Macro Economics
Macro Economics: Is the study of economic problem at the level of whole economy or study
of aggregates of the economic system. Aggregate of the economic system refers to macro
economic variables or the variables which represent the economy as a whole. e.g.
Aggregate consumption, aggregate investment, aggregate demand, aggregate supply etc.
National Income: Is the sum total of factor income earned by the normal residents of the
country, during an accounting year as reward for rendering their factor services.
National Income=Domestic Income (NDPFC ) + Net factor Income from abroad (NFIA)
National Income and National Product mean one and the same thing. In the context of a
country, national income is the sum of all factor payments and national product is the final
goods and services produced.
Gross National product at MP: Gross National product at market prices is the market value
of the final goods and services produced during an accounting year in the economy,
adjusted for net factor income from abroad.
GNPMP=GDPMP+NFIA
Net National product atMP: Net national product at market prices is the market value of the
final goods and services produced in the economy during an accounting year exclusive of
depreciation and adjusted for net factor income from abroad
NNPMP=GDPMP+NFIA-Depreciation
Net nation product at FC: It is the valuation of the national product at factor cost in other
words it is the sum total of rent, wages, interest, profit, mixed income and net factor income
from abroad minus Depreciation and Net indirect taxes.
Gross domestic product: is the market value of the final goods and services produced during
a year within the domestic territory of the country. It includes the value of depreciation or
consumption of fixed capital.
Net domestic product: is the market value of the final goods and services produced during a
year within the domestic territory of the country exclusive of depreciation
NDP=GDP-Depreciation
Personal income: is the total of all 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 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 individual from their income.
Depreciation: is defined as loss or fall in the value of fixed assets due to normal wear and
tear and expected obsolescence. The concept of depreciation is very important in
economics to understand the difference between gross value and net value.
Circular flow of National income:
Real flow: Refers to the flow of goods and service across different sectors of the economy.
Factor services of land labour capital flow from household to firms and goods and services
flow from firms to households.
Money flow: Refers to the flow of money across the different sectors of the economy.
Factor incomes rent interest wages flow from firms to households and consumption
expenditure flow from households to firms
The above diagram explain the circular flow of national income between the firms and
households. It is assumed that there is no other sector and that the households do not save,
do not pay taxes to the government and do not buy goods and services from the rest of the
world. This is a simple two sector economy. It is clear that the income and product flows
are equal, factor payments by firms are equal to factor incomes of the households sector..
Methods of calculating National income
1. Product method /value added method: Product method or value added method is that
method which measures nationl income in terms of value addition by each producing
enteprise, in the economy during an accounting year. According to this method national
income is estimated at production level following the following steps.
Steps int the measurement of national income:
a) First steps: In this stage all the production units in the domesti territory are found
out and divided into various subsector according to their nature, which are primary,
secondary and tertiary.
b) Second step: In this stage the value added at the factor cost of all the production
units in all the three sectors are added up which gives net domestic at factor cost.
c) Third stage : Net factor income earned from abroad is added to net domestic
produced at factor cost which gives net national product at factor cost.
Precautions to be observed while calculating national income by product method:
1. The value of the sale and purchases of second hand goods is not to be included,
because the value of the second hand goods is already accounted for during the year
they were produced.
2. Commission earned on account of the sale and purhases of second hand goods is
included in the estimation of national income, because the commission is the reward
for the serivces rendered.
3. Owned account production of goods of the producing units is taken ino into account
while estimating national income becausse thesse good are like those produced for
the market
4. Value of intermediat goods is nto not included in the estimation of national income
becaus value of interediate goods is reflectd in the value of final goods.
5. Imputed rent on the owners occupied house is also taken into accunt because all
houses have rental values no matters these are self occupied or rented out.
Income method: According to this method national income is measured in terms of factors
payments i.e. rent interest wages and profit, to the owners of factors of payments i.e. land
labour capital and organisation during an accounting year
Stages in income method:
First stage:
In this stage all production units which use factors of production and which lie within the
domestic territory are identified
Second stage:
The factor payments of production units are estimated and divided into into following
categories:
a) Compensation of employees: It includes wages and salaries in cash and payments in
kind. Employer’s contribution to social security scheme and pension on retirement.
