ncert xii macro economics

INTRODUCTION

UNIT-I

Economic decisions of individualhouseholds or firms are guided by theirrational behaviour in a given marketsituation. Here, in our pursuit to studythe logic of consumption or productiondecision, we limit our analysis to thedeterminants of choice and preferencesof households or firms, respectively.Though the study of individual decisionunits is a necessary aspect of ourenquiry into the rationale of theireconomic behaviour, it is by no meansa sufficient condition for a completestudy. So, there has to be another levelof study in which the enquiry isdirected to understand the generaleconomic conditions in the economy. Itis this distinction between the exercisesto understand and interpret thebehaviour of individual units on the onehand and the general state of theeconomy on the other establishes thebasic difference between the subjectmatter of microeconomics andmacroeconomics.

Now, what is macroeconomics allabout? In simple terms it is the studyof the economy as a whole. Everyone isinterested in knowing what is

CHAPTER 1

happening in the economy. Perhaps, itis the concern about the rate ofinflation, level of unemployment, declinein the agricultural and industrialoutput, fluctuations in businessactivities, accumulation of foreignexchange reserves, capital marketchanges, recession in the worldeconomy and so on.

These are macroeconomic eventsthat engage the attention of govern-ments, economists, entrepreneurs andeven ordinary people, as all of themreceive the impact of thesemacroeconomic events. To understandthe forces behind the overall economicperformance, we need concepts andtheoretical frameworks and empiricalmeasurements to assess performancein the given reference year. The subjectof macroeconomics accomplishesthis objective.

Macroeconomic concepts are notoften simple and direct; on the contrary,in microeconomics concepts such asprice, profit, cost, quantity, etc. areintuitive and easy to understand. So,there is nothing difficult incomprehending a basket of apples as

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INTRODUCTION TO MACROECONOMICS 3

an output and its price. But inmacroeconomics, we have a variety ofproblems in the stage of definition itself.While it is relatively easy to define andmeasure individuals income, it is notso in the case of aggregate income andoutput. The scope of macroeconomicscould be further made clear if weattempt to distinguish it frommicroeconomics.

Microeconomics andMacroeconomics

In microeconomics we study theindividual household, individual firmor small groupings of firms. If we studyone automobile firm or the automobileindustry it is microeconomic approach;but when we take up the entiremanufacturing sector, we are in the areaof macroeconomics. In this sense,macroeconomics studies theaggregates of an economic system. Weneed to make a separate study of theseeconomic aggregates because what istrue at the individual level need not betrue at the aggregate level.

Just imagine a case wherein asingle farmer produces paddy or wheat.In terms of individual rationality, thisfarmer has to produce as much outputas possible to reach the maximum levelof profit. This is perfectly logical insofaras an individual farm is concerned. But,what if all the farmers producemaximum output in their respectivefarms? For the economy as a whole, thiswould create more problems thangood. There may be excess supply ofpaddy or wheat relative to demand.Government will have to intervene, as it

happens in India, to take away a partof the output to prevent prices fallingto an unremunerative level for thefarmers. Therefore, what is a good andproper decision at the individual levelneed not be so at the aggregate level. Itis to understand this difference that aseparate study of economic aggregatesis designed in macroeconomics.

Given all the aggregates such astotal employment, output, income, etc.it is essential to find theinterrelationship between them. Doesan increase in national output mean anincrease in employment? Can the valueof foreign exchange rate be fixed interms of domestic countrys prices? Wewill obtain meaningful explanations forthe working of the economy only if wesystematically work out theinterrelationships between theaggregates. Hence, it is said thatmacroeconomics is also the study ofrelations between economic aggregates.Basically, macroeconomics is concernedwith aggregate level of output, incomeand spending for all goods and services.

In contrast, microeconomics dealswith output of individual firm and withthe spending by a single household.Microeconomics is primarily concernedwith the allocation of resources by asingle firm or household.

Whatever microeconomics takes asgiven is what macroeconomics considersas the prime variable, whose size andvalue are to be determined.Alternatively, what microeconomicstakes as variable is considered to begiven in macroeconomics. For instance,aggregate output of the economy istaken as given in microeconomics but

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INTRODUCTORY MACROECONOMICS4

1 John Maynard Keynes published the book General Theory of Employment, Interest and Money(Macmillan: London, 1936) in which he questioned the basis of the then existing macroeconomicsof the Classical School.

in macroeconomics aggregate output isan important variable. Similarly,macroeconomics takes the distributionof output, for example, as given, but inmicroeconomics it is an importantvariable.

