University of Jammu

Syllabus

B.A. SEMESTER-III (Course Code: UECTC: 301)

Title: Principles of Macro Economics - I Credits -6

Preamble: This course aims to introduce the students to the basic concepts of
Macroeconomics. Macroeconomics deals with functioning of the economy as a whole,
including how the economy's total output a goods and services and employment of
resources is determined and what causes these totals to fluctuate This paper has been
designed to make the undergraduate students aware of the basic theoretical framework
underlying the field of macroeconomics.

UNIT I : Introduction

Macroeconomics: Meaning. Nature and Scope, Importance, Macroeconomic variables-goods and

money market, Importance and limitations of Macroeconomics, D ifference between
microeconomics and macroeconomics.

UNIT II : National Income Accounting

National Income, Meaning , definitions and concepts of GDP and others associated with
National Income:, Methods of measuring National Income; Practical and Conceptual difficulties
in the measurement of National Income; Uses of National Income; Nominal GNP and Real GNP,
Limitations of GDP concepts as a measure of social welfare.

UNIT III: Theory of National Income Determination - Classical and Keynesian

Classical theory of output and employment-says law of market, Keynesian criticism of Classical
theory, Keynesian theory of Income and employment Principle of Effective demand.

UNIT IV : National Income Determination

Determination of National Income in Two sector, with Government-Three Sector Model:
Determination of National Income in an open economy-four sector model; Investment Multiplier
and its limitations.

UNIT V : Theories of Consumption and Investment

Keynesian theory of Consumption: Absolute Income Hypothesis, Duesenberry's Relative Income

hypothesis, Friedman's Permanent Income hypothesis, Ando-Modigliani's Life Cycle
Hypothesis, Investment Function-Autonomous & Induced Investment, Marginal Efficiency of
capital.
 UNIT -1

INTRODUCTION TO MACROECONOMICS

MEANING OF MACRO ECONOMICS

Macro Economics is defined as the branch of Economics which studies activities including
economic issues and economic problems at the level of an economy as a whole. It focus on
Macroeconomic variables like aggregate demand, aggregate supply, general price level, national
income and output etc. The term macro is driven from the greek word 'Makros which means
large. Thus macroeconomic means economics of large dimensions, referring to the economy as a
whole. Macro economics is concerned with the economy as a whole or large segments of it.

Modern Macro economic theory is the outcome of the whole body of literature that has grown
out of the income and employment theory initiated by J.M. Keynes in his General theory of
Employment interest and money, published in 1936.

Definitions of Macro Economics

It is the words of Samuel. A. Morley. "Macro economics is the study of key economic
magnitudes, such as general price level, income and employment measured over the entire
economy"

'According to Prof. Rosalind Levacie "Macro economics is concerned with the determination of
the broad aggregates, in the economy such as national product. employment, the general price
level and the balance of payments."

Richard G. Lipsey, list out the problems of macro economics as broad areas of macroeconomics:

(i) Problems relating to the determination and fluctuations of level employment and income.

(ii) Problems relating to the determination and changes of level of prices.

(iii) Problems relating to fluctuations in the general level of money wages and real wages.

(iv) Problems relating to the allocation of resources between the production of consumer goods
and the production of capital goods.

(v) Problems relating to the rate of growth of production capacity of the economy.
(vi) Problems concerning the relation between international trade and the levels of employment,
prices and the level of income in the economy.

NATURE AND SCOPE/IMPORTANCE OF MACRO ECONOMICS

Macro Economics is the study of aggregates or averages covering the entire economy, such as
total employment, national income, national output, total investment, total consumption, total
savings, aggregate supply, aggregate demand, general price level and wage rate etc. it is
aggregative economics which examines the interrelations among the various aggregates, their
determination and causes of fluctuations in them.

Prof. Ackley defines Macro Economics as "Macro Economics deals with economic affairs 'in the
large, it concerns the overall dimensions of economic life. It looks at the total size and shape and
functioning of the elephant of economic experience, rather than working of articulation or
dimensions of the individual parts. It studies the character of the forest,independently of the tress
which compose it."

Macro Economics is of much theoretical and practical importance in understanding, the problem
and policy making in an economy. The scope of the Macro economics means the areas of study
under macroeconomics. It means issues or problems or parameters of Economics that are
included in the macroeconomics.

The scope and nature of macro economics can be explained in the following points:

1. To Understand the working of the Economy: The study of macro economics analysis is of
the paramount importance in getting us an Idea about the functioning of an economic system as a
whole. It is essential for proper and accurate knowledge of aggregations, as such a large and
complex economic system is impossible in term of numerous individual items, at the micro level

2. Understanding the Economic Policies : Macro Economics is extremely useful from the view
point of the fiscal policy, Modern Governments, particularly, the underdeveloped economies are
confronted with innumerable national problems. There are the problems of over population,
inflation, balance of payments, general under production etc. these policies have emerged as
central issues in macro economics.
3. Theory of Employment: Macroeconomics studies problems relating to employment and
unemployment in the economy as a whole. It studies the different factors determining the level of
employment, viz, affective demand, aggregate supply aggregate demand, aggregate
consumptions aggregate investment and aggregate savings etc. which determines the level of
employment in the economy.

4. Theory of National Income: The study of macro economics is very significant for evaluating
the overall performance of the economy in terms of national income. This led to the construction
of the data on national income. National income data help in anticipating the level of economic
activity and to comprehend the distribution of income among different groups of people in the
economy. It also studies the method of measurement of national income and social accounting.

5. Theory of Economic Growth: The theory of economic growth is also the subject matter of
macro economics. Specifically macro economics study the growth problem of underdeveloped
economies. Plans for the overall increase in national income, productivity, employment are
framed and executed so as to raise the level of Economic growth and development of the
economy as a whole.

6. Theory of Money and Monetary Problems: Macro economics also study the monetary
problems of the economy. Frequent changes in the value of money, inflation or deflation, affect
the economy adversely. They can be counteracted by adopting the suitable monetary, fiscal and
direct control measures for the economy as a whole Macroeconomics study the functions of
money and theories related to the demand and supply of money in the system. The system of
banking and other financial institution is also the subject matter of the macroeconomics

7. Business Cycle: The economic activities always shows ups and down. They never shows a
steady pattern of change for all the time to come. This cyclical movement of the is better known
as the business cycle is a major macroeconomic issue and on important area of macroeconomic
study

8. Understanding the Behaviour of Individual Units: For understanding the performance of

individual units, the study of macro economics is imperative Demand for individual products
depends upon aggregate demand in the economy. Unless the causes of deficiency in aggregate
demand are analyzed it is not feasible to understand fully the grounds for a fall in the demand of
individual products. The reasons for increase in costs of a specific firm or industry cannot be
analyzed without knowing the average cost conditions of the whole economy. Thus, the study of
individual units is not possible without macro economics.

9. Budgetary deficit and Fiscal Policy: In the wake of privatization and globalization of the
world economies budgetary deficit and related Fiscal Policy was emerged as a central issue of
Macroeconomics.

GOODS MARKET EQUILIBRIUM: DERIVATION OF THE IS CURVE

The IS-LM curve model emphasises the interaction between the goods and money markets. The
goods market is in equilibrium when aggregate demand is equal to income. The aggregate
demand is determined by consumption demand and investment demand. In the Keynesian model
of goods market equilibrium we also now introduce the rate of interest as an important
determinant of investment. With this introduction of interest as a determinant of investment, the
latter now becomes an endogenous variable in the model. When the rate of interest falls the level
of investment increases and vice versa. Thus, changes in the rate of interest affect aggregate
demand or aggregate expenditure by causing changes in the investment demand. When the rate
of interest falls, it lowers the cost of investment projects and thereby raises the profitability of
investment. The businessmen will therefore undertake greater investment at a lower rate of
interest. The increase in investment demand will bring about increase in aggregate demand
which in turn will raise the equilibrium level of income.

In the derivation of the IS curve we seek to find out the equilibrium level of national income as
determined by the equilibrium in goods market by a level of investment determined by a given
rate of interest. Thus IS curve relates different equilibrium levels of national income with various
rates of interest. With a fall in the rate of interest, the planned investment will increase which
will cause an upward shift in aggregate demand function (C + I) resulting in goods market
equilibrium at a higher level of national income. The lower the rate of interest, the higher will be
the equilibrium level of national income. Thus, the IS curve is the locus of those combinations of
rate of interest and the level of national income at which goods market is in equilibrium. How the
IS curve is derived is illustrated in Fig. . In panel (a) of Fig. , the relationship between rate of
interest and planned investment is depicted by the investment demand curve II. It will be seen
from panel (a) that at rate of interest Or0the planned investment is equal to OI0. With OI0 as the
amount of planned investment, the aggregate demand curve is C + I0 which, as will be seen in
panel (b) of Fig. equals aggregate output at OY0 level of national income. Therefore, in the
panel (c) at the bottom of the Fig. , against rate of interest Or0, level of income equal to OY0has
been plotted. Now, if the rate of interest falls to Or1, the planned investment b y businessmen
increases from OI0 to OI1 [see panel (a)]. With this increase in planned investment, the
aggregate demand curve shifts upward to the new position C + II in panel (b), and the goods
market is in equilibrium at OY1 level of national income. Thus, in panel (c) at the bottom of Fig.
the level of national income OY1 is plotted against the rate of interest, Or1. With further
lowering of the rate of interest to Or2, the planned investment increases to OI2 [see panel (a)].
With this further rise in planned investment the aggregate demand curve in panel (b) shifts
upward to the new position C +I2 corresponding to which goods market is in equilibrium at OY2
level of income. Therefore, in panel (c) the equilibrium income OY2 is shown against the
interest rate Or2. By joining points A, B, D representing various interest-income combinations at
which goods market is in equilibrium we obtain the IS curve. It will be observed from Fig. that
the IS curve is downward sloping (i.e., has a negative slope) which implies that when rate of
interest declines, the equilibrium level of national income increases. Why does IS Curve Slope
Downward? What accounts for the downward-sloping nature of the IS curve.

As seen above, the decline in the rate of interest brings about an increase in the planned
investment expenditure. The increase in investment spending causes the aggregate demand curve
to shift upward and therefore leads to the increase in the equilibrium level of national income.
Thus, a lower rate of interest is associated with a higher level of national income and vice versa.
This makes the IS curve, which relates the level of income with the rate of interest, to slope
downward. Thus, a lower rate of interest is associated with a higher level of national income and
vice versa. This makes the IS curve, which relates the level of income with the rate of interest, to
slope downward. Steepness of the IS curve depends on: (1) The elasticity of the investment
demand curve, and (2) The size of the multiplier. The elasticity of investment demand signifies
the degree of responsiveness of investment spending to the changes in the rate of interest.
Suppose the investment demand is highly elastic or responsive to the changes in the rate of
interest, then a given fall in the rate of interest will cause a large increase in investment demand
which in turn will produce a large upward shift in the aggregate demand curve. A large upward
shift in the aggregate demand curve will bring about a large expansion in the level of national
income. Thus when investment demand is more elastic to the changes in the rate of interest, the
investment demand curve will be relatively flat (or less steep).

Similarly, when investment demand is not very sensitive or elastic to the changes in the rate of
interest, the IS curve will be relatively more steep. The steepness of the IS curve also depends on
the magnitude of the multiplier. The value of multiplier depends on the marginal propensity to
consume (mpc). It may be noted that the higher the marginal propensity to consume, the
aggregate demand curve (C + I) will be more steep and the magnitude of multiplier will be large.
In case of a higher marginal propensity to consume (mpc) and therefore a higher value of
multiplier, a given increment in investment demand caused by a given fall in the rate of interest
will help to bring about a greater increase in equilibrium level of income. Thus, the higher the
value of multiplier, the greater will be the rise in equilibrium income produced by a given fall in
the rate of interest and this makes the IS curve flatter.

On the other hand, the smaller the value of multiplier due to lower marginal propensity to
consume, the smaller will be the increase in equilibrium level of income following a given
increment in investment caused by a given fall in the rate of interest. Thus, in case of smaller size
of multiplier the IS curve will be more steep. Shift in IS Curve: It is important to understand
what determines the position of the IS curve and what causes shifts in it. It is the level of
autonomous expenditure which determines the position of the IS curve and changes in the
autonomous expenditure cause a shift in it. By autonomous expenditure we mean the
expenditure, be it investment expenditure, the Government spending or consumption
expenditure, which does not depend on the level of income and the rate of interest. The
government expenditure is an important type of autonomous expenditure. Note that the
Government expenditure, which is determined by several factors as well as by the policies of the
Government, does not depend on the level of income and the rate of interest.

