BECC-103

INTRODUCTORY
MACROECONOMICS

(Note: This is a draft version of the self learning material (SLM) of the Course.
It is in the process of printing.)

School of Social Sciences

Indira Gandhi National Open University
Maidan Garhi, New Delhi-110068
EXPERT COMMITTEE
Prof. Atul Sarma (retd.) Prof. M S Bhat (retd.) Dr. Anup Chatterjee (retd.)
Former Director Jamia Millia Islamia ARSD College, University of Delhi
Indian Statistical Institute, New Delhi New Delhi
Dr. Surajit Das Dr. Manjula Singh Prof. B S Prakash
CESP, Jawaharlal Nehru University St. Stephens College, University of Indira Gandhi National Open
New Delhi Delhi University, New Delhi
Prof. Kaustuva Barik
Indira Gandhi National Open
University, New Delhi

COURSE PREPARATION TEAM

Block/ Unit Title Unit Writer

Block 1 Issues in Macroeconomics and National Income Accounting
Unit 1 Issues and Concepts Prof. Kaustuva Barik
Unit 2 National Income Accounting Adopted from IGNOU Course Material Unit 8 of EEC 11 with
modifications by Prof. Kaustuva Barik
Unit 3 Measuring Economic Dr. Sarabjit Kaur, Zakir Hussainn College (Evening), University of Delhi
Performance
Block 2 Money in a Modern Economy
Unit 4 Functions of Money
Unit 5 Demand for Money Ms. Priti Aggarwal, Assistant Professor, College of Vocational Studies,
Unit 6 Monetary Policy University of Delhi
Block 3 Inflation
Unit 7 Inflation: Concept, Types and Dr. Gurleen Kaur, Assistant Professor, Sri Guru Govind Singh College
Measurement of Commerce, University of Delhi
Unit 8 Causes and Effects of Inflation
Block 4 The Closed Economy in the Short-Run
Unit 9 Classical and Keynesian Systems Dr. Kaustuva Barik, IGNOU and Dr. Nidhi Tewathia, Assistant
Professor, Gargi College, University of Delhi
Unit 10 Keynesian Model of Income Dr. Nidhi Tewathia, Assistant Professor, Gargi College, University of
Determination Delhi
Unit 11 Fiscal Policy in Keynesian Model
Block 5 IS-LM Analysis
Unit 12 Equilibrium in the Real Sector
Unit 13 Equilibrium in the Monetary Dr. Nidhi Tewathia, Assistant Professor, Gargi College, University of
Sector Delhi
Unit 14 Neoclassical Synthesis

Course Coordinator: Prof. Kaustuva Barik Editors: Prof. Kaustuva Barik and Dr. Jagannath Mallick
Cover Design: Mr. Sandeep Maini

PRINT PRODUCTION
April, 2020
© Indira Gandhi National Open University, 2020
ISBN:
All rights reserved. No part of this work may be produced in any form, by mimeography or any other means, without permission in writings
from the Indira Gandhi National Open University.
Further information on the Indira Gandhi National Open University courses may be obtained from the University’s office at Maidan Garhi,
New Delhi -110068 or visit our website: http://www.ignou.ac.in
Printed and published on behalf of the Indira Gandhi National Open University, New Delhi, by Director, School of Social Sciences.
Laser Typeset by: Mukesh Yadav Printed at:
 CONTENTS
Page
Block 1 Issues in Macroeconomics and National
Income Accounting

Unit 1 Issues and Concepts 5

Unit 2 National Income Accounting 19

Unit 3 Measuring Economic Performance 40

Block 2 Money in a Modern Economy

Unit 4 Functions of Money 57

Unit 5 Demand for Money 66

Unit 6 Monetary Policy 77

Block 3 Inflation
Unit 7 Inflation: Concept, Types and Measurement 90

Unit 8 Causes and Effects of Inflation 98

Block 4 The Closed Economy in the Short-Run

Unit 9 Classical and Keynesian Systems 109

Unit 10 Keynesian Model of Income Determination 125

Unit 11 Fiscal Policy in Keynesian Model 137

Block 5 IS-LM Analysis

Unit 12 Equilibrium in the Real Sector 151

Unit 13 Equilibrium in the Monetary Sector 163

Unit 14 Neoclassical Synthesis 174

Glossary 183
Some Useful Books 194
COURSE INTRODUCTION

Macroeconomics is a branch of economics that deals with the behaviour of aggregate

variables such as output, income, money supply, saving, investment, exports and imports at
the economy level. We need to study macroeconomics, separately from microeconomics, as
the behaviour of the aggregates could be more complex than that of the components. Larger
issues such as economic growth, inflation, unemployment, public debt and balance of
payments could be studied only at the macroeconomic level. Thus macroeconomics helps us
in three aspects, viz., (i) understanding the relationship among aggregate economic variables,
(ii) evaluating the performance of the economy, and (iii) formulation of economic policy.

As the title of the course suggests, the course is introductory in nature. In-depth analysis of
certain complex issues will be carried out in two subsequent courses, viz., BECC 106 -
intermediate macroeconomics – I and BECC 109 - intermediate macroeconomics – II. The
course is divided into five blocks.

Block 1 titled, Issues in Macroeconomics and National Income Accounting, begins with
basic issues of macroeconomics and explains certain concepts frequently used in
macroeconomics. The objective of the Unit is to provide an overview and generate some
curiosity among learners. In subsequent two Units, it deals with the concept of circular flow
of income and measurement of national income.

Block 2 titled, Money in a Modern Economy, deals with the definition and functions of
money, and measures of money supply. Subsequently, it discusses the relationship between
money supply and price level, in the framework of quantity theory of money.

Block 3 deals with an important issue in macroeconomics, that is, inflation. It begins with
the types and measurement of inflation. In the next Unit it discusses the causes and effects of
inflation.

Block 4 titled, The Closed Economy in the Short-Run, begins with a brief idea on the
Classical and Keynesian systems. It highlights the contrast between both the schools of
thought. Subsequently it deals with the Keynesian model of income determination and its
implications for fiscal policy.

Block 5 titled, IS-LM Analysis, deals with the equilibrium in the real sector and the
monetary sector of the economy. The IS curve based on the equilibrium in the real sector, the
LM curve based on the monetary sector, and the interaction of both the curves are discussed
in the block.
UNIT 1 ISSUES AND CONCEPTS*
Structure

1.0 Objectives
1.1 Introduction
1.2 Why Study Macroeconomics?
1.3 Certain Concepts
1.3.1 Stocks and Flows
1.3.2 Short-run and Long-Run
1.3.3 Economic Models
1.3.4 Growth Rate
1.4 Production Possibility Curve
1.5 Importance of Economic Growth
1.6 Inflation and Unemployment
1.7 Business Cycle
1.8 Let Us Sum Up
1.9 Answers/Hints to Check Your Progress Exercises

1.0 OBJECTIVES
After going through this unit you should be in a position to

 distinguish between microeconomics and macroeconomics;

 appreciate the importance of macroeconomics;
 explain the concept of production possibility curve; and
 provide an overview of issues such as inflation, unemployment and business
cycle.
1.1 INTRODUCTION
By now you are familiar with the term microeconomics, which deals with issues
pertaining to economic agents such as households and firms. In the case of
households, we deal with the issue of utility maximization subject to budget
constraint. Similarly, in the case of firms, we deal with the issue of profit
maximization (or its dual, cost minimization) subject to a resource constraint.
Such issues related to maximization of utility by a household, and minimization
of cost (or maximization of profit) by a firm are the subject matter of
microeconomics. Through various diagrams you learnt how households make
choices, what constraints they face, and how they reach their optimum levels of
consumption. The optimization problem before a household can be explained

*
Dr. Kaustuva Barik, School of Social Sciences, Indira Gandhi National Open University
5
Issues in Macroeconomics and through diagrams and can be solved by mathematical methods, particularly linear
National Income Accounting algebra. A similar treatment is made for analysis of the behavior of firms, where
firms optimize their production level given the prices of inputs and resources
available to them. Naturally a question comes to mind, “Does the same
optimization problem applies to countries also?” The answer is yes; countries
have certain objective functions, and they also face constraints. The objective
function for a country could be maximization of growth in gross domestic
product (GDP), minimization of poverty among households, maintaining a stable
price level, reduction of inequality in distribution of income among individuals,
and so on. In order to analyse these issues we need a different framework that is
macroeconomics.

Macroeconomics is the branch of economics that studies the behavior of the

economy as a whole. Thus it deals with aggregate variables such as national
income, national consumption, national saving, national investment, exports,
imports, etc. As you will come to know in later Units of this course, many of
these variables are not simply the aggregation over microeconomic units.

1.2 WHY STUDY MACROECONOMICS?

In the early twentieth century, there was no such branch of economics as
macroeconomics. According to Krugman and Wells, the term macroeconomics
was coined by Ragnar Frisch in 1933. Theoretical developments in
macroeconomics came into prominence with the publication of the book,
‘General Theory of Interest, Employment and Money’ by J M Keynes in 1936.

As mentioned earlier, macroeconomics concerns with the study of aggregate

behavior in an economy. The need for a special branch of macroeconomics arises
because what holds for the individual units may not hold good for the economy
as a whole. For example, suppose a firm employs labour for production of output
(say, cement). It can hire as many workers it requires at the ongoing wage rate.
Thus increase in demand for labour by a single firm does not have any impact on
the wage rate. However, if all firms increase their demand for labour (say due to
economic boom and optimism in the country), there will be a shortage of labour
and increase in wage rate. Further, the number of workers available for work in
the country is limited; thus demand for labour beyond this limit will increase
wage rate only, not the supply of labour.

Let us consider another example – saving by a household and total saving of the
country. As you all will agree with me, saving by an individual is a virtue – we
should not consume all our income and save certain part of it for the future.
In fact, if a person saves more, (s) he will receive interest on her savings, and her
future income level will increase. There is a flip side to this issue however.
Whenever a person saves certain part of income, her/his consumption
expenditure decreases by a similar amount. Consequently, her/his demand for
goods and services on which the amount could have been spent (say, clothing) is
decreased. Thus the sales of the trader from whom (s)he would have bought the
clothing get reduced. As a result, the income (profits) of the trader gets reduced.
6
If the income of the trader is reduced, the amount of money the trader would Issues and Concepts
have spent on purchase of goods and services gets reduced. The ripple effect
continues.
We should not forget however that when we consume, we generate demand for
goods and services. Such demand for goods and services leads to production
activities and creation of employment in the country. If there is no demand for
goods and services, there will be no production, no employment and no income
generation in the country. Thus it is in the interest of the country that there is a
steady growth in household consumption. In view of the above, it is often said
that saving is a private virtue but a social vice! This problem is termed as the
paradox of thrift.