Consider our example of a farmergiven earlier. An individual farmer ishardly conscious of the aggregateoutput of paddy or wheat. He isprimarily concerned with his ownoutput in his farm. Similarly, whengovernment decides its policy ofprocurement, it considers only the stateof the aggregate output of paddy orwheat and not that of any individualfarmer. The same thing is true of asingle manufacturing firm as againstthe aggregate manufacturing output.

Although microeconomics andmacroeconomics areas seem to berigidly distinct, it is not always so inpractice. Both areas of economicanalysis are interdependent. We seek toexplain economic behaviour ofindividual units in the context of thestate of the economy.

That is, a microeconomic decisionby an individual unit has to necessarilyhave a macroeconomic context. Theconsumption plans of households forinstance cannot be independent of thetaxation of personal income andcommodities. Similarly, microeconomicvariables may exert their influence onmacroeconomic variables. For instance,aggregate savings and investment areusually influenced by or a function ofthe pattern of savings at the micro level,

namely households and firms.Therefore, micro and macroeconomicanalyses are not mutually exclusivecategories. Each of them attempts tofocus its attention on one aspect thatthe other does not. While it is the pricesystem and resource allocation thatoccupies the centre stage inmicroeconomics, the twin areas ofincome determination andstabilisation and growth of theeconomy form the core ofmacroeconomics. In such a context,there is an inevitable interlink betweenthese two major branches of economics.

Which branch of economicsassumes primacy and receivesmaximum attention of economistsdepends on whether we need a studyof the part or the whole. Individualrationality in economic behaviour is animportant area of study insofar as weare concerned with demand and supplyforces in the market. On the other hand,in the formulation of policies forarresting fluctuations in the economysperformance and for attaining highergrowth, macro analysis assumes itsimportance.

Emergence of Macroeconomics

Interest in macroeconomics deepenedafter the emergence of the KeynesianRevolution.1 In the pre-Keynesianeconomic theory there was norecognition of economic crises. This isbecause the Classical economics, whichwas the ruling doctrine then, did notprovide an explanation for a major

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INTRODUCTION TO MACROECONOMICS 5

setback to the economy. Classicaleconomists strongly believed in theautomatic adjustment of the marketsso that the system will always be inequilibrium, and that the shocks (thatis, disturbances in markets) are onlytemporary. This contention of theClassical economists was challengedwhen the Great Depression occurred in1929. The system failed to automaticallycorrect the crisis situation and thereforethe failure of the Classical doctrine paved

EXERCISES

1. What is microeconomics?2. What do you understand by macroeconomics?3. Distinguish between micro and macroeconomics.4. Give examples of macroeconomic variables.

the way for Keynesian theory. This is thestarting point of the present daymacroeconomic approach, which isapplied extensively in policy-making.There are many variants of Keynesianapproach as the subject ofmacroeconomics evolved since Keynescontribution.

We may now embark upon learningmacroeconomics, concentrating on theKeynesian approach to the structureand working of the macro economy.

NATIONAL INCOME AND RELATEDAGGREGATES : BASIC CONCEPTS

AND MEASUREMENT

UNIT-I I

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1 An accounting period or a financial year often does not coincide with a calendar year. Ordinarily,a financial year refers to, for example, April 1, 2004 to March 31, 2005.

Macroeconomics, as pointed out earlier,deals with the study of aggregatesexpressed in terms of aggregate income,output, employment, expenditure,exports and imports and so on. In orderto determine the actual performancelevel of the economy, we need to followa framework of measurementprocedures to find these aggregates andeventually we must interpret themacroeconomic behaviour in terms ofmovements in these aggregatemeasures. National income accountingfacilitates the measurement of macroaggregates for a given economy.

Accounting is believed to be anecessary exercise for any economicunit to know its performance. Anindividual unit such as a Household ora Firm maintains its own accountinginformation since it is interested toknow its financial position at the end ofan accounting period.1 Importantdecisions concerning savings,

CHAPTER 2

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investment and tax payments are allmade by the unit after an analysis ofthe accounting information availableto it.

