tells us the fraction of workers who are unemployed. 2.2 GROSS DOMESTIC PRODUCT (GDP) GDP is often considered the best measure of how well the economy to performing. The value of income or product originating in a country in a particular year is one of the most important means of evaluating how the economy has preformed in that year. This statistic is computed every three months by the Bureau of Economic Analysis from a large number of Primary data sources. The goal of GDP is lo summarize in a single number the rupee value of economic activity in a given period of time. GDP is the sum total of market value of all the final goods and services produced on the geographical or domestic territory of on economy in a given period of time. GDP = Market value of good services produced by the residents in the country. Plus (+) = Income earned in the country by foreigners. Minus (-) = Income received by residents of the country from abroad. 13 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) This is a geographical territorial concept of Product. What we are concerned is the increased production, no matter who produces it i.e., whether production is being done by the residents of a nation or by foreign nationals. Thus, GDP does not make any provision for net factor income from abroad; it only includes what has been produced on the domestic territory of the country. Thus, in the context of development GDP is considered as a more appropriate measure. There are two ways to view GDP: (a) It is the sum total of everyone's income in an economy. (b) It is the total expenditure on the economy's output of goods and services. How, GDP measures both the economy's income and expenditure on its output. The reason is that these two quantities are actually the same; for the economy as a whole, income must equal expenditure. The fact follows from, because expenditure by one person becomes the income of the other. In other words, every transaction has both a buyer and a seller. For example, John buys bread of Rs. 10 from Johnny, which is an income of Johnny & expenditure by John. 2.2.1 Rules for Computing GDP 1. To compute the total value of different goods & services we make use of the market prices of these final goods and services. The market price reflects how much the consumers are willing to pay for the goods and services. 2. Used goods GDP measures the value of currently produced goods and services. Thus, the sale of used goods is not included as part of GDP. Used goods were produced in an earlier period and their value was counted in that period. 3. Regarding the Inventories - Production for inventory increases the GDP, but the sale out of inventory does not affect GDP. It will be treated like the sale of used goods. This treatment of inventories ensures that GDP reflects the economy's current production of goods and services. 4. Intermediate goods and value added - GDP includes only the value of final goods. The reason is that the value of intermediate goods is already included as part of the market price of the final goods in which they are used. Adding Value of intermediate goods will lead to double counting. One way to compute the value of all final goods and services is to sum the value added at each stage of production. 14 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics The value added of a firm = value of the firms output-(Minus) value of the intermediate goods that the firm purchases. For the economy as a whole, the sum of all value added must equal the value of all final goods and services. Hence, GDP is also the total value added of all firms in the economy. 5. Housing service and other Imputations - Although most goods and service are valued at their market prices when computing GDP, some are not sold in the marketplace (e.g., sell owned house, Government service etc.), and therefore do not have market prices. To include the value of these goods and services in the figure of GDP, we estimate their imputed value. 2.2.2 Real GDP versus Nominal GDP GDP is useful for comparing economic activity, from year to year. GDP measured at current year prices (i.e., Nominal GDP) does not measure accurately the economy's Performance. It will produce a misleading picture of economy's performance because if the prices doubled without change in quantities, GDP also double which reflects economy's ability to satisfy demands has doubled whereas, in actual the quantity of every good produced remain the same. Therefore, to measure the actual economic performance, value of good and services should be measured using a constant of Prices, called real GDP. Hence real GDP is a better measure of economic well-being, which is not influenced by changes in Prices. It shows what would have happened to expenditure on output if quantities had changed but prices had not. Nominal GDP = Value of goods and services measured at current prices. Red GDP = Value of goods and services measured using a constant set of Prices of the base year. Example of Real vs. Nominal GDP Year Price of Wheat Quantity of Price of Bread Quantity of wheat Bread 2013 10 100 20 50 2014 20 150 30 100 2015 30 200 40 150 Calculating Nominal GDP 2013 (10 x 100) + (20 x 50) = 2000 15 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) 2014 (20 x 150) + (30 x 100) = 6000 2015 (30 x 200) + (40 x 150) = 12000 Calculation Real GDP (Base Yr. 2013) 2013 (10 x 100) + (20x50) = 2000 2014 (10 x 150) + (20 x 100) = 3500 2015 (10 x 200) + (20 x 150) = 5000 Calculating the GDP Deflator 2013 (2000 x 2000) x 100 = 100 2014 (6000 / 3500) x 100 = 171 2015 (12000 / 5000) x 100 = 240 2.2.3 The GDP Deflator It is also called the implicit price deflator of GDP. It reflects what's happening to the overall level of Prices in the economy. GDP is defined as the ratio of nominal GDP to real GDP: GDP Deflator = Nominal GDP Real GDP It is used to deflate (that is, take inflation out of) nominal GDP to yield real GDP. We can also write the equation as: Nominal GDP = Real GDP × GDP deflator OR Real GDP = Nominal GDP GDP Deflator Where, Nominal GDP - measures the current rupee value of the output of the economy. Real GDP - measures output value at constant prices. GDP deflator - measures the price of output relative to its price in the base year. 16 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics Note: The Bureau of Economic Analysis has decided to update periodically the prices used to compute real GDP. About every five years, a new base year was chosen. The prices were then held fixed and used to measure year-to-year changes in the production of goods and services until the base year was updated once again. 