UNIT-3.pdf

UNIT-3 National Income National income in simplest terms refers to the wealth of a nation. The wealth of an economy is measured by the value of goods and services produced in the economy. It is the total monetary value of goods and services produced in...

UNIT-3 National Income National income in simplest terms refers to the wealth of a nation. The wealth of an economy is measured by the value of goods and services produced in the economy. It is the total monetary value of goods and services produced in a nation within a financial year. It may include payments made to all types of resources in the form of rent, wages, profits, and interests. National income is a concept that comes under the purview of macroeconomics. It helps economists and policymakers in the preparation of budgets and various economic policies. Circular Flow of Income  In a free market, companies produce and sell products to earn revenue. They use the income to pay wages to people who outsource their services to these firms  The households then partially spend their income on food, clothing, entertainment, etc., and use the rest for savings and buying things outside of the economy (imports), also called leakages  To equalize the leakages, some firms do business outside the country (exports), and some borrow money for investment. It is known as an injection, as the money eventually returns to the flow  The money spent on necessities by the citizens returns to the firms, which explains the Circular Flow of Income. Example of Circular Flow of Income A ketchup factory’s factors of production are tomatoes, industrial land, and labourers. As a result, the households enjoy monetary compensation for the rented industrial land, farmers profit from selling tomatoes, and the labourers get wages. Once the final ketchup bottles are in the market, the households purchase the ketchup bottles using wages, rent, or profits. The money goes to the producers, and factory owners, eventually completing the circular flow. Factors Determines National Income of a Country 1 Natural resources: The size of national income is high in those countries where natural resources are the main source of entire production of goods and services in a country. However, the extent of utilization of natural resources depend on the level of technology and investment. When the people are uneducated, illiterate and ignorant, the natural resources remain underutilized, under-utilized or misused. It is due to this reason that National income is very low in several developing countries. Efficiency of labour: National income will be high when the labourers are efficient and meritorious in their work. Hard working and honest labourers in different sectors contribute their skills for the promotion of output. If labourers are physically weak and mentally unsound and if they have no devotion and sincerity in their work, output can’t be increased. Hence the size of National income and efficiency of labour are directly related to one another. Capital stock: National income will be high when a country has more capital stock. National income is The sum of the goods and services produced with the help of the natural resources and capital stock. If the capital available in a country is low, then it is not possible to increase production in different sectors. Natural resources and factors of production remain idle or underutilized due to the low capital stock. Entrepreneurial ability: Entrepreneurial ability is another important factor which determines the size of national income. National income will be high in those countries where the entrepreneurs take risk and bear uncertainty. The entrepreneurs who take initiative and interest in productive affairs will reap profits. Foresightedness, enterprising spirit, dynamism, professional commitment, co-ordination between different factors, team-spirit etc. are some other qualities of an entrepreneur. National income will be high when such entrepreneurs exist in a country. Level of Technology: Besides the above factors, the size of national income is determined by the technological conditions and standards. If modern techniques and sophisticated implements are utilized in production and if the labourers are provided with training, national income remains at a higher level. For this, extensive facilities have to be made for the promotion of technological knowledge, education and training for the labourers. Social and political conditions: The social and political conditions prevailing in a country also influence and determine the size of national income. If people assign priority to economic activities by utilizing leisure properly, they can produce more output. National income can be increased when people save considerable portion of their income. Similarly, national income can also be increased when there exists political stability in a country. Besides the size of national income is also determined by the social and political institutions in a country. Thus, the size of national income is determined by several factors. Concepts of National Income  Gross Domestic Product (GDP) GDP at market price is the money value of all goods and services that are produced within the domain of its borders with the available resources during a year. This includes production within the domestic territories. GDP=P×Q where, P = Price of goods and services Q = Quantity of goods and services 2  There are four components of GDP; they are as follows: o Consumption o Investment o Government expenditure o Net foreign exports of a country Hence, GDP = C + I + G + (X−M) where, C = Consumption I = Investment G = Government expenditure X = Export M = Import  Net National Product (NNP) at MP (Market Price) This is the market price of the net output of final goods and services produced by an economy within a financial year and the net factor income from abroad. NNP = GNP − Depreciation or NNP = C + I + G + (X−M) + NFIA + IT − Depreciation where, C = Consumption I = Investment G = Government expenditure X = Export M = import NFIA = Net factor income from abroad. IT = Indirect Taxes  National Income (NI) This is also sometimes called the National Income at factor cost which means the total income earned by the contribution of factors of production which are land, labour, capital, and entrepreneurship. So, the total income achieved by factors of production in the form of rent, interest, wages, and profit is called National Income. Symbolically or as per the formula NI = NNP + Subsidies – Interest, Taxes or, NI = C + G + I +(X−M) + NFIA Depreciation + Subsidies − Indirect Taxes  Gross National Product (GNP) Gross national product is an estimate of the total value of all the final products and services turned out in a given period by the means of production owned by a country's residents. GNP = GDP + NFIA Where, GDP = C + I + G + (X−M) + NFIA C = Consumption I = Investment G = Government expenditure X = Export M = Import 3  NFIA = Net factor income from abroad.  