At the macro level, accountingassumes an even greater significance asthe information is used for a review ofthe economys performance during theyear under study. On the basis of thisappraisal national governments have toformulate their policy programmes tomaximize the welfare of people. This isthe basic purpose of national incomeaccounting as it renders possible a setof procedures for measurement ofincome and output at the aggregatelevel. This means that we are, in fact,measuring the macroeconomic activitiesin the economy for a particular year.

Accounting for transactions byindividual units is relatively a lesscomplicated and a simple process ascompared to macro economicaccounting of aggregate output and


income for the economy as a whole. It isa rather difficult and complex procedureto quantify the macro variables foraccounting purpose. It is not adequateto merely look at the macroeconomicaggregates but it is also equallyimportant to learn the techniques ofmeasuring these aggregates. Therefore,national income accounting has evolvedas a branch of study in its own right.

Primarily, there are two basicfunctions of national income accounting:the first, is to identify specific economicachievements of a country and thesecond, is to provide an objective basisof evaluation and review of policiesunder implementation. Hence, nationalincome accounts data not only help usto measure macroeconomic aggregatesbut also enable us to understand,analyse and interpret the working of theeconomy as well. This is precisely thereason why the road map to the subjectof macroeconomics begin with a studyof national income accounting.

Uses of National Income Accounting

There are some principal uses ofnational income accounting. They maybe stated as follows:

1. National income accounting showsas to how the national income isshared among the various factorsof production;

2. National income statistics indicatethe specific contributions ofindividual sectors and their growthover time;

3. National income accounting helpsto find out structural changes in theeconomy.

4. National income accountingprovides the information forassessment of the economysstrengths and failures.

5. National income statistics enablecomparisons to be made in respectof standard of living, distribution ofincome and actual composition ofnational income over time.

6. National income accounts facilitatescomparison of output amongnations.

Hence, the national income data maybe viewed as a monetary manifestationof material results of human activity inthe economy. They provide standards bywhich economic achievement of policiescould be partly judged in modern times.

Structure of the Macro Economy

Circular flow2 of macroeconomicactivity

National income accounting calls for anunderstanding of the structure of themacro economy. The conceptual basisof measurement of national incomebegins with a depiction of the inter-related manner in which economicactivities are organised in an economy.A pictorial illustration of this inter-dependence between the major sectorsof economic activity is called the circularflow of income and product. This

2 Flow refers to change in an economic variable over time. Income and product are flow concepts.This may be distinguished from stock variable which means that there is no change over time.For example, wealth is a stock concept.

STRUCTURE OF THE MACRO ECONOMY AND NATIONAL INCOME ACCOUNTING 9

simply means that every economicdecision of a sector is in response to thatof another. Therefore, macro economyis in effect a system of interrelationshipsbetween the decision-makers in everysector of the economy.

The circular flow of income involvestwo basic principles:

(a) In any exchange process, the selleror producer receives the sameamount that the buyer or consumerspends; and

(b) Goods and services3 flow in onedirection and money payments toacquire these, flow in the returndirection, thereby causing a circularflow. So, the output or product orreal flow from the seller to the buyernecessarily creates the income orpayment or money flow from thebuyer to the seller.

We shall now explain this two-wayprocess of mutual dependence fordifferent sectors of the economy. This

3 A good is a tangible object (such as a can of fruit juice or a television) that has economicvalue. A service, on the contrary, is an intangible product (such as advertising) that haseconomic value.

Clip 2.1Circular Flow of Income and Product

The inspiration for the exposition of macro economy through a CircularFlow of Income and Product appears to have originated from the writingsof Physiocrats a group of French economists who lived in 18th century.Physiocrats strongly believed in the existence of a natural order to guidethe working of the economy and hence according to them, there should notbe any kind of intervention by the Government in economic activities. Theyadvocated the policy of Laissez faire which means non-interference orminimal interference of the governments in trade and other economicactivities and accorded primacy to agriculture as such. Prominent amongthe Physiocrats was Francois Quesnay who propounded what is called theTableau Economique in 1758. This economic table contains the conceptof circulation of wealth and a schematic presentation of the distribution ofagricultural output between all classes of society. Though this economictable was recognised as the crowning achievement of Physiocrats, thistable was not explained by Adam Smith or those belonging to the classicalschool of economics. It was Karl Marx who rediscovered this table in themid-19th century.