Often the difference between microeconomics and macroeconomics is explained

by giving the example of trees and forest. There are varieties of trees in the forest
and each one could be different. Microeconomics is like studying the trees in a
forest – their species, dimensions, growth, age, etc. Macroeconomics is like
studying the forest – its area, density, composition, and overall ecosystem.
We cannot ignore the forest for the trees – macro aspects as important as the
micro aspects. While microeconomics is useful for analyzing the behavior of
firms and households, macroeconomics is helpful in policy formulation and
policy evaluation. Issues such as economic growth, inflation, employment,
national debt, balance of payments, business cycles, etc. are very important for an
economy. These issues are part of macroeconomics and need to be analysed at
the macro level.

Check Your Progress 1

1. Distinguish between microeconomics and macroeconomics.

.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
2. Explain why macroeconomics is important.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

7
Issues in Macroeconomics and
National Income Accounting
1.3 CERTAIN CONCEPTS

We present certain concepts frequently used in macroeconomics.

1.3.1 Stocks and Flows

A stock is measured at a point of time. For example, the capital stock of a

country includes machines, equipment, and buildings. It refers to the part of
national wealth that is reproducible (i.e., man-made); it consists of resources that
help in production of goods and services. The stock of capital can be measured at
a particular date. Money supply, labour force and external debt are some other
examples of stock.

Flows are measured over an interval of time; thus it is a rate. In microeconomics,

as you would have observed, the output of a firm can be measured on per day or
per month basis. Otherwise, production without a time dimension is ambiguous.
Similarly, if I say that my income is Rs. 10000, it is ambiguous – is it for a day,
for a week, or for a month? In macroeconomics, the same logic applies. The
gross domestic product (GDP) of a country, for example, is a flow. It represents
the value of final goods and services produced over a year. Income, expenditure,
saving, investment, consumption, profits, borrowings, etc. are examples of flows.
Stock gets accumulated over time through change in stock. The change in capital
stock is given by investment. Mathematically, stock can be seen as integration of
a flow variable over a period of time.

1.3.2 Short-Run and Long-Run

You should be familiar with the concepts of short run and long run in
microeconomics – in the short run certain factors of production are fixed. For a
firm capital and technology are assumed to be fixed in the short run; they can be
varied in the long run only. Thus in the long run, there are no constraints for a
firm and the firm can maximize its output when all factors of production are
variable.

In macroeconomics the usage of the terms short run and long are somewhat
different from that in microeconomics. In macroeconomics, we assume certain
variables to be sticky in the short run, particularly price level and wage rate.
As we will see in later Units, the classical economists assumed prices and wages
to be fully flexible in the sense that they instantaneously adjust to changes in
aggregate demand and aggregate supply and a new equilibrium is reached.
According to Keynes these variables are sticky and they need time to adjust to
their desired level. Thus prices and wages reach their equilibrium levels in the
long run, not in the short run. Since policy makers are concerned with the short
run also, they need to take into account rigidities in prices and wages in policy
formulation.
8
 Issues and Concepts
The flow of capital input across various sectors of the economy takes time;
it takes place in the long run, not in the short run. The movement of capital across
countries is another variable which adjusts to its equilibrium level in the long run.
The impact of such flows is spread over a period of time.

1.3.3 Economic Models

In economics we often use the term ‘model’. It refers to a simplified version of

reality. It allows us to understand, analyse and predict economic behavior.
An economic model can be for a microeconomic agent such as household or
firm. In macroeconomics, it represents the behavior of the economy as a whole.

In macroeconomic models we identify relevant macroeconomic variables (such

as income, output, expenditure, investment, saving, exports, etc.) and establish
relationship among them. The relationships among these variables may be
expressed through diagrams or mathematical equations. There could be
macroeconomic models without mathematical expressions, but these may not be
precise.

An economic model is based on certain assumptions. These assumptions are

required so that minute details are ignored and essential elements are included.
Let me illustrate the point through an example. In the case of a firm, we assume
that there are two factors of production, viz., capital and labour. We club all types
of labour into a homogeneous category – we do not distinguish between a
manager and a worker in the field! Similarly, while describing an indifference
curve we overlook the type of households – the behavior of a rich household
would be different from that of a poor household; or the behavior of a household
in a rural area would be different from that of a household in an urban area. We
ignore such details because our objective is to analyse the behavior of households
to changes in prices and income. If our objective is to identify the changes in
consumption pattern across households, we would require a different model and
consider such differences.

In the Keynesian model, to take an example from macroeconomics, we consider

aggregate variables such as total consumption, total investment, government
expenditure, and net exports. We determine equilibrium level of output for the
economy as whole. We ignore the behavior of households and firms. Several
growth models (such as Harrod-Domar model or Solow model) assume that the
economy consists of just one sector – there is an aggregate production function,
which gives the relationship between aggregate output (that is, total output) with
aggregate inputs (that is, total capital and total labour). It may sound unrealistic,
but the objective of these growth models is to analyse the equilibrium conditions
for economic growth, saving ratio and population growth. These models ignore
the details but the broad conclusions drawn are helpful in policy formulation.
A question such as, ‘why growth rate differs across countries?’ can be addressed
through these growth models.

9
Issues in Macroeconomics and 1.3.4 Growth Rate
National Income Accounting
We use growth rate frequently in our day to day dealings. I am concerned with
the rate at which my salary increased over the year, the rate of interest I get on
my savings, and the rate of inflation which affect my purchasing power. At a
broader level I may be interested in the rate at which India’s population is
growing or GDP is growing. The calculation of growth rate is the same in all the
above cases. Annual growth rate of a variable is calculated as

–
Growth rate = × 100

Let us find out the growth rate of GDP

–
Growth rate of GDP = × 100

We find that the GDP of India in financial year 2018-19 was Rs.190.10 lakh
crore at current prices while it was Rs. 170. 95 lakh crore at current prices in
2017-18. If we put these values in the above equation we obtain
. – .
× 100 = 11.20 per cent. Thus the growth rate of GDP we calculate
.
above is 11.20 per cent for the year 2018-19! As we see from official data and
newspaper reports, the growth rate of GDP of India during 2018-19 is not this
high; it is much lower. The error we commit is that we consider GDP at current
prices which include increase in output and increase in prices. Our objective,
however, is to obtain an estimate of the increase in output during the financial
year 2018-19. We need to neutralise the effect of price rise – for this we consider
the GDP at constant prices. In India, GDP at constant prices, as of 2019, is given
at the base year 2011-12. The GDP of India in constant prices for the year
2018-19 is Rs. 140.78 lakh crore compared to Rs. 131.80 crore in 2017-18 (the
base year considered is 2011-12; thus these values are in 2011-12 prices). If we
put these values in the above equation we find real GDP growth rate in
. – .
2018-19 = × 100 = 6.81 per cent.
.

1.4 PRODUCTION POSSIBILITY CURVE

As mentioned earlier, achieving higher economic growth is one of the objectives

of economic policy of most countries. Economic growth of a country however
cannot be higher than certain limit. This limit depends on the availability of
inputs such as land, labour, capital, raw material, energy and technical knowhow.
Availability of certain resources is also limited. Even for countries where natural
resources are available in abundance, financial resources required for exploitation
of natural resources may be in short supply. Every year we are glued to the
television set during the government budget presentation; because it informs us
about the policy and thrust areas of the government. The budget indicates how
much money will be spent on various sectors of the economy. It is important
10
because the resources allotted on various heads of expenditure are limited. In Issues and Concepts
general, we notice that there are several constraints before a country – there may
not be sufficient budget for carrying out the activities, there may be shortages in
supply of certain strategic raw materials, there could be a long gestation period
between initiation of a project and its completion, and so on.

In macroeconomics we present the constraints faced by a country through a

production possibility curve (PPC). For simplicity, let us assume that the country
produces only two commodities (say, one capital good and one consumer good).
The PPC is concave to the origin (see Fig. 1.1) which indicates that more of one
commodity can be produced only if the production of the other commodity is
reduced. The boundary of the PPC shows the potential level of GDP given the
amount of resources available. The combinations of goods and services that can
be produced could be different. We have indicated two points (E and F) on the
PPC in Fig. 1.1. Point E indicates more of consumer good and less of capital
good while point F indicates more of capital good and less of consumer good.
You can observe that there is a trade-off between both the goods. What
combination of goods a country chooses to produce depends on the objectives
and requirements of that country.

F
Y2 G
Capital Good

Y1 E

x
x2 x1

Consumer Good

Fig. 4.1: Production Possibility Curve

You should note that the PPC shows the potential GDP of a country. What
actually is being produced in the country may be different. For example, when
production takes place on the PPC (see points E and F in Fig. 1.1), all resources
are being utilized efficiently. If production takes place at a point inside the PPC
(see points A and D), certain resources are under-utilised. A point outside the
PPC, such as G in Fig.. 1.1, is not attainable. If the country is operating at a point
inside the PPC, then there is an ‘output gap’ as given below.

Output Gap = Potential Output – Actual Output

11
Issues in Macroeconomics and Potential GDP can grow overtime by two methods: technological progress and
National Income Accounting accumulation of more resources. In such cases the PPC shifts outwards to the
right. In case the PPC shifts sufficiently outward, point G (which was not
attainable earlier) could be achieved. When a country’s PPC shifts outward, the
country observes economic growth.

Check Your Progress 2

1. Distinguish between the following concepts: (i) stock and flows; (ii) short
run and long run.

.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

2. Explain the concept of production possibility curve through a diagram.

.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

1.5 IMPORTANCE OF ECONOMIC GROWTH

As mentioned above, growth rate of an economy is given by the growth rate of its
real GDP. Maximisation of growth rate is one of the objectives of most countries.
You might have noticed that growth rate differs across countries – while
countries like China have witnessed more than 10 per cent per annum growth rate
for decades, there are many African countries where growth has been is
negligible. Very high economic growth of Japan is said to be a miracle during the
post World War period. In the past 20 years, however, there has been severe
economic crisis in Japan – highly fluctuating economic growth, declining
population size, and very high public debt. Argentina, a Latin American country,
was richer than many countries such as Australia, Canada and France during the
early twentieth century. Argentina is endowed with vast natural resources,
particularly in the areas of agriculture and energy. In 1913 Argentina’s per capita
income was $3797 compared to $3452 of France and $3134 of Germany.
12
According to International Monetary Fund (IMF), in 2019, the per capita income Issues and Concepts
of Argentina is $9887 while that of France and Germany are $41760 and $46563
respectively. It indicates that per capita incomes of France and Germany have
increased much faster over the past century than that of Argentina. Economists
ascribe this relative stagnation in growth rate of Argentina to several factors
including political instability, lack of technological progress, adherence to the
development strategy of import-substitution (instead of export promotion), and
high inflation. In another example, we compare the per capita incomes of China
and India; two major emerging economies of the world. Per capita GDP of India
and China was almost at the same level till 1990 (in US Dollar terms, GDP per
capita of India was $367 in 1990 compared to $318 of China). In the subsequent
period, however, growth rate of China was much higher than that of India. In
2018, per capita GDP of India was about 20 per cent that of China (India’s per
capita GDP, in US Dollar terms in 2018, was $2010 compared to China’s $9770).
If we compare the per capita income of India and China in purchasing power
parity (PPP) terms for the year 2018, however, India’s per capita GDP was $7762
compared to $18236 of China (about 43 per cent). We can make such
comparisons across countries and analyse the reasons for such differences in
growth by undertaking macroeconomic analysis.

