Economics General

Name of the Course: Introductory Macroeconomics

[For Semester-II]

Unit-1: Introduction to Macroeconomics and National Income Accounting

The study of economics is traditionally divided into two fields-micro and macro.
Microeconomics deals with the behavior of disaggregated individual decision makers such as a
single consumer or a saver or a single production unit(firm) or an industry(collection of firms
producing similar or closely related products).Macroeconomics ,on the other hand, takes as its
subject the economic activity of the entire nation as an indivisible unit. The analysis, in contrast
with microeconomics, is very aggregative in nature. Some of the most important macroeconomic
variables are national income, national investment, the overall state of employment in the economy,
budgetary policy of the government.

Macroeconomists try to understand how an economy operates and, on the basis of that
understanding, suggest policies that may be adopted to improve the performance of the economy.
To understand and improve the economic performance of an economy is not possible without a
proper quantification of the values of the major macroeconomic variables. This is not an easy task,
given the highly aggregative nature of the concepts involved. The standard technique developed by
economists and statisticians for the purpose of measuring the performance of a modern economy are
collectively known as methods of national income accounting.

National Income
National income means the value of goods and services produced by a country during a financial
year. Thus, it is the net result of all economic activities of any country during a period of one
year and is valued in terms of money. National income is an uncertain term and is often used
interchangeably with the national dividend, national output, and national expenditure. We can
understand this concept by understanding the national income definition.

NATIONAL INCOME ACCOUNTING

Gross Domestic Product (GDP): The Gross Domestic Product is the most comprehensive
measure of a country's output in a given period. It is the value at current market prices of all final
goods and services produced within the domestic territory of a country in the current year. These
goods and services are valued at the prevailing market prices of those goods and services. Goods are
tangible while services are not. Performances of actors and singers, activities of lawyers, doctors
and bankers are examples of services.

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Gross National Product (GNP): GNP is the value of final goods and services produced in the
current period by domestically-owned factors of production at home or abroad. The difference with
GDP arises because some production within the domestic economy is done by factors owned by
foreigners. For instance, the salary of an American consultant in IBM‟s office in Bangalore or the
profit repatriated from India by the same company belongs to the GNP of the USA. It is a part of
India‟s GDP, but not her GNP. Similarly, the earnings of an Indian national working in a bank in
Dhaka contribute to Bangladesh‟s GDP and India‟s GNP. Return on capital invested in foreign
countries by Indians or remittance sent by Indian workers is a part of India‟s factor earning from
abroad.
Thus, GNP = GDP + (Income earned by domestically owned factors abroad) –
(Income earned at home by foreign owned factors)

GNP = GDP + Net factor earning from abroad

*Depreciation

In the course of production the fixed capital (plants and machinery) undergoes routine wear and
tear which signifies the extent of consumption of fixed capital. Additionally, over time the
machinery tends to becomes outdated or obsolete, even if perfect in the working condition. To
avoid over estimating the national product, we create a provision for this wear and tear or
depreciation as well as the routine obsolescence. Hence, if we have a gross estimate of the
national product, subtracting the depreciation would give us the net national product.
Formally,

 NNP = GNP - Depreciation

 NDP = GDP - Depreciation

Net Domestic Product (NDP): NDP is the value of net output of the economy during the year.
Some of the country‟s capital equipment wears out or becomes obsolete each year during the
production process. The value of this capital consumption or depreciation is some percentage of
gross investment which is deducted from GDP. Thus
NDP = GDP - Depreciation

Net National Product (NNP): NNP is the value of final goods and services produced in the
current period by domestically-owned factors of production at home or abroad after allowing for
the depreciation of fixed capital during any particular year. Thus, NNP is the deduction of the
consumption of fixed capital or the depreciation allowance from GNP.
NNP = GNP - Depreciation

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Net Domestic Product at Market Price and at Factor Cost

Gross Domestic Product is evaluated at market prices which diverge from the true cost of
production, based on payments to factors of production, due to the presence of indirect taxes and
subsidies. Suppose that the factor cost of one unit of output(including profit) is Rs.10.If there is
a tax of Rs.2 per unit ,on the commodity or service ,the tax-inclusive market price will be
Rs.12(=10+2).Thus market price is higher than factor cost by the amount of indirect taxes. If
instead of a tax, there was a subsidy of Rs.2 per unit, the producer could sell at Rs.8 (=10-2) and
still incur loss, then the market price is lower than the cost price by the amount of the subsidy.
Thus indirect taxes push market price above unit cost of production and subsidies do the
opposite. In other words the net indirect taxes (= Indirect tax - Subsidies) create a wedge
between the valuation of gross domestic product at market price and at factor cost. So to obtain
the value of aggregate output at factor cost (actual payment to factors for their productive service
– which is the true measure of their contribution to GDP), indirect taxes are deducted and
subsidies added on.