4 Firms may produce either producer goods (capital goods used for making other goods) or consumergoods that is, goods meant for only consumption as such. Consumer goods can further beclassified into durable and non-durable variety depending upon whether they have short orlong span of life in their use to the consumers. A washing machine or an air-conditioner may becalled durable good while food items will fall under the category of non-durable or perishablegood, as they do not last long.

would be a helpful pre-requisite tounderstand the concepts used in theaccounting of national income as such.

Circular Flow in a Simple Two-sectorModel

To begin with, let us make the followingassumptions with regard to a simpleeconomy with only two sectors ofeconomic activity. There are only two sectors in the

economy, namely, Households andFirms.

Households supply factor servicesto Firms.

Firms hire factor services fromhouseholds.

Households spend their entireincome on consumption.

Firms sell all that is produced to theHouseholds.

There is no intervention ofgovernment or foreign trade.

Such an economy as described abovehas two types of markets. First, marketfor goods and services Productmarket; and second, market for factorsof production Factor market.

The economic interdependencebetween Households and Firms in thissimple economy can be observed asfollows:

(i) Household sector has theendowment of factors of production(land, labour, capital andentrepreneurial ability) and sellthem to the Firms that producegoods and services, using thesefactor inputs. The Firms, in turn, sellgoods and services thus produced4

to the Household sector for itsconsumption. Therefore, whateverthe Firms produce, is consumed bythe Households.

This type of interactionbetween Firms and Householdscan be described as the real flows,as it involves flow of goods andservices.

(ii) Exchange of goods and servicesbetween Households and Firms inresponse to acquiring factor servicesfrom Households corresponds toflows of income and expenditure ofthese two sectors. That is, Firms paythe Households in the nature ofwages for labour services, interestfor capital, rent for land and profitsto entrepreneurship. These arecalled factor payments by Firmsand factor incomes by Households.This income, in turn, is used byHouseholds to incur expenditure onbuying consumer goods andservices produced by firms.


This flow of money paymentsand expenditure can be described asmoney flows.

So, in the circular flow diagram(Fig. 2.1), we can recognise two realflows and two money flows.

As a result we can derive the following,in the case of our simple economy:1. Total production of goods and

services by firms = Totalconsumption of goods and servicesby Household Sector

PRODUCT MARKET

FACTOR MARKET

Mon

ey

Valu

e of o

utput =

Expenditure on final goods andservices

Final goods and services

Factor Services : land, labour, capital, en

trepren

eurs

hip

Total i ncome = rent +wages+interes

t+prof

its

HouseholdsFirms

Fig 2.1: The Circular Flow of Income in a Two-sector Economy

2. Factor Payments by Firms =Factor Incomes of HouseholdSector

3. Consumption expenditure ofHousehold sector = Income of Firmsector

4. Hence, Real flows of production andconsumption of Firms andHouseholds = Money flows ofincome and expenditure of Firmsand Households


This simple circular flow highlightsthe following interrelationships between: Factor Market and Product Market Output flow and Income flow Business production and

Consumer spendingEach sector is seen in its dual role:

that of the buyer and seller. Thisperpetuates the circular flow betweenthe two sectors.

Circular Flow of Income withFinancial System

A wide variety of financial institutionsand markets constitute the financialsystem5 in our economy. Financialinstitutions are primarily intermediariesbetween savers and investors, or lendersand borrowers. They are specialise intheir respective areas of financialfunction. Development economists pointout the significance of financialdevelopment of an economy as aconcomitant outcome of economicdevelopment. Therefore, understandingthe macroeconomic activity will beincomplete without the inclusionof financial system in our circularflow model.

So far, in our presentation of circularflow of income, we have not consideredthe role of saving and investment. Thisis mainly due to the reason that wehave assumed that the two sectors Households and Firms are balancedspenders (that is, they neither have asurplus nor deficit). Once we relax thisassumption a financial system to which

Households and Firms can lend andfrom which they can borrow wouldbecome relevant.

Households are the net lenders.This is possible due to generation ofpersonal savings, which is the differencebetween household income andconsumption. Firms are net borrowerssince they have to finance newinvestment in plant and equipment. Alllendings and borrowings arechannelled through the financialsystem. So long as lending is equal tothe borrowing, that is, leakage is equalto the injection, the circular flow willcontinue indefinitely (Fig.2.2).

