Module II

National Income Determination

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1. Gross National Product GNP

This is the basic concept related with measurement of national income with total output and
aggregate supply of goods and services. Simply the concept is

Gross National Product is defined as the total market value of all final goods and services
produced in a year in country

First of all two things have to be noted in while calculating the GNP

1. It will be only calculate in terms of money prices

2. For calculating GNP, the goods and services must be calculated once and not more than
once. That means for making a product or final product goods are passing through the
different stages of production and might be bought and sold many times before reaching to
the market or in to the consumers. For getting accurate measurement of the GNP, only the
value of final goods and services have to be taken and have to ignores the intermediate
goods and services.

The GNP includes the following five components

GNP = C+I+G+Xn+Fy

Thus
C=consumer expenditure
I= gross private investment
G= government expenditure
Xn= Net exports
- Value of goods exported minus value of goods imported
Fy Net factor income abroad.

- Factor income means that income from the factors of production in the form of wages,
rent, interest and profit. Both residence and non-residence getting the factor income by
rendering the services to the nation. Thus when we calculate the GNP, one has to take in
to account the factor income received from abroad by normal residence of India by
rendering factor services to the other countries and does not take to consideration the
income received by the foreign national by rendering the services to the domestic
territory of India.

2. Gross Domestic Product (GDP)

Gross Domestic is defined as the total market value of all final goods and services
produced by normal residence as well as non-residence in domestic territory of a country
and it doesnt include the net factor income from abroad
 One of the main difference between the GNP and GDP is the former include the net factor
income from abroad but later it does not include.

GDP mp GNP mp net factor income from abroad

GNP mpGNPmp+ net factor income from abroad

When we calculate the GDP, one should not confuse with the net factor income abroad and
net exports. Net exports means exports minus imports, that means gross exports are part of
the GDP and not part of the net factor income abroad, but in the case of imports, it is the
value of imported goods and services purchased by the domestic buyers and it will be part
of the either GDP or GNP. Thus when we calculate the national we have to substract the
imports from the exports and that would be part of the either GNP or GDP.

The GDP includes the following five components

GDP = C+I+G+Xn- Fn (net factor income from abroad)

Thus
C=consumer expenditure
I= gross private investment
G= government expenditure
Xn= Net exports- Value of goods exported minus value of goods imported

3. Net National Product

NNP is the market value of all final goods and services produced in an economy during a one
year period excluding depreciation. NNP can be calculated from GNP by deducting the
amount of depreciation. NNP is the actual measurement of national income. NNP at factor
cost is the true measurement of national income.

NNP= GNP- Depreciation.

NNP=GNP = C+I+G+Xn+Fy Depreciation
NNPfc= NNPmp Indirect taxes + subsidies

4.Net Domestic Product (NDP)

It is the money value of the all final goods and services produced in a domestic territory of a
country after allowance has been made for the depreciation.
NDP= GDP = C+I+G+Xn- depreciation.

National income at current prices (Nominal income)

This means that the value of the all final goods and services produced in a country expressed
at prices prevailing for them in the current year is called the national income at current prices.
The current price means the prices prevailing for the goods and services in the years of their
production.
National income at constant prices (Real income)

This means that the value of the all final goods and services produced in a country expressed
at prices prevailing for them in the previous (base) year is called the national income at
constant prices. The constant price means the prices prevailing for the goods and services in
the previous years of their production. The real growth of the national income can be
calculated on the basis of prices prevailing the last year.

GNP Deflator

GNP deflator is the relation of nominal GNP to real GNP. Nominal GNP means GNP
compiled on the basis of current prices while Real GNP means GNP compiled on the basis of
constant prices. It is an important concept because it measures the general price level of
goods and services.
GNP Deflator = Nominal GNP
Real GNP

Private income.Private income is the sum of incomes earned by individual and private
corporate sector within domestic territory and from the abroad
Personal Income.It is the total income received by the households from all the sources before
taxes. Personal income can be derived from the private income by deducting the sum of the
corporation taxes and savings of the private corporate sector.