Similarly, some consumption expenditure has to be made if individuals have to survive even by
borrowing from others or by spending their savings made in the past year. Such consumption
expenditure is a sort of autonomous expenditure and changes in it do not depend on the changes
in income and rate of interest. Further, autonomous changes in investment can also occur. In the
goods market equilibrium of the simple Keynesian model the investment expenditure is treated
as autonomous or independent of the level of income and therefore does not vary as the level of
income increases. However, in the complete Keynesian model, the investment spending is
thought to be determined by the rate of interest along with marginal efficiency of investment.
Following this complete Keynesian model, in the derivation of the IS curve we consider the level
of investment and changes in it as determined by the rate of interest along with marginal
efficiency of capital. However, there can be changes in investment spending autonomous or
independent of the changes in rate of interest and the level of income. For instance, growing
population requires more investment in house construction, school buildings, roads, etc., which
does not depend on changes in level of income or rate of interest. Further, autonomous changes
in investment spending can also take place when new innovations come about, that is, when
there is progress in technology and new machines, equipment, tools etc. have to be built
embodying the new technology.

Besides, Government expenditure is also of autonomous type as it does not depend on income
and rate of interest in the economy. As is well known, government increases its expenditure for
the purpose of promoting social welfare and accelerating economic growth. Increase in
Government expenditure will cause a rightward shift in the IS curve.
MONEY MARKET EQUILIBRIUM: DERIVATION OF THE LM CURVE

The money market is the interaction among institutions through which money is supplied to
individuals, firms, and other institutions that demand money. Money market equilibrium occurs
at the interest rate at which the quantity of money demanded is equal to the quantity of money
supplied.

The LM curve can be derived from the Keynesian theory from its analysis of money market
equilibrium. According to Keynes, demand for money to hold depends upon transactions motive
and speculative motive. It is the money held for transactions motive which is a function of
income. The greater the level of income, the greater the amount of money held for transactions
motive and therefore higher the level of money demand curve.

The demand for money depends on the level of income because they have to finance their
expenditure, that is, their transactions of buying goods and services. The demand for money also
depends on the rate of interest which is the cost of holding money. This is because by holding
money rather than lending it and buying other financial assets, one has to forgo interest.

Thus demand for money (Md) can be expressed as: Md = L(Y, r) where Md stands for demand
for money, Y for real income and r for rate of interest.

Thus, we can draw a family of money demand curves at various levels of income. Now, the
intersection of these various money demand curves corresponding to different income levels with
the supply curve of money fixed by the monetary authority would gives us the LM curve.

The LM curve relates the level of income with the rate of interest which is determined by
money-market equilibrium corresponding to different levels of demand for money. The LM
curve tells what the various rates of interest will be (given the quantity of money and the family
of demand curves for money) at different levels of income. But the money demand curve or what
Keynes calls the liquidity preference curve alone rises. In Fig. (b) we measure income on the X-
axis and plot the income level corresponding to the various interest rates determined at those
income levels through money market equilibrium by the equality of demand for and the supply
of money in Fig. (a).
Slope of LM Curve:

It will be noticed from Fig. (b) that the LM curve slopes upward to the right. This is because
with higher levels of income, demand curve for money (Md) is higher and consequently the
money- market equilibrium, that is, the equality of the given money supply with money demand
curve occurs at a higher rate of interest. This implies that rate of interest varies directly with
income. It is important to know the factors on which the slope of the LM curve depends. There
are two factors on which the slope of the LM curve depends. First, the responsiveness of demand
for money (i.e., liquidity preference) to the changes in income.

As the income increases, say from Y0 to Y1, the demand curve for money shifts from Md 0 to
Md 1, that is, with an increase in income, demand for money would increase for being held for
transactions motive, Md or L1 =f(Y). This extra demand for money would disturb the money
market equilibrium and for the equilibrium to be restored the rate of interest will rise to the level
where the given money supply curve intersects the new demand curve corresponding to the
higher income level. It is worth noting that in the new equilibrium position, with the given stock
of money supply, money held under the transactions motive will increase whereas the money
held for speculative motive will decline. The greater the extent to which demand for money for
transactions motive increases with the increase in income, the greater the decline in the supply of
money available for speculative motive and, given the demand for money for speculative motive,
the higher the rise in the rate of interest and consequently the steeper the LM curve, r = f (M2,
L2) where r is the rate of interest, M2 is the stock of money available for speculative motive and
L2 is the money demand or liquidity preference function for speculative motive.

The second factor which determines the slope of the LM curve is the elasticity or responsiveness
of demand for money (i.e., liquidity preference for speculative motive) to the changes in rate of
interest. The lower the elasticity of liquidity preference for speculative motive with respect to the
changes in the rate of interest, the steeper will be the LM curve. On the other hand, if the
elasticity of liquidity preference (money demand function) to the changes in the rate of interest is
high, the LM curve will be flatter or less steep. Shifts in the LM Curve: Another important thing
to know about the IS-LM curve model is that what brings about shifts in the LM curve or, in
other words, what determines the position of the LM curve. A LM curve is drawn by keeping the
stock or money supply fixed. Therefore, when the money supply increases, given the money
demand function, it will lower the rate of interest at the given level of income. This is because
with income fixed, the rate of interest must fall so that demand for money for speculative and
transactions motive rises to become equal to the greater money supply. This will cause the LM
curve to shift outward to the right. The other factor which causes a shift in the LM curve is the
change in liquidity preference (money demand function) for a given level of income. If the
liquidity preference function for a given level of income shifts upward, this, given the stock of
money, will lead to the rise in the rate of interest for a given level of income. This will bring
about a shift in the LM curve to the left. It therefore follows from above that increase in the
money demand function causes the LM curve to shift to the left. Similarly, on the contrary, if the
money demand function for a given level of income declines, it will lower the rate of interest for
a given level of income and will therefore shift the LM curve to the right.

Essential Features: From our analysis of the LM curve, we arrive at its following essential
features:

1. The LM curve is a schedule that describes the combinations of rate of interest and level of
income at which money market is in equilibrium.

2. The LM curve slopes upward to the right.

3. The LM curve is flatter if the interest elasticity of demand for money is high. On the contrary,
the LM curve is steep if the interest elasticity demand for money is low.
4. The LM curve shifts to the right when the stock of money supply is increased and it shifts to
the left if the stock of money supply is reduced.

5. The LM curve shifts to the left if there is an increase in the money demand function wh ich
raises the quantity of money demanded at the given interest rate and income level. On the other
hand, the LM curve shifts to the right if there is a decrease in the money demand function which
lowers the amount of money demanded at given levels of interest rate and income.

DIFFERENCE BETWEEN MICRO AND MACRO ECONOMICS

The main differences between micro-economics and macro-economics can be explained with
the help of the following points:

1. Difference in the Degree of Aggregation. Microeconomics differs from macroeconomics due

to the difference of the degree of aggregation of economic elements. Macroeconomics studies the
individual units of the economy like a firm on the contrary, macroeconomics deals with
aggregates like national income and aggregate savings. It studies the problems of the economy as
a whole.

2. Difference in Objectives. The objective of microeconomics is to study the principles,

problems and policies concerning the optimum allocation of resources; on the contrary,
macroeconomics studies the problems, policies and principles relating full employment of
resources and growth of resources. In this way, both types of economic analysis differ from each
other as they have different objectives.

3. Difference of Subject Matter. The subject matter of microeconomics deals with the
determination of price, consumer's equilibrium; distribution and welfare, etc, On the other side,
the subject matter of macroeconomics is full employment, national income, general price -level,
trade cycles, economy growth, etc.

4. Method of Study. Another difference between the two types of economic analysis is
regarding their methods of study. Laws of micro-economics are formulated by taking some
assumptions. With the help of these assumptions, micro laws establish relationship between the
causes and effects of economic phenomena. For example, the law of demand shows the inverse
relationship between price and demand. But the law of applies only when its assumptions hold
good. These assumptions are: constant prices of other goods, no change in fashion, habit arid
custom, etc. In this law, the effect of change in the prices of other goods is not taken into
consideration. This method of study is known as "partial equilibrium analysis.

In macroeconomics, economic elements are categorized into aggregate units like aggregate
demand, aggregate supply, total consumption, total investment, etc. The interdependence of these
economic factors is also studied in macroeconomics. In other words, the total effect of an
economic factor on the economy is taken into account in macro analysis. This method of study is
called general equilibrium analysis'.

5. Macroeconomic Paradoxes. There are some economists like Prof. Boulding and Samuelson
who pointed out the risks of the distinction between the two types of analysis. The set of errors
arising in this distinction is known as 'macro economic paradoxes' or 'the fallacy of aggregation.
It means that the act which is beneficial for an individual may disturb the working of the
economy as a whole. In other words, the prescriptions which are virtues for individuals. become
vices for the economy if applied. For example, if an individual saves, his family will be
benefited. But if the whole society starts saving, it will reduce - consumption demand supply
income, etc. In this way, higher saving by the people finally reduces the income of the people.
The reason is that one man's expenditure is another man's income. If one person does not spend,
he reduces the income of some other person. In this way, we have seen that micro decisions do
not hold true for the economy as a whole. Such a macro paradox causes differences between
micro and macroeconomic policy.

6. Different Assumptions. The two types of economic analysis are based upon different
assumptions. Micro economics states its laws by assuming full employment, constant production
and income. On the basis of these assumptions, microeconomics analyses how production and
factors of production are allocated or distributed among different uses. On the contrary, macro-
economics assumes how the factors of production are distributed. On the basis of the assumption
of factor distribution, it explains how full employment can be achieved. In this way, both micro-
and macroeconomics state their laws by taking different assumptions. So they differ from each
other..

7. Difference of the Farces of Equilibrium. Microeconomics studies the equilibrium between

the forces of individual demand and supply or market demand and supply. But macroeconomic
analysis deals with the equilibrium between the forces of demand and supply of the whole
economy. Aggregate demand and supply of the economy are estimated in terms of money. So the
aggregate demand and supply are related to the total income.

8. Mortal and Immortal Subjects. Microeconomics deals with individuals. And individuals are
mortal. Man dies after passing some lifetime in the world. Therefore, the tool of
microeconomics, i.e., man is mortal. On the contrary, macroeconomics is concerned with the
aggregates. It studies the problems of the whole economy. The tool of its study is society.
Society never ends. Men may come and men may go but the society remains forever. So
macroeconomics studies the immortal society. This is another difference between the two.

LIMITATIONS OF MACROECONOMIC THEORY

Though macroeconomic theory is useful for various reasons, it also suffers from certain
limitations. The limitations can be pointed out as below: Firstly, in macroeconomic theory we
deal with aggregates and these aggregate entities are generally taken as homogeneous entities.
But this is not true. If we look at the internal composition and structure of the aggregates we find
that they are made up of heterogeneous elements. For example, when we take the concept of rate
of interest we assume that there exists only one rate of interest throughout the economy. But this
is not true. In practice there exist different rates of interest for different types of loans. We
actually take the average rate of interest. But the average does not show the dispersion or
variability of rates of interest.

Secondly, all aggregates are not useful. Only those aggregates which can be functionally related
happen to be useful for the purpose of study.

Thirdly, in macroeconomic theory we formulate a model of the economy and discuss the
functioning of the economy with the help of this model. The model is a theoretical construct
which is based on a number of assumptions some of which are not realistic. Accordingly there
exists a wide gap between the theoretical model and the reality. In many cases reality cannot be
explained with the help of the model because the unrealistic nature of the assumptions.

Fourthly, the major part of the macroeconomic theory developed on the basis of the path-
breaking works of Lord Keynes is applicable for a developed capitalist economy. It is not
suitable for developing or underdeveloped economies Problems of developing countries are
different from those of developed countries. Hence the models built for developed countries
cannot be suitable for the developing countries.

Fifthly, many proposition which are true for individual's on the basis of ceteris and paribus
assumption are true for economy as a whole. The behaviour of an aggregate at the Macro Level
cannot always be obtained from the generalization of the behaviour of the micro unit.
 UNIT -2

NATIONAL INCOME ACCOUNTING

MEANING OF NATIONAL INCOME

By National Income we refers to the money value of all final goods and services produced by the
normal residents of a country during on accounting year or National is some total of factor
income earned by the normal resident of a country during the period of one year.

