BCM109_Macro Economics(Draft 2)-converted

BACHELOR OF COMMERCE SEMESTER-II MACRO ECONOMICS BCM109 Institute of Distance and Online Learning

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CONTENTS Unit 1: Introducton To Macro Economics ........................................................................................... 5 Unit 2: Basic Concepts Of Macro Economics..................................................................................... 18 Unit 3- National Income ....................................................................................................................... 36 Unit 4- National Income (Measurement Methods) ............................................................................ 52 Unit 5- Money And Banking ................................................................................................................ 66 Unit 6- Components Of Aggregate Demand (Ad).............................................................................. 96 Unit 7- Saving And Investment.......................................................................................................... 113 Unit 8- Equilibrium ............................................................................................................................ 140 Unit 9- Theories Of Income And Employment ................................................................................ 153 Unit 10- Inflation And Deflation ....................................................................................................... 172 Unit 11- Government Budget............................................................................................................. 190 Unit 12- Balance Of Payments ........................................................................................................... 209

UNIT 1: INTRODUCTON TO MACRO ECONOMICS Structure Learning Objectives Introduction Nature of macroeconomics Scope & importance of macroeconomics Scope of Macroeconomics Importance of Macroeconomics Difference between Micro and Macro Economics Summary Key Words/Abbreviations Learning Activity Unit End Exercises (MCQs and Descriptive) References LEARNING OBJECTIVES After studying this unit, you will be able to: • Explain the basic concept of macroeconomics • It would list the difference between micro & macro economics INTRODUCTION The term ‘macro’ was first used in economics by Ragner Frisch in 1933. But as a methodological approach to economic problems, it originated with the Mercantilists in the 16th and 17th centuries. They were concerned with the economic system as a whole In the 18th century, the Physiocrats adopted it in their Table Economies to show the ‘circulation of wealth’ (i.e., the net product) among the three classes represented by farmers, landowners and the sterile class. Malthus, Sismondi and Marx in the 19th century dealt with macroeconomic problems. Walras, Wicksell and Fisher were the modern contributors to the 5 CU IDOL SELF LEARNING MATERIAL (SLM)

development of macroeconomic analysis before Keynes. Certain economists, like Cassel, Marshall, Pigou, Robertson, Hayek and Hawtrey, developed a theory of money and general prices in the decade following the First World War. But credit goes to Keynes who finally developed a general theory of income, output and employment in the wake of the Great Depression. Macroeconomics (from the Greek prefix makro- meaning \"large\" + economics) means using interest rates, taxes and government spending to regulate an economy’s growth and stability. It is a branch of economics dealing with the performance, structure, behavior, and decision- making of an economy as a whole. This includes regional, national, and global economies. Macroeconomists study topics such as GDP, unemployment rates, national income, price indices, output, consumption, unemployment, inflation, saving, investment, energy, international trade, and international finance. As we know, Macroeconomics is concerned with economic problems at the level of an economy as a whole. Structure of Macroeconomics implies study of different sectors of the economy. An economy may be divided into different sectors depending on the nature of study. (a) Producer sector engaged in the production of goods and services. (b) Household sector engaged in the consumption of goods and services. Note: Households are taken as the owners of factors of production. (c) The government sector engaged in activities like taxation and subsidies (d) Rest of the world sector engaged in exports and imports. (e) Financial sector (or financial system) engaged in the activity of borrowing and lending. Macroeconomics is a broad field of study. It studies Aggregated Indicators such as GDP, Unemployment Rates, and Price Indices to understand how the whole economy functions. Macroeconomists develop models that explain relationship between factors such as National Income, Output, Consumption, Unemployment, Inflation, Saving, Investment, International Trade and International Finance. Macroeconomics models and their forecasts are used by both Governments and large corporations to assist in the development and evaluation of economic policy and business strategies. Fiscal Policy and Monetary Policies are good examples of how economic management is 6 CU IDOL SELF LEARNING MATERIAL (SLM)

achieved through these government strategies. It is also vital to point out here that to avoid major Economic Shocks, such as Great Depression, Recession, Melt down etc., Government makes adjustments through policy changes, they hope, will stabilize the economy. NATURE OF MACRO ECONOMICS Macroeconomics is the study of aggregates or averages covering the entire economy, such as total employment, national income, national output, total investment, total consumption, total savings, aggregate supply, aggregate demand, and general price level, wage level, and cost structure. In other words, it is aggregative economics which examines the interrelations among the various aggregates, their determination and causes of fluctuations in them. Thus, in the words of Professor Ackley, “Macroeconomics deals with economic affairs in the large, it concerns the overall dimensions of economic life. It looks at the total size and shape and functioning of the “elephant” of economic experience, rather than working of articulation or dimensions of the individual parts. It studies the character of the forest, independently of the trees which compose it.” Macroeconomics is also known as the theory of income and employment, or simply income analysis. It is concerned with the problems of unemployment, economic fluctuations, inflation or deflation, international trade and economic growth. It is the study of the causes of unemployment, and the various determinants of employment. In the field of business cycles, it concerns itself with the effect of investment on total output, total income, and aggregate employment. In the monetary sphere, it studies the effect of the total quantity of money on the general price level. In international trade, the problems of balance of payments and foreign aid fall within the purview of macroeconomic analysis. Above all, macroeconomic theory discusses the problems of determination of the total income of a country and causes of its fluctuations. Finally, it studies the factors that retard growth and those which bring the economy on the path of economic development. The obverse of macroeconomics is microeconomics. Microeconomics is the study of the economic actions of individuals and small groups of individuals. The “study of particular firms, particular households, individual prices, wages, incomes, individual industries, particular commodities.” But macroeconomics “deals with aggregates of these quantities; not with individual incomes but with the national income, not with individual prices but with the price levels, not with individual output but with the national output.” 7 CU IDOL SELF LEARNING MATERIAL (SLM)

Microeconomics, according to Ackley, “deals with the division of total output among industries, products, and firms, and the allocation of resources among competing uses. It considers problems of income distribution. Its interest is in relative prices of particular goods and services.” Macroeconomics, on the other hand, “concerns itself with such variables as the aggregate volume of the output of an economy, with the extent to which its resources are employed, with the size of the national income, with the ‘general price level’.” Both microeconomics and macroeconomics involve the study of aggregates. But aggregation in microeconomics is different from that in macroeconomics. In microeconomics the interrelationships of individual households, individual firms and individual industries to each other deal with aggregation. “The concept of ‘industry’, for example, aggregates numerous firms or even products. Consumer demand for shoes is an aggregate of the demands of many households, and the supply of shoes is an aggregate of the production of many firms. The demand and supply of labour in a locality are clearly aggregate concepts.” “However, the aggregates of microeconomic theory,” according to Professor Bilas, “do not deal with the behaviour of the billions of dollars of consumer expenditures, business investments, and government expenditures. These are in the realm of microeconomics.” Thus the scope of microeconomics to aggregates relates to the economy as a whole, “together with sub-aggregates which (a) cross product and industry lines (such as the total production of consumer goods, or total production of capital goods), and which (b) add up to an aggregate for the whole economy (as total production of consumer goods and of capital goods add up to total production of the economy; or as total wage income and property income add up to national income).” Thus microeconomics uses aggregates relating to individual households, firms and industries, while macroeconomics uses aggregates which relate them to the “economy wide total”. SCOPE & IMPORTANCE OF MACRO ECONOMICS Scope of Macro Economics Macroeconomics is much of theoretical and practical importance. Following are the points covered under the scope of macroeconomics − 8 CU IDOL SELF LEARNING MATERIAL (SLM)