Per capita income Per capita income refers to the average income earned per person in a given area (such as a country or region) within a specific time frame, typically a year. Per capita income is often used as a measure of the standard of living and economic prosperity of a population. It provides insight into the distribution of income within a society and helps policymakers understand the overall economic well-being of a region's residents. Components of National Income There are five main components of National Income. They are a) Consumption - C b) Gross domestic Investment-I c) Government expenditure - G d) Net foreign investment - (x-m) e) Net income from abroad Consumption It is the total expenditure made households on goods and services. It includes both durable and non- durable goods like food grains, clothing, medical services etc. The level of consumption depends on the level of incomes. Gross domestic Investment It is the expenditure by firms on goods and services which are not for current consumption. it includes expenditure on capital goods like Machinery, roadways, bridges etc. which will help in production of consumer goods in future Government Expenditure It is the expenditure made by the Government on infrastructural facilities for the use of their society. It also includes Government expenditure on services like Police, Military and Judicial Services. Net foreign Investment It is the income earned by a country through International Trade Every country exports certain volume goods produced by it and imports goods which are relatively cheaper in the international marker or other countries 4 The difference between the value of exports and imports (either positive or negative) has to be taken into account to estimate the national income of a country The net foreign investment depends on the export-import policy of the Government and the comparative price level of the goods in domestic and International markets Y=C+1+G+(x-m) Net income from Abroad Some of the nationals of this country working in other countries may be sending remittances to this country's. Likewise, foreigners in one country may be sending their income abroad. Hence net income from abroad represents the difference between receipts and payments of the above type a factor income. Measurement of National Income Income Method The income method of measurement of national income consists of the contribution of factors of production. Rent: Rent is the money one has to pay for use of any land or place where the production facilities are created. Rent does not include payments for machinery and other equipment. Royalties offered for assets are also included in rent. Compensation for labour: Salaries, wages, bonuses, allowances, and medical reimbursements are included in this category. Insurance, pension, and provident funds are also included in compensation for labour. Interest in the capital: This includes an interest in loans taken by organizations. In economics, the interest includes only the part of interest for production units. Profits: After the payment of taxes and dividends, the remaining amount is known as profit. Mixed-Income: It is the income of independent workers and sole proprietorships. So, National Income = Rent + Compensation + Interest + Profit + Mixed income Expenditure Method National Income according to the expenditure method can be represented as National Income = C (household consumption) + G (government expenditure) + I (investment expense) + NX (net exports) Here, Household consumption of goods and services represents Consumption expenditure (C). It also includes the government’s expenditure on various goods and services to fulfil social welfare needs (G). Investment expenditure is the expenditure incurred by companies and production units for raising capital (I). and the net exports (NX) are the total exports minus total imports. Output method In the output method, a country’s national income can be calculated by the addition of the output of all the production firms in the economy. The national income is calculated in terms of final goods and services produced in an economy within a given period of time. The final goods are those which are either available for consumption or a form of investment as a part of national wealth. Estimation of National Income in India Soon after independence in the year 1949 the Government of India appointed a National Income estimates committee comprising of Sri P.C. Mahalnobis, Dr. Gadgil and Dr. V.K.R V.Rao to calculate the National Income of India. At present the Central Statistical Organisation (CSO) been entrusted with the responsibility of preparing National Income estimates 5 In India National Income is calculated in two methods. They are incomes method and output method. The CSO has divided the Indian economy into 13 sectors and grouped them under five heads. They are 1. Primary Sectors: Agriculture, forestry and logging, fishing, mining and Quarrying. 2.Secondary Sectors: Manufacturing units, registered and un registered, construction, electricity, gas and water supplying. 3.Transport Communication and Traders: Railways, Transport by other means, storage, Communications, trade, hotels and restaurants. 4.Finance and Real Estate: Banking dance, real estate, ownership of dwelling and business services. 5. Community and personal services: Defence, public administration and other services. Keynesian Theory of Income and Employment Keynesian is a British Economist according to him the level of employment is directly related to the level of production or output (Y). In a market economy, planned spending on business output will determine the level of production. Businesses adjust their levels of production to accommodate demand for their products. Put simply, “Supply adjusts to demand.” Contrast this statement with Say’s Law, which said, “Supply creates its own demand.” Since employment depends on production and production responds to spending, the level of employment in a market economy depends on the level of planned spending in the economy. Simple Keynesian Model of Income Determination According to Keynes, there can be different sources of national income, such as government, foreign trade, individuals, businesses and trusts. For determining national income, Keynes had divided the different sources of income into four sectors namely’ household sector, business sector, government sector, and foreign sector. He prepared three models for the determination of national income, which are shown in Figure The two-sector model of economy involves households and businesses only, while three sector model represents household’s businesses, and government. On the other hand, the four -sector model contains households, businesses, government, and foreign sector. The Keynesian Theory of Determination of National Income in Two-Sector Economy The Keynesian theory of national income determination focuses on the role of aggregate demand in determining the level of national income in an economy. According to this theory, the level of national income is determined by the level of aggregate demand, which is composed of consumption, investment, government spending, and net exports. In a two-sector model, aggregate demand is composed of consumption and investment. The two-sector model assumes that the economy is composed of two sectors: the household sector and the business sector. The household sector consists of individuals who consume goods and services, while the business sector consists of firms that produce goods and services. In this model, the level of national income is determined by the level of aggregate demand, which is composed of consumption and investment. Consumption is the expenditure by