You should be aware of the ‘rule of 70’. It indicates the number of years it takes
to double your money. If you save Rs. 1000 in a bank and the rate of interest is
1 per cent per annum, your saving will take 70 years to double, i.e., to be
Rs. 2000. If the rate of interest is 7 per cent, it takes only 10 years to double. The
formula is

70
Number of years to double the amount = .
rate of inerest

The same rule can be applied to GDP and per capita GDP of a country. If per
capita GDP of a country is growing at the rate of 5 per cent, it takes 14 years (that
is, =14) for the country to double its per capita GDP. If growth rate in per
capita GDP is 10 per cent per annum, it will double in 7 years. Let us compare
between two countries, A and B, which have the same per capita GDP, say
Rs. 1000. Let us assume that per capita GDP of country A is growing at 5 per
cent per annum while that of country B is growing at 10 per cent per annum. If
we consider a time span of 28 years, per capita GDP of country A will be
Rs. 4000 after 28 years that of country B will be Rs. 8000! You can imagine how
much difference a higher growth rate can bring to per capita GDP in the long run.

Economic growth is important because it leads to increase in income of people,

which in turn leads to higher consumption and saving. Second, there is increase
in tax revenue of the government due to higher income and output. Third,
increase in GDP leads to fall in unemployment, as more workers get employed.
Fourth, increased government expenditure leads to improved public services.

13
Issues in Macroeconomics and You should note that economic development is different from economic growth.
National Income Accounting While economic growth indicates increase in GDP, economic development is a
much broader concept. Economic development includes improvement in basic
facilities such as health, education, electricity, drinking water, absence of
poverty, etc. Such improvement is possible if there is economic growth.

1.6 INFLATION AND UNEMPLOYMENT

We come across the terms inflation and unemployment often in

newspapers and in our everyday conversation. Increase in either of these
variables creates miseries in people’s life and much concern for the
policy makers. Inflation is defined as a persistent rise in the general level
of prices. If price level goes up today but falls tomorrow then it may not imply
inflation, but only short-term fluctuations in prices. The term ‘general price level’
is also important since, over a period of time, prices of some commodities may
have gone up while t h a t o f some others may have actually fallen. As a
result, on the whole, the average of these prices may remain constant or even
go down. Similarly if the price of a group of commodities, which constitute a
small fraction of the total value of output of the economy, would go up, then
again it might not be inflationary as such. That is, the effect of rise in prices of
such commodities might be too small so as to affect the average price level of
all the commodities.

Thus we see that inflation is a macroeconomic phenomenon and is not

concerned with the rise in the price of a particular commodity, or, a small group
of commodities. When there is inflation, the purchasing power of people
declines. Inflation has differential impact on various sections of society. While
salaried groups (persons having fixed monthly income) are hit adversely,
producers and traders stand to gain during periods of inflation. Very high
inflation (often called hyper-inflation) puts everyone’s budget in disorder.

Unemployment is another social evil. In economics when we refer to the term

unemployment, we mean involuntary unemployment, that is, a person is looking
for work but not able to find a job. A person who is not looking for a job cannot
be considered as unemployed. There are periods when we quit a job and look for
another. At any point of time, certain fraction of workers is between jobs – such
unemployment is transitory. However, there are time periods when
unemployment rate is quite high. Unemployment is bad on two counts, viz., (i) it
results in loss of income for the unemployed, and (ii) there is wastage of valuable
human resources.

It is generally observed that there is a trade-off between inflation and

unemployment, at least in the short run. If the government wants to decrease the
rate of unemployment, the economy has to tolerate a higher rate of inflation.
Similarly, if the government wants to control inflation, the rate of unemployment
may increase. There is considerable debate on the relationship between inflation
and unemployment; and there is much difference among economists on the
relationship between the two.

14
 Issues and Concepts

1.7 BUSINESS CYCLE

There are ups and downs in economic activities for any country – while growth
rate is high in certain periods, it is low in other periods. It is generally observed
that there are alternating phases of high and low growth rates. Such phases of
growth are called business cycles.

There are four phases of a business cycle: expansion, recession, depression, and
recovery. The duration of a business cycle can vary from two years to twelve
years. Business cycles are synchronic. Depression or contraction occurs
simultaneously in most industries or sectors of the economy. Recession passes
from one industry to another and chain reaction continues till the whole economy
is in the grip of recession. Similarly, prosperity spreads through various linkages
of input-output relations or demand relations between industries or sectors.
Business cycles can be distinguished from other fluctuations as they are usually
larger, longer, and widely diffused.

In business cycles we observe that several inter-related variables move together.

Fluctuations occur simultaneously in the level of output as well as employment,
investment, consumption, rate of interest, price level, etc. The immediate impact
of recession or expansion is on the inventories of goods. When recession sets in,
inventories start accumulating beyond the desired level. In response, producers
cut down on the level of production of goods. In contrast, when recovery starts,
aggregate demand picks up and inventories go below the desired level. It
encourages business houses to place more orders for goods which boosts
production and stimulates investment.

Business cycle is international in character; once started in one country, it spreads

to other countries through contagion effect. The downslide in financial markets,
for example, in one country spreads rapidly to other countries as financial
markets are linked globally through capital flows. Further, recession in one
country, say the United States (US), can spread to other countries as the imports
of the US will decline. Countries which are major exporters to the US will
witness a decline in their exports and may witness recession.

The adverse impact of the Great Depression (1929-34) is well documented. It

resulted in widespread unemployment, poverty and misery among a large section
of society in many countries. In recent years, during 2007-09 (often it is referred
to as the Great Recession) most countries witnessed a phase of severe recession.
The world has overcome the adverse impact of the economic crisis of 2007-09 to
some extent, but its memories are still fresh.

15
Issues in Macroeconomics and Check Your Progress 3
National Income Accounting
1. Explain why economic growth is important for a country.

.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

2. Distinguish between economic growth and economic development.

.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

3. Explain the concept of business cycle.

.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

1.8 LET US SUM UP

In this unit we distinguished between microeconomics and macroeconomics.
Macroeconomics considers broader and aggregative aspects of the economy. It is
helpful in policy formulation and policy evaluation.

We discussed how growth rate can be calculated. In addition, we described the

importance of economic growth. Distinction between concepts such as stock and
flows, and short-run and long run are presented in the Unit. Brief ideas on certain
concepts such as inflation, unemployment and business cycle, which we come
across in our everyday life, are also given in the Unit.

1.9 ANSWERS/ HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1

1. Go through Section 1.2 and answer.

2. Go through Section 1.2 and answer.

16
 Issues and Concepts
Check Your Progress 2

1. (i) Stocks are measured at a point of time while flows are measured per
unit of time. Go through Section 1.2 for further details.
(ii) In the short run certain factors are fixed while in the long run all
factors are variable. Go through Section 1.2 for further details.
2. Production possibility curve depicts the potential output of an economy.
Explain Fig. 1.1 for your answer.

Check Your Progress 3

1. Go through Section 1.5 and answer.

2. Economic growth means the growth in the GDP of a country. Economic
development is a multi-dimensional concept. In addition to per capita
income, it includes various socio-economic variables. Go through Section
1.5 for further details.
3. Go through Section 1.7 and answer.

17
UNIT 2 CIRCULAR FLOW AND NATIONAL
INCOME ACCOUNTING*
Structure

2.0 Objectives
2.1 Introduction
2.2 Concept of Circular Flow
2.2.1 Difference between Money Flows and Real Flows
2.2.2 Flows between Enterprises and Households
2.2.3 Flows between Enterprises, Households, Financial sector
2.2.4 Flows between Enterprises, Households, Financial and Government Sectors
2.2.5 Flows in an Open Economy
2.3 Circular Flows and National Income
2.3.1 National Income as Flow of Goods and Services
2.3.2 National Income as Flow of Factor Incomes
2.3.3 National Income as Flow of Final Expenditures
2.3.4 National Income viewed as Production, Income and Expenditure Flows
2.4 National Income Aggregates
2.4.1 National Income and Various Related Concepts
2.4.2 Interrelationships among Various Macro-economic Aggregates
2.5 Let Us Sum Up
2.6 Hints/Answers to Check Your Progress Exercises

2.0 OBJECTIVES
After going through the unit you would be able to
 explain the term ‘circular flows’;
 distinguish between money flows and real flows; and
 establish the relationship among various macro-economic aggregates.

2.1 INTRODUCTION

An economy operates with the help of economic agents such as producers,

consumers, government and rest of the world. These categories perform various
economic activities comprising production, c on s um pt i o n, income generation,
addition to capital stock, and economic transactions with the rest of the world.
In the process of performing such economic activities, goods and services flow
from one group of agents to another and vice-versa. Corresponding to each
such flow, there takes place a counter monetary flow. For example, if one
person gets 2 kilograms of sugar from a firm, a commodity-flow from a firm to
*
Adopted from IGNOU Course Material Unit 8 of EEC 11 with modifications by Prof. Kaustuva
Barik
Issues in Macroeconomics and a household is taking place. This flow is matched by a monetary flow, from the
National Income Accounting household to the firm. Such flows, if aggregated at various ends, can be summed
up as national income, gross domestic product, etc.

The knowledge of these circular flows along with national income and various
other related macroeconomic aggregates is essential for understanding
macroeconomic theory which deals with the determination of levels of national
income, employment and prices.

2.2 CONCEPT OF CIRCULAR FLOW

The concept of circular flow pertains to the flow of real transaction or money
transaction from one economic agent to another. The flow is not one-sided; it is
two-sided. Because of this feature it can be termed as circular flow. Suppose
person A gives wheat to person B and person B in turn gives rice to person A,
then this can be termed as circular flow which is shown below.

Fig. 2.1

In Fig. 2.1 the direction of the arrows shows the receiving agent. For example,
B is receiving wheat from A and therefore, the arrow is pointing towards B.
Similarly, A is receiving rice from B. Thus, the arrow is pointing towards A.

In the above example, goods have been exchanged so the flows can be referred
to as real flows. Instead of goods, if money was exchanged, the flows could
have been money flows. Note from the example that when B received wheat
from A, money would be given by B to A. Similarly, A would have given
money to B for the purchase of rice. These money flows can be shown as
below.
Payment for purchase Wheat

Payment for purchase of Rice

Fig. 2.2

20
 Comparing Fig. 2.1 and Fig. 2.2, we would notice that real flows take National Income Accounting
clockwise movement, i.e., from left to right. On the other hand, money flows
take anti-clock- wise movement, i.e., from right to left.

2.2.1 Difference between Money Flows and Real Flows

The distinction between money flows and real flows should be clearly
understood. Real flows are the flows of goods from one economic agent to
another and vice-versa. Similarly, real flows can be flows of services from one
economic agent to another and vice-versa. Real flows are difficult to measure as
they comprise bundles of goods or services, expressed in different units and it is
impossible to aggregate these economic agent or flows. It is precisely because
of this reason that we measure money flows.