Fig 1.1 Scopes of Macro Economics Working of the Economy The study of macroeconomics is crucial to understand the working of an economy. Economic problems are mainly related to the employment, behavior of total income and general price in the economy. Macroeconomics help in making the elimination process more understandable. In Economy Policies Macroeconomics is very useful in an economic policy. Underdeveloped economies face innumerable problems related to overpopulation, inflation, balance of payments etc. The main responsibilities of government are controlling the overpopulation, prices, volume of trade etc. Following are the economic problems where macroeconomics study is useful − • In national income • In unemployment • In economic growth • In monetary problems Understanding the Behavior of Individual Units The demand for individual products depends upon aggregate demand in the economy therefore understanding the behavior of individual units is very important in macroeconomics. Firstly, to solve the problem of deficiency in demand of individual products, understanding the causes of fall in aggregate demand is required. Similarly to know the reasons for increase in costs of a particular firm or industry, it is first required to 9 CU IDOL SELF LEARNING MATERIAL (SLM)

understand the average cost conditions of the whole economy. Thus, the study of individual units is not possible without macroeconomics. Macroeconomics enhances our knowledge of the functioning of an economy by studying the behavior of national income, output, savings, and consumptions. The scope of macroeconomics includes the following parts: Table 1.1 Understanding the Behavior of Individual Units Clearly, the study of the problem of unemployment in India or general price level or problem of balance of payment is macroeconomic study because these relate to the economy as a whole. • National Income: Measurement of national income and its composition by sectors are the basic aspects of macroeconomic analysis. The trends in National Income and its composition provide a long term understanding of the growth process of an economy. • Inflation: Inflation refers to steady increase in general price level. Estimating the general price level by constructing various price index numbers such as Wholesale Price Index, Consumer Price Index, etc, are needed. • Business Cycle: Almost all economies face the problem of business fluctuations and business cycle. The cyclical movements (boom, recession, depression and recovery) in the economy need to be carefully studied based on aggregate economic variables. • Poverty and Unemployment: The major problems of most resource - rich nations are poverty and unemployment. This is one of the economic paradoxes. A clear understanding about the magnitude of poverty and unemployment facilitates allocation of resources and initiating corrective measures. • Economic Growth: The growth and development of an economy and the factors determining them could be understood only through macro analysis. • Economic Policies: Macro Economics is significant for evolving suitable economic policies. Economic policies are necessary to solve the basic problems, to overcome the obstacles and to achieve growth. Macroeconomics is a vital field of study for the economists, government, financial bodies and 10 CU IDOL SELF LEARNING MATERIAL (SLM)

researchers to analyze the general national issues and economic well-being of a country. Importance of Macroeconomics: 1. It helps to understand the functioning of a complicated modern economic system. It describes how the economy as a whole functions and how the level of national income and employment is determined on the basis of aggregate demand and aggregate supply. 2. It helps to achieve the goal of economic growth, higher level of GDP and higher level of employment. It analyses the forces which determine economic growth of a country and explains how to reach the highest state of economic growth and sustain it. 3. It helps to bring stability in price level and analyses fluctuations in business activities. It suggests policy measures to control Inflation and deflation. 4. It explains factors which determine balance of payment. At the same time, it identifies causes of deficit in balance of payment and suggests remedial measures. 5. It helps to solve economic problems like poverty, unemployment, business cycles, etc., whose solution is possible at macro level only, i.e., at the level of whole economy. 6. With detailed knowledge of functioning of an economy at macro level, it has been possible to formulate correct economic policies and also coordinate international economic policies. 7. Last but not the least, is that macroeconomic theory has saved us from the dangers of application of microeconomic theory to the problems of the economy as a whole. DIFFERENCE BETWEEN MICRO & MACRO ECONOMICS Key Points Macroeconomics Microeconomics Deals with Macroeconomics deals with social and Microeconomics deals with economic status of system as whole. individuals and activities within the system. Tracking Macroeconomics tracks the big picture, Microeconomics tracks even the not just one unit. smallest units and their functioning. Study A business man studies GDP, A business man studies the resources consumption trends, investment patterns available, costs, employee’s etc. to judge the market. availability etc to sustain the business. 11 CU IDOL SELF LEARNING MATERIAL (SLM)

Target Macroeconomics helps in determining Microeconomics helps in determining aggregate demand and supply of target the current need of demand and economy. supply chain. Factor Income is major determination factor in Price is major determination factor in macroeconomics. microeconomics. Equilibrium Macroeconomics study helps in setting Microeconomics study helps in setting equilibrium between income and equilibrium between consumer and employment in an economy. firm. Example International organization studying Small firms track microeconomics of money exchanges tracks their firm operations. macroeconomics factors. Table 1.2 Differences Between Micro & Macro Economics SUMMARY • It is that part of economic theory which studies the economy in its totality or as a whole. • It studies not individual economic units like a household, a firm or an industry but the whole economic system. Macroeconomics is the study of aggregates and averages of the entire economy. • Such aggregates are national income, total employment, aggregate savings and investment, aggregate demand, aggregate supply general price level, etc. • Here, we study how these aggregates and averages of the economy as a whole are determined and what causes fluctuations in them. Having understood the determinants, the aim is how to ensure the maximum level of income and employment in a country. • In short, macroeconomics is the study of national aggregates or economy-wide aggregates. In a way it is like study of economic forest as distinguished from trees that comprise the forest. Main tools of its analysis are aggregate demand and aggregate supply. • Economics is the study of how a society allocates scarce resources to produce the products and services most desired by that society. Economics can be subdivided into 12 CU IDOL SELF LEARNING MATERIAL (SLM)

microeconomics and macroeconomics. Microeconomics is the study of individual households and firms: how they spend their money, how they set prices, and how they invest. Individuals maximize their utility, while firms maximize their profit. Macroeconomics is the study of the cumulative effect of these households and firms acting in aggregate, and, in turn, how these cumulative effects affect individual households and firms. The major components of macroeconomics include the gross domestic product (GDP), economic output, employment, and inflation. • Macroeconomics is both descriptive and proscriptive. It seeks to explain macroeconomic effects, such as inflation or unemployment, while also offering better guidance in how the economy can be managed to improve the state of the economy, to improve the welfare of its people. Macroeconomics provides insight into the causes of depressions and recessions and how to prevent or mitigate them. It can determine what factors are important for economic wealth and how to maximize employment and economic output, creating greater wealth for society. • Of course, there are still recessions and depressions: long stretches of increased unemployment, when economic output is often considerably less than the maximum possible. Partly why is because macroeconomics is complex and its inputs cannot easily be controlled, but, more often than not, the economy is mismanaged by politicians, who either do not understand economics or do not care, because they need to satisfy their political donors. They do not care, because, being wealthy, they do not usually suffer the economic consequences of their decisions. Certainly, economists agree that mismanagement by politicians was the major cause for the Great Depression during the 1930s, which caused misery for millions of people worldwide. That another Great Depression has not occurred since then is due to the increased amount of macroeconomic knowledge. For instance, John Maynard Keynes, one of the most prominent economists of the 20th century, strongly advocated for increased government spending as a means of spurring the economy out of the depression. KEY WORDS/ABBREVIATIONS • Asset-Anything of value owned by an individual, institution or economic agent. • Consumer-An economic agent that desires to purchase goods and services with the goal of maximizing the satisfaction (utility) from consumption of those goods and services. • Demand- A relationship between market price and quantities ofgoods and services purchased in a given period of time. 13 CU IDOL SELF LEARNING MATERIAL (SLM)

• Equilibrium- A situation where there is no tendency for change. LEARNING ACTIVITY 1. Microeconomics and macroeconomics are two different perspectives on the economy. The microeconomic perspective focuses on parts of the economy: individuals, firms, and industries. The macroeconomic perspective looks at the economy as a whole, focusing on goals like growth in the standard of living, unemployment, and inflation. Macroeconomics has two types of policies for pursuing these goals: monetary policy and fiscal policy., what is the difference in macroeconomic and micro economics? ____________________________________________________________________________ ____________________________________________________________________________ 2. Explain the various terms of macro-economic with real life examples • Scarcity • Efficiency • Opportunity cost ____________________________________________________________________________ ____________________________________________________________________________ UNIT END EXERCISES (MCQS AND DESCRIPTIVE) A. Descriptive Type Questions 1. Note on nature of macro economics 2. State the importance of macro economics 3. Explain the difference between micro & macro economics 4. Note on macro economics 5. Explain the scope of macro economics B. Multiple Choice Questions 1. Who is considered as father of modern macroeconomics? (a) Prof. J. M. Keynes (b) Adam Smith (c) Prof. J. N. Keynes (d) Alfred Marshall 14 CU IDOL SELF LEARNING MATERIAL (SLM)