Two things need special focus from the above definitions of national income viz (a) final good
and services and (b) normal residents of a country.

(a) By final value of goods and services mean only the final goods which have crossed the
boundary line of production and are ready for use by their final users, are included in the
estimation of National income. The intermediate goods which are still within the boundary line
of the production and are purchased by one firm from another either for resale or for use as raw
material do not constitute final goods.

The example of final goods, Bread and butter as used by the consumers and Tractors and
harvastors, used by the farmers.

The example of intermediate goods are like a shirt purchased by firm X from firm Y for resale
like and wood purchased by a carpenter (From a Timber merchant) for making chair are
intermediate goods.

(b) Normal resident is said to a person or institutions who ordinarily resides in a country and
whose centre of economic interest lies in that country. Normal resident, of a country includes
citizen and institution of country who normally resides in that country and the citizen of other
counties or nations who continue to live in a country beyond a period of one year a nd also the
citizen of our country working in the rest of world in the international organization located our
country. Contrary the foreigners who visit for traveling recreation. holidays medical treatment,
studies conference etc are not consider as normal residents a country while estimating the
national income.
Definitions of National Income

(1) According to Marshall, "The labour and capital of a country, acting upon its natural
resources, produce annually a certain net aggregate of commodities, material and immaterial,
including services of all kinds. The limiting word "net" is needed to provide for using up of raw
and half-finished commodities and for the wearing out and depreciation of plant which is
involved in production; all such waste must, of course, be deducted from the gross produce
before the true or net income can be found. And net income due on account of foreign
investments must be added in. This is the true net annual income or revenue of the country, or
the national dividend."

(2) In the words of A.C. Pigou, "The national dividend is that part of the objective income of the
community including, of course, income derived from abroad, which can be measured in
money."

(3) In the words of Prof. J.R. Hicks, "The national income consist of a collection of goods and
services reduced to a common basis by being measured in terms of money"

(4) According to Irring Fisher, "The National or the devident consists solely of services as
received by the ultimate consumer whether from their material or human environments. This a
paino or over coat of this year is not the part of this year's income but on addition to the capital.
Only his services rendered to me during this year by these things are income. Fishers definition
is considered to be better the Marshall's and Pigou's definitions because Fisher provides on
adequate concept of Economics Welfare which is dependent on consumption and consumption
respondents one standard of living.

CONCEPTS OF GDP AND OTHERS ASSOCIATED WITH NATIONAL INCOME

1 Gross Domestic Product at Market Price (GDPmp)

2 Gross National Product at Market Price (GNPmp)

3. Net National Product at Market Price (MNPmp)

4. Net Domestic Product at Market Price (NDPmp)

5. Net Domestic Product at Factor Cost (NDPfc)

6. Gross Domestic Product at Factor Cost (GDPfc)

7. Net National Product at Factor Cost (NNPfc)

8. Gross National Product at Factor Cost (GNPfc)

9. National Disposable Income: Gross and Net Concepts

10. Factor Income from Net Domestic Product accruing to Private Sector

11. Private Income

12. Personal Income

13 Personal Disposable Income

Following is a brief description of these concepts / associates of National income

1. Gross Domestic Product at Market Price (GDPmp): Gross domestic product is the market
value of the final goods and services produced within the domestic territory of a country during
one year inclusive of depreciation. There are both resident as well as foreign producers within
the domestic territory of a country. Gross domestic product includes the market value of the final
goods and services produced by all such producers. The provision of depreciation is the part of
the gross domestic product at Market Price or GDPmp.

2. Gross National Product at Market Price (GNPm):

Gross national product is not a domestic concept, it is a national concept. Here, we are to
estimate national product of all the normal residents of a country, no matter in which part of the
world they are. We are to be no longer confined to the domestic territory of a country. Also, we
are not account for the product of non-resident firms in our domestic territory. Thus, gross
national product is the market value of the final goods and services produced by normal residents
of a country during the period of an accounting year.

GDPmp becomes GNPmp if net factors income from abroad is added to it.

Thus,

GDPmp+Net factors income from abroad = GNPmp

Net factor income from abroad is the difference between factor income (rent, interest, profit and
wages) earned by our residents from rest of the world and factor income earned by non-residents
within our country..

The, net factor income from abroad may be positive or negative.

If net factor income from abroad is positive, gross national product would be greater than gross
domestic product. On the other hand, if net factor income from abroad is negative, gross national
product would be less than the gross domestic product.

3. Net National Product at Market Price (NNPmp ): Net national product at market price
measures the value of final goods and services produced by the normal residents of a country in
an accounting year, after allowing for depreciation losses. We know, some capital goods are used
up in the production process through normal wear and tear, obsolescence and accidental
destruction live accidental or sudden break down of the machinery be deducted from GNPmp to
arrives MNPmp. The cost to replace these capital goods is called depreciation or consumption of
fixed capital.

NNPmp is estimated as the difference between GNPmp and depreciation..

Hence. GNPmp-Depreciation = NNPmp

4. Net Domestic Product at Market Price (NDPmp): Net domestic product at market price is
the market value of the final goods and services produced within the domestic territory of a
country, exclusive of depreciation or the consumption of fixed capital.

NDPmp is estimated as the difference between GDPmp and depreciation.

NDPmp =GDPmp-Depreciation

5. Net Domestic Income or Net Domestic Product at Factor Cost (NDPfc): Net domestic
income is the sum total of factor income generated within the domestic territory of a country
during an accounting year. It is briefly called 'domestic income'. It is equal to net domestic
product at factor cost. Thus, domestic income- NDPfc

NDPfc differs from NDPmp as in the following equation :

NDPfc=NDPmp-Indirect taxes + Subsidies

Or

NDPfc=NDPmp-Net Indirect Taxes (NIT)

(NIT-Indirect taxes- Subsidies)

6. Gross Domestic Product at Factor Cost (GDPfc): Gross domestic product at factor cost is
estimated as sum of the net value added by different producing units and the consumption of
fixed capital. Since the net value added get distributed as income to the owners of factors of
production, we can estimate GDPfc as sum of the domestic factor incomes and consumption of
the fixed capital. Hence,

NDPfc+ Depreciation =GDPfc

7. Net National Product at Factor Cost (NNPfc) or National Income fixed capital
consumption: Any 'domestic' concept becomes a 'national' concept if 'net factor income from
abroad' is added. Accordingly, if 'net factor income from abroad' is added to NDPfc, it becomes
NNPfc. Thus,

NDPfc+ Net Factor Income from Abroad = NNPfc

8. Gross National Product at Factor Cost (GNPfc): The Gross national product at factor cost
is defined as sum total of the gross domestic product and net factor income from abroad i.e.
income earned by normal residents of our country minus the incomes earned by foreign residents
from one country.

NNPfc becomes GNPfc if depreciation is added to NNPfc . Thus,

GNPfc= NNPfc + Depreciation

Obviously,

GNPfc-Depreciation = NNPfc

9. National Disposable Income: National disposable income refers to the net income at market
price available to a country for disposal. It is the sum total of national income (NNPfc), net
indirect taxes and net current transfer from the rest of the world.
National Disposable Income =National Income + Net Indirect Taxes + Net Current Transfers
from the Rest of the World Gross and Net Concepts of National Disposable Income

10. Private Income : Private income is the income of the private sector obtained from any
source, productive or otherwise, and the retained income of the corporations.

Private income includes both factor income as well as transfer income. In order to obtain private
income from national income, we add (i) Current transfer earnings from the government, (ii)
Interest on national debt (iii) Net current transfers from the rest of the world, and deduct from
national income, (i) Property and entrepreneurial income of the government departmental
enterprises, (ii) Saving of non-departmental undertakings.

11. Personal Income: Personal income is the total of all current income received by households
from all sources. It is, in fact, the sum total of all types of factor income actually received by the
households and current transfers. Personal income includes the income actually received by the
households. Some part of the profits is retained by the firms as undistributed profits, also called
corporate saving. Also, some part of the profits is taxed by the government, called corporate
profit tax. The principal difference between private income and personal income, therefore, is
that while private income includes corporate saving and corporate tax, while personal income
does not. Both these components (corporate savings and corporate tax) are not received by the
households. Accordingly, these are deducted from private income to find out private personal
income.

12. Personal Disposable Income: Personal disposable income is that part of personal income
which the households can use the way they like. It is either spent or saved. It is calculated by
deducting direct taxes and miscellaneous fees, fines, etc., paid by the individuals from their
income.

LIMITATIONS OF GDP

There are many limitations to using GDP as a way to measure current income and production.
Major ones as follows.

1. Changes in quality and the inclusion of new goods - higher quality and/or new products
often replace older products. Many products, such as cars and medical devices, are of higher
quality and offer better features than what was available previously. Many consumer electronics,
such as cell phones and DVD players, did not exist until recently.

2. Leisure human costs- GDP does not take into account leisure time, nor is consideration
given to how hard people work to produce output. Also, jobs are now safer and less physically
strenuous than they were in the past. Because GDP does not take these factors into account,
changes in real income could not be understated.

3. Underground economy - Barter and cash transactions that take place outside of recorded
marketplaces are referred to as the underground economy and are not included in GDP statistics.
These activities are sometimes legal ones that are undertaken so as to avoid taxes and sometimes
they are outright illegal acts, such as trafficking in illegal drugs.

4 Harmful Side Effects - Economic "bads", such as pollution, are not included in GDP statistics.
While no subtractions to GDP are made for their harmful effects, market transactions made in an
effort to correct the bad effects are added to GDP.

5. Non-Market Production - Goods and services produced but not exchanged for money,
known as "nonmarket production", are not measured, even though they have value. For instance,
if you grow your own food, the value of that food will not be included in GDP. If you decide to
watch TV instead of growing your own food and now have to purchase it, then the value of your
food will be included in GDP.

MEASUREMENT OF NATIONAL INCOME

There are mainly three methods of measuring national income because national income can be
estimated at, from three different aspects as total output, total income total expenditure. All these
three are flows in the economy per period of time. They are three names for the same thing
which is the aggregate output. As Cairncross has written, "The national income can be looked at
in any one of the three ways as the national income measured by adding up everybody's
output....; as the national outlay measured by adding up the value of all the things that peop le buy
and adding in their saving."
Since the volume of flows in a particular period of time must equal, we can closely define a
fundamental accounting identity which applies in a hypothetical economy in a particular period.
It is

National Income+ Depreciation = Gross National Product = Expenditure on Gross National

product

It is clear from this fundamental identity that the measure of national income must give us the
same result whichever the way we adopt. We explain the three methods of measuring national
income below. The three methods measure the same flow. When production takes places, factors
of production are paid. There is an income flow and an output flow. Output is purchased by
people through expenditures which give rise to income. Thus income, out put and expenditure are
the three facets of the same coin.

PRODUCT METHOD OR VALUE ADDED METHOD

Product Method or Value Added Method is that Method, which measures the national income by
estimating the contribution of each producing enterprise to production in the domestic territory
of the country in an accounting year this method is also called as the industrial origin method or
net output method. The entire output of final goods and services is multiplied by their respective
market prices to find out the gross national product. The gross national product may be arrived at
by adding up the values imparted to the intermediate goods and services during different process
of production. Whether we employ the final products method or the 'value added' method, the
total money-value of the gross national product would be the same. From the gross national
product so estimated, we have to deduct the gross depreciation of equipment and machinery
involved in the process of production to arrive at the country's national income.

Value-added method measures the contribution of each producing enterprise in the domestic
territory of the country. This method involves the following steps: (a) Identifying the producing
enterprise and classifying them into wise sectors according to their activities, (b) estimating net
value added by each producing enterprise as well as each industrial sector and adding up the net
value added by all the sectors.
Precautions regarding Product Method

Following precautions must be taken into account while using the products method:

(1) Value of the sale and purchase of second hand goods is not included in value added.

(2) Commission earned on account of the sale and purchase of second hand goods is included in
the estimation of value added.

(3) Own account production of goods of the producing units is taken into account. while
estimating value added.

(4) Value of intermediate goods is not included in the estimation of value added.

(5) Imputed value of production for self-consumption is taken into account.

(6) Imputed rent on the owner occupied house is also taken into account.

(7) Services for self-consumption is not considered while estimating value added.