GDP at Factor Cost = GDP at Market Price - (Indirect Taxes - Subsidies)

= GDP at Market Price - Net indirect tax

Nominal and Real GDP

The value of GDP for a country changes from time to time. The same goes for prices of goods
and services that keep fluctuating from time to time. If prices change, then there may be
difficulties in comparing GDPs. If we measure the GDP of a country in two consecutive years
and see that the figure for GDP of the latter year is twice that of the previous year, we may
conclude that the volume of production of the country has doubled. But it is possible that only
prices of all goods and services have doubled between the two years whereas the production has
remained constant. Therefore, in order to compare the GDP figures of different countries or to
compare the GDP figures of the same country at different points of time, we cannot rely on
GDPs evaluated at current market prices. For comparison we take the help of real GDP. Real
GDP is calculated in a way such that the goods and services are evaluated at some constant set of
prices (or constant prices). Since these prices remain fixed, if the Real GDP changes we can be
sure that it is the volume of production which is undergoing changes. Nominal GDP, on the other
hand, is simply the value of GDP at the current prevailing prices.

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Nominal GDP measures the value of output at the prices prevailing at the time of production,
while real GDP measures the output produced in any one period at the prices of some base year.
The growth rate of the economy is usually taken to be the rate at which real GDP is increasing.
Table 1 illustrates the concepts. The current year is 2010 and the base year is 2004.

Table 1
Current Quantities Current Year(2010) prices Base Year(2004) prices
Apple 8 6 4
Orange 4 3 7
Pen 10 2 5

Current or Nominal GDP = 8x6+4x3+10x2=80

Real GDP = 8x4+4x7+10x5=110

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1. Product Method:
National income is measured by the output method by calculating the total value of goods and
services produced in the country during the year. The money value of goods and services
produced in an economy in an accounting year is called Gross National Product (GNP).To obtain
national income of a country, we aggregate the money value of all final goods and services
produced in a country in a year. The figure that we obtain is called GNP.

We cannot really add up the physical quantities of all goods and services produced in a year. It is
meaningless to compute the sum of 10 Indica cars, 4- 70 liters of kerosene oil, 50 meters of
cloth. Thus, we have to transform these physical quantities into money values by multiplying the
quantity of each goods produced by the price per unit of each good. That is price per car x 10
cars + price per liter x 70 liters of kerosene +… When this is done we get money value of all
goods.

In the product method multiple counting of the same product may arise if we take the total value
of each and every product separately. To avoid this multiple counting two methods are available.

(i) Value Added Method

(ii) Final Product Method

(i) Value Added Method: In the value added method we take the values added at each stage of
production and add them up. The value added by a productive unit is the difference between the
total value of its output of the year and the value of all raw materials that have been drawn from
the production of the year and have been used up. The value of raw materials drawn from the
accumulated stocks is not deducted and the value of raw materials drawn from the current
production but not used up in the year is also not deducted. Thus, value added = firm‟s revenue –
costs of intermediate goods. In brief, value added is the increase in the value of goods as a result
of the production process.

(ii) Final Product Method: In the final product method all products are divided into two
categories-intermediate product and final product. If a product produced in a year is employed
and used up in the same year as an input, it is called intermediate product. All other uses of a
product are final product, i.e. final product means that the product is ready for its designated
ultimate use. . To avoid the problem of multiple counting only final goods are to be taken into
account but intermediate goods are not to be used to compute national product. Thus, the final
product method to national income sum up the total money value of all final goods and services
produced.

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Example:

Suppose farmers produce Rs. 60 worth of wheat. The farms then sell the wheat to flour mills.
The flour mills produce flour, which they sell to bakeries for Rs.100. The bakeries produce
bread, which they sell for Rs. 150 to retailers (grocers). The grocers sell the bread to consumers
for Rs.180. Table 2.1 illustrates the process.

Table 2: Value Added in Production:

If we add the value of output (goods and services) at each stage of production, we arrive at a
value of Rs. 490. The figure overestimates the value of output because of double counting. The
flour, for instance, was made for Rs. 60 worth of wheat that we had already counted. In fact,
then, the flour producers added only Rs. 40 to the production process.