2. Whose opinions have revolutionized the scope of macro economics (a) Adam Smith (b) Prof. J. M. Keynes (c) Prof. J. N. Keynes (d) Alfred Marshall 3. Macroeconomics is also known as the (a) Theory of employment (b) Theory of interest (c) Theory of income and employment (d) Theory of rent 4. Major determination factor in macroeconomics. (a) Price (b) Employment (c) Demand (d) Income 5. Macroeconomics study helps in setting equilibrium between and in an economy. (a) Interest & employment (b) Employment & price (c) Income & price (d) Income & employment Answers: 1. (a), 2. (b), 3. (c), 4. (d), 5. (d) REFERENCES • Dwivedi, D.N. (2006). Macroeconomics: Theory and Policy. New Delhi: Tata McGraw Hill. 15 CU IDOL SELF LEARNING MATERIAL (SLM)

• Ray, N.C. (1980). An introduction to Macro Economics. New Delhi: The Macmillan Company of India. • Lipsey, R.G. & Chrystal, K.A. (2004). Economics. New Delhi: Oxford University Press. • Shapiro, Edward. (2009). Macroeconomic Analysis. New York: Harcourt Publishers Ltd. • Peterson, L., Jain. (2005). Managerial Economic. New Delhi: Prentice Hall of India. • Mote, V.L., Gupta G.S. (2017). Managerial Economics. New Delhi: McGraw Hill Education. 16 CU IDOL SELF LEARNING MATERIAL (SLM)

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UNIT 2: BASIC CONCEPTS OF MACRO ECONOMICS Structure Learning Objectives Introduction, Stock and flow concept, Real and Money Flow Real Flows versus Money Flows The Real Versus Money Economy 2-sector and 3-sector circular flow of income and expenditure, intermediate and final goods Circular Income Flow in a Two-Sector Economy Circular Income Flow with Saving & Investment Circular Income Flow in a Three Sector Economy with Government 4-sectors of the economy Summary Key Words/Abbreviations Learning Activity Unit End Exercises (MCQs and Descriptive) References LEARNING OBJECTIVES After studying this unit, you will be able to: • Explain various terms related to macro economics • It would describe the circular flow of income of various sectors INTRODUCTION Consider a basic scenario of your school’s annual day celebrations. You and your friends may either volunteer for backstage help or participate in one or more events. Some of your friends may also be involved in stage décor. In most cases, everyone is involved in one 18 CU IDOL SELF LEARNING MATERIAL (SLM)

activity or the other. And amidst all these preparations, there will be someone or some committee overseeing or managing the entire event at a large scale or macro level. Or in other words, the big picture. Now, studying this big picture in terms of a country’s economy is what is called macroeconomics. Wikipedia defines macroeconomics as a branch of economics that studies the structure, behavior, performance, and decision-making of an economy as a whole. Now that you are familiar with the basic idea of macroeconomics, let’s understand a few concepts. Macroeconomics is a vast subject and a field of study in itself. However, some quintessential concepts of macroeconomics include the study of national income, gross domestic product (GDP), inflation, unemployment, savings, and investments to name a few. Let’s discuss a few concepts. Fig. 2.1 Circulation in Macroeconomic STOCK AND FLOW CONCEPT Stock refers to a quantity of a commodity accumulated at a point of time. The quantity of the current production of a commodity which moves from a factory to the market is called flow. The aggregates of macroeconomics are of two kinds some are stocks, typically the stock of capital ’k’ which is a timeless concept. A stock is always specified to a particular moment. Other aggregates are a flow concept, such as income, output, consumption and investment. A flow variable has the time dimension, it specified per unit of time. Stock is the quantity of an economic variable relating to a point of time. For example, store of cloth in a shop at a point of time is a stock concept. Flow is the quantity of an economic 19 CU IDOL SELF LEARNING MATERIAL (SLM)

variable relating to a period of time. The monthly income and expenditure of an individual, receipt of yearly interest rate on various deposits in a bank, sale of a commodity in a month are some examples of a flow concept. The concepts of stock and flow are used in the analysis of both micro and macroeconomics. In micro economics, the concept of stock and flow are related to the demand for and supply of goods. The market demand and supply of goods. The market demand and supply of goods at a point of time is expressed as stock. The stock demand curve of good slopes downward from left to right like an ordinary demand curve, which depends upon price. But the stock supply curve of a good is parallel to the y axis because the total quantity of stock of a good is constant at a point of time. On the other hand, the flow demand and supply curves are like the ordinary demand and supply curves which are influenced by current prices. But the price is neither a stock nor a flow variable because it does not need a time dimension nor is it a stock quantity. In fact, it is a ratio between the flow of cash and flow of goods. The concepts of stock and flow are used in more in macroeconomics or in the theory of income, output and employment. Money is a stock variable, whereas the spending the money is a flow variable. Wealth is stock, income is flow, saving by a person within a month is flow, while the total saving on a day is stock. The government debt is stock while the government deficit is a flow and its outstanding loan is a stock. Some macro variables like imports, exports, wages, income, tax payments, social security benefits and dividends are always flow concept. Such flows do not have direct stocks but they can affect other stocks indirectly, just as imports can affect the stock of capital goods. A Stock can change due to flow, but the size of flows can be determined itself by changes in stock. This can be explained by the relation between stock of capital and flow of investment. The stock of capital can only increase with the increase in the flow of investment, or by the difference between the flow of production of new capital goods and consumption of capital goods. On the other hand, the flow of investment itself depends upon the size of capital stock. But the stocks can affect flows only if the time period is so long that the desired change in stock can be brought about. Thus, flows cannot be influenced by changes in stock in the short run Lastly, both the concepts of stock and flow variables are very important in modern theories of income, output, employment, interest-rate, business cycles etc. 20 CU IDOL SELF LEARNING MATERIAL (SLM)

REAL AND MONEY FLOW Money flow and real flow are the two main aspects of the circular flow of income economic model. Both refer to exchanges of goods and services for money, but the two concepts differ in how they refer to the opposite sides of these exchanges as they relate to individuals and companies. Real flows refer to the flow of the actual goods or services, while money flows refer to the payments for the services (wages, for example) or consumption payments. Real Flows versus Money Flows Real flows include the factors of production, such as labor or land, that flow from individuals to companies, as well as the flow of goods and services from companies to individuals. Meanwhile, money flows occur when companies pay wages in return for labor or services provided by individuals, as well as when individuals spend money to obtain goods or services produced by companies. The Real versus Money Economy When mainstream economists speak of the economy, they are most likely referring to the \"real\" economy—that is, the production and consumption of actual goods and services. In this model, money is merely a \"veil\" that obscures the actual production economy underlying it, where money serves as a lubricant to make trade and transactions more efficient and less costly. Other economists, however, such as those in the Keynesian and Monetarist traditions, believe that money and finance are real factors in the economy and cannot be ignored as a simple veil. Karl Marx, writing about capitalism in the 19th century, famously linked the real and money flow together using his conception of M - C - M', where money is converted into commodities (M - C), which are then sold for a profit greater than the money put in (M'). The 2008 financial crisis, which resulted in part from a lack of financial liquidity in credit and money markets, speaks to the importance of the money economy, especially in today's global market. 2-SECTOR AND 3-SECTOR CIRCULAR FLOW OF INCOME AND EXPENDITURE, INTERMEDIATE AND FINAL GOODS Circular Income Flow in a Two Sector Economy: Real flows of resources, goods and services have been shown in Fig. 2.2. In the upper loop of 21 CU IDOL SELF LEARNING MATERIAL (SLM)