Money flows, as the name suggests, show the flow of money from one
economic agent to another. Suppose economic agent A supplies goods to
transactor B. That is a real flow. The transactor B, in turn must have paid for
these goods to transactor A, which is a money flow. Similarly, transactor B may
have supplied labour services or services of land to transactor A which is a
real flow. Transactor A, in turn, must have paid for these factor services in the
form of wages to transactor B that would be money flow.

The distinction between money and real flows and their interaction can be very
well shown with the help of a diagram such as Fig. 2.3, where transactor A is
represented as a producer and transactor B as a household.

Fig. 2.3

In Fig. 2.3, a producer supplies wheat to a household. The direction of the arrow
indicates who receives the goods. Similarly, the household supplies factor
services to a producer as shown by the arrow. Note that clock-wise direction of
the arrow indicates real flows.

21
Issues in Macroeconomics and Corresponding to real flows we can also see money flows taking place in the
National Income Accounting opposite direction or in an anti-clock-wise direction. For instance, for the goods
supplied by the producer to a consumer, the consumer has paid for these goods in
money terms, which can be called consumption expenditure.
Similarly, the producer has paid for these factor services. We can call these factor
payments. Remember that anti-clock-wise arrows indicate money flows.

It is important to realize that a barter economy where goods/services are

exchanged for goods/services will have only real flows. On the other hand, in an
economy where goods/services are exchanged for money and then money is
exchanged for goods we will have real as well as money flows. It is also possible
that in a modern economy we may have only money flows taking place without
any corresponding real flows. For instance, if a father gives pocket money to
his son, money flow may take place from father to son. But son, in turn, has not
supplied anything in return and thus the circular money flow is not complete.
Can we think of some cases where the circular money flows may complete
circular movement?

2.2.2 Flows between Enterprises and Households

Various transactions taking place among transactors or economic agents can be

better understood when put in the form of flows.

An enterprise is an economic agent, which employs factor services supplied by

households. It creates goods and services, which may either be supplied to other
firms in the form of raw materials, or produce consumer goods meant for the
final consumption. It may produce machines/plants to help in the creation of
more goods and services.

Similarly, we can define a household, which, by definition, supplies the factor

services such as land, labour, capital and entrepreneurship to enterprises. Further,
it consumes consumer goods and services produced by enterprises.

The distinction between households and producers is not always mutually

exclusive. A person can be a household as well as a producer. To take an
illustration, a teacher is a producer when she produces teaching services and will
be a household when she buys or consumes the goods and services produced by
other producers. Thus, the distinction is not personal, but functional in nature.

The flows between enterprises and households can be shown with the help of
Fig. 2.4.

22
 National Income Accounting

Fig. 2.4

In Fig. 2.4 both real and money flows are shown. The flow of consumer goods
and services from enterprises to households and of factor services from
households to enterprises constitute real flows. Similarly, flows taking place
from consumers to producers in the form of consumption expenditure and from
enterprises to households in the form of factor incomes relate to money flows.
It would not be out of place to state that m oney flows a r e the counterparts
of real flows. Note that Fig. 2.4 is not much different from Fig. 2.3. In Fig. 2.3
we had shown transaction between one firm and one household only, now all the
producers and consumers have been added together to make two groups.

2.2.3 Flows between Enterprises, Households and Financial sector

So far we have discussed flows in a situation where there is no saving and

investment. To introduce saving and investment we have to include financial
sector along with enterprises and households.

Financial sector collects savings of various sectors and lends these to enterprises
for investment. The introduction of financial sector along with enterprises and
households is illustrated in Fig. 2.5.

Fig. 2.5

23
Issues in Macroeconomics and In Fig. 2.5, t h e flows between enterprises and households are shown as in Fig.
National Income Accounting 2.4. The additional flows shown here are between (i) households and financial
sector, and (ii) enterprises and financial sector. The factor income received by
households need not be fully used for final consumption expenditure; a part of
the incomes may be saved in banks or funds used f o r buying shares, or
buying, say, an i n s u ra n c e p o l i c y , which are all considered as part of t h e
financial sector. Thus, the arrow from households towards financial sector is
indicative of the savings flowing from household sector to financial sector.
These savings are collected by financial sector from households along with
savings of the enterprises in the form of undistributed profits, accumulated for
expansion purposes, and depreciation fund used for replacement investment
purposes. The savings of the financial sector are used to finance gross investment
of the economy, which is shown, with the help of an arrow from the financial
sector towards the enterprises.

The investment activity of the economy is undertaken by the enterprises, which

produce capital goods for net accumulation of capital stock, or for replacing the
worn-out capital. Saving in national income accounting is so defined as to be
equal to investment.

2.2.4 Flows between Enterprises, Households, Financial and Government

Sectors

Flows between enterprises, households and financial sector were shown in Fig.
2.5 above. Let us now introduce the government sector.

The government sector can be viewed in two ways: First, the government can
act as a producer or enterprise meaning thereby that it can contribute to total
production activity along with the private sector. Second, the government can act
as a redistributors of incomes, i.e., tax a particular sector of the economy and
subsidies another either by giving cash help to the enterprises or offering transfer
incomes in the form of old-age pensions or unemployment benefits to households.
The government production activity can be categorized as, 'General Government'
where the government produces primarily services which are collectively
consumed. These can take the form of police, or defense services, which are
ordinarily not available for sale; instead they are consumed collectively and are
financed from the tax revenue raised by the government.

The government has undertaken departmental and non-departmental enterprises,

which produce goods and services for sale in the market, are grouped in the
category of enterprises. Therefore, General Government is only an activity of the
government as redistributors of income or producer of services, which is meant
for collective consumption.

In Fig 2.6 we introduce the g o v e r n m e n t sector in the circular flows. We are

introducing a change in our presentation here: Now onwards, we will show only
the monetary flows without the corresponding real flows. This is being done to
keep the diagrams simple in appearance.
24
 National Income Accounting

Fig. 2.6

In Fig. 2.6, the flows between enterprises, households and financial sector are the
same as shown in Fig. 2.5. However, Fig. 2.6 has an additional flow; namely,
a part of the saving may come from government sector to the financial
sector. These savings may be positive or negative. If the government
expenditure on transfer incomes, subsidies or maintenance of collective services
is more than the tax revenue raised in the form of direct personal tax, indirect taxes
and corporation tax, savings is negative. On the other hand, if government
expenditure were less than tax revenue, government saving contributed by the
government sector would be positive.

The income received by households for the supply of factor services to the
government sector need not be spent only on the purchase of consumer goods
produced by enterprises. A part of the factor income may be passed on to the
government in the form of direct personal taxes as indicated by the arrow towards
government from households. On the other hand, the government can give
transfer incomes to households as shown by arrow facing households from
government. Similarly, the incomes received by enterprises from the sale of
consumer goods to households or for meeting collective consumption of
government, may get leaked to government in the form of indirect taxes and
corporation taxes as shown by the arrow facing government originating from
enterprises. The government may also use tax revenue to subsidise production of
goods and services by enterprises. This is shown by the arrow facing
enterprises starting from government.

2.2.5 Flows in an Open Economy

So far we have shown the flows in a closed economy, i.e., an economy that
does not have any transactions in the form of exports and imports.

25
Issues in Macroeconomics and
National Income Accounting Now, we introduce transactions of an economy with the other countries of the
world (referred to as rest of the world). When an economy is opened up, the
following variables have to be incorporated in the flows of an economy:

1) A part of the output produced by enterprises of the economy may be retained

for consumption or investment purposes within the economy and the rest
may be exported to the rest of the world. The payment for such exports is
made by rest of the world to enterprises of the domestic economy.

2) Consumption expenditure of households may be not only on goods and

services produced within the economy but also on those imported from the
rest of the world.

3) Households may earn fa c t o r incomes not only from domestic enterprises

but also from normal residents of an economy who are temporarily, up to one
year, stationed in other countries. Similarly the normal residents of the rest
of the world may temporarily be stationed within the economy in question and
therefore factor income earned by them is a part o f the national income of
the country of which they are the normal resi dents. This to get he r gives
us the variable called ‘net factor income from abroad' which can be
positive or negative. It is positive if factor income earned by the normal
residents of an economy in the rest of the world is more than factor income
earned by the normal residents of the rest of the world stationed in the
economy.

4) Another factor to be considered is the fact that savings accumulated in the

financial sector may not originate from household's enterprises or the
government. A part of the saving may flow from the rest of the world
which is termed as ‘net capital inflow from the rest of the world,’ which
may be positive or negative. It is positive when borrowings from rest of the
world are more than lending to rest of the world and negative when
lending exceeds borrowing.

5) Another factor is that savings generated within the economy and from the
rest of the world may be used not only for generating gross domestic capital
formation (replacement investment plus net domestic capital formation) but
also for the purposes of net investment aboard, which can be positive or
negative. It is positive when investment made by the economy in the rest of
the world is more than investment made by the rest of the world in the
economy in question and negative in case of a reverse situation.

6) Lastly, just like there can be unilateral transfers (which do not have quid-pro-
quo) within the economy there can be unilateral transfers from the rest of
the world to the economy and vice-versa. The variable is termed as
'net current transfers from the rest of the world', which can be positive or
negative. It is positive when current transfers from the rest of the world to
the economy in question are more than current transfers by the
economy to the rest of the world are and negative when the reverse is
true.

26
 In Fig. 2.6, the flows in a closed economy were shown. The corresponding flows National Income Accounting
in an open economy are shown in Fig. 2.7. The incorporation of variables arising
because of opening up of the economy would bring in quite a difference to the
flows of a closed economy shown in Fig. 2.6.

Enterprises receive money not only through consumption expenditure of

households but also by net exports of goods and services of enterprises.
Net exports are the difference between exports and imports. It can be positive or
negative. It is positive w h e n exports are more than imports and negative
when reverse is true. In the figure, the arrow originating from the rest of the
world to enterprises indicates exports whereas the arrow originating from
enterprises to the rest of the world indicates imports.

Similarly, ‘Net Factor Income from Aboard’ (NFIA) is shown with the help of
an arrow pointing towards households from the rest of the world. The same is
true of 'net current transfers from aboard' where arrow is pointing t o w a r d s
households from ‘Rest of the World’.

Fig. 2.7

Net borrowings from the rest of the world are indicated by an arrow
pointing towards financial sector starting from the rest of the world. Finally,
net foreign investment is shown with the help of an arrow pointing towards the
rest of the world from financial sector.

Thus, Fig. 2.7 presents a full picture of the flows taking place in an economy,
which has enterprises, households, government, financial sector and the rest of
the world sector as the main players.

The situation gets more complicated if each of the sectors is sub-divided into
smaller units. For instance, enterprises sector is to be divided into a number of
enterprises; household sector into individual households; the financial sector into
banks, insurance, share market, etc.; government into Central Government, State
27
Issues in Macroeconomics and Governments, Local Governments; and the Rest of the World into a number of
National Income Accounting countries. The situation will get complicated because inter-unit transactions of a
sector are also to be accounted for.

Check Your Progress 1

1) Distinguish between money flows and real flows with the help of suitable
illustrations.

......................................................................................................................................

......................................................................................................................................