households on goods 6 and services, while investment is the expenditure by businesses on capital goods such as machinery and equipment. According to Keynesian theory, the level of consumption is determined by disposable income. Disposable income is the income that households have left over after paying taxes and other mandatory expenses. The relationship between consumption and disposable income is called the consumption function, which can be expressed as: C = A+ BYD Where C is consumption, A is autonomous consumption, B is the marginal propensity to consume (MPC), YD is disposable income. The MPC is the proportion of additional income that is spent on consumption. For example, if the MPC is 0.8, then 80% of additional income is spent on consumption, and 20% is saved. The level of investment is determined by the expected rate of return on capital. The expected rate of return is the return that businesses expect to earn on their investments, taking into account the cost of borrowing and the expected future income. The equilibrium level of national income is determined by the point at which aggregate demand equals aggregate supply. Aggregate supply is the total amount of goods and services produced in the economy, which is assumed to be fixed in the short run. The equilibrium level of national income can be expressed as: Y = C +I Where Y is national income, C is consumption, and I is investment. In the two-sector model, the equilibrium level of national income can be determined graphically by plotting the consumption function and the investment function on the same graph. The intersection of the two functions represents the equilibrium level of national income. The Keynesian theory of national income determination has important policy implications. According to this theory, the government can stimulate economic growth by increasing government spending or by cutting taxes, which increases disposable income and consumption. Similarly, the government can use monetary policy to lower interest rates, which increases investment and stimulates economic growth. Aggregate Supply: AS can be defined as total value of goods and services produced and supplied at a particular point of time. It comprises consumer goods as well as producer goods. When goods and services produced at a particular point of time is multiplied by the respective prices of goods and services, it provides the total value of the national output. The national output is the aggregate supply in the form of money value. The Keynesian AS curve is drawn based on an assumption that total income is equal to total expenditure. In other words, the total income earned is fully spent on different types of goods and services. The correlation between income and expenditure is represented by an angle of 45°, as shown in Figure 7 According to Keynes theory of national income determination, the aggregate income is always equal to consumption and savings. The formula used for aggregate income determination: Aggregate Income = Consumption(C) + Saving (S) Therefore, the AS schedule is usually called C + S schedule. The AS curve is also named as Aggregate Expenditure (AE) curve. Aggregate Demand: AD refers to the effective demand that is equal to the actual expenditure. Aggregate effective demand refers to the aggregate expenditure of an economy in a specific time frame. AD involves two concepts, namely, AD for consumer goods or consumption (C) and aggregate demand for capital goods or investment (I). Therefore, the AD can be represented by the following formula: AD = C + I Therefore, AD schedule is also termed as C+I schedule. According to Keynes theory of national income determination in short-run investment (I) remains constant throughout the AD schedule, while consumption (C) keeps on changing. Therefore, consumption (C) acts as the major determinant or function of income (Y). Graphical representation of national income determination in the two-sector economy 8 While drawing AS schedule it is assumed that the total income and total expenditure are equal. Therefore, the numerical value of AS schedule is one. AD schedule is prepared by adding the schedule of C and I. The aggregate demand and aggregate supply intersect each other at point E, which is termed as equilibrium point. The Keynesian Theory of Determination of National Income in Three Sector Model The Keynesian theory of national income determination can also be extended to a three-sector model, which includes the government sector in addition to the household and business sectors. In this model, the level of national income is determined by the level of aggregate demand, which is composed consumption, investment, government spending, and net exports. The three-sector model assumes that the government sector plays an important role in the economy by providing public goods and services, redistributing income, and stabilizing the economy through fiscal policy. Government spending can be divided into two categories: current spending, which is spent on goods and services that are consumed within the current period, and capital spending, which is spent on goods and services that provide a long-term benefit to the economy. In the three-sector model, the level of national income is determined by the level of aggregate demand, which is composed of consumption, investment, government spending, and net exports. Consumption and investment are determined by the same factors as in the two-sector model: disposable income and the expected rate of return on capital. Government spending is determined by the government's fiscal policy, which is influenced by its objectives and constraints. The government can increase government spending to stimulate economic growth, reduce unemployment, or address social problems such as poverty and inequality. The government can also reduce government spending to balance the budget, reduce inflation, or address other economic problems. Net exports are the difference between exports and imports. Exports are the goods and services produced in the domestic economy and sold to other countries, while imports are the goods and services produced in other countries and sold in the domestic economy. Net exports can be positive or negative depending on the balance of trade. In the three-sector model, the equilibrium level of national income is determined by the point at which aggregate demand equals aggregate supply. Aggregate supply is the total amount of goods and services produced in the economy, which is assumed to be fixed in the short run. The equilibrium level of national income can be expressed as: Y=C+I+G + NX Where Y is national income, C is consumption, I is investment, G is government spending, and NX is net exports. The equilibrium level of national income can be determined graphically by plotting the aggregate demand curve and the aggregate supply curve on the same graph. The intersection of the two curves represents the equilibrium level of national income. The Keynesian theory of national income determination in the three-sector model has important policy implications. According to this theory, the government can stimulate economic growth by increasing government spending, which increases aggregate demand and national income. The government can also use fiscal policy to stabilize the economy by adjusting government spending and taxation in response to changes in the business cycle. 