2.2.4 Consumer Price Index CPI is the Direct Price index and most suitable (appropriate) to consumers because it measures the Prices of those goods and services which are directly consumed or purchased by the consumers. Many govt. pensions like social security benefits, and some wage rates are indexed to the CPI. (i) CPI is constructed by using following information – (i) consumption basket in the base year (ii) Prices of items in the basket in the base year (iii) Prices of items in the given year CPI measures retail prices on which consume purchase CPI increases due to increase in inflation & vice-versa goods & services from the market. TotalCost of thegoodsin thecurrent year CPI = x100 Totalcos t of thegoodsin the base year Price index is the measuring level of Aggregate Price, relative to a chosen base year. WPI the Laspeyres Index is used Pq l o or x w i i P qo o x w o o Producer Price index is a measure of the cost of a basket of goods & services bought by firms. CPI is a measure of the cost of a basket of goods & services bought by households. Indexation is the automatic correction by law or contract of a dollar / rupee amount for the effect of inflation, that amount is said to be indexed for inflation. Index is a main feature of many laws for example when price increases, social security benefits are also adjusted every year to compensate it. Same as when Price rises dearness allowance also adjusted every year to compensate it. 17 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) The inflation rate is a rate which is calculated on the basis of the current year’s Price (Pt) & last year’s Price (Pt-1). In other words, it is the rate of change in prices & the price level is the accumulation of past inflation. = ( Pt − Pt −1 ) x100 Pt −1 2.3 OTHER MEASURES OF INCOME The national income accounts include other measures of income that differ slightly in definition from GDP. They all are also important to study as they also are often referred by economists. 2.3.1 Gross National Product (GNP) It is the most comprehensive machine of the nation’s productive activities. It measures the total income earned by nationals (residents of a nation). GNP is the sum total of market value of all the final goods and services produced by the residents of a country in a given period of time. GNP = market value of goods and services produced by the resident in the country. + (plus) = Income earned abroad by nationals. - (Minus) = Incomes earned locally by the foreigners. In other words, to obtain Gross national product (GNP), we add receipts of factors income (wages, profit and rent) from the rest of the world and subtract payments of factor income to the rest of the world. GNP = GNP + Factor payments from Abroad – factor Payments to Abroad. 2.3.2 Net National Product (NNP) It is another concept of National income. The concept of NNP is closely related to the concept of GNP. The concept of GNP includes the output of both final consumer and capital goods. However, a part of capital goods is used up or consumed in the process of production of these goods. That is called depreciation or capital consumption (the amount of the economy's stock of plants, equipment and residential structure that wears out during the year). So, GNP is gross of depreciation and NNP is net of depreciation. NNP = GNP - Depreciation 18 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics 2.3.3 National Income (NI) The next adjustment in the national income accounts is for indirect business taxes such as sales taxes. As firms never receive these taxes, it is not a part of their income. Once, we subtract indirect business taxes from NNP, we obtain a measure called national income. National Income (NI) = NNP - Indirect Business Taxes 2.3.4 Personal Income (PI) It is the sum total of all kinds of incomes received by the individuals (including transfer earnings) from all source’s income within and outside the country during an accounting year. It includes wages and salaries, fees & commissions, bonus fringe benefits. dividends, interest earnings and also includes transfer incomes like pension, allowances, old age security benefits etc. Personal Income = National Income + Dividend + Government Transfers to Individuals + Personal Interest Income-Corporate Profits-Social Insurance Contributions-Net Interest 2.3.5 Personal Disposable Income (DI) It is the amount households and non-corporate businesses have available to spend after satisfying their tax obligations to the government. It is the amount households and non-corporate businesses have available to spend after satisfying their lax obligations to the government. Personal Disposable Income = Personal Income – Personal Tax and non-tax Payments 2.3.6 Private Saving –private saving is the income of the households which left for saving purpose after paying the direct taxes to the govt. and expenditure on consumption. Private Saving – Private disposable Income minus Consumption expenditure. SPvt. = Private disposable income – Consumption = (Y-T+TR+INT+NFP) – C Private saving is very useful because it helps in capital formation or investment in the economy. Private saving provides financial resources to the govt. to overcome the problem of deficit budget and it reduces the burden of foreign borrowings. As we know that under expenditure method 19 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) Y = C+I+G + NX National Saving = (C+I+G+NX) + NFP – C – G S = I + (NX + NFP) The sum of Net exports (NX) & Net factor Payment (NFP) may be called current Account balance (CA). Now we can rewrite saving in this form. S = I + CA Private Saving = 1 + (-Sgovt.) + CA Where, -Sgovt. Govt. budget deficit Uses of private saving Private saving can be used in the economy be following ways- 1) For Investment – Business firms & producing units can take loans or borrow money from financial institutions for smooth functioning of the business enterprises. 2) Govt. budget deficit (-Sgovt.) – when govt. Revenue is less than govt. expenditure then Govt. make deficit budget & to compensate it govt. need money, so Private saving can help in solving the problem of budget deficit. 3) The Current Account balance – Current A/c balance is the summation of Net Exports & net Factor payment. To finance current account balance Private saving is useful. 2.3.7 Public Saving Public Saving is that part of govt. income or tax revenue which left after paying for its expenditure. Public saving or govt. saving = Govt. saving is calculated by deducting govt. Purchases from govt. Income. Sgovt. = Net govt. income – govt. purchase (T-TR-INT) – G 2.3.8 National Saving National Saving is the sum of Private saving & Public Savings 20 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics National Saving = SPV+ + SGovt. S= SPVT + Sgovt. = (y+NFP – T + TR + INT – C) + (T-TR – INT – G) = Y + NFP – C – G Here Y + NFP is Total income of the economy which is equivalent to GNP (Gross National Product) C – Consumption expenditure G – Govt. Purchases NFP – Net Factor Payment 2.3.9 Distinguish between National Income, National Capital & National Wealth National Income is a flow concept, but National Capital and National Wealth is a stock concept. National Income is estimated every year but National Capital and Wealth Can’t be estimated every year because it includes Stock of capital goods and land, and net foreign Assets (Which is the difference between foreign Assets minus foreign Liabilities). S = I + CA If the investment is greater than National Saving S then the current account balance will be negative. 