......................................................................................................................................

......................................................................................................................................

5) State various economic transactions, which are used to study circular flow
of an economy.

......................................................................................................................................

......................................................................................................................................

......................................................................................................................................

......................................................................................................................................

3) How does circular flow get complicated when financial sector is introduced
along with enterprises and household sectors?

......................................................................................................................................

......................................................................................................................................

......................................................................................................................................

......................................................................................................................................

2.3 CIRCULAR FLOWS AND NATIONAL INCOME

The circular flows presented in Section 2.2 are essential for the purposes of
visualizing the working of an economy. By studying these flows it is possible to
derive various macro-economic aggregates. Some of these aggregates are gross
domestic product (GDP), net domestic product (NDP), gross national product
(GNP), net national product (NNP) and national income (NY). In the following
sub- sections we try to derive these aggregates from circular flows.
28
 National Income Accounting
We would employ Fig. 2.7 to arrive at national income ( NY) in three phases,
viz., (i) as flow of goods and services, ( i i ) as flow of factor incomes, and
( i i i ) as flow of final expenditures.

2.3.1 National Income as Flow of Goods and Services

Taking a fresh look at Fig. 2.7, we can try to view NY aggregate at the
enterprises end. If we add up the money value of the flow of goods and
services produced over a year without duplication, after deducting the production
of capital goods meant for replacing worn out capital stock and adding with this
the net factor income from abroad, it would be possible to get a figure of NY of
an economy. To spell out further, enterprises produce consumer goods (C) and
take up net domestic capital formation (I). Add with this t h e net factor income
from abroad to get NY of an economy. Thus we can say Y = C + I + NFIA
where Y is NY. In this definition i t may be kept in mind that the value of
goods and services have to be computed at factor cost (FC) and not at market
price (MP), where v a l u e a t MP = Value at F C + N I T . NIT i s net indirect
t a x e s i.e., indirect taxes minus subsidies. Moreover, it is also to be seen that
those goods and services which are produced by enterprises meant for the
purposes of intermediate consumption (raw materials bought by one enterprises
from another are not to be added along with goods and services meant either
for final consumption on the part of households or for adding to the total capital
stock of the economy. This needs to be done to avoid double counting. To give
an example, if we take the total production of wheat along with total production
of bread we would indulge in duplication since bread also includes wheat in
the form of flour.

This way of calculating NY is known as the production method, or the product

method. Production method as we will see later is also known as the value added
method.

2.3.2 National Income as Flow of Factor Incomes

Again, going back to Fig. 2.7, let us view NY aggregate, at the households' end.
Households supply factor services to enterprises to produce goods and services.
These factor services can be supplied by four factors of production, viz.,
labour, land; capital and enterprise are to be remunerated in the form of
wages, rent, interest and profits, respectively.

Thus, by adding up wages, rent, interest and profits along with net factor
income from abroad we get NY of an economy. Or, Y = W + R + In + P
+ NFIA, where Y is national income which is equal to the sum of wages (W),
rent (R), interest (In), profits (P) and net factor income from abroad (NFIA).
What we have done is to add up all the factor incomes received by households
for supplying factor services to enterprises. By definition, national income
viewed, as flow of final goods and services is identical to the one viewed as flow
of factor income generated in the process of production.
29
Issues in Macroeconomics and
National Income Accounting Sometimes factor incomes instead of being categorized into W, R, In, and P are
put differently. In this new way of categorization of factor incomes we have
the groups, viz., compensation of employees (CE), operating surplus (OS)
and mixed income of self-employed ( MY) so that Y = CE + OS + MY
+ NFIA, where CE is compensation given to labour for rendering labour
services, OS is factor income generated by the ownership and to distinguish
between CE a n d OS and NFIA is net factor income from aboard (already
defined). While CE and OS are easy to understand, MY requires a little
explanation. The MY arises in the case of self- employed. For example, if we
ask a shopkeeper, running a shop at her own place of residence using her own
capital,

Herself working as labourer or manager and herself undertaking the risk of

running the business out of the income of such an enterprise, how much is
rent, interest, wages and profits? It would not be possible for her to categorise
her income under various heads. Such factor incomes instead can be put under
the label mixed income of self-employed.

2.3.3 National Income as Flow of Final Expenditures

Making use of Fig. 2.7 national income can also be viewed as sum of final
expenditures of various transactors of an economy. In other words, this time we
look at not the production of final goods and services but how they are
disposed of. The various heads of final expenditures can originate from either
households in the form of private final consumption expenditure (Ch) or from
government in the form of public final consumption expenditure (Cg) or from
firms i n the form o f purchase of net domestic capital goods (NDKF) a n d
change in inventories (K) or from the rest of the world in the form of
payments towards net exports (NE).

Change in inventories is defined as stocks of finished goods or raw

materials/semi- finished products at the end of the year minus the stocks of these
goods at the beginning of the year. Change in stocks is positive if closing stocks
are more than opening stocks and negative in the reverse situation.

We are now in a position to arrive at NY viewed as flow of final expenditures,

which is equal to

Y = Ch + Cg + NDKF + NE.

Since NY is defined as NNP at FC, it is important to make final adjustment

in the above equation by deducting ‘net indirect taxes’ (NIT); since Ch, Cg,
NDKF and NE are normally presented at market price, in order to convert
these figures at factor cost, NIT has to be deducted.

In the final reckoning the equation of national income as flow of final

expenditure will be
30
 National Income Accounting
Y = Ch + Cg + NDKF + NE - NIT.

2.3.4 National Income viewed as Production, Income and Expenditure Flows

We are in a position to state now that in Sub-Sections 2.3.1, 2.3.2 and 2.3.3 the
national income aggregate is arrived at considering circular flows from
production, income and expenditure respectively. Since production of goods and
services requires factor services.

And factor incomes are generated and such incomes are disposed of for financing
final consumption expenditure or saved. Savings, in turn, are used to finance
capital formation activity within the economy or for financing net foreign
investment

These three ways of measurement will give us the same magnitude of national
income, provided full statistical data required are available. In reality, the requisite
information may not be available because of which we a r e forced to employ a
combination of these three methods to measure national income of an
economy.

The first step to measure national income of an economy is to divide the economy
into a number of industrial sectors like agriculture, mining, logging,
manufacturing, construction, real estate, government services, transport services,
commercial services etc. Then depending on the availability of data we decide
which method to employ. For example, in agriculture and manufacturing sectors
production figures may be more readily available and thus we find out the
contribution o f these sectors by employing production or value added method;
for construction sector expenditure figures may be more easily available and its
contribution to national income can be estimated by using expenditure method.
Finally, for services sector, figures of incomes generated during a year are more
easily available which necessitates the employment of income method.

Check Your Progress 2

1) Show how Production Flow, Income Flow and Expenditure Flow in an

economy are related to each other.

......................................................................................................................................

......................................................................................................................................

......................................................................................................................................

31
Issues in Macroeconomics and 2) State the main components of National Income as flow of:
National Income Accounting
(i) Currently produced goods and services.

......................................................................................................................................

......................................................................................................................................

......................................................................................................................................

......................................................................................................................................

(ii) Currently generated factor incomes.

......................................................................................................................................

......................................................................................................................................

......................................................................................................................................

......................................................................................................................................

3) Why does India employ a combination of production, income and expenditure

methods to measure its national income?

......................................................................................................................................

......................................................................................................................................

......................................................................................................................................

......................................................................................................................................

2.4 NATIONAL INCOME AGGREGATES

National income is a macro-economic aggregate, which is indicative of

economic progress of an economy. There are a number of other related concepts
which are equally important and we should clearly understand the inter-
relationship among various macro-economic aggregates.

2.4.1 National Income and various Related Concepts

Some of the important related concepts of national income are as follows:

1) Gross National Product at Market Price (GNPMP): It is the sum of the

values of currently produced goods and services without duplication, over a

32
 year, by the normal residents of an economy, gross of depreciation, where National Income Accounting
goods and services are valued at the market prices.

2) Gross National Product at Factor Cost (GNPFC): It is the sum of the

value of currently produced goods and services, over a year, by the normal
residents of an economy, gross of depreciation, when goods and services are
valued at factor cost (market price minus net indirect taxes).

2) Net National Product at Market Price (NNPMP): It is the sum of value of

currently produced goods and services without duplication, over a year, by
the normal residents of an economy, net of depreciation, where goods and
services are valued at market price.

4) Net National Product at Factor Cost (NNPFC): It is the sum of value of

currently produced goods and services without duplication, over a year, by
the normal residents of an economy, net of depreciation, where goods and
services are valued at factor cost (market price minus net indirect taxes).

5) National Income (NY): It is the same as the NNPFC.

6) Gross Domestic Product at Market Price (GDPMP): It is the sum of

value of currently produced goods and services without duplication, over a
year, within the domestic territory of an economy, gross of depreciation,
valued at market price.

7) Gross Domestic Product at Factor Cost (GDPFC): It is the sum of the

value of currently produced goods and services without duplication, over a
year, within the domestic territory of an economy, gross of depreciation,
where goods and services are valued at factor cost (market price minus net
indirect taxes).

8) Net Domestic Product at Market Price (NDPMP): It is the sum of value

of currently produced goods and services without duplication, over a year,
within the domestic territory of an economy, net of depreciation, where
goods and services are valued at market price.

9) Net Domestic Product at Factor Cost (NDPFC): It is the sum of value of

currently produced goods and services without duplication, over a year,
within the domestic territory of an economy, net of depreciation, where
goods and services are valued at factor cost (market price minus net
indirect taxes).

10)Net National Disposable Income (NNDY): It is the factor and transfer

incomes earned or enjoyed by the normal residents of an economy, over a
year, inclusive of net indirect taxes. It is identical to NNPM MP + Net
Current Transfers from R est of the W orld.

11) Income from Domestic Product Accruing to Private Sector (Z): It is the
factor income enjoyed by households and private corporate sector in an
economy, over a year.
33
Issues in Macroeconomics and
National Income Accounting 12) Private Income (PY): It is the factor income and current transfers
within the economy along with net current transfers from the rest of the
world enjoyed by the normal residents of an economy, over a year.

13) Personal Income (Personal Y): It is factor income and current transfers
within the economy along with net current transfers from the rest of the
world enjoyed by households of normal residents of an economy, over a
year.

14) Personal Disposable Income (PDY): It is factor income and current

transfers within the economy along with net current transfers from the rest of
the world, net of personal direct taxes and other administrative payments,
at the disposal of households of normal residents of an economy, over a
year.

15) Personal Consumption Expenditure (Ch): It is personal disposable income

minus personal savings (i.e., savings of households), over a year.

2.4.2 Interrelationships among various Macro-economic Aggregates

In Sub-Section 2.4.1 various national income and related concepts were

introduced. In this section, we will discuss the interrelationships among
these aggregates.

GNPMP - Net Indirect Taxes (NIT) = GNPFC

GNPFC - Depreciation (D) = NNPFC

NNPFC - N et Factor Income from Abroad (NFIA) = NDPFC

NDPFC + NIT + NFIA + net current transfers from Rest of the World
(NCT from RoW) = NNDY

NNDY - X - NCT from RoW - NIT = NDPFC

NDPFC - Income from domestic product accruing to Government

administrative departments - savings of non-departmental enterprises =
income from domestic product accruing to private sector (Z).