9 Overall, the Keynesian theory of national income determination in the three-sector model provides a framework for understanding the role of aggregate demand in determining the level of national income in an economy. In this model, the level of national income is determined by the level of consumption, investment, government spending, and net exports, which are in turn influenced by factors such as disposable income, the expected rate of return on capital, and government fiscal policy. The Keynesian Theory of Determination of National Income in Four Sector Model The Keynesian theory of national income determination can also be extended to a four-sector model, which includes the international sector in addition to the household, business, and government sectors. In this model, the level of national income is determined by the level of aggregate demand, which is composed of consumption, investment, government spending, net exports, and foreign investment. The four-sector model assumes that the international sector plays an important role in the economy by providing a source of foreign demand for domestic goods and services and by offering opportunities for foreign investment in domestic assets. Foreign investment can take the form of direct investment in businesses or financial investment in stocks, bonds, or other assets. In the four-sector model, the level of national income is determined by the level of aggregate demand, which is composed of consumption, investment, government spending, net exports, and foreign investment. Consumption, investment, government spending, and net exports are determined by the same factors as in the three-sector model: disposable income, expected rate of return on capital, government fiscal policy, and balance of trade. Foreign investment is determined by the expected rate of return on domestic assets and the availability of foreign funds. When the expected rate of return on domestic assets is high and foreign funds are abundant, foreign investment in domestic assets increases, increases national income. Which increases national income. In the four-sector model, the equilibrium level of national income is determined by the point at which aggregate demand equals aggregate supply, which is the total amount of goods and services produced in the economy. The equilibrium level of national income can be expressed as: Y=C+I+G + NX + FI Where Y is national income, C is consumption, I is investment, G is government spending, NX is net exports, and FI is foreign investment. The equilibrium level of national income can be determined graphically by plotting the aggregate demand curve and the aggregate supply curve on the same graph. The intersection of the two curves represents the equilibrium level of national income. The Keynesian theory of national income determination in the four-sector model has important policy implications. According to this theory, the government can stimulate economic growth by increasing government spending or reducing taxes, which increases disposable income and consumption, and hence, aggregate demand and national income. The government can also use fiscal policy to stabilize the economy by adjusting government spending and taxation in response to changes in the business cycle. Foreign investment also plays an important role in the four-sector model. When foreign funds are abundant and the expected rate of return on domestic assets is high, foreign investment can stimulate 10 economic growth and increase national income. However, excessive foreign investment can also lead to problems such as currency instability and loss of control over domestic assets. Keynesian Multiplier The Keynesian Multiplier is an economic theory that asserts that an increase in private consumption expenditure, investment expenditure, or net government spending (gross government spending – government tax revenue) raises the total Gross Domestic Product (GDP) by more than the amount of the increase. Therefore, if private consumption expenditure increases by 10 units, the total GDP will increase by more than 10 units. The concept of the change in aggregate demand was used to develop the Keynesian multiplier. It says that the output in the economy is a multiple of the increase or decrease in spending. If the fiscal multiplier is greater than 1, increase in spending will increase the total output by a value greater than 1. The increase from AD1 to AD2 leads to an increase in output from Y1 to Y2. But with a multiplier, there is a rise to AD and a further increase in output at Y3. Calculating the Keynesian Multiplier The value of the multiplier depends on the marginal propensity to consume and the marginal propensity to save. 1. Marginal Propensity to Save The change in total savings as a result of a change in total income is known as the marginal propensity to save. When an individual’s income increases, the marginal propensity to save (MPS) measures the proportion of income the person saves rather than spend on goods and services. It is calculated as MPS = ΔS / ΔY. Suppose an individual receives a year-end bonus of 600 and spends 300 on goods and services. The MPS is (600 – 300) / 600 = 0.5. 2. Marginal Propensity to Consume The change in total consumption as a result of a change in total income is known as the marginal propensity to consume. The marginal propensity to consume (MPC) measures how consumer spending changes with a change in income. Using the figures above, the MPC is ΔC / ΔY = 300/600 = 0.5. The Keynesian Theory states that an increase in production leads to an increase in the level of income and therefore, an increase in spending. The value of MPC allows us to calculate the size of the multiplier using the formula: 1 / (1 – MPC) = 1 / (1 – 0.5) = 2 It means that every 1 of new income will generate 2 of extra income. 11 Consumption Function The functional relationship between consumption and national income is known as Consumption Function. It was introduced by John Maynard Keynes and represents the willingness of households to purchase goods and services at a given income level during a given period of time. It is represented as C = f(Y); where C = Consumption, Y = National Income and f = Functional Relationship. The consumption function is a psychological concept that shows consumption levels at different income levels in an economy. Besides, it is influenced by subjective factors like consumer habits, preferences, etc. Consumption Function is based on the Psychological Law of Consumption introduced by Keynes. The Psychological Law of Consumption states three main things:  Even at zero income level, there is minimum consumption, i.e., autonomous consumption which is required for the survival needs of people.  Consumption increases with the increase in income.  The rate at which income increases is more than the rate of increase in consumption. Let’s understand the concept of Consumption Function with the help of the following consumption schedule and consumption curve. 