2.3.10 Interest Rate Interest is the reward of capital which the owner of capital gets by separating the money from himself and give it to others for business purpose. Nominal Interest rate = i Real Interest rate = r Expected inflation = e Nominal Interest rate is the summation of real interest rate & expected inflation. 21 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) I = r + e And Real interest rate = I – e Fisher’s effect shows the adjustment Process of the nominal Interest rate to the inflation rate. If inflation is higher nominal interest rate will be higher & vice-versa. Fisher effect has maintained a long-period perspective & this effect need not hold in the short run because in short term inflation may be unanticipated. Nominal interest rate is that rate which pays by the bank & real interest rate increase purchasing power the quantity theory of money & the fisher’s equation both tells us how growth of money affects the nominal interest rate. According to the quantity theory of money, an increase in the rate of growth of money of 1% causes a 1% increase in the rate of inflation and in turn it increases nominal interest rate by 1%. The one-for one relationship between the inflation rate and nominal interest rate is called the fisher effect. 2.4 THE COMPONENTS OF EXPENDITURE (GDP) Economists and policy makers care not only about the economy's total output of goods and services but also about the allocation of this output among alternative uses. The national income accounts divide GDP into four broad categories of spending, according to the identity of the purchaser: Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX) Mathematically, their relation could represent as Y = C + I + G + NX Where, Y stands for GDP GDP is the sum of consumption, investment, government purchases and net exports. Each rupee of GDP falls into one of these categories. This equation is the national income account’s identity. 22 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics NATIONAL INCOME EQUATION In a closed economy: In a Two Sector economy, Y = C + I In a Three Sector economy, Y = C + I + G In an open economy: In a Four Sector economy, Y = C + I + G + NX Let us now discuss each of the components of GDP in a detailed manner. 2.4.1 Consumption (C) Consumption is expenditure on final goods and services with a view to derive satisfaction. It is the most important function used in macroeconomic theory because all forms of consumption together make up two-thirds of GDP. Consumption depends on number of factors e.g., income wealth, lifestyle, sex etc. but assumption is aggregate amount of real consumer spending is determined exclusively by the real disposable income of consumers. The relationship between consumption and income is described by consumption function. Thus, The consumption function is the assumed direct relationship between the disposable income level and the planned or desired consumption expenditures. Algebraically, the basic relationship between country's consumption spending and disposable income is shown as: C = F(Yd) ……………………consumption function in which, C Stands for the consumption spending, and Y Stands for the disposable income. 23 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) Fig. 2.1: The Consumption function The consumption curve has a positive slope showing that when the income increases consumption also increases. Consumption consists of the goods and services brought by households. It is divided into three subcategories: (1) Durable goods: Goods that last a long time, such as T.V. and cars etc. (2) Non- durable goods: Goods that last only a short time, such as food and clothing. (3) Service: In includes the work done or services rendered for consumers by individuals, and firms such as consultation, doctor visits, hair cuts etc. 2.4.2 Investment (I) Investment consists of goods bought for future use. In other words, it is expenditure on goods not for current consumption. Sometimes confusion arises because what looks like investment for an individual may not be investment for the economy as a whole. For an economy investment is something which adds or creates new capital. In other words, investment means additions to the physical stock of capital. Economy's investment does not include purchases that merely reallocate existing assets among different individuals. Let’s consider an example. Suppose we observe two events: Mack buys for himself a 100-year-old factory. Jones builds for himself a brand-new factory. What is total investment here? Two factories, one factory or zero? A macro economist seeing two transactions counts only the Jones' factory as investment. Mack's transaction has not created new housing for the economy: it has merely reallocated existing housing. Mack's purchase is investment for Mack, but it is disinvestment for the 24 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics person selling the factory. By contrast, Jones has added new factory to the economy, his new factory is counted as investment. Investment is divided into three subcategories: (1) Business fixed investment: It is the purchase of new plant and equipment by firms. (2) Residential fixed investment: It is the purchase of new housing by households and landlords. (3) Inventory Investment: It is the increase in firms' inventories of goods. The investment is inventory can be positive or negative depending on the fact whether investments rise or are depleted. Investment (I) depends on the rate of interest (r) Investment function is I = f(r) Investment is the cost of borrowing and so when interest rate increases, cost of borrowing (funds) increases. Thus, investment curve has a negative slope. 