Z + NFIA + national debt interest + transfer payments by government

administrative departments + Net current Transfers from RoW = Private
Income

Private Income (PY) - undistributed profits of private corporate sector -

corporation tax = Personal Y.

Personal Y - direct personal taxes - miscellaneous receipts of

34
 government administrative departments = PDY National Income Accounting

PDY - Personal Consumption E xpenditure = Household S aving.

Household Saving + Private Corporate Saving + Government Saving

+ Depreciation = Gross Domestic Saving

× 100 = Rate of Gross Domestic Saving

Gross Domestic Capital Formation (GDCF) = Depreciation + Net Domestic Fixed

Capital Formation + C hange in S tocks.

GDPMP
× 100 = Rate of GDCF

Gross D omestic S aving - Depreciation = Net D omestic S aving

× 100 = Rate of N et D omestic S aving

NDPMP

Gross Domestic Capital Formation - Depreciation = Net Domestic Capital

Formation

NDPMP
× 100 = Rate of Net Domestic Capital Formation

Rate of G ross D omestic C apital F ormation - Rate of G ross D omestic

S aving = Rate of Net Foreign Capital Inflow = Rate of Net Domestic Capital
Formation - Rate of Net D omestic S aving

Check Your Progress 3

1) Starting from Personal Consumption Expenditure arrive at GDP FC.

....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................

2) State the relationship between NNDY and PDY.

....................................................................................................................
....................................................................................................................

35
Issues in Macroeconomics and ....................................................................................................................
National Income Accounting
....................................................................................................................

3) Identity the factors, that result in the distinction between

i) GDP and NDP
ii) GNP and GDP
iii) NY and NNDY
iv) GDPMP and GDPFC
v) NNPMP and NNDY
vi) Personal Y and PDY

....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................

2.5 LET US SUM UP

In this unit, we have given you an idea of the concept of circular flows and how
national income of an economy can be derived by studying the working of circular
flows. The concept of circular flow relates to the flow of real transactions
or money transactions from one group of e c on om i c agents to another. Flow of
real transactions gives us real flows and the flow of money from one group of
economic agents to another gives us money flows.

Real or money flows can be studied between f irm s or enterprises and

households. Their study can be extended in an economy, which has enterprises,
households and financial sector as the transactors. Similarly, we can extend this
study further by incorporating Government sector and the rest of the world sector.
Once enterprises, households, financial sector, government sector and the rest
o f the world sector are introduced we study the flows of an open economy.

National income can be studied in its three ways, viz., as flow of goods and
services or as flow of factor incomes or as flow of final expenditures: National
income looked at in either of the three ways gives us the same total. Finally, in the
last section of this unit we have gone into the discussion of national income and
various related concepts and also introduced the inter-relationships among the
related concepts.
36
 National Income Accounting
The main concepts introduced are GNPMP, NNPMP, NNPFC, NNDY, income from
domestic product accruing to private sector, private income, personal income,
personal disposable income, personal savings, and rate of gross and net domestic
capital formation, rate of gross and net domestic savings and rate of net foreign
capital inflow. An attempt is also made to discuss the relationship among these
concepts.

2.6 ANSWERS/ HINTS TO CHECK YOUR

PROGRESS EXERCISES

Check Your Progress 1

1) Money flows take place between one transactor and another or between one
group of transactors to another. For example, producers produce goods and
services and pass these on to households for which payments are made by
them to producers. In return households supply factor services to
producers and producers make factor payment to households. Real flows,
on the other hand, are the flows of goods and services from producers to
households. Supply of factor services by households to producers, also
constitute real flows.

2) Economic transactions can be grouped into various categories such as

production, income generation, addition to capital stock and the Rest of the
World transactions. Economic transactors can also be divided into various
sectors such as enterprises, households, government, financial sector and the
rest of the world.

3) When financial sector is introduced along with enterprises and households

sectors the circular flow gets complicated. Complication arises from the fact
that households buy consumer goods and services produced by enterprises
and they need not use the whole of factor income. The leakage takes place
in the form of households saving, which get transferred to financial sector.

Similarly, the enterprises may save a part of their revenue (which they get by
selling consumer goods and services) in the form of depreciation fund and
undistributed profits.

These savings of households and enterprises which the financial sector

accumulates are lent to enterprises for investment or creation of capital
goods (fixed capital goods or change in inventories). Thus, it is the saving
and the investment, which need to be introduced in the circular flow
besides other flows.

Check Your Progress 2

1) Production flow is the goods and services produced in an economy over a

37
Issues in Macroeconomics and year. Production of goods and services requires factor inputs, which are
National Income Accounting supplied by households.
Employment of factors of production leads to generation of factor
incomes or income flows. The incomes received by households for
supplying factor inputs to producers can be used to either buy consumer
goods and services produced by enterprises or save. Whatever is saved is,
in turn, used for the purposes of addition to capital stock (or investment
of an economy).
Thus, production flow leads to income flow and income flow leads to
flow of expenditures or flow of addition to capital stock. The process
continues once again by consumption expenditure and capital expenditure
going to enterprises and once again the process gets initiated.

2) i) currently produced goods and services can be divided into consumer

goods and services and capital or investment goods. Goods or services
produced can also be of the nature of intermediate goods but they are not
included in other two categories because otherwise there would be
duplication in the computation of GDP of an economy.

ii) Factor incomes generated over a year can be classified into compensation
of employees, operating surplus and mixed income of self-employed.
Operating surplus is constituted of rent, interest and profits. Mixed
income of self- employed (MY) is that category of factor incomes where it is
not possible to distinguish between compensation of employees and
operating surplus. Net Factor Income from Abroad has also to be added to
domestically generated factor incomes to arrive at national income of an
economy.

iii) Expenditures currently generated can be divided into (a) Private Final
Consumption Expenditure; (b) Government Final Consumption
Expenditure; (c) Gross D omestic C apital F ormation; a n d (d) Net
E xports to Rest of the World.
From the sum of (a), (b), (c) and (d) we have to deduct net indirect taxes,
depreciation and add with this net factor income from abroad to arrive at
national income of an economy.

3) Production, income and expenditure are three ways of measuring national

income of an economy. National income measured by any of the three
methods gives us the same total. In the case of India we use
combination of three methods to measure national income of India.
For agriculture, manufacturing, etc., we use production method,
while for services sector we use income method. For the construction
sector, expenditure method is used because expenditure data are more
readily available for this sector.

38
 Check Your Progress 3 National Income Accounting

1) Personal Consumption Expenditure + Personal Saving = Personal Disposable

Income. Personal Disposable Income + direct personal taxes +
miscellaneous receipts of government administration departments =
Personal Income.
Personal Income + Undistributed Profits of Private Corporations
+ Corporation Tax = Private Income.

Private income - net factor income from abroad - net current transfers from
abroad - national debt interest - transfers from government = Income from
domestic production accruing to private sector.

Income from domestic product accruing to private sector + savings of non-

departmental enterprises + income from domestic product accruing to
government administrative departments = NDP at FC.

NDP at FC + Depreciation = GDP at FC.

2) NNDY - net indirect taxes - income from domestic product accruing to

government administrative departments - savings of non-departmental
enterprises + national debt interest + current transfers from government
- undistributed profits - corporation taxes - direct personal taxes
- Miscellaneous receipts of government administrative departments
= Personal Disposable Income.

3) (i) Depreciation
(ii) Net F actor I ncome from A broad
(iii) Net indirect taxes + net current transfers from abroad
(iv) Net indirect taxes
(v) Net current transfers from abroad
(vi) Direct or Personal Taxes + Miscellaneous receipts of government
administrative departments

39
UNIT 3 MEASURING ECONOMIC
PERFORMANCE*
Structure
3.0 Objectives
3.1 Introduction
3.2 Methods of Measuring National Income
3.2.1 Expenditure Method
3.2.2 Income Method
3.2.3 Value Added Method
3.3 Measures of Aggregates: Saving and Wealth
3.4 Real and Nominal GDP
3.5 Limitations of GDP
3.6 Balance of Payments
3.6.1 Current Account
3.6.2 Capital Account
3.7 Let Us Sum Up
3.8 Answers/ Hints to Check Your Progress Exercises

3.0 OBJECTIVES
After going through this unit you will be able to

 explain various methods of measurement of national income;

 differentiate between saving and wealth;
 distinguish between real income and nominal income; and
 explain the concept of balance of payments of an economy.

3.1 INTRODUCTION
In the previous Unit we discussed various concepts of national income
accounting. In this Unit we discuss the methods of measuring national income.
Measurement of national income is carried out in an accounting framework, in
the sense that there is an economic activity attached to each and every item
included in the national income. Thus national income is a flow and it is
measured for a particular period of time, usually a year. In recent times, some of
the aggregates, such as gross domestic product (GDP) are measured on a
quarterly basis. National income is measured in terms of:

*
Dr. Sarabjit Kaur, Zakir Hussain College (Evening), University of Delhi
40
 1. the amount of spending by purchasing final output by the economic Measuring Economic
agents (the expenditure approach) Performance

2. the incomes received by the factors of production (the income approach)

3. the amount of final output produced (the product approach)
The three methods give three different angles of looking at the economic activity
but they give identical measure of the current economic activity in an economy.

3.2 METHODS OF MEASURING NATIONAL

INCOME

As pointed out above, there are three methods of measuring national income.
We describe each method in detail below.

3.2.1 Expenditure Method

The amount of economic activity occurring during a given period of time can be
measured in terms of the amount of spending on final goods and services.
You should note that expenditure on goods purchased for re-selling (i.e.,
intermediate goods) is not included in this method. According to this method,
final expenditure on GDP at market prices is considered to represent the
economic activity. Under this method, the components of GDP are the private
consumption expenditure (C), private investment expenditure (I), government
expenditure (G), and net foreign expenditure or net export (NX). Hence, in this
method, expenditure incurred by various sectors, viz., household, business,
government, and rest of the world are added together to get final expenditure of
the economy.

According to this method, GDP at market prices (Y) is the aggregate of all the
final expenditure in an economy during a financial year which is presented by the
following Income- Expenditure Identity:

Y= C + I + G + NX

The procedure of obtaining various macroeconomic aggregates from GDP is

discussed in Unit 2. We elaborate on the components of GDP below.

1. Consumption
Consumption expenditure is incurred by the household sector. It includes
expenditure incurred on goods and services sold to the final users during the
financial year. It captures both durable goods like car, furniture etc., non-durable
goods like food, fuel, etc. and services like banking, healthcare, etc.

2. Investment
Investment expenditure is incurred by business firms in inputs for production of
goods and services. It includes business fixed investment, residential investment,
and inventory investment (or, change in stock).
41
Issues in Macroeconomics and 3. Government Expenditure
National Income Accounting It includes expenditure incurred by local, state and central level governments.
Government pays salaries to their employees, spends on social security benefits
like medical benefits, unemployment allowance, etc.