Financial institutions pay interest tothe savers as their funds are placed withthem for a period of time under acontract. Firms pay dividend andinterest for the sums they have borrowedfrom the financial markets in the form ofshares, bonds and public deposits.Financial institutions, through their roleof intermediation, enable funds transferfrom ultimate lenders to ultimateborrowers. Saving and investmentprocess create better prospects for capitalformation, thanks to the operations offinancial institutions and markets.

Financial system is therefore veryimportant to the working of the moderneconomy. But it is sometimes believedthat money and finances are only acover over the production of goods andservices. But we cannot dismiss the

5 Here we assume that Households and Firms save part of their income, which constitutes a leakagefrom the circular flow of income. The saved amount is made available in the financial system. Firmsborrow for purposes of investment, which becomes injection into the circular flow.


funds flow between sectors asunimportant. Finance as someeconomists have held, is only alubricant that makes the economy towork smoothly.

Circular Flow of Income withGovernment6

Whatever has been presented in theforegoing section leads us to theconclusion that under the two-sectormodel, the value of total output flow inour simple economy is equal to the totalvalue of factor incomes and the valueof personal consumption flow. Let usnow expand the two-sector model andobtain a three-sector model with the

inclusion of the Government sector.Economic interrelationships betweenHouseholds and the Government on theone hand and Firms and Governmenton the other are very important fromthe point of view of the role ofGovernment as regulator and as anagent of promoting general welfare ofthe people of the country.

All the changes which arenecessitated by inclusion of Governmentsector are shown in Fig. 2.3. In order tomake the analysis simple, now onwardswe will see only monetary flows.

Government purchases goods andservices from Firms and labour servicesfrom Households. Government collects

PRODUCT MARKET

FACTOR MARKET

Money

valueof final goods and services

Final c

onsumer goods and services

Factor Services

Factor Payments

Savings

FinancialSystemFirms

Households

Savings

Borrowings Borrowings

Fig 2.2: Circular Flow of Income in a Two-sector economy with Financial System

6 Government purchases of goods and services are included in the circular flow. Other flows includetax payments by households to government and transfer payments by governments to households.
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taxes from Households and Firms inorder to finance its expenditure. Thegovernment makes transfer paymentsto the Households in the form of socialsecurity, scholarships, etc. It also givessubsidies to the Firms for variouspurposes. In India, subsidies are givento small industries, export units, andother priority sectors of our economy.7

Circular Flow of Income withExternal Sector

We now need to study the internationaldimension of macroeconomic activitybecause international economicenvironment affects output andemployment in the domestic economy.

The external sector is also called theRest of the World (ROW) sector and this

is connected with circular flow ofdomestic economy (Fig. 2.4). Thedomestic economy and the rest of theworld are connected throughinternational trade and capital flows.One countrys exports are anothercountrys imports. This import andexport of goods and services ultimatelydecide what the domestic economygains or loses in the international trade.Home economy enjoys a trade surpluswhen there is excess of exports overimports; it suffers a trade deficit whenthe opposite happens.8

The four -sector model of theeconomy demonstrates the overallmacro economic condition of incomeand output in the following identity:

7 All taxes are leakages and all government expenditures are injections into the circular flow.8 Note that imports are leakages and exports are injections into the circular flow of income in the economy.

Bor

row

ings

Savings

Borrowings

Savings

GovernmentSector

FirmsFinancialSystem Households

Gov

ernm

ent P

urch

ases

Ta

xes

Subs

idies

Payments for services

Taxes

Transfer PaymentsF

actor

Payments

Savin

gs

Consumption Expenditur

e

Borrowings

Fig 2.3: The Circular Flow of Income in a Three-sector Economy
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SUMMARY

Structure of the macro economy is given by the circular flow of income andoutput.

National income accounting has its foundation in the circular flow model. National income accounting has several uses for economic policy and

research. Circular flow of income can be depicted in two-sector, three-sector and

four-sector models. National income accounting provides the standards by which economic

activity of a country could be assessed.