Contribution to social security schemes, maternity benefits, casualty insurance, life
insurance pension on retirement etc.
b) Operating surplus: it refers to income from property and entrepreneurship it includes
rent, interest and profit. Profit is further split into three components as under:
Dividend: that part of the profit which is distributed among the share holders it is also called
distributed profit
Corporate tax: That part of the profit which is paid to the government by way of profit tax.
Undistributed profit: That part of the profit which is retained by the firms for future use
particularly to meet some contingent expenses
C) Mixed income: Refers to the income of the self employed persons using their own
labour capital and entrepreneurship to produce goods and services these income are
mixture of wages rent interest and profit that is why it is called mixed income separate
estimation of rent interest, profit and wages is not possible owing to the fact that factors
of production are not hired or purchased from the market, only self owned factors are
used in household enterprises
Precaution to be observed while calculating national income
1. Transfer earning is not to be included as they are mere transfers of income and do
not generate goods and services for the economy
2. Income from illegal activities like smuggling, theft, gambling etc not to be included
3. Commission paid on the sale and purchase of second hand good are to be included
4. Income from windfall fall gain like lotteries likewise capital gain is not to be
included.
Expenditure method:
According to this method national income is measured in terms of expenditure on the
purchase of final goods and services produced in the economy during an accounting year.
Since, final expenditure comprises consumption and investment it is also called
consumption and investment method. Expenditure on the final goods and services during
the year within the domestic territory of a country is equal to the market value of GDPMP
Final expenditure is classified into:
1. Private final consumption expenditure:
It refers to expenditure on final goods and services by the individuals, households and non
profit private institutions serving society. It includes consumer services, consumer non
durable goods and consumer durable goods.
2. Government final consumption expenditure:
It refers to the expenditure on final goods and services by the government like expenditure
on the purchase of goods for consumption by the defence personnel compensation of
employees, rent of government building etc.
3. Investment expenditure:
It refers to the expenditure on the purchase of final goods by the producers these goods are
to be further used in the process of production e.g. expenditure by the farmers on the
purchase of tractors or thrashers.
Investment expenditure is further classified into:
a) Fixed investment and (b) Inventory investment
Fixed investment refers to expenditure by the producers on the purchase of fixed assets
like plant and machinery and
Inventory investment refers to change in stock during the year
Net export(X-M): Net exports refers to the difference between exports and imports during
an accounting year exports is an expenditure by the foreigners on the domestically
produced final good and services while imports are an expenditure on the goods and
services Produced abroad the difference is added to GDP
Precaution to be observed while calculating National Income:
a) Only final expenditure on the final goods and services is to be taken into account to
avoid error of double counting
b) Expenditure on second hand goods is not to be included because value of second
hand goods has already been accounted for during the year of their production.
c) Expenditure on transfer payments by the government is no to be included because
transfer payments do not cause an value addition
d) Imputed value of expenditure on goods produced for self consumption should be
taken into account e.g. imputed rent on owner occupied house.
Gross domestic product and welfare
GDP is taken as an index of welfare of the people in an economy. More income in the
hands of people means more purchase of goods and services, so t it is treated as a level of
wellbeing. So we may treat higher level of GDP of a country as an index of greater well
being of people but this may not be true for the following reasons.
a) Distribution of GDP:
If the GDP of the country is raising the welfare may not rise this may happen because
of concentration of rise in GDP in the hands of few, for the rest the income may in fact have
fallen in such a case the welfare of the entire country cannot be said to have increased
b) Non monetary exchanges:
In developing countries, in many remote regions economics activities are not evaluated in
monetary terms. These exchanges are not registered as part of economic activity this is a
case of underestimation of GDP. Hence GDP calculated in the standard manner may not give
us a clear indication of the productive activity and wellbeing of a country.
c) Composition of GDP:
If rise in GDP is the result of more production of war material like weapons
ammunitions or more expenditure on police, military services etc which provide less
welfare as compared to consumer goods like food items, clothes, etc. GDP will not
contribute equally to economic welfare.
d) Externalities:
These are the benefits or harms firms or individual causes to another for which they are not
paid or penalised. GDP does not take into account externalities. If we take GDP as a
measure of welfare of the economy we shall be overestimating the actual welfare in the
case of negative externalities and underestimating in case of positive externalities.