In a like manner, the Rs. 150 worth of bread sold by the bakeries contains Rs.100 worth of flour
which we had already counted in the output of flour mills. This means that the bakeries added
only Rs.50 of production. In other words, value added (that is, the difference between output
value and input value) by the flour producers is Rs. 40 and by the bakeries Rs. 50.

The wheat bought by the flour mills and the flour bought by the bakeries are called intermediate
products. These are outputs of one firm or industry but are used as inputs by other firms or
industries. The bread sold by the retail groceries is a final product. If all these value added to
intermediate stages of production are summed up, the value of bread then becomes Rs. 180 only.
The value added is just equal to the value of final bread, i.e. bread sold by the retail groceries.
GNP is, thus, measured by calculating the value added at every stage of production. GNP = sum
of value added of all firms.

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2. Income Method:

The GDP of an economy in a given year can also be measured by adding incomes earned by all
factors of production within the geographical boundary of the economy for their factor services.
The factor services include land, labour, capital and entrepreneurs. These factor services received
the income against their services. The factors income distributed as follow:

Factors of Production Factors Income

1.Land 1. Rent
2.Labour 2.Wages or Salaries
3.Capital 3.Interest
4. Entrepreneurs 4. Profit
To show this we have to break up the Value Added of a firm into its income components. To
bring out the interrelationship between the Value Added of a firm and the total factor income that
originates within it, we have to start with the concept of profit of a firm. The profit of a firm from
its production in a given year is defined by the difference between total revenue and total
production cost in the same year. The total production cost of the output of a firm in a given
year consists of wage, rent and interest payment(i.e. Primary Cost)made to household by the
firm for the factor services purchased from them for the production of the given year plus cost of
intermediate inputs used by the firm in the production of the given year. Here we start with the
concept of value added of a firm.

Value Added of a firm = Total Revenue – Costs of Intermediate Inputs

Profit of a firm = Total Revenue – Total cost

Total cost = Costs of Intermediate Inputs + Primary Cost

Thus, Profit = Total Revenue – Total cost

= Total Revenue - (Costs of Intermediate Inputs + Primary Cost)

= (Total Revenue - Costs of Intermediate Inputs) - Primary Cost

= Value Added - (Rent + Interest + Wage)

So, Value Added= Profit + Rent + Interest + Wage

This means that GDP is taken to be the total income earned by all factors of production within
the geographical boundary of the economy in the given year. For each production unit value
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added is the excess of revenue over cost of intermediate inputs. This surplus gets distributed as
payment to factors employed by the firms within economy. Therefore, if we sum up value added
of all the production units, the value of aggregate factor income will give us GDP at factor cost
of the economy in the given year. This is the income method of estimating GDP.

To measure GNP we must take into account the following facts to make an accurate estimate of
national income.

1. Transfer Payments:
In the first place, national income accountants consider only those incomes that arise from the
current production of final goods and services. Thus, some incomes are excluded. The principal
exclusion is transfer payments that include income earned by beggar unemployment allowance,
retirement pensions, flood or drought relief, etc. Transfer payments are the payments for which
no direct service is rendered by the beneficiaries. As these payments involve no exchange of
goods and services and only incomes are redistributed from one pocket to another, these transfer
payments are not included in GNP.

2. Capital Gains and Windfall Gain:

Capital gains arising out of asset transactions are excluded from GNP. If the sale price of a house
exceeds its purchase price, a situation of capital gains emerges. Such gains are coincidental. Any
such gain may lead to a rise in national income as there is no economic production. Similarly,
any windfall incomes (i.e., incomes from lottery, word puzzle) are not included in GNP.

3. Immeasurable activities:
Many activities are often excluded from the national income on account of simply problems of
measurement. These are activities usually which are not sold in the market, such as time spent in
household work, even though part of the productive set of activities carried out in an economy. In
addition there are several other activities which are included in the national income but have associated
costs which remain excluded from the national income. For instance, the production of bricks in the kiln
might be included as part of the production in the national income, but what about the pollution it causes?
The cost of environmental degradation is a depletion of sorts, and yet remains excluded from getting
captured in any of the variants of national income. Although there are several reasons to incorporate the
productive activities of unpaid domestic work and costs of environmental degradation, they remain
excluded because of practical difficulties of measurement. Of course, efforts are being made by different
countries to incorporate some of these activities in their estimates.

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3. Expenditure Method:

According to the expenditure method, the gross domestic product (GDP) is the sum total of all
final expenditure on various goods and services within domestic territory of the country, during a
year. In fact, this approach is another way of calculating the value of final goods of the economy.
This approach considers where those goods go. There are four possibilities some final goods are
consumed by individuals, some are used by firms, some are purchased by government and some
of them go abroad.