2.4.3 Government Purchases (G) By Government Purchases we refer to the Government spending on goods and services as purchase of goods and services by federal, state and local governments. This category includes such items as military equipment, highways, and the services that government workers provide. In addition, the Government makes transfer payments, payments that are made to people without their providing a current service in exchange. Typical transfer payments are social security benefits and unemployment benefits. Transfer payments are not counted as part of GDP, because transfer payment reallocates existing income and are not made in exchange for some of the economy's output of goods and services; they are not part of current production. Govt. purchases = Government Expenditure – Transfer payments 25 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) 2.4.4 Net Exports (NX) The final component of GDP is net exports. It takes into account trade with other countries. Net export is the difference between the value of goods and services exported by Domestic County to other countries and the value of goods & services that other countries provide to the domestic economy. In other words, Net exports represent the net expenditure from abroad on our goods and services which providers income for domestic produces. NX = Value of goods and services exported (EX) Minus = Value of goods and services imported (IM) NX = EX-IM The difference between exports and imports, called net exports, is a component of total demand for our goods. The GDP is expressed as the sum of expenditure on domestically produced final goods and services. The four types of expenditure that are included in GDP and the economic group who makes those expenditures and some examples of each type of expenditure are summarized in the following table: Type of Expenditure Economic group that Examples makes the expenditure Consumption Individuals, households Food, clothing, shelter Investment Business firms New plant and machinery equipment, new houses, increase in inventory. Government purchases Central, state and local New defence equipment, governments. salaries of government officials, new government schools etc. Net Exports Foreign Sector Export of manufactured items, services provided to foreigners by domestic residents. 26 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics In Short, Expenditure Method – It is useful in the calculation of National Income in secondary sector or Manufacturing sector in which raw material is converted into finished goods. GDP = C + I + G + NX (X-M) Private Final consumption expenditure + Govt. Final consumption expenditure + Gross Domestic Capital Formation – i) Gross Domestic fixed Capital formation ii) Change in Stock (Closing – opening stock) + Net Exports (Exports – Imports) NNPFC or National Income = GDPMP – Dep. – NIT + NFIA Income Method: This method can be used in Testing sector or service sector in which banking, insurance, Transportation, communication is included in it. In this method we will take factors Income in form of Rent, Interest, wages and Profit which factors of production receive by rendering their services in the production of goods and services. Classification of factors income into three main broad categories 1. Compensation of employees 2. Operating Surplus 3. Mixed Income (i) Compensation of Employees: It is the reward of labour by rendering their services in the form of cash or in kind. It includes wages and salaries in cash or in kind and employer’s contribution in social security schemes like Bonus, PPF etc. 27 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) (ii) Operating Surplus: It is the summation of income from property including Rent and Interest and Income from entrepreneurship includes profit. If we add all income like Rent, Interest and Profit then we can get operating surplus. Profit is also divided into three categories – Dividend, Undistributed Profit and Corporate Tax. (iii) Mixed Income: It is the sum of all factors of income like Income from work, Income from Property and Income from entrepreneurship. When we can't classify the factors income into some specific category that type of income is called mixed income of self- employed person. NDPFC or Domestic Income = Compensation of employees + Operating Surplus + Mixed Income National Income = NDPFC + NFIA (Net factor income from abroad) NFIA is the difference b/w income received from abroad and income paid to the abroad Product Method  This method is useful to calculate N.Y in primary sector in which Agriculture and its allied activities are included in it. GDP or GVA = Value of output - Intermediate Consumption NNP FC or National Income = GDP - Dep - NIT + NFIA Identity of National Income Accounting Total output = Total Income = Total expenditure 2.5 INCOME EXPENDITURE AND THE CIRCULAR FLOW As macroeconomics is the study of the economy as a whole. An economy can be defined as an integrated system of production, exchange and consumption. The three economic activities are inter-related. Changes in one lead to changes in the other. In carrying out these economic activities, people are involved in making transactions - they buy and sell goods and services. The transactions take place between different sectors of the economy due to which income and expenditure moves in a circular form called circular flow of income and expenditure. 28 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics Real flow: It is the flow of goods is services from the firm to the households and flow of factor services from the household to the firm. Money flow: It is the flow of money from the household to the firms in the form of Payment for goods and services and from the firm to the households, the flow of factor payments. Note: Both Real flow and money flow go in opposite direction in a circular fashion. In our economy, both commodities and factors of production are constantly being exchanged for money. The money flows hand to hand in much the same way as water flows through pipe or electricity through a circuit. Therefore, the entire economic system can be viewed as circular flows of income and expenditure. The magnitude of these flows, in fact determines the size of national income. The mechanism of Income and Expenditure flows is extremely complex in reality. Therefore, to present this; the economy is divided into four sectors: (1) Households (2) Business firms (3) Government sector (4) Foreign sector 29 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) 2.5.1 The Circular Flow in 2-Sector Model A two-sector model is obviously an unrealistic model consisting of household and business firm which represents a private closed economy but provides a convenient starting point to analyze the circular flow. Features of households: (1) Households are the owners of at factors of production. (2) They are the consumers. (3) Their total income consists of wages, rent, interest and profits. (4) Whole of their income is spent on the consumption expenditure and therefore, savings =0 Features of Business firms: (1) They own no resources of their own. (2) They hire and use the factors of production from households (3) They produce and sell goods and services to the households. (4) There are no corporate savings. Fig. 2.5 The circular flow of Income and Expenditure in a two-sector model 30 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics In the factor market (Upper Hall) (1) Firm purchases the factors of Production (Land, labour capital and entrepreneurship) from the households who own them. This makes real flow shown by a continuous arrow. (2) In return to the services, provided, the households receive income in the form of wages, rent, interest and profits (factors income) - shown by dolled arrow. In reverse direction from firms to households. Therefore, real or factor flow causes another and a reverse money flow. In the product market (Lower half) (1) Firm produces goods and services with use of factors of production (purchased from households) and sell the same to the households. This is shown by continuous inner loop of real flow but in opposite direction from firms to households. (2) The households spent their earned income and make payments to firms for goods and services and create money flow but this too, in opposite direction shown by dotted arrow. Now, when we continue the goods and money flows in factor and product market and look at the flows in continuity we find circularity in flows. The circular flow in a simple economy is thus complete wherein: (i) Firm purchases factors of production from households and then use these factors to produce commodities that are bought by households – circular flow of goods. (ii) Money paid for factor services become income for households, which they spent to purchase goods and services so produced become income of the firms. Money flows around the circuit, passing from firm to household and back again - circular flow of income. 