4. Net Exports
Net exports are defined as exports minus imports. Exports can be seen as
spending by foreigners on domestically produced goods and services whereas
imports are spending on foreign goods and services by domestic residents. When
value of exports is greater than value of imports, net exports are positive and vice
versa.

Precautions involved in the Expenditure Method

1. To avoid the problem of ‘double counting’, only the value of final goods
and services are included in the national income.
2. The sale and purchase of second hand goods are not included in national
income. Because these goods have already been included in national
income at the time they were produced. But commission and brokerage
paid to facilitate the sale of such goods is a fresh activity and should be
included.
3. Imputed value of owner-occupied houses is included.
4. Value of own-account production of fixed assets by enterprises,
household and government are included.

Example 3.1: Calculate GDP from the following data.

Items Value (in Rs. crore)

1. Personal consumption expenditure 45000

2. Govt. consumption expenditure 5000
3. Gross domestic fixed investment 5000
4. Increase in inventories 1000
5. Exports of goods and services 6000
6. Imports of goods of services 7000
7. Net Indirect Taxes 3500
8. Depreciation 4500

Solution:
GDP = 1 + 2 + 3 + 4 + 5 – 6
= 45000 + 5000 + 5000+ 1000 + 6000 – 7000
= Rs. 55,000 crore.

42
3.2.2 Income Method Measuring Economic
Performance
The value of product is equal to the payments made to the factors of production.
In general, there are four factors of production, viz., land, labour, capital and
entrepreneurship which are compensated through rent, wages, interest and profit,
respectively. According to this method, national income is measured in terms of
payments made to all factors of production. Hence, based on the this approach,
the GDP at market prices is the sums of the compensation of employees, gross
operating surplus, mixed income and net indirect taxes, which is taxes on
production and imports less subsidies on production. The income-side approach
shows how various factors contribute to the GDP in the production process.

1. Compensation of Employees: This comprises wages, salaries, employee

benefits such as employers’ contribution to pension plans, social security, etc.
It is the total remuneration, in cash or in kind, paid by an employer to an
employee for the labour during the accounting period. It is composed of
wages and salaries (in cash and in kind), and employers’ social contributions.

2. Gross Operating Surplus: It is net business income during the production

process from property and enterprises in the form of rent, interest, royalty and
profit. Profit includes dividends, corporate taxes and retained earnings. The
Central Statistical Office (CSO) defines operating surplus as “the value of
gross output less the sum of intermediate consumption, compensation of
employees (including labour income of self-employed), consumption of fixed
capital and net indirect taxes.” Thus,
Gross Operating Surplus = Rent +Interest + Royalty + Profit
= Value of Gross Output at Market Price – Intermediate Consumption
– Compensation of Employees – consumption of Fixed Capital – Net
Indirect Taxes

3. Income of Self Employed: This is the remuneration for the work carried out
by the owner or by owner’s family of an unincorporated enterprise, which is
also called ‘mixed income’. Income of a proprietor (owners of capital, land,
and skills) earn mixed income in the form of mix of capital income, labour
income and profits. The income of this group is referred to as mixed income
because it is not clear what proportion of their income is equivalent to wage
or profit. Mixed income is different from the operating surplus in the sense
that the former is available to the self employed, while the latter accrues to
corporate and semi-corporate enterprises.

4. Taxes on production and imports less subsidies on production: The

former consist of compulsory, non-refundable payments to or from general
government or institutions in India, in respect of the production or import of
goods and services, the employment of labour, and the ownership or use of
land, buildings or other assets used in production. The latter consist of all the
subsidies except those subsidies on products which resident producer units
may receive as a consequence of engaging in the production process.

43
Issues in Macroeconomics and 5. Precautions involved in the Income Method
National Income Accounting To estimate correct national income by income method the following
precautions have to be taken:
1. Transfer payments are not included.
2. Windfall gains, such as income from lotteries, are not part of national
income.
3. Income earned from illegal activities (such as theft, smuggling, etc.) are
excluded.
4. The income earned through sale and purchase of second hand goods is not
included in national income. But commission and brokerage paid to
facilitate the sale of such goods should be included.
5. Since wealth tax, estate duties, gift tax are paid out of current income,
these are excluded from national income.
6. Imputed rent of self occupied houses is included.
7. Value of production for self consumption is included.

Check Your Progress 1

1. Outline the steps involved in the estimation of national income by

expenditure method.

……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

2. Explain how expenditure method is different from the income method in

estimation of national income.

……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

3.2.3 Value Added Method

This method is also known as ‘Output Method’ or ‘Product Method’. It measures

the contribution made by each producing enterprise in the production process in
the domestic territory of the economy in a financial year. The method measures
44
economic activity by adding the market values of goods and services produced, Measuring Economic
excluding any goods and services used up in the intermediate production stages. Performance
Under this method, we aggregate the value added by the various sectors of
production of goods and services to get GDPMP. Each firm’s value added is ‘the
value of its output minus the value of the intermediate goods it purchased from
other firms’. In other words, it is the addition of value in final product to the
intermediate goods at different stages of production.
You should note that

Gross Value added = Gross output – Intermediate Consumption

and,

Net Value added = Gross output – intermediate consumption – Depreciation.

Further,

Net Value added at FC = NVAFC = Gross output – intermediate consumption

– Depreciation – Net Indirect Taxes.

By adding ‘net factor income from aboard’ to domestic income (NVAFC), we

obtain

Net National Product (NNPFC). Thus, National Income or NNPFC = Gross Output
– Intermediate Consumption – Depreciation – Net Indirect Taxes + Net Factor
Income from Aboard

The Value Added method measures national income in different stages. The main
advantage of the value added method is that it avoids the problem of ‘double
counting’.

National income estimated by the above three methods, viz., income method,
expenditure method, and value added method are identical. Thus, National
Income ≡ National Product ≡ National Expenditure (where the symbol ≡ denotes
identical).

Estimation of Value Added

The term value added refers to the addition of value by a production unit to
intermediate inputs used in production. Value added is the difference between the
value of output and the cost of intermediate inputs.

Lets us illustrate the concept of value added with an example. Suppose a textile
firm purchased raw materials worth Rs. 40000 and hired labour worth Rs. 10000
to manufacture clothes. The intermediate inputs purchased is Rs. 50000. The
textile firm sold its output (clothes) for Rs. 55000. Thus, the value added by the
textile firm is Rs. 5000.

45
Issues in Macroeconomics and Precautions involved in the Product Method
National Income Accounting For correct computation of national income by income method, following
precautions need to be taken
1. Only factor incomes which are earned by rendering productive
services are included. All the transfer incomes are excluded.
2. Income earned from illegal sources (such as smuggling, theft, etc.)
should be excluded.
3. The income earned through sale and purchase of second hand
goods should not be included in national income.
But commission and brokerage paid to facilitate the sale of such
goods should be included.
4. Imputed rent of self occupied building should be included. It does
not make any difference whether a house is rented or self-
occupied.
5. Value of production for self consumption should be included. For
example, a farmer retains part of his produce for self consumption.
It does not enter the market, but it contributes to output.
6. Household work by family members (say cooking of food by a
home maker) are not included in national income. On the other
hand, the same food, if cooked by a domestic help (who is paid for
doing the work) is included in GDP.

Example 3.2: Calculate NDPFC from the following data.

Items In Rupees crore

Purchase of raw material 300
Depreciation 120
Sales 2000
Excise Tax 200
Opening Stock 150
Intermediate Consumption 480
Closing Stock 100

Solution:

Value of Output = sales + changes in stock

Change in stock = closing stock – opening stock
= 100 – 150= –50
Therefore, Value of Output = 2000 + (–50) = Rs.1950 crore
Gross value added = Value of output – Intermediate Consumption
= 1950 – 480 = Rs.1470 crore
NDPFC = Gross Value Added – Net Indirect Taxes
= 1470 – 200 = Rs.1270 crore

46
Example 3.3: A firm makes and sells jam using fruit it buys from another firm Measuring Economic
for 80,000 rupees. The firm pays its workers 50,000 rupees; pays 20,000 rupees Performance
in taxes and has profits of 40,000 rupees. What is its value added?

Solution:

Fruits bought from other firms 80,000

Wages paid to workers 50,000
Taxes paid 20,000
Profit 40,000

Profit = Sales revenue – wages paid – Taxes – Intermediate Consumption

40,000 = Sales revenue – 50,000 – 20,000 – 80,000
Sales revenue = 40000 + 50000 + 20000 + 80000
= Rs. 1,90,000
Value Added = Sales – Intermediate Consumption
= 190000 – 80000 = Rs. 110000
Hence, Value Added = Rs. 1,10,000 crore

Check Your Progress 2

1. Explain the problem of double counting in measuring national

income.

……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

2. What are the precautions taken while calculating national income by

Value Added method?

……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

3.3 MEASURES OF AGGREGATE SAVING AND

WEALTH

Saving and wealth are closely related with each other; but they are not the same.
Saving is that part of income which is not spent. In other words, saving is the
current income minus its spending on current needs. When we divide total saving

47
Issues in Macroeconomics and of a country by its national income then we obtain saving ratio. On the other
National Income Accounting hand, wealth is calculated as asset minus liability. Saving is a flow concept
(measured per unit of time) whereas wealth is a stock concept (measured at a
point of time). Saving takes the form of an accumulation of assets or a reduction
in liabilities; therefore, saving is the addition to wealth. The following are the
three important measures of saving:

1. Private Saving (Spvt): It is the saving by the private sector. Private saving
is the private disposable income minus consumption. Symbolically,
Spvt = Private Disposable Income – Consumption
= (Y + NFPA – T + TR +INT) – C

where,
Y = GDP
NFPA = Net factor payments from aboard
T = Taxes
TR = Transfer earnings received from government
INT = Interest income

Private Saving Ratio = Private Saving / Private Disposable Income

2. Government Saving (Sgovt.): It is net government or budget surplus. It is

government income minus government purchases of goods and services,
i.e.,
Sgovt = Government Income – Government Purchases of Goods
and Services
Sgovt = (T – TR – INT) – G
where,
T = Tax
TR = Transfer payments
INT = Interest payments
G = Government Purchases of Goods and Services

3. National Saving (S): National saving is the saving of the economy as a

whole. It is the sum of private saving and government saving.

S = Spvt + Sgovt.
S = [Y + NFPA – T + TR + INT – C] + [T –TR – INT – G]
= Y + NFPA – C – G
= GNP – C – G

The above equation shows that national savings is equal to GNP minus current
needs of private and government sectors.

We know that

GNP or Y = C + I + G + NX

48
Substituting the value of Y in national saving equation, we get Measuring Economic
Performance
S = [C + I + G + NX] + NFPA – C – G
S = I + NX + NFPA
S = I + CA
where CA = NX + NFPA, i.e., current account balance.

Also,
S = Spvt + Sgovt.
And Spvt = S – Sgovt.
= I + CA – Sgovt. (where S = I + CA)

Hence, private saving can be used in three ways, as given below.