this figure, the resources such as land, capital and entrepreneurial ability flow from households to business firms as indicated by the arrow mark. In opposite direction to this, money flows from business firms to the households as factor payments such as wages, rent, interest and profits. Fig. 2.2 Circular Income Flow in a Two Sector Economy: In the lower part of the figure, money flows from households to firms as consumption expenditure made by the households on the goods and services produced by the firms, while the flow of goods and services is in opposite direction from business firms to households. Thus we see that money flows from business firms to households as factor payments and then it flows from households to firms. Thus there is, in fact, a circular flow of money or income. This circular flow of money will continue indefinitely week by week and year by year. This is how the economy functions. It may, however, be pointed out that this flow of money income will not always remain the same in volume. In other words, the flow of money income will not always continue at a constant level. In year of depression, the circular flow of money income will contract, i.e., will become lesser in volume, and in years of prosperity it will expand, i.e., will become greater in volume. This is so because the flow of money is a measure of national income and will, therefore, change with changes in the national income. In year of depres•sion, when national income is low, the volume of the flow of money will be small and in years of prosperity when the level of national income is quite high, the flow of money will be large. In order to make our analysis simple and to explain the central issues involved, we take many 22 CU IDOL SELF LEARNING MATERIAL (SLM)

assumptions. In the first place, we assume that neither the households save from their incomes, nor the firms save from their profits. We further assume that the government does not play any part in the national economy. In other words, the government does not receive any money from the people by way of taxes, nor does the government spend any money on the goods and services produced by the firms or on the resources and services supplied by the households. Thirdly, we assume that the economy neither imports goods and services, nor exports anything. In other words, in our above analysis we have not taken into account the role of foreign trade. In fact we have explained above the flow of money that occurs in the functioning of a closed economy with no savings and no role of government. Circular Income Flow with Saving and Investment: In our above analysis of the circular flow of income we have assumed that all income which the households receive, they spend it on consumer goods and services. A result, circular flow of money speeding and income remains undiminished. We will now explain if households save a part of their income, how their savings will affect money flows in the economy. When households save, their expenditure on goods and services will decline to that extent and as a result money flow to the busi•ness firms will contract. With reduced money receipts, firms will hire fewer workers (or lay off some workers) or reduce the factor payments they make to the suppliers of factors such as workers. This will lead to the fall in total incomes of the households. Thus, savings reduce the flow of money ex­penditure to the business firms and will cause a fall in economy’s total income. Economists therefore call savings a leakage from the money expenditure flow. But savings by households need not lead to reduced aggregate spending and income if they find their way back into flow of expenditure. In free market economies there exists a set of institutions such as banks, insurance companies, financial houses, stock markets where households deposit their savings. All these institutions together are called financial institutions or financial market. We as•sume that all the savings of households come in the financial market. We further assume that there are no inter-households borrowings. It is business firms who borrow from the financial market for investment in capital goods such as machines, factories, tools and instruments, trucks. Firms spend on investment in order to expand their productive capacity in future. Thus, through investment expenditure by borrowing the savings of the households deposited in financial market, are again brought into the expenditure stream and as a result total flow of spending does not decrease. Circular money flow with saving and investment is illustrated in 23 CU IDOL SELF LEARNING MATERIAL (SLM)

Fig. 2.3 where in the middle part a box representing financial market is drawn. Money flow of savings is shown from the households towards the financial market. Then flow of investment expenditure is shown as borrowing by business firms from the financial market. Fig. 2.3 Circular Income Flow with Saving and Investment: Condition for the Constancy of Circular Income Flow: Now the question arises what is the condition for the flow of money income to continue at a steady level so that it makes possible the production and subsequent flow of a given volume of goods and services at constant prices. To explain this we have to introduce saving and investment in the analysis of circular flow of income. Saving a part of income means it is not spent on consumer goods and services. In other words, saving is withdrawal of some money from the income flow. On the other hand, investment means some money is spent on buying new capital goods to expand production capacity. In other words, investment is injection of some money in circular flow of income. For the circular flow of income to continue unabated, the withdrawal of money from the income stream by way of saving must equal injection of money by way of investment expenditure. Therefore, planned savings must be equal to planned investment if the constant money income flow in an economy is to be obtained. Now, what will happen if planned investment expenditure falls short of the planned savings? As a result of fall in planned investment expenditure, income, output and employment will fall and therefore the flow of money will contract. If the equality between planned savings and planned investment is disturbed by increase in savings, then the immediate effect will be that the stocks of goods lying in the shelves of the shops will increase (as some of the goods will not be sold due to the fall in consumption i.e., 24 CU IDOL SELF LEARNING MATERIAL (SLM)

increase in savings). Owing to the deficiency of demand for goods and the accumulation of stocks, retailers will place small orders with the wholesalers. Consequently, smaller amount of goods will be produced and therefore fewer capital goods like ma•chinery will be indeed with the result that fixed investment will tend to fall. Thus the ultimate effect of either the fall in planned investment or the increase in planned savings is the same, namely, the fall in income, output, employment and prices with the result that the flow of money will contract. On the other hand, if the equality between planned savings and planned investment is disturbed by the increase in investment demand, the result will be increase in income, output and employment. Consequently, the flow of money income will expand. It is thus clear from the above analysis that the flow of money income will continue at a constant level only when the condition of equality between planned saving and investment is satisfied. It was believed by classical economists that financial market provides a mechanism which coordinates the savings of households and the investment expenditure, by the firms. Rate of interest, which is the price for the use of savings, is determined by saving and investment. If savings exceed investment expenditure, rate of interest falls so that, at a lower rate of interest, investment increases and both become equal. On the contrary, if investment expenditure is greater than savings, rate of interest will rise so that at a higher rate of interest savings increase and become equal to planned investment expenditure. However, an eminent British economist J.M. Keynes refuted the above argument that changes in rate of interest will cause saving and investment to become equal. According to him, since in a free market capitalist economy, investment is made by business enterprises and savings are mostly done by households and for different reasons, there is no guarantee that planned investment will be equal to planned savings and thus fluctuations in income, output and employment are inevitable. As a result, circular flow of income does not continue at a steady level in a free-enterprise capital•ist economy unless certain corrective and preventive steps are taken by the government to maintain stability in the economy. Saving-Investment Identity in National Income Accounts in a Two Sector Economy: Despite the fact that people who save are different from the business firms which primarily invest, in national income accounts savings are identical or always equal to investment in a simple two sector economy having no roles of Government and foreign trade. This is a basic identity in national income accounts which needs to be carefully understood. 25 CU IDOL SELF LEARNING MATERIAL (SLM)

Of course, in our above analysis of circular flow of income, we explained that planned investment by business firms can differ from savings by household. But in that analysis we referred to planned or intended investment and savings which often differ and affect the flow of national income. However, in national income accounts we are concerned with actual saving and actual investment. It is these actual or realized saving and invest•ment that are identical in national income accounts. We can prove their identity in the following way. In a simple economy which has neither government, nor foreign trade, the value of output produced which we denote by Y is equal to the value of output sold. Since the value of output sold in a simple two sector economy is equal to the sum of consumption expenditure and investment expenditure we have Y = C+ I where Y = Value of aggregate output, C = Consumption expenditure and I = Investment expenditure. A pertinent question which arises here is what happens to the unsold output. The unsold output leads to the increase in the inventories of goods and in national income accounting increase in inven•tories of goods is treated as a part of actual investment. This may be considered as the firms selling the goods to themselves to add to their inventories. Thus, gross national product (GNP) produced is used either for consumption or for investment. Now, look at the gross national product or income in the simple economy from the viewpoint of its allocation between consumption and saving. Since national income (which is equal to GNP) can be either consumed or saved, we have Y = C+ S From the identities (i) and (ii) we get C+ I = Y = C+ S The left hand side of the identity (iii), namely C + I = Y shows the components of aggregate demand (that is, aggregate expenditure on goods and services produced) and the right-hand side of the identity (iii) namely Y = C + S shows the allocation of national income to either consumption or saving. Thus, the identity (iii) shows that the value of output produced or sold is equal to the total income received. It is income received that is spent on goods and services produced. Now subtracting the consumption (C) from both sides of the identity (iii) we have I=Y=S or I = S Thus, in our two sector simple economy with neither government, nor foreign trade, investment is identically equal to saving. 26 CU IDOL SELF LEARNING MATERIAL (SLM)