Personal income = Private income corporation taxes +undistributed corporation profit

Personal disposable income.It is the total income actually remains with individuals after
paying direct taxes.
Percapita income (PCI).It is the average income of the individuals of a country in a
particular year is called the PCI for that year. The PCI can be derived from dividing the
national income of a country by the population of that country in that year.

PCI= National income

Population
Methods of Measuring National Income

There are three methods of measuring national income.

1. Income method
2. Expenditure method (Outlay method)
3. Value added method (Product Method).

1. Income method.
According to this method, national income is equal to the income accruing to the factors
production used in producing national product. The different factors of production
employed in production process are land, labour, capital and organizer. The remunerations
for the services rendered by them are rent, wages/salaries/, interest and profit. Thus income
method shows that national income is sum of all incomes earned by the factors of
production.

NI= Rent+wages/salaries+interest+profit.

2. Expenditure method.
According to this method, when we add all expenditures on goods and services during a
year we will get national income at expenditure method. Income can be spent either on
consumer goods or investment goods. The NI can be derived by summing up of all the
consumption expenditure, investment expenditure made by all individual as well as
government of a country during a year.
Thus NI according to the expenditure method

NI=C+I+G+(X-M)
C= Personal consumption expenditure
I=Gross private domestic Investment
G=Government expenditure on goods and services
X-M=Net exports

3. Value added method (Product method)

Calculation of the difference between value of material out put and input at each stages of
production, we will get NI at product method. It is the value added by each industry to the
raw materials or other goods and services that it brought from other industries before
passing on the products to the next stage link in the whole chain of production. Thus if we
calculate contribution of each separate industry to the value of final out put, we arrive at the
gross national income by value added. Through this method double counting can be
avoided from estimating national income.

Problems for Measurement of National Income.

1. Treatment of non-monetary transactions. The first problem relates to the treatment of

non-monetary transactions such as housewives to the members of their families and the
farm out put consumed at home. On this point the general agreement to exclude the
services of housewives while to include the value of farm output consumed at home in the
estimation of national income.
2. Treatment of government activities in national income accounts. The administrative
functions of the government like justice, administration and defence should be treated as
final consumption to the community as whole so that the contribution of general
government activities will be equal to the amount of wages and salaries paid by the
government.
3. Treatment of income generated by foreign firms. This is also one of the important
problems faced in the national income estimation, means inclusion of foreign nationalities
income. As per the IMF regulation, production and income arising from the foreign
enterprises should be treated as countries production, however the profits earned by the
foreign companies are credited to the parent country.
4. Estimation of farm consumption of rural people. Because in India most of the people
depends on subsistence farming.
5. Illiteracy. Because of the lack of literacy, most of the producers do not know the proper
quantity and the value of the output
6. Problem of double counting
7. Problems of getting adequate data from the un-organized sectors.That means some of
the institutes like agriculture, cottage industries and indigenous banking are come under the
un-organized sectors.
8. Lack of adequate statistical measurements.

Importance of measuring the national income.

National income is the most important variable from both theoretical and practical point of
view. At the theoretical level, a major part of the macro economic theories seeks to explain
the determination of national income, the interrelation ship and interaction between its
various components, growth and fluctuation in national income.
For practical point of view a countrys national income data is used for
- Measuring the standard of living and economic welfare of its people
- Formulation of economic policies for the management of the economy
- Making international comparisons about the status of the economy
Besides, a major part of the macro economic theories deals with the performance and
behavior of GDP or GNP. Given importance of GDP/GNP, one needs to have a clear
understanding of the national income concepts and their measurement.