INCOME METHOD

According to this method, the incomes accruing to all the factors of production during the
process of production are aggregated together to arrive at the national income of the country.

Income method: classification of factor income:

The factor income seen broadly classified as under :

(i) Compensation of employees: It includes (a) wages & salaries in cash (b) payment in kind (c)
employees contribution to the social security scheme (d) pension on retirement.

(ii) Operating surplus : It refer to as income from property and entrepreneurship as (a) Rent (b)
Interest (c) profit is further divided into Dividends Corporate profit tax and undistributed profit.

(iii) Mixed income. Mixed income refers to the income of the self employed person, using the
own labour, labour land capital and entrepreneurship to produce goods and services in the
economy.
This is known as national income at factor cost. As is well known, the various factors of
production are paid remuneration for their services rendered by them in production. These
payments are known as factor payments. They represent the costs to the producers. But for the
owners of the factors of production, they constitute factor-incomes which have to be aggregated
to estimate the national income of the country. Thus according to this method, the national
product is obtained by adding up the factor-incomes accruing to the concerned factors during the
process of production. Sum of the factors income generated within the domestic territory of a
country is called NDPfc simply domestic income, National from it is found by adding not factor
income from abroad to NDPfc. As NDPfc+ Net factor income from abroad

Precautions while using Income Method

The following precautions are to be taken while income method:

(1) Transfer earnings like old age pensions, unemployment allowances, scholarships, pocket
expenses, etc. should not be included in national income. (2) Income from illegal activities like
smuggling, theft, gambling, etc. should not be included in national income.

(3) Sale proceeds of second hand goods like second hand car, second hand house,second hand
TV sets are not included in national income. (4) The sale proceeds of shares and bonds are not
included in national income.

(5) Windfall gains, like lotteries and capital gains should not be included as there is no value
addition corresponding to windfall gains.

(6) Imputed rent of owner occupied houses is included in national income.

(7) Imputed value of production of goods for self-consumption should be included but value of
self-consumed services should not be included.

(8) Indirect taxes like sales tax, excise duty, etc. tend to increase the market price of goods and
services. These are included in the estimation of national income at market price but are not to be
included while estimating national income at factor cost.

(9) Corporate tax, dividends and undistributed profits are all the components of corporate profits.
Once profit is included in the estimation of national income, any of these components should not
be separately added, separately .
(10) Income tax is paid out of compensation of employees. It should not be added separately
added in the estimation of national income.

EXPENDITURE METHOD

Expenditure is equal to gross domestic product at the market price (GDPMP) this is also called
as income disposal method or consumption and investment method. Labour gets wages, land gets
rent, capital gets interest and entrepreneur gets profit. The factor incomes of all the owners of
factors of production form the subject-matter of cultivation of national income by expenditure
method.

The final expenditure is broadly classified into the following four categories (1) consumer final
expenditure (c) (ii) Govt. final expenditure (G) (iii) Investment expenditure (I)) and (iv) Net
export (X-M)

Private final expenditure (C) refers to the expenditure on final goods and services by the
consumers, households, and non-profit making institutions, serving society (live Help age) it
includes:

Precautions while using Expenditure Method

The following precautions are to be taken while using expenditure method:

(1) Final Expenditure is to be taken into account to avoid error of double counting.

(2) The intermediate expenditure is not included in the calculation of national income.

(3) Expenditure on second hand goods is not included.

(4) Expenditure on shares and bonds is not included in total expenditure, as these are mere paper
claims and are not related to the flow of final goods and services. Such expenditures do not cause
any value addition.

(5) Expenditure on transfer payments by the government is not included in total expenditure, eg
old age pension, scholarship, etc. Because transfer payments do not cause any value addition in
the economy.
Conclusion
In view of the above we may say that the three methods of estimating the national income given
above need different types of approaches to calculate the national income Product method
requires a census of manufactures and agricultural output. Income method can use personal taxes
data and the financial statements of different, enterprises Expenditure method requires extensive
family-budget data. In developed economies such data are easily collected. Some countries,
therefore, use all the three methods and obtain national income estimates consistent with one
another

PRACTICAL AND CONCEPTUAL DIFFICULTIES IN MEASUREMENT BY

NATIONAL INCOME

Although all methods are used almost in all countries of the world to calculate national income,
yet the national income calculation is a complex affair and is beset with the following
difficulties.

1. Difficulty of Defining the Nation. The first and foremost difficulty in the way of measuring
National Income is the defining of nations in National Income. There is the difficulty of defining
'nation' in national income. National income doesn't only included income produced within the
country, but also income earned in other countries, by way of shipping charges, interest
insurance and banking, minus any payments made to foreign countries. Therefore, the definition
of nation goes beyond the political boundaries

2. Non-Marketed Services. Another Important difficulty in the measurement of National

income is that which kind of goods and services included in the National Income? Commodities
and services having money value are included in the national income but there are numbers of
goods and services which may not have corresponding flow of money payments. Services
performed for love, kindness and mercy and not for money have an economic value but have no
money value. The difficulty is whether these services should be included in national income and
how to measure their money value. For example, a paid maid servants services are included in
the national income but later when she marries the master, she is not paid any more, through she
continues to perform the same services. There is, thus, a reduction in the national income.
3. Choice of Method. There are different methods of measuring National Income. It becomes
difficult for the investigator/statistician which method to be used in the estimation of national
income. It is, however, preferred to use all methods simultaneously depending upon the
availability of data or statistics.

4. There is Little of Occupational Specialization. Another difficulty in the way of measuring

national Income is that there is little of occupational specialization on the part of the people in
underdeveloped countries and developing nation. Most of people take up more than one activity
at a time to earn their livelihood. It becomes difficult to collect information about their incomes,
etc. For example, the small farmers in India not only do farming, but also engaged themselves in
other works to the industrial cities during. The slack season to supplement their meagre earnings
from agriculture.

5. Which Stage to Choose. Regarding the stage of economic activity at which national income
be calculated, it is agreed that any stage of economic activities line production, consumption and
distribution may be adopted depending upon the function of the national income estimate is
expected to discharge. If the aim is to show the economic progress and power of the economy,
then the production stage would be more suitable, if the aim is to measure the welfare of
individuals, then consumption stage would be more useful.

6. Double Counting. Another difficulty is of double counting usually associated with the
inventory method. Double counting implies the possibility of a commodity like raw material or
labour being included in national income more than once, e.g., a farmer sells wheat worth rupees
one hundred to a mill-owner. The mill owner' further sells the wheat flour to a wholesale dealer,
who further sells it to a retailer and who in turn sells it to consumer, if we calculate it at every
stage, its money value will increase the eight hundred rupees but actually the increase in national
income has been to the extent of two hundred rupees only. The best way to avoid this difficulty
is to calculate only the value of allgoods and service that entered into final consumptions.

7.Transfer Payment. Transfer Payment is another difficulty in calculating the National Income.
Individual gets pension, scholarship, unemployment allowance and interest on public loans, but
whether these should be included in national income is a difficult problem to avoid this difficulty
these payments needs to be deducted from national income.
8. Price Changes. Another difficulty in calculating national income is the price changes. When
the price level in the country rises the national income also shows an increase even though the
production might have fallen. On the other hand, with a fall in price level, the national income
shows decline even though the production might have gone up. Thus, due to price changes the
national income cannot be adequately measured.

9. Self-Consumed, Bartered Production Self-consumed and bartered production is also one of

the important difficulty in the measurement of national income. A substantial part of the produce
is not brought to the market to be exchanged with the measuring rod of money. It is either
consumed directly by the producers or is exchanged for other goods and services. Only rough
estimates are made about the part of the produce. This difficulty is mostly in rural areas in
agricultural sector of the economy.

10. No Systematic Accounts. Majority of the producers do not keep any accounts of their
produce because most of them are illiterate. They mostly produce for self-consumption, not for
the market. Thus, the national income estimates are based only on guess work.

11. Inadequate and Unreliable Data. Another important difficulty in the way of calculating
National Income is the Inadequate and Unreliable data. The available statistics in these countries
are not only inadequate but also torreliable. For example, statistics pertaining to agriculture in
India are not complete. We have no reliable estimates of production costs in Indian. agriculture.
There are no statistics worth the name for small-scale and medium industries.

12. The Existence of A Large Non-monetized Sector. The another important difficulty in the
calculating of National Income is the existence of a large non monetized sector in
underdeveloped countries which makes the computation of national income difficult. A
substantial part of the agricultural output in these countries does not reach the market at all.
Either it is consumed at home by the agriculturists themselves or is exchanged for other goods
and services in the village. This presents several difficulties in the calculation of income.

13. Illiteracy and Ignorance . The majority of the small producers in the underdeveloped
countries are illiterate and ignorant, and are not in a position to keep any account of their
productive activities. So they cannot give to the investigator information about the quantity or
value of their output. Inevitably. an element of guesswork enters into the assessment of income
or output in large sectors of the economy.

USES OR IMPORTANCE OF NATIONAL INCOME

National Income is of great importance for the economy of a country. In these days the National
Income data are regarded as the accounts of the economy. The importance of national income
can be explained by the following points:

(1) Estimation of National Income. National income accounting helps to show. the level of
production in the economy and the level of income of the people in the countr y.

(2) Structure of the Economy. National income accounting gives us the knowledge about the
structure of the economy. We come to know how different sectors of the economy are
interdependent and performing.

(3) Relative Significance of the Production Sectors. The estimation of national income gives
us the knowledge about the relative significance of the production sectors of the economy,
Production sectors of the economy include primary, secondary and tertiary sectors. National
income accounting offers techniques of estimating output across these sectors. Accordingly,
relative significance of these sectors is studied as contributor in the national income.

(4) Factoral Distribution of Income . National income accounting gives us the knowledge about
the distribution of national income in terms of rent, interest, profit and wages to owners of
factors of production. It also facilitate to show. the relative significance of the factors of
production in the economy.

(5) Inter-regional and International Comparison. Another importance of national income

accounting is that it facilitates a comparison across different regions of a country and across
different countries of the world.

(6) Formulation of Policie s. With the help of Estimation of national income we can formulate
the policies for the economic growth and economic development of the country: Govt. on the
basis of national income data framed several economics problems for the smooth functioning and
progress of the economy is a whole.
(7) Economic Planning. For economic planning, the national income accounting is of great
significance. For economic planning, it is very important that the data pertaining to a country's
gross income, output, saving, consumption from different sources should be available. Without
these economic planning is impossible.

(8) Research Scholars of Economie s. The national income accounting is very useful for the
research scholars of economics. The research scholars of economics make use of the various data
of the country's input, output, income, saving, consumption, investment, employment etc., which
are obtained from social accounts for their research purposes.

(9) Indicator of Economic Progress . Another great importance of national income accounting
is that it is an indicator of economic progress. The economic welfare of the country is directly
with the increase in its national income. Hence, national income presents clear economic picture
of the economy.

(10) Distribution of National Income. Distribution of national income is also one of the
importance of national income accounting. National income data help us to know about the
distribution of income in the country. From the data pertaining to wages, rent, interest and profits
we learn of the disparities in the incomes of different sections of the society.

(11) Inflationary and Deflationary Gaps. With the help of national income accounting we are
in a position to get a idea about the inflationary and deflationary gaps. Hence, for accurate and
deflationary policies, we need regular estimates of national income.

(12) Budgetary Policies. With the help of the national income accounting we can formulate the
budgetary policies. Modern governments try to prepare their budgets within the frame work of
national income data.

(13) National Expenditure. With help of national income accounting we can get an idea how
national expenditure is divided between consumption expenditure and investment expenditure

(14) Standard of Living. With the help of national income accounting we can compare the
standards of living of people in different countries and of people living in the same country at
different times.
(15) International Sphere . National income studies are very important in the international
sphere. These estimates help us to fix the burden of international payments equitable amongst
different nations. These are also enable us to determine the subscriptions and quotas of
international organization like U.N.O., I.M.F., I.B.R.D. etc.

(16) Defence and Development. National income accounting gives us the knowledge to divide
the national product between defence and development purposes. With the help of these
estimates we can easily know how much can be spared for war by the civilian population.

(17) Public Sector. With the help of national income accounting we can get an idea about the
relative roles of public and private sectors in the economy.

NOMINAL GNP AND REAL GNP (INCOME)

Difference Between Nominal GNP and Real GNP.