Circular Income Flow in a Three Sector Economy with Government: In our above analysis of money flow, we have ignored the existence of government for the sake of making our circular flow model simple. This is quite unrealistic because government absorbs a good part of the incomes earned by households. Government affects the economy in a number of ways. Here we will concentrate on its taxing, spending and borrowing roles. Government purchases goods and services just as households and firms do. Government expenditure takes many forms including spending on capital goods and infrastructure (highways, power, communication), on defense goods, and on education and public health and so on. These add to the money flows which are shown in Fig. 2.4 where a box representing Government has been drawn. It will be seen that government purchases of goods and services from firms and households are shown as flow of money spending on goods and services. Fig. 2.4 Circular Income Flow in a Three Sector Economy with Government: Government expenditure may be financed through taxes, out of assets or by borrowing. The money flow from households and business firms to the government is labelled as tax payments in Fig. 2.4 This money flow includes all the tax payments made by households less transfer payments received from the Government. Transfer payments are treated as negative tax payments. Another method of financing Government expenditure is borrowing from the financial market. This can be represented by the money flow from the financial market to the Government and is labeled as Government borrowing (To avoid confusion we have not drawn this money flow from financial market to the Government). Government borrowing increases the demand for credit which causes rate of interest to rise. 27 CU IDOL SELF LEARNING MATERIAL (SLM)

The government borrowing through its effect on the rate of interest affects the behaviour of firms and households. Business firms consider the interest rate as cost of borrowing and the rise in the interest rate as a result of borrowing by the Government lowers private investment. However, households who view the rate of interest as return on savings feel encouraged to save more. It follows from above that the inclusion of the Government sector significantly affects the overall economic situation. Total expenditure flow in the economy is now the sum of consumption expendi•ture (denoted by C), investment expenditure (I) and Government expenditure (denoted by G). Thus Total expenditure (E) = C + I + G …. (I) Total income (K) received is allocated to consumption (C), savings (S) and taxes (T). Thus Y = C + S + T … (ii) Since expenditure) made must be equal to the income received (Y), from equations (i) and (ii) above we have C + I + G = C + S + T … (iii) Since C occurs on both sides of the equation (iii) and will therefore be cancelled out, we have I + G = S + T …(iv) By rearranging we obtain G – T = S – I … (v) Equation (v) is very significant as it depicts what would be the consequences if government budget is not balanced, that is, if Government expenditure (G) is greater than the tax revenue (7), that is, G >T, the government will have a deficit budget. To finance the deficit budget, the Government will borrow from the financial market. For this purpose, then private investment by business firms must be less than the savings of the households. Thus Government borrowing reduces private investment in the economy. In other words, Government borrowing crowds out private investment. 4-SECTORS OF THE ECONOMY We now turn to explain the money flows that are generated in an open economy, that is, economy which have trade relations with foreign countries. Thus, the inclusion of the foreign sector will reveal to us the interaction of the domestic economy with foreign countries. 28 CU IDOL SELF LEARNING MATERIAL (SLM)

Foreigners interact with the domestic firms and households through exports and imports of goods and services as well as through borrowing and lending operations through financial market. Goods and services produced within the domestic territory which are sold to the foreigners are called exports. On the other hand, purchases of foreign-made goods and services by domestic households are called imports. Fig. 2.5 illustrates additional money flows that occur in the open economy when exports and imports also exist in the economy. In our analysis, we assume it is only the business firms of the domestic economy that interact with foreign countries and therefore export and import goods and services. Fig. 2.5 4-Sectors of the Economy A flow of money spending on imports have been shown to be occurring from the domestic business firms to the foreign countries (i.e., rest of the world). On the contrary, flow of money expenditure on exports of a domestic economy has been shown to be taking place from foreign countries to the business firms of the domestic economy. If exports are equal to the imports, then there exists a balance of trade. Generally, exports and imports are not equal to each other. If value of exports exceeds the value of imports, trade surplus occurs. On the other hand if value of imports exceeds value of exports of a country, trade deficit occurs. In the open economy there is interaction between countries not only through exports and imports of goods and services but also through borrowing and lending funds or what is also called financial market. These days financial markets around the world have become well integrated. 29 CU IDOL SELF LEARNING MATERIAL (SLM)

When there is a trade surplus in the economy, that is, when exports (X) exceed imports (M), net capital inflow will take place. By net capital inflow we mean foreigners will borrow from domestic savers to finance their purchases of domestic exports. In this way as a result of net capital inflow domestic savers will lend to foreigners, that is, acquire foreign financial assets. On the contrary, in case of import surplus, that is, when imports are greater than exports, trade deficit will occur. Therefore, in case of trade deficit, domestic consumer households and business firms will borrow from abroad to finance their excess of imports over exports. As a result, foreigners will acquire domestic financial assets. From the circular flows that occur in the open economy the national income must be measured by aggregate expenditure that includes net exports, that is, X-M where X represents exports and M represents imports. Imports must be subtracted from the total expenditure on foreign produced goods and services to get the value of net exports. Thus, in the open economy National Income = C + I + G + NX Where NX represents net exports, X-M. Since national income can be consumed, saved or paid as taxes to the Government we have C + I + G + NX = C + S + T SUMMARY • In a modern exchange economy, one in which all economic exchanges involve money, the circular flow of income model attempts to depict the back and forth flows of money and services between individuals (or households) and companies. In explaining the flow of money, this economic model uses the terms \"money flow\" and \"real flow\" to designate the nature of the different exchanges that take place. • Within the model, individuals are considered to be both the possessors of factors of production (such as labor, services or property) and as consumers, the purchasers of goods. Companies are considered to be both the producers of goods and the purchasers of factors of production. • Economics is the study of how individuals and societies choose to allocate scarce resources, why they choose to allocate them that way, and the consequences of those decisions. • Scarcity is sometimes considered the basic problem of economics. Resources are 30 CU IDOL SELF LEARNING MATERIAL (SLM)

scarce because we live in a world in which humans’ wants are infinite but the land, labor, and capital required to satisfy those wants are limited. This conflict between society’s unlimited wants and our limited resources means choices must be made when deciding how to allocate scarce resources. Any economic system must provide society with a means of making choices that answer three basic questions: • What will be produced with society’s limited resources? • How will we produce the things we need and want? • How will society’s output be distributed? • Economics is a social science. This means that economists, in their study of human interactions, use models to simplify, analyze, and predict human behavior. Models include graphs and mathematical models. • The purpose of these graphs and mathematical models is to simplify the many interactions that occur in an economy. In their use of models, economists usually make the assumption, when analyzing the effect of a particular change on a market or on a nation’s economy, that all else is held constant. The term we use for “all else equal” is the Latin expressions, ceteris paribus. • Another assumption economists make is that economic agents are rational and have an incentive to make decisions that are always in their own self-interest. While in reality human beings often act irrationally, by assuming people, businesses, governments, and other agents are rational decision-makers, and by assuming ceteris paribus, economists attempt to establish laws and make predictions about how human interactions will affect society. • When thinking about economic problems, we can use either positive analysis or normative analysis. Positive analysis is objective, fact-based, and cause-and-effect thinking about problems. When economists disagree it is typically due to different normative analysis. When using normative analysis, the focus is on what should happen or how desirable one action is compared to a different action. KEY WORDS/ABBREVIATIONS • Factors of Production- An exhaustive list of inputs required for any type of production. • Savings- The difference between income and expenditure in the current time period. 31 CU IDOL SELF LEARNING MATERIAL (SLM)

• Scarcity- A physical or economic condition where the quantity desired of a good or service exceeds the availability of that good or service in the absence of a rationing system. • Shortage- A market condition where the quantity demanded of a particular good or service exceed the quantity available. LEARNING ACTIVITY 1. Explain the term Real & Money Flow 2. Explain the Stock & Flow Concept UNIT END EXERCISES (MCQS AND DESCRIPTIVE) A. Descriptive Type Questions 1. Diagrammatically explain the 3 sector economy 2. Explain the 4-sector economy in detail 3. Explain the 2-sector economy without savings 4. Explain the 2-sector economy with savings 5. Explain how equilibrium is attained at various sector economy. B. Multiple Choice Questions 1. refers to a quantity of a commodity accumulated at a point of time (a) Stock (b) Flow (c) Real Flow (d) Money Flow 2. is neither stock now flow 32 CU IDOL SELF LEARNING MATERIAL (SLM)