12 In the above graph, X-axis represents National Income, and Y-axis represents Consumption Expenditure. Observation: 1. Starting Point: The consumption curve (CC) starts from point C and not from point O, which means that even at a zero level of national income, there is autonomous consumption (\bar{c}) of OC. 2. Slope of Consumption Curve: The slope of the consumption curve CC is positive, which means that with an increase in income, consumption also increases. However, the rate at which consumption increases is less than the rate of increase in income because the consumer saves a part of his income and spends the rest. 3. Income is less than Consumption: As seen in the above table and graph, income is less than consumption at income levels less than ₹200 Crores and OM, respectively. This gap between consumption and income level is covered by dissavings. Dissavings is the previous savings of the consumer. In the above graph, dissavings is the shaded area \Delta{COE}. 4. Break-even Point; i.e., C = Y: Break-even point is the point at which consumption is equal to income. In the above graph, the break-even point is achieved at point E with OM income level; i.e., at the income of ₹200 Crores. Also, at the break-even point, savings is zero. 5. Income is more than Consumption: As seen in the above table and graph, income is more than consumption at income levels more than ₹200 Crores and the points to the right of Point E, respectively. This excess income results in savings. It means that the gap after point E between the 45° line and the CC line represents positive savings. Note: The 45° line is drawn to indicate whether the consumption is less than, equal to, or more than the income level. Investment Function A strategy or concept of economics that helps in identifying the connection between shifts in the investment patterns of people and other variable factors affecting investment in an economy is known as Investment Function. The expenditure incurred to create new capital assets is known as Investment. These capital assets include buildings, machinery, raw material, equipment, etc. The expenditure on these assets results in an increase in the economy’s productive capacity. The investment expenditure can be classified under the heads:  Induced Investment  Autonomous Investment Induced Investment The investment which depends upon the profit expectations and has a direct influence of income level on it is known as Induced Investment. Induced Investment is income elastic. It means that the induced investment increases when income increases and vice-versa. 13 The above graph shows that the induced investment curve II has an upward slope from left to right. It indicates that as the income increases from OY to OY1, the investment also increases from OM to OM1. Autonomous Investment The investment on which the change in income level does not have any effect and is induced only by profit motive is known as Autonomous Investment. Autonomous Investment is income inelastic. It means that if there is a change in income (increase/decrease), the autonomous investment will remain the same. In general, autonomous investments are made by the Government in infrastructural activities. However, a country’s level of autonomous investment depends upon its social, economic, and political conditions. Therefore, the investment can change when there is a change in technology, or there is a discovery of new resources, etc. The above graph shows that the amount of investment remains the same, i.e., OI, no matter whether the income level in the economy is OY or OY1. Determinants of Investment As per Keynes, the decision to invest in a new project or private investment depends upon two factors; i.e., Marginal Efficiency of Investment and Rate of Interest. 1. Marginal Efficiency of Investment (MEI): MEI is the expected rate of return from an additional investment. The following two factors are required to determine MEI: Supply Price: It is the production cost of a new asset of that kind. Simply put, the supply price is the price at which one can supply or replace the new capital asset. For example, if old equipment is replaced by equipment of ₹20,000, then ₹20,000 is the supply price. Prospective Yield: It is the net return or net of all costs, which is expected from the capital asset over its lifetime. For example, if the equipment of ₹20,000 in the previous example is expected to yield receipts of ₹2,500 and the running expenses will be ₹500, then the prospective yield will be ₹2,500 – ₹500 = ₹2,000. The Marginal Efficiency of Investment (MEI) of the given equipment will be: 2,000/20,000X100=10% 2. Rate of Interest (ROI): It is the cost of borrowing money for financing investment. There is an inverse relationship between ROI and the volume of investment. If the Rate of Interest is high, then the investment spending will be less and if the Rate of Interest is low, then the investment spending will be more. 14 Comparison between MEI and ROI To know about the profitability of an investment, a comparison between MEI and ROI is done. If the Marginal Efficiency of Investment is more than the Rate of Interest, then the investment is profitable, and if the Marginal Efficiency of Investment is less than the Rate of Interest, then the investment is not profitable. For example, if a businessman has to pay 10% rate of interest on the loan and the MEI or expected rate of profit is 15%, then the businessman will surely invest and will continue to make the investment till the Marginal Efficiency of Investment becomes equal to Rate of Interest. Keynesian Multiplier The Keynesian Multiplier is an economic theory that asserts that an increase in private consumption expenditure, investment expenditure, or net government spending (gross government spending – government tax revenue) raises the total Gross Domestic Product (GDP) by more than the amount of the increase. Therefore, if private consumption expenditure increases by 10 units, the total GDP will increase by more than 10 units. Calculating the Keynesian Multiplier The value of the multiplier depends on the marginal propensity to consume and the marginal propensity to save. Marginal Propensity to Save The change in total savings as a result of a change in total income is known as the marginal propensity to save. When an individual’s income increases, the marginal propensity to save (MPS) measures the proportion of income the person saves rather than spend on goods and services. It is calculated as MPS = ΔS / ΔY. Suppose an individual receives a year-end bonus of 600 and spends 300 on goods and services. The MPS is (600 – 300) / 600 = 0.5. Marginal Propensity to Consume The change in total consumption as a result of a change in total income is known as the marginal propensity to consume. The marginal propensity to consume (MPC) measures how consumer spending changes with a change in income. Using the figures above, the MPC is ΔC / ΔY = 300/600 = 0.5. The Keynesian Theory states that an increase in production leads to an increase in the level of income and therefore, an increase in spending. The value of MPC allows us to calculate the size of the multiplier using the formula: 1 / (1 – MPC) = 1 / (1 – 0.5) = 2 It means that every 1 of new income will generate 2 of extra income. 