Inflation

Continues rise in the general price level over long period of time has been the most
common feature of the both developed and developing countries. Persistent inflation is
perhaps the one of the most serious economic problem confronting the world economy
today. Inflation is a situation in which there is a persistent and appreciable increase in the
general level of prices over a long period of time. A moderate rate of inflation is inevitable
in a dynamic and progressive economy. Moderate inflation in developed countries 2-3
percent while in the developing countries it is 4-6 percent may be considered as the
desirable rate of inflation.

According to Coulborn. Inflation is a situation of too much money chasing too few goods

According to Samuelson. Inflation denotes a rise in general price level.

A moderate rate of inflation is considered to be desirable and acceptable for smooth
economic growth. Moderate rate of inflation keeps the economic outlook optimistic,
promotes economic activity and prevents economic stagnation. It helps to mobilization of
resources and will to increase the saving and investment.

Different types of Inflation

Creeping inflation: when price rises very slow that means less than 3% per annum is
called creeping inflation. Such an increase in prices regarded as the safe and essential for
economic growth.
Walking inflation: when price rise is moderately and the annual inflation rate is in between
3-10 percent per annum is called the walking inflation. Inflation at this rate is warning
signal for the government to control it before it turns in to running inflation.
Running inflation: when price rise in between the 10-20 percent per annum is called the
running inflation. Its control requires strong monitory and fiscal measures; otherwise it
leads to the hyperinflation.
Galloping or hyperinflation: When price rises in between 20%-100% per annum or more is
called galloping or hyperinflation. Such a situation brings total collapse of the monitory
system because of continues fall in the purchasing power of money.
Demand pull inflation: It occurs when the aggregate demand increases greater than
aggregate supply. When there is higher demand the firms will respond by increase the price
of the product.
Cost push inflation: general price level increases due to the increase the cost of production
of goods and services. When the cost of production increases the firm will reduce the
supply and that will increase the average price level in the economy.

Concepts of Inflation.

Deflation. It is the sustained fall in the general price level. That is rate at which prices are
falling. It is supposed to extremely dangerous for the functioning
Disinflation. It is the situation where the prices rises are accompanied by increases the real
income
Stagflation. It is the situation when economy experiences high rate of unemployment and
high rate of inflation.

Measurement of Inflation in India

Basically the measurement of inflation is two types

1. CPI
2.WPI.
Many developing countries used CPI as the measurement of inflation rate, but government
adopted the WPI till 2014 April, since then our government started using the CPI as the
measurement of inflation. Every Thursday CSO is measuring the inflation. By calculating
inflation commodities have been divided in to three groups

1. Primary articles (20% weight)

2. Power and fuel (15% as weight)
 3. Manufacturing (65%)
Together all there are 676 commodities consist in the index in 2004-05