Therefore, it cannot be taken as good measure of welfare of the economy.
Determination of income and employment
The equilibrium of national income is determined at a point where aggregate supply and
aggregate demand are equal; there for understanding the process of determination of
income and employment, we should know well the following concepts:
Aggregate demand: means the total amount which people are willing to spend at a given
level of income therefore this is also called total or aggregate expenditure the following are
the component of aggregate demand.
a) Consumption expenditure: Is the most important constituent of aggregate demand
it depends upon income and there for consumption function explains the
relationship between consumption expenditure and income.
b) Private Investment expenditure:
Investment mean real investment and not financial investment real investment signifies
the increase in the stock of capital assets such as machines equipments construction
activities and increase in the stock of consumers goods, the money spent on government
securities debentures shares etc. come within the category of financial investment, hence
not include in the real investment.
c) Government expenditure: Is an important buyer of goods and services in the modern
economies government has to spend on school, hospital, water supply, defence, law and
order, civil administration etc. providing these services it demands various goods and
services and spend huge amount. Government investment is generally autonomous
investment, determined by social consideration of social welfare.
d) Net export (X-M):
It is the difference between export and imports of a country during a period of one year. In
other words it is a surplus of exports over imports.
Aggregate Demand = consumption +investment/ AD = C+I
Aggregate supply: Means the value of total output of goods and services that is available in
an economy during a given period of time. In other words, the value of goods and services
produced in a country during a given period of time is aggregate supply. This value is equal
to national product or national income and therefore aggregate supply and national
income are equal. The component of aggregate supply is Rent, Interest, Wages and Profit.
(Consumption + Saving)
Aggregate Supply = Consumption + Saving/AS=C+S
The consumption function/Propensity to consume/Psychological law of consumption:
Explains the relationship beween consumption and income in other words, it is the
functional relationship between these two variables. Consumption functions explains how
change in income will leads to changes in consumptions, this can be better understood
with he help of a schedule.
Schedule
Total income(Y) Total consumption expenditure
0 50
100 100
200 150
300 200
500 300
Saving function or propensity to save: Explains the relationship between saving and
income it is the excess of income over consumption during an accounting year. Like
consumption, saving is also directly related to the level of income, it increases as income
increases. Since, there is always some minimim level of consumption, saving must be
negative so long as consumption is greater than income, obiviously at the break even point
savingis equal to zero. The behaviour of saving with respect to income is called saving
function
schedule
Income Consumption saving
0 50 -50
100 100 0
200 150 50
300 200 100
400 250 150
500 300 200
Excess demand: Excess demand refers to a situation when aggregate demand in the
economy is more than aggregate supplyat full employment level of output. When aggregate
demand is more than full employment output, there exist a gap which is called inflationary
gap.
Deficient demand: Refers to a situation where in aggregate deamand in the economy is
lower than aggregate supply at full employment level of income. The excess of availble
output over aggregate demand is called deficient dmand.
Measures to correct Excess demand or deficient demand:
Fiscal measures: Fiscal measues refers to budgetary policy of the government or the policy
related revenues and expenditure of the government with a view to correcting the situation
of excess demand or deficient demand in the economy.
Public revenue: taxes, public debt and borrowing and deficit financing
Public expenditure: public work public welfare defence and subsidies
Measures to correct deficent demand
a) Increase in govt expenditure: in a situation of deflationary gap or deficient demand
the government should raise its expenditure i.e. there should be more economic
activities in the economy like building of road, bridges, canal, etc. this will in turn
increasse income and purchasing power of people.
b) Decrease in taxes: In the situation of demand government should reduce taxes it will
increase the purchasing power of the people and they will spend more on
consumption goods and services the government can also give tax concession to
leave more dispossable income in the hands of people, as a result aggregate deman
will increase.
c) Increase in defecit financing: To correct deficient demand or to increase the demand
in the economy government should take resort of deficit finanacing or printing notes
to increase purhasing power of the ecnomy.
d) increase in public expenditure: In case fo deficient demand government sould
decreasse its borrowing from the public so that people are left with greater liquidity
and aggregate expenditure remains high.