Gross Domestic Product or GDP refers to the economic value of goods and services produced
within the nation's boundaries, in a particular financial year plus income earned by foreign
residents locally less income earned abroad by country's residents. When the GNP is estimated at
current prices, it exhibits Nominal GNP, whereas when Real GNP is measured at constant prices
or with the price of base year it is called as real GNP

Both Nominal and real GNP are considered as a financial metric for evaluating country's
economic growth and development However, the confusion still exists that which o ne is better
indicates the country's progress.

The basic differences between Nominal and Real GNP are discussed as under.

1. Nominal Gross National Product refers to the monetary value of all goods and services
produced during the year, within the geographical limits of the country. The economic worth of
all goods and services produced in a given year, adjusted as per changes in the general price level
is known as Real Gross National Product

2. Nominal GNP is the GNP without the effects of inflation or deflation whereas you can arrive
at Real GNP, only after giving effects of inflation or deflation.
3. Nominal GNP reflects current GNP at current prices. Conversely, Real GNP reflects current
GNP at past (base) year prices.

4. The value of nominal GNP is greater than the value of real GNP because while calculating it,
the figure of inflation is deducted from the total GNP.

5. With the help of Nominal GNP, you can make comparisons between different quarters of the
same financial year. Unlike Real GNP, in which comparison of various financial years can be
made easily because by removing the figure of inflation, the comparison is made only between
the outputs produced.

6. Real GNP shows the actual picture of the economic growth of the country, which is not with
the case of Nominal GNP.

Conclusion

These two exhibits the country's financial soundness, whereby Real GNP is given preference
over Nominal GNP, it makes the comparison easy for between different financial years. On the
other end, Nominal GNP provides a better perspective for comparing different economies at
current price level.
 UNIT - 3

THEORY OF NATIONAL INCOME DETERMINATION- CLASSICAL AND

KEYNESIAN

SAY'S LAW OF MARKET

Say's Law of market lies at the centre of the classical notion of full employment J.B. Say, a
French economist of the 19th century, introduced a theory of markets, according to which
"supply creates its own demand."

In a barter economy, Say's Law simply holds good that supply creates its own demand, because
goods will be produced either for self consumption or for the direct exchange to get something
else. This is merely a tautology. The neo-classicists, however considered that Say's Law had
wider application in a monetary economy. In a monetary economy, the money costs of the goods
produced by the firms are actually paid out as incomes to the households for their factor services
rendered, so the households get enough money to buy the goods supplied. This means tha t the
supply of a product through the process of production generates the necessary income (earned by
the factor of production in the form of wages, interest, rent and profits) to demand the goods
produced. By this method, an equivalent demand is created in accordance with supply.
According to Say, the main source of demand is the flow of factor incomes generated from the
process of production itself. Any productive process has generally two effects:

(1) Due to the employment of factors of production in the process, an income stream is generated
in the economy on account of the payment of remuneration to the factors of production; and

(ii) a certain output results which is supplied to the market.

Thus, according to Say's Law, additional output creates addit ional incomes, which creates an
equal amount of extra expenditures Therefore, every product produced generates equivalent
amount of purchasing power (income) in the economy which ultimately leads to its sale. In short,
a new production process, by paying out income to its employed factors. generates demand at the
same time as it adds to supply. Thus, every increase in production soon justifies itself by a
matching increase in demand. Then, by doubling production, the producer would invariably
double sales too.
In his Principles of Political Economy, J. S. Mill provides his version of Say's Law as follows:

"What constitutes the means of payment for commodities is simply commodities. Each person's
means of paying for the production of other people consists of those which he himself possesses.
Should we suddenly double the productive powers of the country, we should double the supply
of commodities in every market; but we should by the same stroke, double the purchasing power,
Every-body would bring a double demand as well as supply, everybody would be able to buy
twice as much, because everyone would have twice as much to offer in exchange.

According to Say's Law, as every additional supply creates an additional demand, there can be
no general overproduction. It stresses that aggregate supply always equals aggregate demand. In
other words, while individual goods can be over-produced, the supply need not equal demand in
a single market. But it will be absorbed by the economy as a whole. At the same time, while
general over-production was considered impossible according to Say's Law, it also denied the
possibility of a deficiency in aggregate demand. Similarly, it also denied the possibility of
general unemployment. For, if resources are less than fully employed, there are incentives to
expand production as entrepreneurs always strive for maximization of profits

ASSUMPTION OF THE SAY'S LAW OF MARKET

Say's law of market is based on the following assumptions:

1. There is optimum allocation of resources.

2. Commodity prices and factor prices are in perfect equilibrium.

3. There is free enterprise economy.

4. There is no government intervention in the economic activities. The government follows

laissez-faire policy to facilitate automatic adjustment and smooth working of the market
mechanism in the capitalist economic system.

5. The size of the market has no limits. Thus, there is automatic expansion of the market with an
increase in output offered for sale.

6. The free market economy and its working of price mechanism provide duc scope to labour
supply and the rising population also stimulate capital formation.
7. The circular flow of money is regular and continuous without any leakages.

8. Since all savings are automatically invested, saving always equal investment, Sa vings-
investment equality is the basic condition of equilibrium in the economy. It is maintained by
interest flexibility.

IMPLICATIONS OF SAY'S LAW MARKET

The Say's Law of markets implies that:

1. In the long run, free economy automatically attains equilibrium at full employment level.

2. There is automatic adjustment when supply creates its own demand. Increase in supply will
meet its own demand in the process of the functioning of a free capitalist economy. Hence, there
is no need for the government to intervene. On the contrary, any government interference in the
economic field comes in direct conflict with the self-adjusting mechanism of the Say's Law of
markets.

3. Since supply creates its own demand automatically there is no possibility of any general over-
production. Thus, Say's Law is a denial of the possibility of a deficiency in aggregate demand.

4. When there is no general overproduction, then there can be no problem of general

unemployment in the long run, and the economy tends to remain at full employment equilibrium
level.

5. In an expanding free enterprise economy when new workers and new firms are productively
absorbed, they do not supplant the output, income and employment of the existing ones and as
they release additional output and income, the community becomes automatically rich with
increasing size of national income It also means that employment of new or unused resources in
productive process tends to pay its own way and confer benefits to the society at large.

6. Supply creates its own demand in real terms. Thus, money is just a veil. Behind the flow of
money, there is a real flow of goods and services which is important. Thus, changes in the supply
of money has no impact on the real economy's process of equilibrium at full employment level.
7. A capitalist economy under the laissez-faire policy has built-in flexibility. It functions
automatically to optimum adjustments through freely operating market mechanism and the price
system.

8. Savings investments equality is brought about by the flexibility of interest rates. Rate of
interest is, thus, a strategic variable in the equilibrium process of the economy.

9. Wage flexibility in a competitive labour market tends to bring about full employment of
workers.

KEYNES'S OBJECTION TO CLASSICAL THEORY OF EMPLOYMENT

Though logically the classical theory is sound and well-knit on the basis of its axioms, Keynes
has criticized and completely discarded it on the ground of its false premises.

The following are the main points of Keynes's criticisms against the classical theory:

Assumption of full employment unrealistic:

(1) Keynes considered the fundamental classical assumption of full employment equilibrium
condition as unrealistic. To him, there is the possibility of equilibrium condition at unde r-
employment as a normal phenomenon. Keynes regarded it as a rare phenomenon. Keynes in fact
considered the under employment condition of equilibrium to be more realistic.

(2) Long term equilibrium opposed. Keynes opposed the classical insistence on long-term
equilibrium; instead, he attached greater importance to short term equilibrium.

(3) Disregard the impossibility of general over production and disequilibrium. Classical
economists rest on the Say's Law which blindly assured that supply always creates its own
demand and affirmed the impossibility of general overproduction and disequilibrium in the
economy. Keynes totally disagreed. with this and stressed the possibility of supply exceeding
demand, causing disequilibrium in the economy and pointed out that there is no automatic self
adjustment in the economy.

(4) Refuted the process of equilibrium automatic and self-balancing. Say's Law. laid down
that supply and demand would always be in equilibrium and the process of equilibrium was
automatic and self-balancing. Keynes refuted this too. He pointed out that the structure of
modern society rests on two principal classes the rich and the poor-and there is unequal
distribution of wealth between them. The haves have too much of wealth all of which cannot be
consumed by them and the have-nots too little even to meet their minimum consumption needs.
Thus, national production can exceed national consumption, which means a deficiency in
aggregate demand in relation to additional supply, and this results in general overproduction and
unemployment. Thus, Keynes pointed out the error of the classicists in denying the general
overproduction and unemployment.

(5) Rejected Pigou's notion of unemployment disappear on acceptance of low wages by the
workers. Keynes strongly objected to the classical formulation or employment theory,
particularly Pigou's notion that unemployment will disappear if the workers will just accept
sufficiently low wage rates. He rejected Pigou's plea for wage flexibility as a means of
promoting employment at a time of depression. According to Pigou, employment in the society
can be increased by a device of money wage cuts and noted that by following a policy of wage -
cuts, costs would fall, resulting in the expansion of demand, greater production, and therefore,
greater investments and employment.

(6) Objected to the classical idea of saving and saving investment. Keynes also attacked the
classical theory in regard to saving and investment. He objected to the classical idea of saving
and investment equilibrium through flexible rates of interest. To him saving and investment
equilibrium are obtained through changes in income rather than in the interest rate.

(7)Attacked the Classicists for their unrealistic approach to the problems of the
contemporary capitalist economic system. Keynes strongly attacked the classicists for their
unrealistic approach to the problems of contemporary capitalist economic system. Pigou's plea
for a return to free perfect competition to solve the problem of unemployment seeme d 'obsolete'
in the changed conditions of the modern world. Pigou grieved at the modern state's intervention
with the free working of the economic system because it causes unemployment. He also
condemned the activities of the trade unions which prevent the falling of wage level and thereby
cause increase in unemployment. Keynes pointed out that trade unions are an integral part of
modern society and they will grow further. Besides, a progressival welfare state will not refrain
from accepting or adopting the principle of fixation of minimum wages. Keynes wanted
governmental action to bring about adjustment in the economic system, because the modern
economic system is not self-adjusting in character as assumed by the classicists.

Conclusion

In view of the above we may say that classical theory of employment, in Keynes's view, is
unrealistic and irrelevant to the present conditions and out of date, and, thus, cannot be a guide to
the solution of modern economic problems. Thus, the basic need is for a theory which will
diagnose the ills of the modem economic system and furnish a guide for the solution of problems
like unemployment, business cycles, inflation and other economic ills.

Keynes‟ Theory of Employment: Concept of Effective Demand

Great Depression of 1930's created problems of increasing unemployment, reducing national

income, declining prices and failing firms increased in intensity. The classical model miserably
failed to explain and provide a workable solution for how to escape the depression. Definition of
a recession A recession is characterized as a period of negative economic growth for two
consecutive quarters. In a recession, unemployment will rise, output fall and government
borrowing increase. Definition of depression A depression is a recession but much more severe
and long lasting. There is no agreed upon definition of a depression. But, generally a depression
would have some of the following characteristics.

• Decline in output for a prolonged period e.g. greater than 2 years.

• A drop in output of 10% or greater.

• Unemployment rate touching 20% (rather than the 10% rate associated with recessions)

It was at that time when J. M. Keynes wrote his famous book 'General Theory'. In it he presented
an explanation of the Great Depression of 1930's and suggested measures for the solution. He
also presented his own theory of income and employment. According to Keynes- "In the short
period, level of national income and so of employment is determined by aggregate demand and
aggregate supply in the country. The equilibrium of national income occurs where aggregate
demand is equal to aggregate supply. This equilibrium is also called effective demand point".
What is Effective Demand?

Keynes‟ theory of employment is a demand-oriented theory. This means that Keynes visualized
employment/unemployment from the demand side of the model. According to Keynes, the
volume of employment in a country depends on the level of effective demand of people for
goods and services. Unemployment is attributed to the deficiency of effective demand. It is to be
kept in mind that Keynes‟ theory is a short run theory when population, labor force, technology,
etc., do not change. Keynes‟ theory of employment is based on the principle of effective demand.
In order to understand the concept of effective demand we have to visualize two prices operating
in the economy, viz., aggregate demand price and aggregate supply price.

The aggregate demand price refers to the level of price (aggregate or average) at which goods
and services are actually sold, that is, the producers actually receive the price by selling their
goods and services. In other words, this is the price which the consumers are prepared to pay for
purchasing goods and services.