Causes of increase in price level

1. Increase in money supply:
Over the last few years the rate of increase in money supply has varied between 15 and 18 per
cent, whereas the national output has increased at an annual average rate of only 4 per cent.
Hence the rate of increase in output has not been sufficient to absorb the rising quantity of
money in the economy. Inflation is the obvious result.
2. Deficit financing:
When the government is unable to raise adequate revenue for its expenditure, it resorts to deficit
financing. During the sixth and seventh Plans, massive doses of deficit financing had been resorted to.
It was Rs. 15,684 crores in the sixth Plan and Rs. 36,000 crores in the seventh Plan.
3. Increase in government expenditure:
Government expenditure in India during the recent years has been rising very fast. What is more
disturbing, proportion of non-development expenditure increased rapidly, being about 40 per cent of
total government expenditure. Non-development expenditure does not create real goods; it only
creates purchasing power and hence leads to inflation.
Not only the above mentioned factors on the Demand side cause inflation, factors on the Supply side
also add fuel to the flame of inflation.
4. Inadequate agricultural and industrial growth:
Agricultural and industrial growth in our country has been much below what we had targeted for.
Over the four decades period, food grains output has increased and-.i.e. of 3.2 per cent per annum.
But there are years of crop failure due to droughts. In the years of scarcity of food grains not only the
prices of food articles increased, the general price level also rose.
Failure of crops always encouraged big wholesale dealers to indulge in hoarding which accentuated
scarcity conditions and pushed up the price level.
Performance of the industrial sector, particularly in the period 1965 to 1985, has not been satisfactory.
Over the 15 years period from 1970 to 1985, industrial production increased at a modest rate of 4.7
per cent per annum.
Our industrial structure, developed on the basis of heavy industry-led growth, is not suitable to meet
the current demand for consumer goods.
5. Rise in administered prices:
In our economy a large part of the market is regulated by government action. There are a number of
important commodities, both agricultural and industrial, for which the price level is administered by
the government.
The government keeps on raising prices from time to time in order to cover up losses in the public
sector. This policy leads to cost-push inflation.
The upward revision of administered prices of coal, iron and steel, electricity and fertilisers were
made at regular intervals. Once the administered prices are raised, it is a signal for other price to go
up.
6. Rising import prices:
Inflation has been a global phenomenon. International inflation gets imported into the country through
major imports like fertilisers, edible oil, steel, cement, chemicals, and machinery. Increase in the
import price of petroleum has been most spectacular and its contribution to domestic price rise is very
high.
7. Rising taxes:
To raise additional financial resources, government is depending more and more on indirect taxes
such as excise duties and sales tax. These taxes invariably raise the price level.
Inflation is caused by the failure of aggregate supply to equal the increase in aggregate demand.
Inflation can, therefore, be controlled by increasing the supplies of goods and services and reducing
money incomes in order to control aggregate demand.
The various methods are usually grouped under three heads: monetary measures, fiscal measures and
other measures.
1. Monetary Measures:
Monetary measures aim at reducing money incomes.
(a) Credit Control:
One of the important monetary measures is monetary policy. The central bank of the country adopts a
number of methods to control the quantity and quality of credit. For this purpose, it raises the bank
rates, sells securities in the open market, raises the reserve ratio, and adopts a number of selective
credit control measures, such as raising margin requirements and regulating consumer credit.
Monetary policy may not be effective in controlling inflation, if inflation is due to cost-push factors.
Monetary policy can only be helpful in controlling inflation due to demand-pull factors.
(b) Demonetisation of Currency:
However, one of the monetary measures is to demonetise currency of higher denominations. Such a
measures is usually adopted when there is abundance of black money in the country.
(c) Issue of New Currency:
The most extreme monetary measure is the issue of new currency in place of the old currency. Under
this system, one new note is exchanged for a number of notes of the old currency. The value of bank
deposits is also fixed accordingly. Such a measure is adopted when there is an excessive issue of notes
and there is hyperinflation in the country. It is a very effective measure. But is inequitable for its hurts
the small depositors the most.