2.5.2 Computation or GDP from the Circular Flow GDP measures the flow of rupees in an economy. Since the circular flow shows ·that the GDP is both the total expenditure on the goods and services and the total income from the production of the goods and services, so to compute GDP we can look at either the flow of rupees from firms to households or the flow of rupees from households to the firms. 31 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) These two alternative ways of computing GDP must be equal because the expenditure of buyers on products is, by the rules of accounting, income to the sellers of those products. In other words, Expenditure by the buyers = Income of the sellers. 2.5.3 The Circular Flow in a Three-Sector Model A three-sector model depicts a more realistic economy. It reflects more accurately how real economies function. It includes government, the central authority, which plays an important role in the economy. In other words, it shows the linkages among the economic factors— households firms and the government—and how rupees flow among them through the various markets in the economy. Features: (1) The economy is a closed economy and does not trade with rest of the world. The economy consists of three sectors: (a) Households (b) Firms (c) The Government (2) Three fiscal variables are included in the circular flow: (a) Direct taxes (b) Government expenditure on goods and services (c) Transfer payments (3) The three markets under study are: (a) The factor markets (b) The product market, and (c) The financial market (4) The Central authority (Government) affects the circular flow both by withdrawing income from it through taxes and by infecting income into it through their spending. 32 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics Fig. 2.5 Circular flow of Income and Expenditure in a three-sector model (showing only money flow) (1) The household receive factor income by supplying factor services to the firms, they use the factor income to consume goods and services, to pay taxes to the government and to save through the financial markets. (2) Firms receive revenue from the sale of goods and services and use it to pay for the factors of productions, and to pay business taxes to the government. (3) Both households and firms borrow in financial markets to buy investment goods, such as houses and factories. (4) The government receives revenue from taxes and uses it to pay for government purchases and transfer payments. (5) In case, the tax revenue of the government is greater than government purchases, the government will have a budget surplus and is termed as public savings. However, if tax revenue is less than government purchases the government will have a budget deficit (and negative public savings). Thus, the circular flow of income and expenditure takes place as long as the leakages = injection. The circular flow binds the various segments and its different units together and keeps the system moving without any interference or regulation. 33 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) Summary The GDP is the country's total income or the total expenditure on its output of goods and services. In the computation of the GDP only the value of the currently produced goods and services is included where the goods are valued at market prices. The real GDP is a better measure of economic well-being than the nominal GDP. GNP is the total value of final goods and services produced in the economy during a year plus net income from abroad. NNP is GNP – (Minus) Depreciation Personal income is total income received by individuals in a year. Personal disposable income amounts to personal income minus direct taxes, fines, fees, etc. paid to the government. All economic transactions in an economy generate two kinds of flows–real flow and money flow. Real flow and money flow moves in circularity but in opposite direction. The magnitude of real flows and money flows determines the size of National Income in an economy. 2.6 SELF-ASSESSMENT QUESTIONS 1. What is the GDP? How can GDP measures two things at once? 2. How is the Gross Domestic Product computed? What is the treatment given to inventories, intermediate goods and housing services in the computation of the GDP? 3. Distinguish between real and nominal GDP? Nominal GDP is a better measure of economic well-being. Do you agree? 4. Write a short note on the following: (a) Gross National Product (GNP) (b) Net National Product (NNP) (c) Disposable Income (DI) (d) GDP Deflator (e) Uses of Private Saving 34 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics (f)Nominal Versus Real interest rate 5. What are the different components of Expenditure? What is the significance of these components in national income accounts? 6. What are the adjustments required to be made to the national income lo arrive all the personal income? Discuss. 7. Explain the circular Now of income in a two-sector economy. 