Aggregate supply price is the minimum price necessary for producers to carry on production of
such foods and services. Below this minimum price no producer would be willing to cover
production. Now, in the short run, as long as the aggregate demand price is greater than the
aggregate supply price, all producers will experience profits which would motivate them to
increase output and employment. Only when the aggregate demand price is just equal to the
aggregate supply price the producers find themselves in a state of indifference or „equilibrium. If
this point is exceeded, i.e., if aggregate supply price is greater than the aggregate demand price
so that producers are not able to receive their expected minimum price, they would rather be
rethinking about continuing output and employment. The point of equilibrium or equality
between aggregate demand and aggregate supply prices has been defined as the “effective
demand‟.

GRAPHICAL EXPLAINATION With the idea of aggregate demand and aggregate supply
prices are associated two curves, aggregate demand curve and aggregate supply curve. While
both the curves appear as upward rising from left to right, the former (aggregate demand curve)
lies above the latter aggregate supply curve). Also, while AD curve increases at a decreasing
rate, the AS curve increases with an increasing rate . The equilibrium in the economy and
equilibrium level of employment occurs at point YE where AD =AS with equilibrium level of
employment of OY. However, OY is not necessarily the full employment level even though
economy is at equilibrium. This is what Keynes defined as an underemployment equilibrium. In
fact, the total available supply of labour is OY1, more than OY by YY1, suggesting the
magnitude of involuntary unemployment.

Why does such a situation of underemployment equilibrium develop in the economy? Keynes
visualizes that the extent of aggregate demand (or, aggregate expenditures) falls short of the
producers expectations (or, aggregate supply) or their minimum supply prices necessary to
continue output and absorb the unemployed labour force. Clearly, the prescription suggested is to
increase the level of aggregate demand. In terms of Fig. , it would possibly happen when the
entire AD function shifts upward so much that AD intersects AS beyond E and employment
increases so much to allow the producers to produce at the “potential level‟, Y1, as shown in
Figure by shifted AD curve and the ultimate equilibrium point of E. Thus, in terms of Keynesian
analysis, economy may achieve „equilibrium‟ but not necessarily at full employment output. It is
a coincidence if that happens but the normal situation is that of underemployment equilibrium
with potential output greater than the actual output.
 UNIT -4

NATIONAL INCOME DETERMINATION

DETERMINATION OF NATIONAL INCOME IN TWO SECTOR/ CIRCULAR FLOW

OF INCOME IN TWO SECTOR MODEL

What is Circular Flow of Income?

The circular flow means the unending flow of production of goods and services, income, and
expenditure in an economy. It shows the redistribution of income in a circular manner between
the production unit and households.

These are land, labour, capital, and entrepreneurship.

 The payment for the contribution made by fixed natural resources (called land) is known
as rent.

 The payment for the contribution made by a human worker is known as wage.

 The payment for the contribution made by capital is known as interest.

 The payment for the contribution made by entrepreneurship is known as profit.

Circular Flow of Income in a Two-Sector Economy

It is defined as the flow of payments and receipts for goods, services, and factor services between
the households and the firm sectors of the economy.
Explanation

 The outer loop of the diagram shows the flow of factor services from households to firms
and the corresponding flow of factor payments from firms to households.

 The inner loop shows the flow of goods and services from firms to households and the
corresponding flow of consumption expenditure from households to firms.

 The entire amount of money, which is paid by firms as factor payments, is paid back by
the factor owners to the firms.

Circular Flow of Income in a Three-Sector Economy

 The Circular Flow of Income in a Three – Sector Model The three sector model of circular flow
of income highlights the role played by the government sector. This is a more realistic model
which includes the economic activities of the government however; we continue to assume the
economy to be a closed one. There are no transactions with the rest of the world. The
government levies taxes on the households and the firms and it also gives subsidies to the firms
and transfer payments to the household sector. Thus, there is income flow from the household
and firms to the government via taxes in one direction and there is income outflow from the
government to the household and firms in the other direction. If the government revenue falls
short of its expenditure, it is also known to borrow through financial markets. This sector adds
three key elements to the circular flow model, i.e., taxes, government purchases and government
borrowings. This is explained with the help of the following diagram

A three-sector economy model rectifies some of the drawbacks of the two-sector model by
introducing the following.

1. The government plays a pivotal role in consuming a major portion of the money flow in taxes.
2. Hence, the flow of money follows from the firms and households to the government in taxes.
3. The government utilizes taxes to develop infrastructure and other services like healthcare,
education, etc. So, the government pays back in terms of incentives and purchases goods from
the firms.
4. The government pays the households interest rates in government securities, pay revisions,
government jobs, etc.
5. Together, it all completes the circular movement of money.
6. If the government‟s income from the taxes is less than its expenditure, it is said to have a deficit
budget.

As such, the role of government cannot be ignored in any economy because of such a huge
control it possesses over the economic cycle. Consequently, governmental interference affects
the overall economic performance of a country.

A three-sector economy does not consider the role of foreign markets, which has become even
more prevalent in the current globalized world.

Circular Flow of Income in A Four Sector Economy

The four-sector economy model is an open-ended economy that goes beyond by considering the
foreign sector‟s role in the overall economic cycle.
 The main features of the four-sector economy are as follows:

1. With the introduction of the foreign sector, the scope widens further. The money flows to
households or firms when they buy goods and services from a foreign country, a lso known as
imports.
2. The money flows back to households when foreign countries give them employment. For firms,
money flows back when foreign countries purchase goods and services, also called exports.
3. If the value of imports is equal to the value of exports, it is called a balanced trade. If imports are
greater than exports, it is a trade deficit. If exports are greater than imports, it is called a trade
surplus.
4. However, in the diagram, for the sake of simplicity, the trade relation (for goods and services) is
shown only between firms and foreign markets.

Thus, we can say that the foreign players are investing in the US market, or the US firms rely on
the foreign market to fulfill their production needs and vice-versa.

MEANING OF INVESTMENT MULTIPLIER

The Investment Multiplier J.M. Keynes has formulated the concept of investment multiplier, the
multiplier refers to the effects of changes to investment outlays on aggregate income through
induced consumption expenditures. Thus, the multiplier expresses a relationship between an
initial increment in investment and the resulting increase to aggregate income. In fact, the
multiplier is the name given to the numerical coefficient which indicates the increase in incomes
which will result in response to an increase on investment. For instance, if investment increases
by one crore of rupees and the aggregate income (or the national income) rises by four crores of
rupees, then the multiplier is 4 (increase in income of Rs. 4 crores + increase in investment of Rs.
1 crore 4). The multiplier may be defined as the ratio of the realised changed in aggregate
income to the given change in investment.

Symbolically,

K = ∆Y/∆I
Where, K stands for the investment multiplier, ∆Y represents change in income, and ∆Il refers to
a given change in investment.

It follows that, given the multiplier coefficient K, we can measure the resulting change in the
level of income caused by an intended change in investment.

∆Y=k.∆I

ASSUMPTIONS OF INVESTMENT MULTIPLIER

The assumptions which are implicit in the Keynesian theory of the multiplier may be stated as
under:

1. The original propensity to consume remains constant during the income propagation.

2. Fiscal and monetary policies remain stable, so that they do not affect the propensity to
consume.

3. Excess capacity exists in the economic system. The assumption is that the economy operates
at less than full-employment level, so that the multiplier effect is realized in real terms in that it
raises the level of output and employment.

4. A closed economy model is assumed: That is, the country has no foreign trade activity. With
this assumption, the impact of international economic transaction and consequent position of "the
balance of payments on the domestic level of income and consumption is ruled out.

5.A static economy model is assumed. That is, there is absence of dynamic change in the
economy. The state of technology, capital formation and accumulation, labour supply, stock of
raw materials, power resources and other input variables are assumed to be given.

6. There is no significant time lag involved between the receipt of income and its expendit ure.
Thus the process of income propagation in each round assumed to be instantaneous.

SHORT COMINGS OF THE MULTIPLIER THEORY

Keynes's multiplier theory has the following drawbacks/Short comings.

1. By assuming an instantaneous relationship between income, consumption and investment,
Keynes treated the multiplier as a timeless phenomenon. In reality, however, there is a time lag
(interval) between the receipt of income and consumption expenditure of the same as well as
between consumption expenditure and its reappearance as income. Thus, modern economists
point out that the multiplier effect always takes some time to materialize its full impact That is
time lag is very important to get the investment material.

2. Keynes's principle of investment multiplier is a static phenomenon, which is unsuited to the

changing processes of the dynamic world. Under certain static assumptions, it shows the process
of income propagation from one point of equilibrium to another, there is no analysis of the actual
sequence of events nor is there a reckoning of time lag. The result is obtained only after under
static conditions.

3. Keynes presents no empirical evidence of his multiplier theory. As Gottfried Haberler points
out, "Keynes offers no adequate proof, only a number of rather disconnected observations. His
central theoretical idea about the relationship between the propensity to consume and the
multiplier, which is destined to give shape and strength to these observations turns out to be not
an empirical statement which tells us something about the real world, but a barren algebraic
relation which no appeal to facts can either confirm or disprove. In short. Keynes's theory of
multiplier is an unverified hypothesis.

4. Probably, the greatest weakness of the multiplier theory, according to Gordon, is its exclusive
emphasis on consumption. It would be more realistic to speak of a "marginal propensity to
spend" rather than consumer, and then to consider the repercussions of an initial increase in
investment, not only on consumption but also on total private investment and government
spending.

5. The multiplier takes into account only the effects of induced consumption on income; it
neglects the repercussions of induced consumption on induced investment. It fails to see the
typical relationship between the demand for capital goods is a derived demand.

6. Professor Hazlitt held that about the concept of multiplier some Keynesians make fuss than
about anything else in the Keynesian system. In his view, there can never be any precise , pre-
determinable or mechanical relationship between investment and income, and that the multiplier
is in fact a worthless concept. It is a myth.

LIMITATIONS OR LEAKAGES OF INVESTMENT MULTIPLIER

Leakages are the potential diversions from the income stream which tend to weaken the
multiplier effect of new investment. Given the marginal propensity to consume, the increase in
income in each round declines due to leakages in the income steam and ultimately the process of
income propagation "peters out". The following are the important leakages:

1. Saving. Saving is the most important leakage of the multiplier process. Since the marginal
propensity to consume is less than once, the whole increment in income is not spent on
consumption. A part of it is saved which peters out of the income stream and the increase in
income in the next round declines. Thus the higher the marginal propensity to save, the smaller
the size of the multiplier and the greater the amount of leakage out of the income stream, and
vice versa. For instance, if MPS=1/6, the multiplier is 6, according to the formula K=1/MPS and
the MPS of 1/3 gives a multiplier of 3.

2. Strong Liquidity Preference. If people prefer to hoard the increased income in the form of
idle cash balances to satisfy a strong liquidity preference for the transaction, precautionary and
speculative motives, that will act as a leakage out of the income stream. As income increases
people will hoard money in inactive bank deposits and the multiplier process is checked.

3. Purchase of Old Stocks and Securities . If a part of the increased income is used in buying
old stocks and securities instead of consumer goods, the consumption expenditure will fall and
its cumulative effect on income will be less than before. In other words, the size of the multiplier
will fall with a fall in consumption expenditure when people buy old stocks and shares.

4. Debt Cancellation. If a part of increased income is used to repay debts to banks, instead of
spending it for further consumption, that part of the income peters out of the income stream. In
case, this part of the increased income is repaid to other creditors who save or hoard it, the
multiplier process will be arrested.

5. Price inflation. When increased investment leads to price in nation, the multiplier effect of
increased income may be dissipated on higher prices. A rise in the prices of consumption goods
implies increased expenditure on them. As a result, increased income is absorbed by higher
prices and the real consumption and income fall. Thus price inflation is an important leakage
which tends to dissipate increase in income and consumption on higher prices rather than in
increasing output and employment.

6. Net Imports. If increased income is spent on the purchase of imported goods it acts as a
leakage out of the domestic income stream. Such an expenditure fails to effect the consumption
of domestic goods. This argument can be extended to net imports when there is an excess of
imports over exports thereby causing a net outflow of funds to other countries.

7. Undistributed Profits. If profits accruing to joint stock companies are not distributed to the
shareholders in the form of dividend but are kept in the reserve fund, it is a leakage from the
income stream undistributed profits with the companies tend to reduce the income and hence
further expenditure on consumption goods thereby weakening the multiplier process.