1. To fund new capital investment (I)

2. To provide the money to finance government budget deficit (Sgovt.)
3. To acquire assets from or to lend to foreigners.

3.4 REAL AND NOMINAL GDP

Nominal variables are valued at their current market price and real variables are
nominal variables adjusted for inflation or deflation; valued at some base year.
The base year or constant year should be carefully selected. A change in nominal
variable reflects the combined effects of changes in quantities and changes in
prices whereas real variable provides correct picture of a variable change or
change in quantity.

Nominal GDP: It is also termed as ‘monetary national income’. It is defined as

the value of goods and services at current year prices. It is a poor indicator of
measuring economic growth. It is obtained by multiplying goods and services
produced in a current year with the current year prices.

Real GDP: It is also termed as GDP at constant prices. It measures the actual
growth of the economy. It is obtained by multiplying goods and services
produced in a current year with the base year prices. Increase in real GDP means
over time indicates improvement in performance of the economy. It reflects
changes in quantities.

GDP at constant price = × base year price index

where, base year = Price index of base year is always taken to be 100

Example3.4: Convert nominal GDP into real GDP in the following cases.

49
Issues in Macroeconomics and i) GDP at current year prices is Rs. 2,50,000 and price index for the
National Income Accounting current year is Rs. 250
ii) GDP at current year prices is Rs. 4,00,000 and current year price
index is Rs. 400

Solution:

, ,
i) GDP at constant prices = × 100 = Rs. 1,00,000
, ,
ii) GDP at constant prices = × 100 = Rs. 1,00,000

3.4.1 Price Indexes

A price index is a measure of the average level of price for particular goods and
services, relative to base year prices. In other words, it is a measure of the current
price level relative to base year. There are mainly two types of price indexes:

1. GDP Deflator
2. Consumer Price Index (CPI)

GDP Deflator

The GDP deflator measures the average level of prices of goods and services that
are included in GDP. It can be used to convert nominal GDP to real GDP. It
eliminates the effect of price increases and determines the real change in physical
output. It is the ratio of nominal GDP in a given year to real GDP In other words,
it is a price index with changing basket. Symbolically,

GDP Deflator = × 100

Example 3.5: If nominal GDP is Rs. 21,100 crore and real GDP is Rs. 20,000
crore, calculate the GDP Deflator.

Solution:

,
GDP Deflator = × 100 = 105.5
,

We can convert the nominal GDP into Real GDP by using GDP deflator, i.e.,

Real GDP = × 100

Consumer Price Index (CPI)

Consumer Price Index (CPI) measures prices of buying fixed basket of consumer
goods and services. The basket have fixed list of goods and services like food,
50
clothing, fuel and housing. CPI is calculated on monthly bases. While, GDP Measuring Economic
deflator is a price index with changing basket.CPI is calculated by dividing of Performance
current cost of the basket of consumer items by the cost of the same basket of
items in the base period. CPI is the single index which can be used to measure
prices of various goods and services prevailing in an economy.

CPI = × 100

Inflation Rate

The inflation rate is the rate at which the general level of prices increases per
period. Price indices can be used to measure inflation rate. It is measured as the
percentage change in any of the price indices during a time period. It is calculated
as follows:

Inflation rate = × 100

where P1 is the value of the price index in the previous period and P2 is the value
of the price index in the current period.

If GDP deflator rises from 100 in the previous period to 112 in the current period
then inflation rate is calculated as:

Inflation Rate = × 100 = 12 %.

3.5 LIMITATIONS OF GDP

GDP is a useful measure of economic progress but not economic welfare. But
there are certain limitations of GDP as a measure of economic progress. The
main limitations are as follows:

1. Composition of GDP: If GDP increases because of increase in production

of war products (e.g., tanks, bombs, weapons, etc.) then there may not be
an improvement in economic welfare.

2. Population effects are ignored: A country may have high national income
but the country may have a large population. Thus per capita income is
more representative of economic progress compared to GDP.

3. Large contribution by few: The country may have very steep inequality.
The GDP may be high, but it may be contributed by very few. Therefore,
if a small section of the population owns a large share in the GDP leaving
a smaller percentage of GDP to be shared by a greater number of people,
economic growth will not reach the poorest sections of an economy.

4. GDP ignores quality of environment: There may be increase in output

with an increase in environmental degradation. Having higher GDP does
51
Issues in Macroeconomics and not mean that people have better quality of life if water, air etc. are more
National Income Accounting polluted.

5. Only Legal products are included: GDP includes goods and services
produced and sold in legal markets. It also ignores certain productive
activities that does not have market transaction. For example, services of
a home maker, caring for her children and other family members, are
excluded from GDP.

In view above, GDP may not be an adequate index of social and economic
welfare. GDP and welfare may not be positively related. In many cases, an
increase in GDP does not bring about corresponding increase in economic
welfare.

Check Your Progress 3

1. What are the components of saving?

……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

2. Explain the difference between Real and Nominal GDP.

……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

3.6 BALANCE OF PAYMENTS: NATIONAL

INCOME ACCOUNTING FOR OPEN
ECONOMY

The Balance of Payments (BoP) of a country records all economic

transactions between the residents of the country and the rest of world in a
particular period of time, usually over a year or a quarter of a year. The BOP
is a summary of all monetary transactions between a country and rest of the
world, which are made by individuals, firms and government bodies. Thus,
the BoP records all external visible and non-visible transactions. The BOP is
an account of (i) what residents of a country receives from rest of the world in
52
a particular period on account of sale of goods and services and other Measuring Economic
invisible items, (ii) capital transfers from other countries, (iii) what these Performance
residents have paid to the other countries on account of purchases of all these
items, and (iv) transfers of capital from the domestic residents to rest of the
world.

These transactions have both credit entry and debit entries. It records the
payments for the country’s exports and imports of goods, services
and financial capital, and financial transfers. All the receipts from ‘rest of the
world’ are recorded as credit, while all the payments made to ‘rest of the
world’ are recorded as debit. You should note that ‘the BoP account is always
balanced’ as it is maintained by ‘double entry book keeping system’. The
sources of funds for a country, viz., exports or the receipts
of loans and investments, are entered as credit items, while uses of funds, viz.,
imports or investment in foreign countries, are entered as debit items. The
BoP account comprises two parts, viz., current account and capital account.
3.6.1 Current Account

The current account of BOP includes all transactions related to exchange of

goods and services and unilateral transfers. It deals with payment of currently
produced goods and services. Hence, balance of current account can be
estimated as the sum total of balance of trade, balance of services and balance
of unilateral transfers.

Items in the Current Account are as follows:

1. Balance of Trade: It includes export and import of visible goods only.

Therefore, it is also known as visible trade. Difference between export
and import gives trade balance.

2. Balance of Services: It includes all invisible transactions such as services

(travel, insurance, banking, news agency services, etc.), aid, transfers, etc.

3. Unilateral Transfers: These transactions are done by one country to

another without purchases of goods and services, e.g., aid, gifts, etc.

3.6.2 Capital Account

It records all the transactions which cause a change in the assets or liability of
a country. It includes all capital transfers such as loans and investment,
commercial borrowings between the one country and rest of the world. It
includes the following:

1. Foreign Investment: Foreign investment is of two types:

a. Foreign Direct Investment (FDI): It means purchase of assets by

foreign nationals or institutions and at the same time acquiring control

53
Issues in Macroeconomics and of it, e.g., acquisition of a firm in one country by a firm in another
National Income Accounting country.

b. Portfolio Investment: it is the acquisition of an asset that does not

give the purchaser control over assets, e.g., purchase of shares or
bonds in foreign country.

2. Loans: It includes all short term, long term,and external commercial

borrowings (ECB).

3. Banking Capital: It includes foreign currency deposits by foreign

nationals.

The overall BOP is obtained by adding current account balance and capital
account balance. A country may have deficit in the current account. Such deficit
is compensated by surplus in capital account or depletion of foreign exchange
reserve of the country. Similarly, surplus in the current account is compensated
by deficit in capital account or accumulation of foreign exchange reserve. Thus,
in accounting sense, BoP always balances.

Structure of India’s BoP

In the following table we present India’s BoP entries for the year 2013-14 so that
you get an idea of the various components.

Items 2013-14 (in US $ million)

1. Imports 4,66,216
2. Exports 3,18,607
3.Trade Balance (2– 1) – 1,47,609
4.Invisibles 1,15,212
5.Current Account Balance – 32,397
6.Capital Account
a) Foreign Investment (Net) 26,386
b) Loans (Net) 7,765
c) Banking (Net) 5,449
d) Rupee debt services (net) – 52
e) Other Capital (Net) – 10,761
f) Errors and Omissions (Net) – 882
7. Total Capital (a+b+c+d+e+f) 47,905
8. Overall Balance (5+7) 15,508
9. Monetary Movements – 15,508
10. Total Reserve Movements – 15,508

Source: Economic Survey 2014-15

54
 Check Your Progress 4 Measuring Economic
Performance
1. What are the items included in the current account of BOP?

……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

2. Explain the difference between balance of trade and balance of payments.

……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………
……………………………………………………………………………

3.7 LET US SUM UP

In this unit we learnt that there are mainly three methods of measuring national
income, viz., income method, expenditure method, and output or value-added
method. In income method, sum total of all factor incomes is taken into
consideration for measurement of national income. Expenditure method deals
with expenditure on final goods and services produced during a period. In the
value-added method, we find the sum of total value added by all the sectors of an
economy. Value of national income is identical whether it is calculated by
income method or expenditure method or value added method.

We also discussed that saving is the part of income which is not consumed at the
present time; rather it is kept aside for future consumption. There are three
important measures of saving: private saving, government saving, and national
saving. For the measurement of the economic performance, we prefer real GDP
instead of the nominal GDP, as the former controls for the increase in prices.

Subsequently we discussed BOP, which is a systematic record of all economic

transactions that takes place between one country and rest of the world. There are
two components of BOP, current account and capital account. Current account
deals with export and imports of all goods and services between the nations,
whereas capital account shows inflow and outflow of capital.

55
Issues in Macroeconomics and
National Income Accounting
3.8 Answers/ Hints of Check Your Progress Exercises

Check Your Progress 1

1. Refer to Sub-Section 3.2.1 and answer.
2. Income method accounts the factor income of the factors of the
production whereas expenditure method deals with expenditure made on
final goods and services. Refer to Sub-Sections 3.2.1 and 3.2.2.

Check Your Progress 2

1. Problem of double counting arises when a transaction is counted more
than once. Refer to Sub-Section 3.2.3.
2. Refer to Sub-Section 3.2.3 under the heading Precautions.

Check Your Progress 3

1. Three measures of saving are public saving, private saving, and national
saving. Refer to Section 3.3.
2. Real GDP is based on constant prices or base year prices whereas
nominal GDP is based on current prices. Refer to Section 3.4.

Check Your Progress 4

1. The current account of BOP includes balance of trade, balance of
services, and unilateral payments. Refer to Sub-Section 3.6.1.
2. Balance of trade includes the trade of visible goods whereas BOP
includes both visible and invisible items. Refer to Section 3.6.

56