4 Major Sectors of an Economy For the macroeconomic analysis, the four aggregate macroeconomic sectors that form the basic foundation are household, business, government, and foreign which account for four gross domestic product expenditures. On the macroeconomic stage, these four sectors are the major ‘actors’. Household Sector 15 It plays a huge role in the Economic Development of any Country. The following are brief descriptions of some of the performances: Work as a producer: In India, there are numerous families that own multiple small production businesses. These families are self-employed or generate a variety of goods and services. They create businesses that are essentially semi-corporate in character. Act like a consumer: Households are the end customers of the companies’ goods and services. They generate demand in the market based on their interests and inclinations. Firms created and provided commodities in response to market demand. As a result, households decide on a country’s production line. Pay taxes to Government: Households are the primary source of tax income for the government. They are the primary taxpaying entity. A household pays direct taxes to the state in the form of income tax, wealth tax, estate duty, gift tax, and so on. Similarly, a household pays the government numerous indirect taxes such as sales tax, customs duty, VAT, and so on. All of these tax monies are collected for the economy’s welfare and growth. Work as a professional: Households provide all sorts of professional services, such as doctors, teachers, lawyers, and engineers. Their efforts are critical to the country’s continued economic prosperity. People’s living standards are raised as a result of these professional services. Act as a saver: Any money left over after consumption is set aside for savings. As a result, families receive money after providing a variety of services to the economy. After consumption, the remaining amount of their income is stored in banks or financial organizations. These savings are regarded as one of India’s primary sources of capital generation. Production sector The production sector is responsible for the creation of products and services. This sector pays for household factoring services, government taxes, and material imports. The stages that raw materials go through to become a finished product are referred to as the manufacturing process. The product design and materials specifications from which the product is manufactured are the first steps in the manufacturing process. These materials are subsequently transformed into the needed part through manufacturing procedures. The production sector is responsible for 22% of GDP and employs 22% of the overall workforce. According to the data of the World Bank, in 2015, India gained the sixth position in the Industrial manufacturing GDP output which value was $559 billion US dollars and the 9th largest in inflation- adjusted constant Which value was $197.1 billion US dollars. Government Sector 16 The government sector is a segment of the economy that includes both government services and government-owned businesses. It is a welfare agency that is responsible for preserving law and order, defence, and other public welfare services. Governmental services such as the military, law enforcement, infrastructure, public transit, and public education, as well as health care and individuals who work for the government, such as elected politicians, are all included in the government sector. The government sector may offer services that a non-payer cannot be denied (such as street lighting), services that benefit society as a whole rather than simply the person who utilizes them. Public businesses, often known as state-owned firms, are self- financing commercial companies controlled by the government that sells a variety of private goods and services. They usually work on a for-profit basis. The External Sector All international economic interactions between inhabitants of the country (private and public sector) and the rest of the world are referred to as the external sector of a country’s economy. Export, import, international investment, external debt, current account, capital account, and balance of payment are all examples of economic operations that take place in foreign exchange. Few components of external sectors are discussed below: Foreign investment Foreign direct investment and portfolio investment are the two types of foreign investment. Until 1999- 2000, the majority of foreign direct investment (FDI) into and out of India was in the form of equity capital. Since 2000-01, the definition of FDI has been broadened to include, in addition to equity capital, reinvested earnings (retained earnings of FDI businesses), and ‘other direct capital,’ in line with worldwide best practices (intercorporate debt transactions between related entities). In addition to equity of incorporated organizations, data on equity capital includes equity of unincorporated businesses (mostly foreign bank branches in India and Indian bank branches operating overseas). Portfolio investment FIIs, raise money through GDRs/ADRs by Indian firms, and funds raised through offshore funds make up the majority of portfolio investments. Since 2000-01, data on foreign investment has been divided into equity capital and portfolio investment. Exchange rate The exchange rate is also one of the parts of the external sector. It is the rate at which one currency of a country will be exchanged with the currency of another country. The exchange rates are of two types. The first one is the fixed exchange rates, which are set by a country’s central bank, whereas the second one is floating exchange rates, which are determined by market demand and supply. Taxes Taxes are termed as an obligatory contribution made by individuals or corporations falling under the tax slab, to the Government of India. From local to national, taxes are applicable on all levels in India and are considered to be one of the major sources of income for the Government. Types of Taxes 17 There are two types of taxes namely, direct taxes and indirect taxes. The implementation of both taxes differs. You pay some of them directly, like the income tax, corporate tax, wealth tax, etc., while you pay some of the taxes indirectly, like sales tax, service tax, value added tax, etc. Direct Tax Direct tax can be defined as a type of tax in which the incidence and impact of the tax are levied on the same person. It can be further explained as a type of tax in which the liability of paying the tax cannot be shifted to someone else. It is directly paid to the government by the assesse and not to anyone else. Direct Taxes are charged on every source of income earned by any individual or business residing in the country. Types of Direct Tax Income Tax: Income Tax is a direct tax that is levied on any individual’s or entity’s income. It is directly paid to the government like all the other direct taxes. Any individual whose gross total income is over Rs.2,50,000 in a financial year should compulsorily file Income Tax Return (ITR). For senior citizens, the limit is Rs.3,00,000 and for super senior citizens, it is Rs.5,00,000. Wealth Tax: The tax levied on the net wealth of super-rich individuals, companies, and Hindu Undivided Families is called Wealth Tax. It was introduced in the late 1950s, with the aim to reduce the inequality of wealth in the country. Wealth Tax was levied on all individuals and Hindu Undivided Families having net wealth above Rs. 30 Lakh. However, it was abolished in the budget 2015 by the government. Instead of Wealth Tax, the government increased the surcharge levied on the ‘super rich’ class by 2% to 12%. Any individual having an income of more