2. Fiscal Measures:
Monetary policy alone is incapable of controlling inflation. It should, therefore, be supplemented by
fiscal measures. Fiscal measures are highly effective for controlling government expenditure, personal
consumption expenditure, and private and public investment.
The principal fiscal measures are the following:
(a) Reduction in Unnecessary Expenditure:
The government should reduce unnecessary expenditure on non-development activities in order to
curb inflation. This will also put a check on private expenditure which is dependent upon government
demand for goods and services. But it is not easy to cut government expenditure. Though this measure
is always welcome but it becomes difficult to distinguish between essential and non-essential
expenditure. Therefore, this measure should be supplemented by taxation.
(b) Increase in Taxes:
To cut personal consumption expenditure, the rates of personal, corporate and commodity taxes
should be raised and even new taxes should be levied, but the rates of taxes should not be so high as
to discourage saving, investment and production. Rather, the tax system should provide larger
incentives to those who save, invest and produce more.
Further, to bring more revenue into the tax-net, the government should penalise the tax evaders by
imposing heavy fines. Such measures are bound to be effective in controlling inflation. To increase
the supply of goods within the country, the government should reduce import duties and increase
export duties.
(c) Increase in Savings:
Another measure is to increase savings on the part of the people. This will tend to reduce disposable
income with the people, and hence personal consumption expenditure. But due to the rising cost of
living, people are not in a position to save much voluntarily.
Keynes, therefore, advocated compulsory savings or what he called deferred payment where the
saver gets his money back after some years. For this purpose, the government should float public
loans carrying high rates of interest, start saving schemes with prize money, or lottery for long
periods, etc. It should also introduce compulsory provident fund, provident fund-cum-pension
schemes, etc. All such measures increase savings and are likely to be effective in controlling inflation.
(d) Surplus Budgets:
An important measure is to adopt anti-inflationary budgetary policy. For this purpose, the government
should give up deficit financing and instead have surplus budgets. It means collecting more in
revenues and spending less.
(e) Public Debt:
At the same time, it should stop repayment of public debt and postpone it to some future date till
inflationary pressures are controlled within the economy. Instead, the government should borrow
more to reduce money supply with the public.
Like monetary measures, fiscal measures alone cannot help in controlling inflation. They should be
supplemented by monetary, non-monetary and non-fiscal measures.
3. Other Measures:
The other types of measures are those which aim at increasing aggregate supply and reducing
aggregate demand directly.
(a) To Increase Production:
The following measures should be adopted to increase production:
(i) One of the foremost measures to control inflation is to increase the production of essential
consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.
(ii) If there is need, raw materials for such products may be imported on preferential basis to increase
the production of essential commodities,
(iii) Efforts should also be made to increase productivity. For this purpose, industrial peace should be
maintained through agreements with trade unions, binding them not to resort to strikes for some time,
(iv) The policy of rationalisation of industries should be adopted as a long-term measure.
Rationalisation increases productivity and production of industries through the use of brain, brawn
and bullion,
(v) All possible help in the form of latest technology, raw materials, financial help, subsidies, etc.
should be provided to different consumer goods sectors to increase production.
(b) Rational Wage Policy:
Another important measure is to adopt a rational wage and income policy. Under hyperinflation, there
is a wage-price spiral. To control this, the government should freeze wages, incomes, profits,
dividends, bonus, etc.
But such a drastic measure can only be adopted for a short period as it is likely to antagonise both
workers and industrialists. Therefore, the best course is to link increase in wages to increase in
productivity. This will have a dual effect. It will control wages and at the same time increase
productivity, and hence raise production of goods in the economy.
(c) Price Control:
Price control and rationing is another measure of direct control to check inflation. Price control means
fixing an upper limit for the prices of essential consumer goods. They are the maximum prices fixed
by law and anybody charging more than these prices is punished by law. But it is difficult to
administer price control.
(d) Rationing:
Rationing aims at distributing consumption of scarce goods so as to make them available to a large
number of consumers. It is applied to essential consumer goods such as wheat, rice, sugar, kerosene
oil, etc. It is meant to stabilise the prices of necessaries and assure distributive justice. But it is very
inconvenient for consumers because it leads to queues, artificial shortages, corruption and black
marketing. Keynes did not favour rationing for it involves a great deal of waste, both of resources
and of employment.
Conclusion:
From the various monetary, fiscal and other measures discussed above, it becomes clear that to
control inflation, the government should adopt all measures simultaneously. Inflation is like a hydra-
headed monster which should be fought by using all the weapons at the command of the government.

Keynesian Theory of Employment.

It is considered as the first systematic theory of employment. This is also called the demand
deficiency theorem or under employment equilibrium. According to the classical
economists, full employment is the normal situation in the capitalist economy.
According to Keynes
Employment is determined by effective demand
Demand becomes effective when aggregate demand function is equal to the aggregate
supply function.
Aggregate demand function implies the receipt side of an entrepreneur
Aggregate supply function implies the cost side of an entrepreneur

Effective Demand

Effective demand refers to that level of demand in the economy which is fully met by the
corresponding supply so that there is no tendency on the part of the entrepreneur to either
expand or contrast production. In other words effective demand is a situation where
aggregate demand is equal to aggregate supply. Thus the aggregate demand function and
aggregate supply function are the two important determinants of effective demand.