8. Explain are the circular flow of income in a three-sector economy. Self-Check Exercise Compute all the product and income aggregates shown in the chart and also personal and disposable incomes from the four sets of data given below which relate to India’s national incomes for the years 1980-81 to 1983-84. The figures are in crores of rupees. COMPONENTS 1980-81 1981-82 1982-83 1983-84 1. Indirect taxes (net of subsidies) 13905 16914 19175 21357 2. Undistributed profits of the private corporate sector (net of 1188 1034 1039 961 retained earnings of foreign enterprises) 3. Capital consumption 8103 9797 11473 13448 4. Corporate profits tax 1377 1970 2184 2493 5. Net fixed capital formation 17106 19986 23446 27113 6. Change in stocks 6248 6446 5557 6694 7. Property and entrepreneurial income accruing to the 2135 2409 3352 3231 government 8. Net factor income from abroad (ROW) + 298 (-) 7 (-) 681 (-) 991 9. Exports minus imports (-) 4574 (-) 4560 (-) 4138 (-) 4374 10. Savings of non-departmental enterprises 116 1046 1560 1476 11. National debt interest 1490 1873 2675 3696 12. Private consumption 89775 102404 112730 134609 13. Government consumption 13033 15276 18016 20788 14. Statistical discrepancy (-) 2238 (-) 1665 (-) 1948 (-) 4217 15. Other current transfers from the government 2835 3370 4009 4640 16. Labour income from abroad (net) (-) 29 (-) 18 (-) 62 (-) 63 17. Labour income from domestic production 43029 49093 56248 64893 18. Operating surplus from abroad (net) 327 11 (-) 619 (-) 928 19. Operating surplus from domestic production 17336 21558 25083 27668 35 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) 20. Other current transfers from abroad 2257 2221 2527 2774 21. Mixed income of self-employed 45080 50022 53157 66695 22. Direct taxes paid by the households 2500 2881 3129 3367 ANSWERS Name of the Product / Income Aggregate 1980.81 1981.82 1982.83 1983.84 1. Gross National Product at Market 127751 147677 16445 193070 2. Gross Domestic Product at Market Prices 127453 147684 165136 194061 3. Net National Product at Market prices 119648 137880 152982 179622 4. Net Domestic Product at Market Prices 119350 137887 153663 180613 5. Gross National Product at Factor Cost 113846 130763 145280 171713 6. Gross Domestic Product at Factor Cost 113548 130770 145961 172704 7. Net National Product at Factor Cost 105743 120966 133807 158265 8. Net Domestic Product at Factor Cost 105445 120973 134488 159256 9. Gross National Income at Market Prices 127751 147677 164455 19307 10. Gross Domestic Income at Market Prices 127453 147684 165136 194061 11. Net National Income at Market Prices 119648 137880 152982 179622 12. Net Domestic Income at Market Prices 119350 137887 153663 180613 13. Gross National Income at Factor Cost 113846 130763 145280 17173 14. Gross Domestic Income at Factor Cost 113548 130770 145961 172704 15. Net National Income at Factor Cost 105743 120966 133807 158265 16. Net Domestic Income at Factor Cost 105445 120973 134488 159256 17. Personal income 107509 121971 134883 161214 18. Disposable Personal Income 105009 119090 131754 157847 36 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics LESSON-3 NATIONAL PRODUCT/NATIONAL INCOME STRUCTURE 3.1 Introduction 3.2 National Product (NP)/National Income (NI) 3.3 Classification of The Product Aggregates According to Basis of Valuation 3.4 From National Product to National Income 3.5 Different Product/ Income Aggregates and Their Inter-Relationship 3.6 Changes in Prices: Nominal and Real National Income 3.7 Measurement of National Income 3.8 Different Methods of Measurement 3.9 The Income Method 3.10 The Expenditure (or Final Products Method) 3.11 National Income and Economic Welfare 3.12 National Income Estimation on India 3.13 Difficulties in Measurement of National Income in India 3.14 National Capital: Concept and Measurement 3.1 INTRODUCTION NP/NI is a single measure (in monetary terms) of the flow of final goods and services that accrues to the normal residents of a country as the result of their production efforts during a year, (whether carried out at home or abroad), without adversely affecting the initial capital stock of the country. 3.2 NATIONAL PRODUCT (NP)/NATIONAL INCOME (NI) National Product (NP)/National Income (NI) basically is the measure (in monetary terms) of the total amount of goods and services produced by the normal residents of a country during a given period. The diverse types of goods and services which comprise NP /NI cannot be added together into a single meaningful aggregate except by converting them in money values by multiplying various quantities with the respective prices. Here money acts 37 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) merely as the unit of account (i, e, as the measuring rod of value) and not as wealth. The expression of NP NI in monetary terms should not blind us to the quantities of goods and services that the money values represent. Whenever we talk of the NP /NI of a country we always refer to the aggregate of goods and services produced during a given period. For example, when we say that during 1984-85 India's NP /NI was Rs. 1, 97,515 crores, this simply means that goods and services worth so much accrued to India as the result of the production efforts of its residents during that year. This aggregate of Rs. 1,97,515 crores consisted of (a) Rs. 1,45,327 crores worth of consumer goods and services supplied to the households, (b) Rs. 24,062 crores worth of goods and services used by the govt. for providing collective services to the people, (e) Rs. 28,974 crores worth of durable use capital goods and another Rs. 8,016 crores worth of stocks (raw-materials, semi-finished goods, goods in process, etc.) accumulated by business enterprises, households and the government, and (d) goods and services worth Rs. (-) 6,447 crores exported to other countries. Net exports were negative because during the year in question imports exceeded exports by Rs 6,447 crores. Thus, the basic thing to remember about NP INI concept is that it always refers to the quantities of goods and services produced during a given period and money is used merely as the unit of account. 3.1.2 Second, NP /NI Second, NP /NI is a flow Production is a process which generates goods and services over a period. Without time period there cannot be any production nobody speaks of output at a point of time. Being a flow, production can be measured only for different periods of time. The unit of time for the measurement of NP /NI is generally one year. 3.1.3 Third, Np /Ni Third, NP /NI measures goods and services which accrue to a country only as the result of its production efforts and it excludes all goods and services received otherwise. Goods and services can be received by a country as gifts or as aid from other countries or by the use of force as reparation, through piracy, etc. These are not included in the NP /NI measure Marshall aid given to countries during the post-world-war Il period or goods received through U.N. agencies or from other countries are examples of international gifts or aid. It also does not include goods and services produced illegally. NP /NI measures only the goods and services accrued as the result of the production efforts of the normal residents of a country and not the availability of goods and services as such. Production refers to the complex of human activities concerned with the creation, with the aid of scarce human and material resources, of good and services capable of satisfying 38 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics human wants, directly and goods that aid their production, having determinable economic price or cost. This concept of production is known as the comprehensive production concept. This concept underlies the view of NP /NI in capitalist countries. This view has been sanctified by the United Nations and also adopted by India. National income, according to this concept, includes