(a) Income (b) Price (c) Employment (d) Interest 3. Real flow includes (a) Factors of Payment (b) Factors of Interest (c) Factors of Production (d) None of these 4. This circular flow of money will continue indefinitely week by week and year by year. This is how the . (a) Price function (b) Employment function (c) Economy function (d) Income function 5. Government borrowing crowds out investment (a) Private (b) Public (c) Both (a) & (b) (d) None of these Answers: 1. (a), 2. (b), 3. (c), 4. (d), 5. (a) REFERENCES • Dwivedi, D.N. (2006). Macroeconomics: Theory and Policy. New Delhi: Tata McGraw Hill. 33 CU IDOL SELF LEARNING MATERIAL (SLM)

• Ray, N.C. (1980). An introduction to Macro Economics. New Delhi: The Macmillan Company of India. • Lipsey, R.G. & Chrystal, K.A. (2004). Economics. New Delhi: Oxford University Press. • Shapiro, Edward. (2009). Macroeconomic Analysis. New York: Harcourt Publishers Ltd. • Peterson, L., Jain. (2005). Managerial Economic. New Delhi: Prentice Hall of India. • Mote, V.L., Gupta G.S. (2017). Managerial Economics. New Delhi: McGraw Hill Education. 34 CU IDOL SELF LEARNING MATERIAL (SLM)

35 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 3- NATIONAL INCOME Structure Learning Objectives Introduction GDP at Market Price & GDP at Factor Cost Significance of Distinction NNP at Factor Cost & NDP at Market Price Subsidy Government Surplus Depreciation Gross, Net & Domestic National Income Gross National Product Net Domestic Product (Domestic National Income) National Income (Net National Income) Net Indirect Taxes Significance of Net Indirect Taxes NFIA Significance of NFIA Components of NFIA Normal resident treatment, Factor cost & market price, Personal Income Disposable Personal Income Summary Key Words/Abbreviations Learning Activity Unit End Exercises (MCQs and Descriptive) 36 CU IDOL SELF LEARNING MATERIAL (SLM)

References LEARNING OBJECTIVES After studying this unit, you will be able to: • Explain various terms related to national income INTRODUCTION National income of a country means the sum total of incomes earned by the citizens of that country during a given period, say a year. It should be noted that national income is not the sum of all incomes earned by all citizens, but only those incomes which accrue due to participation in the production process. Individuals participate in the production process by supplying factors of production which they possess. There are four factors of production: natural resources or land; human resources or labour; produced means of production or capital; and entrepreneurs or organization. The payment for the use of land is called rent. Payment for the use of labour is known as wages and payment for the use of capital is known as interest. The factors of production — land, labour and capital are primary factors of production and their contractual payments are called factor incomes. The surplus—what is left after the payment of these primary factors — is called the profit. This residual income is paid to the organizer of production as profit. Thus, income for the participation in the production process may take four forms: rent, wages, interest and profit. By national income we mean the sum-total of all rent, wages, interest and profit earned in the production process during a given period by all the citizens, which is known as the factor payments total. From this definition of national income, we exclude two types of personal income. The first is transfer payments and the second is capital gains. When a citizen receives a certain sum of money without participating in the production process it is called transfer payments. For example, the unemployment benefit, income of a beggar, etc. are personal incomes but not national income because they provide no services against their receipts. Again, when we sell out assets which has appreciated in value, and realize a gain it is known as capital gain which is excluded from the calculation of national income because it renders no productive service for reaping this gain. 37 CU IDOL SELF LEARNING MATERIAL (SLM)

GDP AT MARKET PRICE & GDP AT FACTOR COST We have seen that GDP Is broadly the market value of final goods and services produced within domestic (economic) territory of a country. It can be measured in two ways: at current market prices and at constant prices. When final goods and services included in GDP are valued at current market prices, i.e., prices prevailing in the year for which GDP is being measured, it is called GDP at current market prices or Nominal GDP, For example. Nominal GDP of 2012-13 is the value of output produced in 2012-13 at the market prices that prevail in 2012-13. On the other hand, when goods and services included in GDP are valued at constant [fixed) prices, i.e., prices of the base year, it is called GDP at constant prices or Real GNP. For example real GDP of 2012-13 is the value of output produced in 2012-13 measured at base year’s (say 2004-2005) prices. Constant prices refer to prices prevailing in some carefully chosen year called base year. Mind, a base year is a normal year devoid of price fluctuations. Presently in India, 2004-2005 is taken as the base year for estimating GDP (or any other related aggregate) at constant prices. Real GDP and Nominal GDP (A2010; D11, 11C, 12C): Simply put, GDP at current prices is called Nominal GDP whereas GDP at constant prices is termed as real GDP In other words, nominal GDP of a given year is estimated on the basis of prices of the same year whereas real GDP of a given year is measured on the basis of base year’s prices (constant prices). Significance of distinction: (i) Real GDP (i.e., at constant prices) truly reflects performance and level of economic growth in an economy whereas Nominal GNP (i.e., at current prices) does not. How Rs Nominal GDP is affected by two factors, namely, (a) Change in physical output and (b) Change in prices .If current market prices rise fast. Nominal GDP will also rise fast even though physical output remains the same. This means that Nominal GDP can increase without increase in physical output. Consequently, Nominal GDP becomes deceptive. For instance, in 1991-92, India’s GDP at current market prices increased by 14.7% but at constant prices decreased by 0.1% On the contrary. Real GDP is affected by only one factor, namely. Change in physical output because prices are fixed or are constant. Thus, Real GDP can rise only when there is rise. In physical output during a year .A country is interested in rise in physical output (or Real GDP) and not in Monetary or Nominal GDP because an increase in Real GDP leads to rise in 38 CU IDOL SELF LEARNING MATERIAL (SLM)

standard of living of the people. (i) Real GDP is a better tool to make a year to year comparison of changes in the physical output of goods and services. A sustained rise in Real GDP reflects the economic growth of the country whereas continuous fall in Real GDP is the indicator of recession. (ii) Real GDP eliminates the effect of change (rise or fall) in prices whereas Nominal GDP does not. Therefore, Real GDP truly reflects growth of the country. Can Nominal GDP be ever less than Real GDPRs Yes, when prices of current year are less than the prices in the base year? GDP is the market value of all final goods and services produced within a domestic territory of a country measured in a year. All production done by the national residents or the non-residents in a country gets included, regardless of whether that production is owned by a local company or a foreign entity. Everything is valued at market prices. GDPMP = C + I + G + X – M C (household consumption), G (government expenditure), I (investment expense) X= Exports M= Imports GDP at factor cost is gross domestic product at market prices, less net product taxes. Market prices are the prices as paid by the consumers Market prices also include product taxes and subsides. The term factor cost refers to the prices of products as received by the producers. Thus, factor cost is equal to market prices, minus net indirect taxes. GDP at factor cost measures money value of output produced by the firms within the domestic boundaries of a country in a year. GDPFC = GDPMP – NIT NNP AT FACTOR COST & NDP AT MARKET PRICE The phrase at factor cost is to be contrasted with the phrase at market prices. Goods produced are sold at market prices which include the indirect taxes imposed by the Government. Indirect taxes are levied on commodities, such as excise duty on beer and cloth etc. Thus, the market value of the national product exceeds the income paid to the factors of 39 CU IDOL SELF LEARNING MATERIAL (SLM)