Aggregate Supply

It refers to the total quantity of goods and services that the nations business willingly
produces and sells in a given period. Aggregate supply depends upon the price level, the
productive capacity of the economy and the level of costs. In general business would like to
sell everything they can produce at higher prices.

AS = C+S

Aggregate Demand
Aggregate demand refers to the total amount that different sectors of the economy willingly
spend in a given period. AD depends upon the prices, monetary policies, fiscal policies and
other factor.
AD=C+I
National out put and the overall price level are determined by the twin baldes of the scissors
of the aggregate demand and aggregate supply
Thus effective demand refers
ED- AD=AS
ED- C+I=C+S
Thus according to Keynes, equilibrium level of employment is determined by the effective
demand (AD=AS), which is really a less than full employment. Less than full employment
is the normal situation in the economy and un employment is caused by lack of effective
demand.

Keynesian Consumption Function.

Consumption function is the functional relationship between the consumption and income.
It is s schedule showing the consumption expenditure at various levels of income.
According to Keynes, consumption is a function of aggregate disposable income.
Technical attributes of consumption function.
There are two technical attributes or technical coefficients which make a significant impact
on the Keynesian consumption function.
1. Marginal Propensity to Consume MPC
2. Average Propensity to Consume APC.
MPC.
MPC is the ratio of changes in consumption to changes in income
MPC= Changes in consumption
Changes in income
MPC is the slope of the consumption line. If the consumption is a straight line MPC is slope
is constant where as if the consumption is a curve, MPC will rise at a diminishing rate with
the increase in income.
MPS=1-MPC
APC.
It is the ratio of consumption expenditure to a particular level of income. It can be
calculated at various levels of consumption and income. Means the proportion income
spending for the consumption
APC= consumption
income

APS= 1-APC
Macroeconomic equilibrium is an economic state in an economy where the quantity of
aggregate demand equals the quantity of aggregate supply. Significant changes in either
aggregate demand or aggregate supply will have important effects on price, unemployment,
and inflation. For example, if aggregate demand is too low, then businesses don't need to
keep up production and will lay off workers causing the unemployment rate to increase.

Aggregate Supply

Aggregate supply is the total economic output of goods and services in an economy during
a specific period of time, which is the country's gross domestic product (GDP). In the long
term, aggregate supply is determined by the supply of labor, capital, natural resources and
technology to turn these factors of production into goods and services. Price level does not
affect aggregate supply in the long run.

However, in the short run, aggregate supply is affected by the price level. If the price level
in an economy increases, aggregate supply will increase in the short run, as sellers are
induced to produce more if all other things remain the same. On the other hand, if the price
level declines, aggregate supply will decline in the short run, if all other things remain
constant.

Aggregate Demand

Aggregate demand is the total demand for goods and services in an economy during a
specific period of time. A decline in the price level in an economy will increase aggregate
demand if everything else remains constant. On the other hand, an increase in the price
level will decrease aggregate demand if everything else remains constant.

Macroeconomic Equilibrium

An economy is at a state of equilibrium when the quantity of goods and services supplied in
an economy equals the quantity of goods and service demanded in it. The price level where
aggregate supply equals aggregate demand is called the equilibrium price.

The economy tends to move towards equilibrium. For example, if demand exceeds supply,
prices will increase as consumers compete for limited goods and services. Additionally,
suppliers will start to produce more goods and services because of the profit potential.
Eventually, the quantity demanded will equal the quantity supplied and the economy will
reach equilibrium.
The above curve shows that macroeconomic equilibrium where aggregate demand and
aggregate supply are equal at the point e.

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