than Rs. 1 Crore or higher and any company earning Rs. 10 Crore or higher are considered under the category of ‘super rich’. The market value of all the assets owned by the individual or any firm is considered to calculate wealth tax irrespective of whether they yield any returns or not. Estate Tax: The tax levied on the right to transfer the property owned by a deceased person on the day of death is called Estate Tax. It takes into consideration all the things that one possesses at the time of death. The properties that are included in calculating estate tax are cash and securities, real estate, insurance, trusts, annuities, business interests, and other assets. Corporate Tax: According to Income Tax Act, Corporations have to pay tax on the income earned by them. A corporation can be defined as an artificial person created under the jurisdiction of law having a distinct legal personality and its own signature referred to as the common seal. All companies either domestic or international are liable to pay tax on the income earned. Domestic companies have to pay corporate tax on their universal income and international companies working in India have to pay tax only on the income earned within India. Corporate Tax includes the following taxes: Securities Transactions Tax (STT) Any income earned through security transactions is taxable, and Securities Transactions Tax (STT) must be paid on it. 18 Dividend Distribution Tax (DDT) DDT is levied on any domestic company who have declared, distributed, or paid any amount as dividends to shareholders. Foreign companies are exempted from this. Fringe Benefits Tax: It is levied on companies that provide fringe benefits for maids, drivers, etc. Minimum Alternate Tax (MAT): MAT is levied on companies having zero tax liability and whose accounts are prepared according to the Companies Act. Capital Gain Tax: Profit earned from the sale of capital assets is known as Capital Gain. Property, Plant and Equipment are all examples of capital assets. Gain on the sale of capital assets is categorised as an income, so they are liable for taxation. Capital Gain tax is levied on the capital gain. It is levied when such an asset is transferred from one owner to another. Types of Capital Gain Tax: Short-term Capital Gain Tax: Short-term assets can be defined as an asset that is held for less than 36 months. For immovable properties, the duration is 24 months. Short-term capital gain tax is charged on profit generated from the sale of those short-term capital assets. The short-term capital gain is taxed at 20%. Long-term Capital Gain Tax: Long-term assets can be defined as an asset that is held for over 36 months. Long-term capital gain tax is charged on profit generated from the sale of those long-term capital assets. The long-term capital gain is taxed at 10%. Indirect Tax The tax imposed by the government on goods and services purchased by anyone in the country is called Indirect Tax. Generally, Indirect Tax is levied on sellers (Manufacturers, retailers, etc.) on the purchase of raw materials or goods purchased for resale and then they pass it onto the end consumer of the product who has purchased it for final consumption. Types of Indirect Tax Service Tax: This tax was levied by any entity specifically on any service provided by them. All the services offered by any company if taxable in nature were considered under this. Excise Duty: 19 It was a form of Indirect Tax levied on the production, sale, or license of certain products. It was replaced by GST in July 2017. Currently, only specific items like petrol & diesel, etc., are charged with excise duty. Value-Added Tax: All the movable products that are directly sold to customers was taken into consideration under Value- added Tax. VAT was collected by the respective state government in the scenario of intra-state sales. Currently, only specific items, like petrol & diesel, etc., are charged with VAT. Custom Duty: Any goods imported to India from foreign countries was charged with Custom Duty by the Government of India. It depends on the value and type of goods imported. Stamp Duty: Stamp Duty was levied on the transfer of any immovable property in a state of India. It included all the legal documents also. Entertainment Tax: Any product or transaction related to entertainment, i.e., purchase of any video games, movie shows, sports activities, arcades, amusement parks, etc., were subjected to be charged with Entertainment Tax by the State government of any state of India. Goods and Services Tax (GST) The Goods and Services Tax or GST is a single, indirect tax that integrates all indirect taxes within the Indian economy. The GST Act was passed on 29th March 2017 in the Parliament of India and came into effect on 1st July 2017. The idea behind it was to replace multiple layers of taxation with one tax (GST). It has replaced 17 indirect taxes (9 State-level taxes and 8 Central level taxes) and 23 cesses of the States and Centres that existed earlier, including Central excise duty, Service tax, Value Added Tax (VAT), Luxury Tax, etc. The aim behind implementing the GST Act was ‘One Nation and One Tax’. When GST was implemented, 1300 goods and 500 services were taken into consideration. The three types of taxes under GST are: Central Goods and Services Tax (CGST): GST levied by the Centre on the Intra-State supply of goods or services. State Goods and Services Tax (SGST): GST levied by the State (including Union Territories with legislatures) on the Intra-State supply of goods or services by the State. Integrated Goods and Services Tax (IGST): GST collected by the Centre and levied on the Intra-State supply of goods or services. In other terms, IGST is the total of CGST and SGST. 20 Difference between Direct Tax and Indirect Tax Basis Direct Tax Indirect Tax These are those taxes whose These are those taxes that are final burden falls on the paid to the government by Meaning person who makes the one person, but their burden payment to the government. is borne by another person. When the incidence and When the incidence and Incidence and Impact of impact of the tax lie on the impact of the tax lie on a Tax same person, it is called different person, it is called direct tax. an indirect tax. The impact of direct taxation The impact of indirect Shift of Taxation cannot be shifted. taxation can be shifted. These are generally These are generally Nature progressive in nature. regressive in nature. These taxes have a direct and These taxes do not affect the Effect on the market price positive effect on the market market price of the product. price of the product. Income Tax, Wealth Tax, Goods and Services Tax Example Corporation Tax, etc. (GST). Subsidies Subsidies are classified as revenue expenditures since they do not diminish the government’s obligation or increase its assets. Subsidies are a sort of government intervention in which the government compensates suppliers for lowering their manufacturing costs. The government encourages producers to increase the output of a good or service by providing subsidies. Types of subsidies Agriculture: The government has taken several steps to increase investment in the agriculture sector, including increasing institutional credit to farmers, promoting scientific warehousing infrastructure to extend the shelf life of agricultural produce, establishing