the following first two categories of goods and services and excludes those mentioned under the third category. I. Goods and Services Produced by the Market Economy All goods and services produced for sale by private and public enterprises (small or big) including current services of dwellings are included in NP NI and evaluated at their market prices. II. Goods and Services Produced by the Non-Market Economy A. Foods and other goods produced on the farm for farmer's self-consumption are included in national income and evaluated at their market prices. Rental values of owner-occupied houses and all payments in kind for current services are evaluated on the basis of their market prices. B. Goods and Services supplied free by government and non-profit institutions are included in NP /NI and evaluated on the basis of their cost III. Goods and Services Excluded from NP /NI A. Unpaid services of housewives and other members of the family including self- services (e g; shaving, dressing, driving own car, etc.), other "do-it-yourself hobbies" (eg, gardening, carpentering, painting, singing etc.), neighbourly advice and cooperation and social services of all kinds are excluded from national income B. Current services of consumer durables, properties of the government and non-profit making institutions are excluded from NI. 3.1.4 Four, not all goods and services produced during a year are included in NP/NI measure It includes only the final goods and services produced during a year and excludes all goods and services used up in the production of the former. In other words, NP /NI includes only the goods and services that finally emerge out of the year's production process and excludes all those used up as materials or ingredients of other goods-i.e., intermediate consumption. For example, NP /NI measure includes only the value of bread and not also the materials and services that have gone into the production of the bread. In NP /NI accounting, final goods 39 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) are not to be confused with finished goods. Here the word 'final' only signifies the fact that the goods in question have not been used up in the production of other goods during the year. When a good or service is used up in the production of another good, the value of the former gets incorporated into the latter. The former simply ceases to exist. Therefore, counting the final good as well as the goods (and services) that have been used up as materials in the production of the former as the year's production, would be double counting. For measuring NP /NI the period of accounting is one year. Therefore, the question whether goods are final or intermediate has to be settled with reference to the accounting period. Goods used up in production during the year are intermediate goods and goods not used up in the year's production process are final goods. Whether goods produced during a year are used as final goods or as materials for the production of other goods during subsequent years is not relevant. From the standpoint of the current year if cement produced during the year is not used up in the production of other goods during the same year, it is a final good even if it is used up as an intermediate good in the construction of a bridge during any subsequent year. On the other hand, if cement produced has been used up in the construction of a building during the same year, it is an intermediate good Its value having been incorporated into the building, it will not be included in NP /NI again. Thus, counting the final goods as well as the intermediate goods used up in their production would be double counting. This is the real significance of the distinction between 'final' and 'intermediate goods in national accounting. The goods and services worth Rs. 1,97,515 crores referred to as India's NP /NI during 1984-85 were the goods and services made available to the final users -consumers, government, investors and foreign countries and did not duplicate the values of the goods and services used up in their production during the year. 3.1.5 Five, NP /NI is the aggregate measure of the goods and services produced during the current year only and do not include any element or past production Obviously, old goods (like, old houses, old cars, refrigerators, T. V sets, etc). produced in some past period cannot be counted in current year's production. Doing so would be double counting. Secondly, durable-use capital goods, which aid production for a number of years, are an embodiment of the country's production efforts in the past. As a result of their use in production their productive efficiency diminishes, i e; they depreciate. This depreciation of capital goods in production is also known as capital consumption. The part of capital goods consumed (or used up) in current production represents a claim of past production over current production. The value of the capital goods used up in current 40 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics production gets incorporated into the value of the mat put produced during current period. Thus, a part of the newly produced capital goods has to be viewed as a replacement of those used up in production during the current year. Therefore, to get true or net measure of what a country has actually produced during a year we must deduct capital consumption from the - final product of the year. The final product net of depreciation, known as the net national product (NNP), is the true measure of the final goods and services accrued to the country as the net result or its current production efforts, without adversely affecting the country's initial capital stock. However, the conceptual issues and the difficulties involved in the measurement of capital consumption are insurmountable and allowances actually made for this purpose are generally based on considerations other than economic logic Economists, therefore, prefer to present NP / NI in gross as well as net terms. Final product without deducting capital consumption is known as gross national product (GNP) and final product net of capital consumption is known as net national product (NNP). Thus, we have net and gross versions of NP /NI -NNP and GNP. Rs. 1,97,515 crores were the NNP and Rs. 2,12,914 crores were the GNP of India during 1984-85, the difference between the two figures (Rs. 15,399 crores) being the amount of capital consumption during that year. 3.1.6 Six, National Product is the measure of the result of production by normal resident of a country Six, NP /NI is the measure of the results of the production efforts of the normal residents of a country, whether these production efforts are carried out at home or abroad. In other words, the concept of NP /NI is the measure of production due to national resources, irrespective of where this production takes place on the other hand, there is a territorial concept of production, according to which whatever