8. Taxation. Taxation policy is also an important factor in weakening the multiplier process.
Progressive taxes have the effect of lowering the disposable income of the taxpayers and
reducing their consumption expenditure. Similarly commodity taxation tends to raise the prices
of goods, and a part of increased income may be dissipated on higher prices. Thus increased
taxation reduces the income stream and lowers the size of the multiplier.

9. Excess Stocks of Consumption Goods. If the increased demand for consumption goods is
met from the existing excess stocks of consumption goods there will be no further increase in
output, employment and income the multiplier process will come to a half till the old stocks are
exhausted.
 UNIT V

THEORIES OF CONSUMPTION INVESTMENT

Keynes's Psychological Law of Consumption

Keynes‟s Theory of Consumption: Keynes in his “General theory”, published in 1936, laid the
foundations of modern macroeconomics. The concept of consumption function plays an
important role in Keynes‟ theory of income and employment.

According to Keynes, of all the factors it is the current level of income that determines the
consumption of an individual and also of society. Keynes laid stress on the absolute size of
current income as a determinant of consumption, his theory of consumption is also known as
absolute income theory of consumption.

Keynes put forward a psychological law of consumption, according to which, as income

increases consumption increases but not by as much as the increase in income. In other words,
marginal propensity to consume is less than one. 1> MPC>0 While Keynes believed that there
are many other factors including interest rate and wealth that influenced the level consumption
expenditure, he emphasized that it is the current level of income on which the consumption
spending of an individual and the society depends.

About consumption behaviour, Keynes makes three points. First, he suggests that consumption
expenditure depends mainly on absolute income of the current period, that is, consumption is a
positive function of the absolute level of current income. The more income in a period one has,
the more is likely to be his consumption expenditure in that period. In other words, in any period
the rich people tend to consume more than the poor people do. Secondly, Keynes points out that
consumption expenditure does not have a proportional relationship with income.

According to him, as the income increases, consumption increases but not in the same
proportion. The proportion of consumption to income is called average propensity to consume
(APC). Thus, Keynes argues that average propensity to consume (APC) falls as income
increases.
The Keynes‟ consumption function can be expressed in the following form C = a + bYd where C
is consumption expenditure and Yd is the real disposable income which equals gross national
income minus taxes, a and b are constants, where a is the intercept term, that is, the amount of
consumption expenditure at zero level of income. Thus, a is autonomous consumption. The
parameter b is the marginal propensity to consume (MPC) which measures the increase in
consumption spending in response to per unit increase in disposable income.

Thus MPC = ΔC/ΔY Since the average propensity to consume falls as income increases, the
marginal propensity to consume (MPC) is less than the average propensity to consume (APC).

The Keynesian consumption function is depicted in Fig . In Fig. we have shown a linear
consumption function with an intercept term. In this form of linear consumption function, though
marginal propensity to consume (ΔC/ΔY) is constant, average propensity to consume is
declining with the increase in income as indicated by the slopes of the lines OA and OB at levels
of income Y1 and Y2 respectively. The straight line OB drawn from the origin indicating
average propensity to consume at higher income level Y2 has a relatively less slope than the
straight line OA drawn from the origin to point A at lower income level Y1. The decline in
average propensity to consume as the income increases implies that the proportion of income that
is saved increases with the increase in national income of the country. This result also follows
from the studies of family budgets of various families at different income levels. The fraction of
income spent on consumption by the rich families is lower than that of the poor families. In other
words, the rich families save a higher proportion of their income as compared to the poor
families.

The assumption of diminishing average propensity to consume is a significant part of Keynesian

theory of income and employment. This implies that as income increases, a progressively larger
proportion of national income would be saved. Therefore, to achieve and maintain equilibrium at
full-employment level of income, increasing proportion of national income is needed to be
invested. If sufficient investment opportunities are not available, the economy would then run
into trouble and in that case it would not be possible to maintain full employment because
aggregate demand will fall short of full-employment output. On the basis of this increasing
proportion of saving with the increase in income and consequently, the emergence of the
problem of demand deficiency, some Keynesian economists based the theory of secular
stagnation on the declining propensity to consume.

rawbacks of the Absolute Income Hypothesis First serious drawback of the Keynes's absolute
income hypothesis is that it is based more on

introspection rather than on observed facts. It is also argued that the Keynesian the ory is
'Conjectural-a

theory not supported by empirical data on consumption and disposable income. Second, the early
empirical studies have supported only the first and the third properties of the Keynesian
consumption function. That is, the empirical tests have supported the view that C-f(Y) and
ACAY<CIY. The second and the fourth properties have not only failed to stand the empirical
test and have also been a major source of controversy. Third, and more importantly, the post-War
studies based on the US data cast serious doubts on the validity of the simple Keynesian
consumption function. Kuznets's study", (which earned him Nobel Prize) of the disposable
income and savings in the US during the period from 1869 to 1929 disclosed that MPC remained
constant during the whole reference period and that MPC APC Kuznets estimated a consumption
function of the form C-bY, b being approximately equal to 0.9. This contradicted the third
property of the Keynesian consumption function, i.e., MPC APC. Furthermore, the Keynesian
consumption function applied to the pre-War data predicted a consumption level which was
much higher than that of the aggregate income. This created doubts about the empirical validity
of the Keynesian consumption theory.
RELATIVE INCOME HYPOTHESIS

Consumption Relative income theory has been given by an American economist JS Duesenberry.
The relative income hypothesis of James Duesenberry is based on the rejection of the two
fundamental assumptions of the consumption theory of Keynes. Duesenberry states that:

(1) every individual‟s consumption behaviour is not independent but interdependent of the
behaviour of every other individual, and

(2) that consumption relations are irreversible and not reversible in time. A rich person will have
a lower APC because he will need a smaller portion of his income to maintain his consumption
pattern. On the other hand, a relatively poor man will have a higher APC because he tries to keep
up with the consumption standards of his neighbours or associates. The relat ive income
hypothesis suggests that households try to imitate or copy the consumption levels of their
neighbours or other households in a particular community. This is called 'Demonstration Effect'

This provides the explanation of the constancy of the long-run APC because lower and higher
APCs would balance out in the aggregate. Thus even if the absolute size of income in a country
increases, the APC for the economy as a whole at the higher absolute level of income would be
constant. But when income decreases, consumption does not fall in the same proportion because
of the Ratchet Effect.

The hypothesis states that during a period of prosperity, consumption will increase and gradually
adjust itself to a higher level. Once people reach a particular peak income level and become
accustomed to this standard of living, they are not prepared to reduce their consumption pattern
during a recession.

As income falls, consumption declines but proportionately less than the decrease in income
because the consumer dissaves to sustain consumption. On the other hand, when income
increases during the recovery period, consumption rises gradually with a rapid increase in
saving. Economists call this the Ratchet Effect.

It’s Criticisms:

1. No Proportional Increase in Consumption:

The relative income hypothesis assumes a proportional increase in income and consumption.
But increases in income along the full employment level do not always lead to proportional
increases in the consumption.

2. No Direct Relation between Consumption and Income:

This hypothesis assumes the relation between consumption and income to be direct. But this has
not been borne out by experience. Recessions do not always lead to decline in consumption, as
was the case during the recessions of 1948-49 and 1974-75.

3. Reversible Consumer Behaviour:

According to Micheal Evants, “The consumer behaviour is slowly reversible over time, instead
of being truly irreversible. Then previous peak income would have less effect on current
consumption, the greater the elapsed time from the last peak.” Even if we know how a consumer
spent his previous peak income, it is not possible to know how he would spend it now.

4. Neglects Other Factors:

This hypothesis is based on the assumption that changes in consumer‟s expenditure are related to
his previous peak income. The theory is weak in that it neglects other factors that influence
consumer spending such as asset holdings, urbanisation, changes in age-composition, the
appearance of new consumer goods, etc.

5. Consumer Preferences do not depend on others:

Another unrealistic assumption of the theory is that consumer preferences are interdependent
whereby a consumer‟s expenditure is related to the consumption patterns of his rich neighbour.
But this may not always be true.

Permanent Income Theory of Consumption:

Permanent income theory of consumers‟ behaviour has been put forward by a well-known
American economist, Milton Friedman. Though Friedman‟s permanent income hypothesis
differs from life cycle consumption theory in details, it has important common features with the
latter. Like the life cycle approach, according to Friedman, consumption is determined by long-
term expected income rather than current level of income.

It is this long-term expected income which is called by Friedman as permanent income on the
basis of which people make their consumption plans. To make his point clear, Friedman gives an
example which is worth quoting. According to Friedman, an individual who is paid or receives
income only once a week, say on Friday, he would not concentrate his consumption on one day
with zero consumption on all other days of the week.

He argues that an individual would prefer a smooth consumption flow per day rather than plenty
of consumption today and little con-sumption tomorrow. Thus consumption in one day is not
determined by income received on that particular day. Instead, it is determined by average daily
income received for a period. This is on the line of life cycle hypothesis. Thus, according to him,
people plan the ir consumption on the basis of expected average income over a long period which
Friedman calls permanent income.

It may be noted that permanent income or expected long-term average income is earned from
both “human and non-human wealth”. The income earned from human wealth which is also
called human capital refers to the return on income derived from selling household‟s labour
services, that is, efforts and abilities of its labour.

This is generally referred to as labour income. Non-human wealth consists of tangible assets
such as saved money, debentures, equity shares, real estate and consumer durables. It is worth
noting that Friedman regards consumer durables such as cars, refrigerators, air conditioners,
television sets as part of households‟ non-human wealth. The imputed value of the flow of
services from these consumer durables is considered as consumption by Friedman.

Relationship between Consumption and Permanent Income:

Now, what is the precise relationship between consumption and permanent income (that is, the
expected long period average income). According to permanent income hypothesis, Friedman
thinks that consumption is proportional to permanent income

CP=kYP
where

YP is the permanent income

CP is the permanent consumption

k is the proportion of permanent income that is consumed.

The proportion or fraction k of permanent income that is consumed depends upon the following
factors:

1. Rate of interest (i):

At a higher rate of interest the people would tend to save more and their consumption
expenditure will decrease. The lowering of rate of interest will have opposite effect on the
consumption.

2. The proportion of non-human wealth to human wealth:

The relative amounts of income from physical assets (i.e., non-human wealth) and income from
labour (i.e., human wealth) also affects consumption expenditure. This is denoted by the term w
in the permanent consumption func-tion and is measured by the ratio of non-human wealth to
income. In his permanent income hypoth-esis Friedman suggests that consumption expenditure
depends a good deal on the wealth or assets possessed by the people. The greater the amount of
wealth or assets held by an individual, the greater would be its propensity to consume and vice -
versa.

3. Desire to add to one‟s wealth:

Lastly, households‟ preference for immediate consumption as against the desire to add to the
stock of wealth or assets also determines the proportion of permanent income to be devoted to
consumption. The desire to add to one‟s wealth rather than to fulfill one‟s wants of immediate
consumption is denoted by u.

Thus rewriting the consumption function based on Friedman‟s permanent income hypothesis we
have

CP =k (i, w, u) YP
The above function implies that permanent consumption is function of permanent income. The
proportion of permanent income devoted to consumption depends on the rate of interest (i), the
ratio of non-human wealth to labour income (w) and desire to add to the stock of assets (u).

Permanent and transitory income:

In addition to permanent income, the individual‟s income may contain a transitory component
that Friedman calls as a transitory income. A transitory income is a temporary income that is not
going to persist in future periods. For example, a clerk in an office may get a substantial income
from overtime work in a month which he thinks cannot be maintained.

Thus, this large overtime income for a month will be transitory component of income. According
to Fried-man, transitory income is not likely to have much effect on consumption.

Thus, income of an indi-vidual consists of two parts, permanent and transitory, which we may
write as under:YM

= Yp + Yt

where YM is measured income in a period, Yp is the permanent income and Yt is transitory

income.Measuring permanent income:

To make the permanent income hypothesis operational we need to measure permanent income.
Permanent income, as is generally defined is “the steady rate of consump-tion a person could
maintain for the rest of his or her life, given the present level of wealth and income now and in
the future.”

However, it is very difficult for a person to know what part of any change in income is likely to
persist and is therefore permanent and what part would not persist and is therefore transitory.
Friedman has suggested a simple way of measuring permanent income by relating it to the
current and past incomes. According to him, permanent income is equal to the last year‟s income
plus a proportion of change in income occurred between the last year and the current year.