production by the amount of indirect taxes. Hence, net national income at factor cost shows the income actually received by the factors of production. Let us presume that the actual cost of producing a certain output is Rs. 100, which is given to different factors of production as wages, rents, interest and profits. The Government imposes taxes worth Rs. 25 on this output so that it is sold in the market for Rs. 125. This is the market value of output, while income payments made to factors of production amount to Rs. 100 only. Thus, from the money value of NNP at market price or NNI we deduct the amount of indirect taxes to arrive at the net national income at factor cost. NNP at MP – Indirect Taxes = Net National Income at Factor Cost Subsidy: On the other hand, a subsidy causes the market price to be less than the factor cost. Subsidy is an aid in money. Suppose handloom cloth is subsidized at the rate of 10 paise per yard and sells at 90 paise per yard. Thus, while the consumer pays 90 paise per yard, the factors of production will receive Re. 1 per yard. The money value of cloth at factor cost would be equal to its market price plus the subsidies paid on it. NNI at Factor Cost = NNI at MP plus Subsidies minus Indirect Taxes Government Surplus: Sometimes Governments render productive services and earn profits— these profits or surplus earned by the Governments must be deducted before we can find out Net National Income at Factor Cost because these profits do not go to factors of production in the form of incomes but are deposited in the government treasury and, therefore, must be deducted. NNI at Factor Cost – NNI at MP plus Subsidies minus Indirect Taxes and Government earned profits. DEPRECIATION In economics, depreciation is the gradual decrease in the economic value of the capital stock of a firm, nation or other entity, either through physical depreciation, obsolescence or changes in the demand for the services of the capital in question. If the capital stock is Kt in one period t, gross (total) investment spending on newly produced capital is It and depreciation is Dt,, the capital stock in the next period, Kt+1 is Kt + It + Dt. The net increment to the capital stock is the difference between gross investment and depreciation, and is called net investment. In economics, the value of a capital asset may be modeled as the present value of the flow of 40 CU IDOL SELF LEARNING MATERIAL (SLM)

services the asset will generate in future, appropriately adjusted for uncertainty. Economic depreciation over a given period is the reduction in the remaining value of future goods and services. Under certain circumstances, such as an unanticipated increase in the price of the services generated by an asset or a reduction in the discount rate, its value may increase rather than decline. Depreciation is then negative. Depreciation can alternatively be measured as the change in the market value of capital over a given period: the market price of the capital at the beginning of the period minus its market price at the end of the period. Such a method in calculating depreciation differs from other methods, such as straight-line depreciation in that it is included in the calculation of implicit cost, and thus economic profit. Modeling depreciation of a durable as delivering the same services from purchase until failure, with zero scrap value (rather than slowing degrading and retaining residual value), is referred to as the light bulb model of depreciation, or more colorfully as the one-hoss shay model, after a poem by Oliver Wendell Holmes, Sr., about a carriage which worked perfectly for exactly one hundred years, then fell completely apart in an instant. GROSS, NET & DOMESTIC NATIONAL INCOME Gross National Product The gross national product (GNP) measures the value of the final output created by Americans, whether they are located within the country or outside of it. What is included in the gross domestic product (GDP) but not in GNP is the domestic production by foreign workers and companies. So the production of Mercedes-Benz cars in Alabama is counted in GDP but not GNP. On the other hand, the production of cars by GM in China is counted in the GNP but not GDP. The differences between GDP and GNP are small because the additions or subtractions of foreigners working within the country and residents working abroad are small relative. Net Domestic Product (Domestic National Income) A more accurate measure of growth than the GDP is the net domestic product (NDP), which is simply the GDP minus capital depreciation, which is a measure of the amount of output used to replace aging stock of capital. Net domestic product measures how much the economy has grown. Generally, the smaller the difference between GDP and NDP, the more efficient the economy. The amount of depreciation is lowered by producing better quality that lasts longer, lessening the need for replacement. 41 CU IDOL SELF LEARNING MATERIAL (SLM)

Obsolescence also contributes to capital depreciation, since many firms abandon outdated equipment and machinery, since they can reduce their production costs by shifting to new, more efficient machinery and equipment. Because there is always some capital depreciation, the rate of NDB growth will always be less than GDP growth. National Income (Net National Income) National income (NI) sums the total amount earned by Americans for their land, labor, capital, and entrepreneurial talent, whether within the United States or abroad. Hence, national income is sometimes called factor income, because it equals the income received by Americans for all factors of production provided by them. NI can be derived from NDP by subtracting 2 quantities used in the domestic product but not pertinent to the national income. First, net foreign factor income must be subtracted from NDP since it is the income earned by foreigners in the United States minus the income earned by Americans abroad. This makes sense, since the earnings of foreigners should not be included in the United States national income. Indirect business taxes, including sales taxes, excise taxes, custom duties, business property taxes, and license fees are also excluded from NDP because they are not payments for factors of production. National income can also be calculated by simply summing up all employee compensation, rent, interest, proprietors' income, and corporate profits. Gross Domestic Product (GDP) = Value of Final Output by people and businesses located within the United States, regardless of nationality Gross National Product (GNP) = Value of Final Output by Americans, regardless of geographic location Net Domestic Product (NDP) = GDP – Capital Depreciation National Income (NI) = Total Earnings by Americans for their land, labor, and capital, not including transfer payments, such as Social Security. NI = NDP – Net Foreign Factor Income – Income Earned by Americans Abroad – Indirect Business Taxes. NET INDIRECT TAXES Taxes which are levied by the government on production and sale of commodities are called indirect taxes, e.g., excise duty, sales tax, customs duty, octroi, etc. These are called indirect taxes because buyer of a taxed commodity pays the tax indirectly which in fact is included in the price. Leaving aside the aims of the government in levying indirect taxes, we study here the effect of an indirect tax on the price of a commodity on which tax is levied. 42 CU IDOL SELF LEARNING MATERIAL (SLM)

What is the effect of indirect tax on the price of a commodity on which it is levied? The effect of indirect tax is that it increases the price of a commodity. Let us take the example of electrical appliances on which government has levied Central Sales Tax @ 10% in Delhi. A ceiling fan, which was being sold at Rs 1,000 before levying of sale tax, will now be sold at Rs 1,100 (= 1,000 + S. Tax 100). Similarly at present, the price of Maruti (Standard) car in Delhi is Rs 1,84,000 without Sales Tax but with Sales Tax @ 12% the price has gone up to Rs 2,06,080. In short, an indirect tax on a commodity increases its price. The market price of a commodity which does not include indirect tax (or subsidy) is called at factor cost. The price is called at Factor Cost (FC) because It is the cost incurred by the enterprise which it pays to the factors of production for their contribution in the production of a commodity. Thus, in the above example, the market price of a ceiling fan is Rs 1,100 whereas the price at FC is Rs 1,000. Significance of Net Indirect Taxes: Net Indirect Tax is the difference between the Indirect tax and subsidy. To find out Market Prices (MP), indirect taxes are added and subsidies are subtracted from Factor Cost (FC) as explained above. Symbolically: Market Price = Factor Cost + Indirect taxes – Subsidies = Factor Cost + Net indirect taxes In short, MP includes net indirect tax whereas FC does not. Thus, FC becomes MP when net indirect taxes are added to FC. In the absence of indirect taxes and subsidies, MP and FC are the same. NFIA It refers to the difference between factor income received from the rest of the world and factor income paid to the rest of the world. NFIA = Factor income earned from abroad – Factor income paid abroad 1. ‘Factor income from abroad’ is the income earned by the normal residents of a country from the rest of the world (ROW) in the form of wages and salaries, rent, interest, dividend and retained earnings. 2. ‘Factor income to abroad’ is the factor income paid to the normal residents ofother 43 CU IDOL SELF LEARNING MATERIAL (SLM)

countries (i.e. non-residents) for their factor services within the economic territory. Significance of NFIA: NFIA is significant to differentiate between ‘Domestic Income’ and ‘National Income’. In practical estimates, domestic income is estimated first and then, National Income is derived from Domestic Income in the following manner: National Income: = Domestic Income + Factor income from abroad (due to contribution of normal residents to production outside the economic territory) – Factor income to abroad (due to contribution of non-residents to production inside the economic territory) The difference of Factor income from abroad and Factor income to abroad is termed as “Net factor income from abroad” or popularly abbreviated as NFIA. So, National Income = Domestic Income + NFIA NFIA can be Positive, Negative or Zero: 1. NFIA is Positive when income earned from abroad is more than income paid to abroad. 2. NFIA is Negative when income earned from abroad is less than income paid to abroad. 3. NFIA is Zero when income earned from abroad is equal to income paid to abroad. Components of NFIA: There are three main components of NFIA: 1. Net Compensation to Employees: It refers to difference between income from work received by resident workers living or employed abroad for less than one year and similar payments made to non-resident workers staying or employed within the domestic territory of the country for less than one year. 2. Net Income from property and entrepreneurship: It refers to difference between income from property and entrepreneurship (in the form of rent, interest and dividend) received by residents of the country and similar payments made to the non-residents. 3. Net Retained Earnings: It refers to difference between retained earnings of resident companies located abroad and 44 CU IDOL SELF LEARNING MATERIAL (SLM)