production takes place within the territorial boundaries of a country, irrespective of who participated in this production and to whom the product belongs, is known as the country's domestic product. What is the relationship between these two concepts of production? Let us first imagine a country which has no economic relations with other countries in the sense that neither it permits foreign productive resources to engage in production on its territory nor does it permit its own resources to participate in the domestic production of other countries. It is evident that whatever production takes place within the territorial boundaries of such a country will be entirely the result of its own productive resources. Therefore, the domestic product (DP) of such a country will also be its national product (NP). However, in today's world, it is difficult to find such a county Normally, productive resources of most countries 41 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) participate in each other's domestic production, though the degree of this participation varies widely among different countries. As a result, a part of the DP of such countries belongs to foreigners as the reward for the factor services rendered by them. On the other hand, such countries may also have similar counterclaims over several other countries. Even in such a case, if the factor incomes payable by a country to the Rest of the World (ROW) exactly equals factor incomes receivable by it from the ROW, its NP will still equal its DP. However, if the factor incomes receivable from and factor incomes payable to ROW are different, as is normal, NP must be different from DP. If a country's factor incomes receivable from the ROW are greater than the factor incomes payable by it to the ROW, its net factor incomes from ROW will be positive and as a result its NP will exceed its DP by the same amount On the other hand, if factor incomes payable by a country to the ROW exceed factor incomes receivable by it from the ROW, the net factor incomes of the country from the ROW will be negative and as a result its NP will fall short of its DP by this amount. Thus; GNP = GDP plus net factor income from ROW (Rest of the World) NNP = NDP plus net factor income from ROW (Rest of the World) Let us note that while the amount of capital consumption accounts for the difference between the gross and net concepts of NP as well as DP, the amount of net factor income from the ROW accounts for the difference between the concepts of National Product and Domestic Product. Thus; NNP = GNP minus Depreciation NDP = GDP minus Depreciation GNP = GDP plus net factor income from ROW NNP = NDP plus net factor income from ROW During 1984-85 India's GDP was Rs. 2,14,385 crores. During the same year Rs. 2,073 crores were payable by India to ROW as factor income (that is Rs. 113 crores as compensation of employees and Rs. 1,960 crores as property and entrepreneurial income), while it claimed only Rs. 602 crores as factor income from ROW. In other words, during 1984-85, India's net factor income from ROW was (-) Rs. 1,471 crores. Consequently. India's GNP (= GDP + net factor income from ROW) was Rs. 2,12,914 crores. (= Rs. 2,14,385 + (-) 1,471 = 2,12,914), while NNP amounted to Rs. 1,97,515 crores (= 1,98,986 + (-) 1,471 = 1,97,515). 42 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  Introductory Macroeconomics Besides labour income, factor incomes earned abroad include (a) profits derived from the operations of branch plants and offices abroad, and from the ownership of foreign subsidiaries, (b) dividends from the ownership of foreign stocks, (c) interest on foreign (government and private) bonds, foreign mortgages and saving accounts, and (d) rents and royalties from foreign properties and rights. Summary 1. NP is basically a measure of goods and services produced and money is used merely as the unit of account to add them together into a meaningful aggregate, 2. It is a measure of goods and services accruing to a country only as the result of production and excludes goods and services received otherwise. 3. It is a measure only of the final goods and services produced and does not duplicate the values of the intermediate goods and services used up in their production. 4. NP, being a measure only of currently produced goods and services, does not include any element of past production either in the form of old goods or in the form of capital consumption Thus, NNP is the real measure of the country's current production. However, because of the conceptual issues and practical difficulties involved in the measurement of capital consumption, economists prefer to present NP in gross as well as net terms. Thus, we have two basic concepts: GNP and NNP. Finally, NP is the measure of goods and services produced by the country's national resources, irrespective of where they work, at home or abroad. NP, therefore, equals DP plus net factor income from ROW. Thus, we have four product aggregates distinguished on the basis of inclusion or exclusion of (1) net factor income from ROW (National and Domestic Products) and (2) Capital consumption (Gross and Net Products). II 3.3 CLASSIFICATION OF THE PRODUCT AGGREGATES ACCORDING TO BASIS OF VALUATION 3.3.1 Market Prices and Factor Cost Valuation Basis Goods and services which constitute any national or domestic product aggregate have necessarily to be valued in terms of market prices in order to add them together into a 43 | P a g e © Department of Distance & Continuing Education, Campus of Open Learning, School of Open Learning, University of Delhi  B.A.(Hons.) Economics / B.A.(Programme) meaningful aggregate. However, market prices of most goods and services include taxes such as sales fax, excise duties of various types, custom duties, property taxes, etc. Such taxes, which are collected from or through sellers and which can be shifted to the buyers through higher prices, are known as indirect taxes. Taxes of this type do not affect the size of incomes directly. They affect incomes only indirectly through their price-increasing effect-by reducing the purchasing power of money. 3.3.2 When taxes are levied on the sale or production of goods, their market prices rise. The tax part of market prices is collected by the government and the rest accrues to the producers as factor incomes. Thus, NP valued at market prices actually paid by the purchasers in higher than what accrues to producers as factor incomes by the amount of indirect tax revenue collected by the government. As a result, we have two alternative valuations of the product aggregates, one in terms of market prices paid by the purchasers (which include indirect taxes) and the second, in terms of factor incomes (i.e., market prices excluding indirect taxes). Any product aggregate NP or DP. valued at market prices, states the value of the product aggregate in question from the viewpoint of the purchasers while the same product aggreg