Criticism of the permanent income hypothesis

First. Friedman's assumption that there is no correlation between transitory components of
consumption and income is unrealistic. This assumption implies that with the increase or
decrease in the measured income of the household, there is neither any increase or decrease in
the measured income of the household, there is neither any increase or decrease in his
consumption, because he either behavior. A person who has a windfall gain does not deposit the
entire amount in his bank account buy enjoys the whole or part of it on his current consumption.
Second, Friedman's hypothesis states that the APC of all families, whether rich or poor, is the
same in the long-run. But this is against the ordinary observed behavior of households. It is an
established fact that low-income families do not have the capacities to save the same fraction of
their incomes as the high income families.
Third, Friedman's use of the terms "permanent", "transitory", and "measured" have tended to
confuse the theory. The concept of measured income mixes together permanent and transitory
income on the one hand, and permanent and transitory consumption on the other.
Lastly, another weakness of the permanent income hypothesis is that Friedman does not make
any distinction between human and non-human wealth and includes income from both in a single
term in the empirical analysis of his theory.

LIFE CYCLE THEORY OF CONSUMPTION:

An important post-Keynesian theory of consumption has been put forward by Modigliani and

Ando which is known as life cycle theory. According to life cycle theory, the consumption in any

period is not the function of current income of that period but of the whole lifetime expected
income.

Thus, in life cycle hypothesis the individual is assumed to plan a pattern of consumption

expenditure based on expected income in their entire lifetime. It is further assumed that
individual maintains a more or less constant or slightly increasing level of consumption.
However, this level of consumption is limited by his expectations of lifetime income. A typical

individual in this theory in his early years of life spends on consumption either by borrowing
from others or spending the assets bequeathed from his parents.

It is in his main working years of his lifetime that he consumes less than the income he earns and

therefore makes net positive savings. He invests these savings in assets, that is, accumu lates

wealth which he consumes in the future years. In his lifetime after retirement he again dis-saves,

that is, consumes more than his income in these later years of his life but is able to maintain or
even slightly increase his consumption in the lifetime after retirement.

Life cycle hypothesis has been de picted in Fig. It is assumed that a typical individual knows

exactly at what age he will die. In Fig. , it is taken that the individual would die at the age of 75

years. That is, years 75 is his expected lifetime. It is further assumed in the life cycle theory that

net savings in the entire lifetime is zero, that is, the savings done by the individual in his working

years of his life is equal to the dissavings made by him in his early years of life before he is able
to earn income as well as the dissavings which he makes after retire ment.

It is also assumed for the sake of simplicity that interest paid on his assets is zero. The curve YY

shows income pattern of the whole life-time of the individual whereas CC‟ is the curve of
consumption which is assumed to be slightly increasing as the individual grows old. It is
assumed that our individual enters into labour force (i.e., working life) at the age of 15 years.

It will be noticed from Fig. that upto the age of 25 years his income, though increasing, is less

than his consumption, that is, he will be dissaving during the first 13 years of his working life.
To finance hi s excess consumption over his income, he may be borrowing from others.

Beyond the age of 25 or point A on the income and consumption curves and upto the age of 65

years his income exceeds his consumption, that is, he will be saving during this period of his

working life. With these savings he will build up assets or wealth. He may use these savings or

wealth to pay off his debt incurred by him in the early stage of his working life. Another

important motive of his savings and building up assets or wealth is to provide for his
consumption after retirement when his income drops below his level of consumption.

It will be observed from the that beyond point B (that is, after retirement at 65 years) his current

income falls short of his consumption and therefore he once again dissaves. He would be using

his accumulated assets or wealth from his earlier working years to meet the dissavings after

retirement at the age of 65. It is important to note that we assume that he does not intend to leave
any assets for his children. Given this assumption, his net savings over his lifetime will be zero.

Therefore, in Fig., his savings during the period when he earns more than his consumption

expenditure, that is, the shaded area AHB will be equal to the two areas of dissavings, CYA +

BC‟Y‟. Thus he dies leaving behind no assets or wealth. He has planned his consumption

expenditure over the years that his net savings at the time of death are zero. However, this
assumption can be rela xed if he wishes to leave some assets or wealth for his children.

Some important conclusions follow from the life cycle theory of consumption. The fundamental

idea of the life-cycle hypothesis is that people make their consumption plans for their entire

lifetime and further that they make their lifetime consumption plans on the basis of their
expectations of lifetime income. Thus in the life cycle model consumption is not a mere function

of current income but on the expected lifetime income. Besides, in life cycle theory the wealth
presently held by individuals also affects their consumption.

Criticisms of Life Cycle Theory

 It assumes people run down wealth in old age, but often this doesn‟t happen as people
would like to pass on inherited wealth to children. It assumes people are rational and
forward planning. Behavioural economics suggests many people have motivations to
avoid planning.
 People may lack the self-control to reduce spending now and save more for future.
 Life-cycle is easier for people on high incomes. They are more likely to have financial
knowledge, also they have the „luxury‟ of being able to save. People on low-incomes,
with high credit card debts, may feel there is no disposable income to save.
 Leisure. Rather than smoothing out consumption, individuals may prefer to smooth out
leisure – working fewer hours during working age, and continuing to work part-time in
retirement.
 Government means-tested benefits for old-age people may provide an incentive not to
save because lower savings will lead to more social security payments.

INVESTMENT AND ITS TYPES

Investment is an asset or item accrued with the goal of generating income or recognition. In an
economic outlook, an investment is the purchase of goods that are not consumed today but are
used in the future to generate wealth. In finance, an investment is a financial asset bought with
the idea that the asset will provide income further or will later be sold at a higher cost price for a
profit.

Classification of investment
1. induced investment
2autonomous investment.

Induced investment
It is that investment which is undertaken as a result of a change in the level of income or
consumption. It depends on profit expectations. Entrepreneurs purchase or produce capital goods
when they anticipate high level of sales of final goods. This anticipation depends upon the level
of income and the level of effective demand of consumers. An increase in the level of income
leads to an increase in the level of employment and in the demand for consumer goods. This, in
turn, results in an increase in investment. Thus, increased investment increases or decreases with
the increase or decrease in the level of income. This functional relationship between income and
investment could also be explained by means of a diagram.
\

In, income is measured along the X-axis and investment along Y-axis. It represents induced
investment curve. As income increase from OY 1 to OY2, the level of induced investment
increases from Y1E1 to Y2E2. So, the larger the income of the community, the higher will be the
induced investment. Hence, induced investment is income-elastic.
Autonomous investment
It refers to that kind of investment which is not affected by the changes in the level of income or
output and is not induced solely by profit, motive. Autonomous investment is not a function of
output or income. It is related to the technological development, discovery of the new resources,
growth of population etc. On each level of income, autonomous investment remains unaltered. In
it is autonomous investment which remains constant at each level of income. Hence autonomous
investment is income-inelastic.

It should, however, be noted that autonomous investment does not always remain fixed or
constant. It may be fixed at a point of time but may change over time. The government may
increase this investment in future by undertaking new proper as construction of roads. bridges,
etc.

CONCEPT OF MARGINAL EFFICIENCY OF CAPITALDEFINITION AND

EXPLANATION:

Marginal efficiency capital (MEC) is a Keynesian concept. According to J.M. Keynes, nations
output depends on its stock capital. An increase in the stock of capital increases output. The
question is how much increase in investment raises output? Well, this depends on the
productivity of new capital i.e. on the marginal efficiency of capital. Marginal efficiency of
capital is the rate return expected to be obtainable on a new capital asset over its life time.

J.M. Keynes defines marginal efficiency of capital as the: “The rate of discount which makes the
present value of the prospective yield from the capital asset equal to its supply price”.

A businessman while investment in a new capital asset, examines the expected rate of net return
(profit) on it during its lifetime against the supply price of capital asset (cost of capital asset) if
the expected rate of profit is greater than the replacement cost of the asset, the businessman will
invest the money in the project.

Example: For example, if a businessman spends $10,000 on the purchase of a ne w griding

machine. We assume further that this new capital asset continues to produce goods over a long
period of time.

The net return (excluding meeting all expenses except the interest cost) of the griding machine
expected to be $1000 per annum. The marginal efficiency of capital will be 10%. (1000/10000)
Χ (100/1) = 10%

Formula: The following formula is used to know the present value of aeries of expected income
throughout the life span of the capital assets. Sp = (R1 /1+r) + (R2 /1+r2 ) + ............ = (Rn /1+rn
)

Here: Sp = Stands for supply price of the new capital asset. R 1 + R2 - R n = Stands for returns
received on yearly basis. R = It is the rate of discount applied each the years Schedule:

According to J.M. Keynes, the behavior of investment in respect of new investment depends
upon the various stock of capital available in the economy at a particular period of time. As the
stock of capital increases in the economy, the marginal efficiency of capital goes on diminishing.
In the above table, it is shown when stock of capital is equal to $20 billion, the marginal
efficiency of capital is 10% while at a capital stock of $100 billion, it declines to 2%. This
investment demand schedule when depicted graphically in figure 30.7 gives us the investment
demand curve which goes on sloping downward from left to right. Relative Role of MEC and the
Rate of Interest: The MEC and the rate of interest are the two important factors which affect the
volume of new investment in a country. An investor while making a new investment, weighs the
MEC of new investment against the prevailing rate of interest.

As long as the MEC is higher than the rate of interest, the investment will be made till the MEC
and the rate of interest are equalized. For example, if the rate of interest 7%, the induced
investment will continue to be made till the MEC and the rate of interest are equalized. At 7%
rate of interest, the new investment will be $40 billion. In case, the rate of interest comes down
to 2% , the new investment in capital assets will be $100 billion. Summing up, if investment is to
be increased in the country, either the rate of interest should go down or MEC should increase.

Factors Affecting MEC:

The marginal efficiency of capital is influenced by short run as well as long run factors. These
factors are now discussed in brief:

Short Run Factors

(i) Demand for the product. It the market for a particular good is expected to grow and its costs
are likely to fall, the rate of return from investment will be high. If entrepreneurs expect a fall in
demand of goods and a rise in cost, the will decline.

(ii) Liquid assets. If the entrepreneurs are holding large volume of working capital, they can take
advantage of the investment opportunities that come in their way. The MEC will be high and
vice versa.

(iii) Sudden changes in income. The MEC is also influenced by sudden changes in income of the
entrepreneurs. If the business community gets windfall profits, or there are tax concession etc.,
the MEC will be high and hence investment in the country will go up. On the other hand, MEC
falls with the decrease in income.

(iv) Current rate of investment. Another factor which influences MEC is the current date of
investment in a particular industry. If in a particular industry, much investment has already taken
place and the rate of investment currently going on in that industry is also very large, then the
marginal efficiency of capital will be low.

(v) Wave of optimism and pessimism. The marginal efficiency of capital is also affected by
waves of optimism and pessimism in the business circle. If businessmen are optimistic about
future, the MEC will be overestimated. During periods of pessimism the MEC is under
estimated.

Long Run Factors:

The long run factors which influence the marginal efficiency capital are as under:

(i) Rate of growth of population. Marginal efficiency of capital is also influenced by the rate of
growth of population. If population is growing at a rapid speed, it is usually believed that at the
demand of various classes of goods will increase. So a rapid rise in the growth of population will
increase the marginal efficiency of capital and a slowing down in its rate of growth will
discourage investment and thus reduce marginal efficiency of capital.

(ii) Technological development. If investment and technological development take place in the
industry, the prospects of increase in the net yield brightens up. For example, the development of
automobiles in the 20th century has greatly stimulated the rubber industry, the steel and oil
industry, etc. So we can say that inventions and technological improvements encourage
investment in various projects and increase marginal efficiency of capital.

(iii) The quantity of capital goods of relevant types already in existence. If the quantity of any
particular of goods is available in abundance in the market and the consumers can partially or
fully meet the demand, then it will not be advantageous to invest money in that particular project.
So in such cases, the marginal efficiency of capital will be low.

(iv) Rate of taxes. Marginal efficiency of capital is directly influenced by the rate of taxes levied
by the government on various commodities, When taxes are levied, the cost of commodities is
increased and the revenue is lowered. When profits are reduced, marginal efficiency of capital
will naturally be affected. It will be low.