an Agri-tech Infrastructure Fund to make farming more competitive and profitable, and developing commercial organic farming, among other things. The government is pursuing different plans to provide farmers in the country with subsidized farm inputs such as seeds, fertilizers, agricultural machinery and equipment, irrigation infrastructure, institutional finance, and so on. As farming provides an opportunity for people in underdeveloped countries to escape poverty. Education: 21 Education is a critical component of any country’s economic development. Since our independence, India has always placed a high priority on raising our country’s literacy rate. Even now, the government of India operates a number of programs to promote primary and secondary education. More funding also ensures that pupils attend schools with improved facilities and a wider range of curriculum alternatives. Education spending is seen as a human capital investment because it aids in skill-building and hence increases the ability to work and create more as it improves productivity. Health: People can avoid diseases and live longer if they receive high-quality health care. The more productive a country’s workforce is, the healthier its citizens are. Despite the fact that healthcare costs are unexpected, it is still necessary to budget for them. Healthcare can help to enhance human capital and increase productivity, boosting economic performance. As a result, analysing a country’s healthcare spending phenomenon is essential. Energy: Shifting from polluting energy sources to clean, locally produced renewable energy preserves people’s health, keeps our air and water cleaner, and increases our economy by providing excellent employment and new opportunities for workers in these sectors. By promoting the use of renewable energy sources like wind, biomass, water, nuclear, and solar, the economy can use its resources wisely. Women and Nutrition: Women require adequate nutrition not only to be productive members of society but also because maternal nutrition has a direct impact on the health and development of the future generation. This must be remembered, children who do not obtain adequate nourishment today will suffer permanent, lifelong physical and cognitive deficits. So expenditure in this section is mandatory. Pregnant and nursing women receive meals and counselling through programs like “Anganwadis” which is an example of the government budgeting in this sector. For the Upliftment of Backward Class: The Indian Constitution provides protection and safeguards for Scheduled Castes (SCs), Scheduled Tribes (STs), and other marginalized groups. Either specifically or as a means of enforcing its people’s rights in general, to advance their educational and economic interests and eradicate social barriers. Research and Development: The money spent on research and development is the money spent on systematic creative activity to grow the stock of knowledge and the use of that information to develop new applications. Exports and Imports International trade consists of exports and imports. The goods and services that are sold by a country to other countries are called exports. The goods and services that are purchased by a country from other countries are called imports. The commodities India exports to other countries are handicrafts (including gems for jewellery), readymade garments, engineering goods, coffee, tea, tobacco, cashew kernel, fruits and vegetables, rice, fish cotton yarn and manufactures, iron ore and chemicals etc... Prominent among the countries to which India exports commodities include USA, UK, Germany and Japan. 22 The commodities India imports from other countries are Petroleum, oil, lubricants, metals, pearls and precious stones etc... Prominent among the countries from which India imports include Japan, USA, UK, Germany and Russia. Exports and imports are classified into visible and invisible items Visible items: The term visible items refer to the exports and imports of goods which have a physical form. Invisible items: Invisible items do not have a physical form. Therefore, commodities are not included. They include items such as travel charges, freight charges, insurance, brokerage, commission etc. There are two concepts is use with regards to the accounts of international trade They are Balance of Trade, and Balance of Payments. Balance of Trade Balance of trade is a statement showing the receipts and payments relating to the exports and imports of visible items only. It is a difference in the value of visible transactions i.e. exports and imports of commodities. When the value of exports is more than the value of imports, it is called favourable balance of trade. When the value of imports exceeds the value of exports, it is called unfavourable balance of trade. Unfavourable balance of trade is not desirable Balance of Payments Balance of payments is the difference between the value of visible and invisible exports and the value of the invisible imports. Thus balance of payments includes balance of trade also. Balance of payments refers to the sum of the balance of both visible and invisible transactions Advantages of Imports and Exports: Easiest and Simplest: Exporting and Importing is the easiest way to enter into the international market as compared to any other modes of entry. Here, there is no need to set up and manage any business unit abroad, which makes the process easier. Less Investment: Less investment is required in the case of exporting/importing as it is not mandatory for the enterprise to set up a business unit in the country they are dealing with. Less Risky: If there is no investment or very less investment required in exporting/importing in the foreign country, the firm is free from many risks involved in foreign investment. Availability of Resources: As the resources are unevenly scattered around the globe, it is very important for every country to export/import goods around the globe, as no nation can be 100% self-sufficient. 23 Better Control: Exporting/Importing can provide better control over the trade, as there is very less involvement in the foreign country. Everything is controlled by the home country and there is no need to set up a unit in the foreign country. Disadvantages of Imports and Exports: Extra Cost: Since goods are to be sent to different nations, there is some extra cost, incurred in packaging and transportation of goods, which is a major limitation. Regulations: Different countries have different policies for foreign trade, and sometimes it becomes difficult for a company to comply with the rules and regulations of each country they are dealing with. Domestic Competition: The companies involved in exporting/importing have to face severe competition in the domestic country due to the presence of domestic sellers. Country’s Reputation on Stake: Goods that are exported to different countries are subject to quality standards. If any goods that are of low quality are exported to any other country, the reputation of the home country becomes questionable. Documentation: Exporting/Importing requires obtaining licenses and documentation for foreign trade from every country, which can become frustrating at times. Multitasking: Managing business across different countries involves a lot of multitasking, which can be hectic for a company. 24