In a two-sector economy consisting of consuming sector and producing sector, total expenditure
is divided into consumption spending (symbolised by C) and investment spending (symbolised
by I). „C‟ includes expenditure on all types of goods (both durable and non-durable) and services
produced and sold. „I‟ is defined as the expenditure on newly produced capital goods acquired
for the purpose of providing services in the future. It includes investment in fixed capital
formation, stock building and residential housing. Again, investment may be gross or net. Net
investment is obtained by subtracting depreciation expenditure or capital consumption allowance
from gross investments. Thus,

GDP = C + I

If we now consider a three-sector economy (i.e., closed economy) that includes governmental
sector then GNP from the expenditure side becomes

GDP = C + I + G

„G‟ consists of expenditures on goods and services provided by the government. However, not
all government expenditures are included in GDP accounts. Expenditure on government transfer
payments (e.g., unemployment benefit, welfare grants, interest on national debt, etc.) is excluded.

The fourth category of expenditure in a four-sector economy, i.e., open economy, arises from
international trade. Here we will now include export (symbolised by X) and exclude imports
(symbolised by M). Market value of all exportable goods should be included in national income.
But market value of all imported final goods and services are to be subtracted from the GDP
figure. This is because that national income figure of any country must not reflect the
contribution of foreign nationals. Thus, in an open economy,

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GDP = C + I+ G + (X-M)

This equation may be called an identity. By definition, thus, GDP equals consumption plus
investment, plus government expenditures plus net exports.

CIRCULAR FLOW OF INCOME

In this model, the economy is assumed to be a closed economy and consists of only two sectors,
i.e., the household and the firms. There is only one way in which the households may dispose off
their earnings – by spending their entire income on the goods and services produced by the
domestic firms. The other channels of disposing their income are closed: we have assumed that
the households do not save, they do not pay taxes to the government – since there is no
government, and neither do they buy imported goods since there is no external trade in this
simple the goods and services which they assisted in producing. The aggregate consumption by
the households of the economy is equal to the aggregate expenditure on goods and services
produced by the firms in the economy. The entire income of the economy, therefore, comes back
to the producers in the form of sales revenue. There is no leakage from the system – there is no
difference between the amount that the firms had distributed in the form of factor payments
(which is the sum total of remunerations earned by the four factors of production) and the
aggregate consumption expenditure that they receive as sales revenue.

In the next period the firms will once again produce goods and services and pay remunerations to
the factors of production. These remunerations will once again be used to buy the goods and
services. Hence year after year we can imagine the aggregate income of the economy going
through the two sectors, firms and households, in a circular way. This is represented in figure.
When the income is being spent on the goods and services produced by the firms, it takes the
form of aggregate expenditure received by the firms. Since the value of expenditure must be
equal to the value of goods and services, we can equivalently measure the aggregate income by
“calculating the aggregate value of goods and services produced by the firms”. When the
aggregate revenue received by the firms is paid out to the factors of production it takes the form
of aggregate income.

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In the above figure, the uppermost arrow, going from the households to the firms, represents the
spending the households undertake to buy goods and services produced by the firms. The second
arrow going from the firms to the households is the counterpart of the arrow above. It stands for
the goods and services which are flowing from the firms to the households. In other words, this
flow is what the households are getting from the firms, for which they are making the
expenditures. In short, the two arrows on the top represent the goods and services market – the
arrow above represents the flow of payments for the goods and services, the arrow below
represents the flow of goods and services. The two arrows at the bottom of the diagram similarly
represent the factors of production market. The lower most arrow going from the households to
the firms symbolizes the services that the households are rendering to the firms. Using these
services the firms are manufacturing the output. The arrow above this, going from the firms to
the households, represents the payments made by the firms to the households for the services
provided by the latter.

Since the same amount of money, representing the aggregate value of goods and services is
moving in a circular way, if we want to estimate the aggregate value of goods and services
produced during a year we can measure the annual value of the flows at any of the dotted lines
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indicated in the diagram. We can measure the uppermost flow by measuring the aggregate value
of spending that the firms receive for the final goods and services which they produce. This
method will be called the expenditure method. The upper flow from firm to household measures
the aggregate value of final goods and services produced by all the firms; it will be called
product method. The lower flow from firm to household measures the sum total of all factor
payments will be called income method. Here aggregate spending of the economy must be equal
to the aggregate income earned by the factors of production since the same flow is being
measured at two different points.

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