retained earnings of non-resident companies located within the domestic territory of the country. Retained Earnings refer to that part of profits which is kept as reserve after paying the corporate tax and dividends. Thus, it may be concluded that: Net factor income from abroad = Net compensation of employees + Net income from property and entrepreneurship + Net retained earnings. It must be noted that NFIA is zero in a closed economy as such economy does not deal with the rest of the world sector. NORMAL RESIDENT TREATMENT Normal resident of a country refers to an individual or an institution who ordinarily resides in the country and whose center of economic interest also lies in that country. Normal residents include both, individuals and institutions. ‘Centre of Economic Interest’ implies two things: • The resident lives or is located within the Domestic Territory; and • The resident carries out basic economic activities of earnings, spending and accumulation from that location. Following are not included under the category of Normal residents: • Foreign tourists and visitors who visit a country for recreation, holidays, medical treatment, study, sports, conferences, etc. • Foreign staff of Embassies, officials, diplomats and members of the armed forces of a foreign country, located in the given country; • International organizations like UNO, WHO, etc. are not considered as normal residents of the country in which they operate. They are treated as the normal residents of international area. • Employees of international organizations are considered as residents of the countries to which they belong and not of the international area. For example, an American working in UNO office located in India will be treated as normal resident of America. However, if the employees are working for more than one year in such International 45 CU IDOL SELF LEARNING MATERIAL (SLM)

Institutions, then they become the normal resident a country in which such institutions are located. It means, in the given example, if the American is working in UNO office in India for more than one year, then he will be treated as normal resident of India. Crew members of foreign vessels, commercial travelers and seasonal workers, provided their stay is less than one year. • Border workers who live near the international border and cross the border on a regular basis to work in the other country. They are treated as normal residents of the country where they live, and not where they work. FACTOR COST & MARKET PRICE The next adjustment in the national income accounts is for indirect taxes. Market prices are very often distorted by indirect taxes and subsidies: indirect taxes have the effect of raising the prices of goods above its costs, while subsidies lower such prices. National income and national product are both measured at ‘factor costs’. To ensure that national expenditure is also the same as the national income and national product, it is necessary to convert market prices to factor cost by adding subsidies and subtracting indirect taxes. Thus, we get national expenditure at market price, minus indirect taxes plus subsidies = Net National Expenditure at factor cost. It is preferable to measure the value of total output at factor cost rather than in Market prices so as to remove the influence of indirect taxes and subsidies PERSONAL INCOME This measures all of the income that is received by individuals, but not necessarily earned. Examples of this include social security benefits, unemployment compensation, welfare payments, benefits for veterans, and food stamps. Individuals also contribute income which they do not receive. This includes corporate profits that are undistributed, indirect business taxes, and the contribution of employers to Social Security. PI = NI + income received but not earned - income earned but not received Disposable Personal Income (DI): There are other personal taxes which are not considered when calculating personal income. In order to derive disposable personal income we must subtract these personal taxes from personal income. DI = PI - Personal Income Taxes 46 CU IDOL SELF LEARNING MATERIAL (SLM)

Disposable personal income represents what people actually have that they can spend. It is also a result of consumer spending as well as private saving. SUMMARY • National Income is because goods and services are produced by factors of production that income is created in the economy, so another way of calculating the value of total output is to add up all the incomes paid out to the owners of the factors of production. Moreover, it comes to the same thing to add the values- added by all firms at the different stages of production. • National income is the net product of or net return on the economic activity of individuals, business firms, and the social and political institutions that make up a nation. Because product or income yielding activities can be gauged at several stages of the economic process, national income can be measured in various ways, each permitting different groupings of components. At its origin in the productive system, it can be estimated as the sum of returns to the several factors of production—labor, capital, enterprise—each allocated by industrial origin. At this stage, the total can also be obtained by subtracting from the gross value-product of each industry the value o: f materials, semi fabricates, durable capital, and services of other industries consumed in the production process. The corresponding allocation would be that of net income (and of value of product) by industrial origin. At the stage of the distribution of money compensation for economic activity, national income is the sum of income receipts of individuals and undistributed net profits of enterprises, the former possibly classified by type (wages, salaries, dividends, etc.), by size among, groups of recipients, and by industrial origin, and the latter by industrial affiliation and type of enterprise. Finally, at the stage of use, national product or its monetary equivalent, national income, is the sum of either the flow of goods to consumers and net capital formation, allocated to whatever divisions of these two major categories are significant; or of expenditures and savings of consumers plus outlays of enterprises financed from their undistributed profits, also allocated to divisions of these three major categories. • National income can, therefore, be described in various ways, corresponding to the several stages in the flow-process of economic activity at which it can be measured. However measured, the totals should be identical. Likewise, they can be subdivided into various categories, of which those mentioned above are a few. Indeed, the interest and usefulness of national income estimates lies in their distribution, so that the level of and changes in the total can be understood and interpreted in terms of its origin in 47 CU IDOL SELF LEARNING MATERIAL (SLM)

the industrial system and of types of ultimate use. As problems in the solution of which national income may be helpful shift, the emphasis in the measurement and analysis of national income shifts from one grouping of components to another. • The task of both subsuming the diver’s economic activities within a nation under a single total and distinguishing within it the major categories raises a host of conceptual and statistical problems. Since World War I these problems have received much attention and the estimates have been extended and elaborated. In recent years national income, or closely related totals, has become a tool of public policy, discussed widely. A jaundiced observer might characterize this interest and discussion as symptoms of hypochondria, likening them to the behavior of a man who continually worries about his pulse, temperature, and blood pressure; and might describe the more detailed work on national income estimates as an escape into quantitative minutiae of doubtful relevance to the problems of the day. A fairer diagnosis might perhaps be that, granted the accentuation of economic problems to whose solution national income estimates can contribute, the growing interest and understanding are encouraging signs that social action may be more intelligent; and that the greater complexity of the statistical structure underlying the estimates is indispensable, if they are to be sufficiently detailed and reliable to be used in both economic analysis and public policy. • Whatever the reasons, the fact is that during the last twenty five years we have learned a great deal about the national income of this country and its components. In attempting a brief summary, which must omit many details yet cover the high spots, we analyze first the structure of national income during the two decades between the two world wars, then the longer term changes in it and its components, as revealed by estimates for the seven decades 1869-1938, consider the fluctuations in it and its components during business cycles, and finally enumerate some of the problems. of use and interpretation. KEY WORDS/ABBREVIATIONS • Factors of Production - An exhaustive list of inputs required for any type of production. • Factor Prices - The payments made to the factors of production (rents, wages, interest, and profits). • Final Goods and Services - Goods and services that are purchased for direct consumption. • Fixed Costs of Production - Those costs of production that are independent of production levels in the short run. 48 CU IDOL SELF LEARNING MATERIAL (SLM)

• Flow Variable - A variable that is measured per unit of time. LEARNING ACTIVITY 1. Explain the concept National Income 2. Explain the term Personal Income UNIT END EXERCISES (MCQS AND DESCRIPTIVE) A. Descriptive Type Questions 1. Explain the following term GDP at Market Price 2. Explain the following term NDP at Market Price 3. Explain the following term NFYA 4. Note on Depreciation 5. Note on Normal resident treatment B. Multiple Choice Questions 1. The market value of all final goods and services produced within domestic territory of the country during a year is known as------------- (a) GDP at MP (b) GDP at FC (c) GNP at FC (d) GNP at MP 2. The money value of all final goods and services produced in the domestic territory of a country during a year plus Net factor income from abroad is called------------ (a) GDP at MP 49 CU IDOL SELF LEARNING MATERIAL (SLM)