Fig 2.4 : The Circular Flow of Income in a Four-sector Economy

Savings

Borrowings

Savings

Bor

row

ings

Gov

er

nmen

t Purc

hases

Taxe

s

Su

bsidi

es

Payments for Services

TaxesTransfer Paym

entsFac

torPayments

Savin

gs

GovernmentSector

FirmsFinancialSystem Households

ExternalSector

Consumption Expenditu

re

Internati

onal T

rans

fe

r Inc

omeR

eceipts for Expert s

Paym

ents for Import s

Interna

tiona

l Fac

tor

Incom

e

(Net)

Borrowings

Y C + I + G + (X M)Wherein

Y = Income or outputC = Private Consumption Expenditure

on Consumer goodsI= Investment expenditure by

Producing sectors

G = Government Purchases

X M = Net exports (Where, X = Exports,M = Imports)

The science of national incomeaccounting is based on this identity.
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EXERCISES

1. What are the uses of national income accounting?2. What is the principle of circular flow of income and product?3. Explain the circular flow in two-sector economy.4. Explain the circular flow in three-sector economy.5. Explain the circular flow in four-sector economy.6. With the help of a circular flow model, show that income and product

flows are equal.7. Explain the concepts of leakages and injections in the circular

flow of income.

The structure of the macro economy hasbeen portrayed in the circular flow ofoutput and income as dealt with in theprevious chapter. This circular flowdepiction of macroeconomic activitiesprovides logical foundation for theconcepts and measurement of nationalincome aggregates. A strikingly uniquefeature of national income concepts isthat they are quantifiable and are notabstract ones. Hence, they render asmuch precision as feasible in thenational income statistics, given thelimitations in the estimation of nationalincome aggregates and in theconstruction of national incomeaccounts. There have been manyattempts in the past to evolve methodsof national income accounting and theseefforts have contributed to the systemthat we have at present. In this chapter,we shall present principal methods tomeasure national income aggregates. Itis pertinent at this juncture to remindourselves of an important observationmade in respect of the circular flow ofmacroeconomic activities. We have, inthat context, stated that the value of

CHAPTER 3

aggregate output equals the value ofaggregate income, which in turn mustequal to the aggregate expenditure.Based on this, national incomemeasurement can be categorised intothree approaches : output or productapproach, income approach andexpenditure approach. All these must,in principle, yield the same result.

Measuring Gross Domestic ProductLet us first take up the measurementof the value of all that is produced inthe economy. This is expressed as GrossDomestic Product. Here, themeasurement procedure is actuallythree-fold. We use the product method,the income method and the expendituremethod to compute the Gross DomesticProduct. As this aggregate is held to bevery important for macroeconomicassessment, greater attention is calledfor in the computation of this measure.

Gross Domestic Product : The OutputApproach

Gross Domestic Product (GDP) is asummary statistic, which is widely usedby economists and policy analysts to
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assess the rate of growth of an economyduring a year. GDP is generallyrecognised to be the primary measure.

GDP is defined as the market valueof all final goods and services producedby the factors of production located inthe country during a period of one year.A key phrase in this definition is finalgoods and services which require someelaboration.

Final goods are those that are meantfor final use by consumers or firms. Thesegoods are not required to enter intofurther stages of production or resale tochange their form and content. They arefinished goods meant only for finalconsumption and investment.

Measurement of GDP includes onlythe aggregate value of final goods. Also,from a development perspective, thestrength of an economy is seen in itscapability of producing final goods andservices.

It may be useful at this stage to drawa distinction between final goods andintermediate goods. The latter are not

taken into account in the measurementof GDP.

Intermediate goods are thosegoods that are used to produce othergoods and therefore they always movefrom one stage of production to anotherin the manufacture of a final product.

Let us now show the differencebetween final and intermediate goods withthe example of producing an automobile.

The industrial process tomanufacture an automobile involvesmaterials such as steel, paint, rubber,foam, plastic, glass, cables, battery, etc.and a variety of component parts. Allthese items are produced by therespective firms only to be used in theproduction of another product; in ourexample it is the automobile. But oncethe process of producing an automobilestarts, all these are converted intointegral parts of an automobile. So,these goods are not important in theirown right; they are just a means to anend. Such goods are called intermediategoods. The automobile that is produced

Clip 3.1

PIONEERS IN NATIONAL INCOME ANALYSIS

In the contemporary world now, national income concepts and accounting methodsare widely recognised and applied to measure the economic performance of countries.However, these concepts and methods became popular only a few decades ago.

Simon Kuznets

A seminal contribution to the field of National Income andProduct Accounts (NIPA) made by Simon Kuznets (19011985)set the trend of using national income aggregates to measurethe direction of growth of economies. He was a great pioneer inthis field and due to his research efforts, the first nationalincome figures for the US economy was published in 1934 asan official document of the US Senate. This helped immenselyto understand the severe impact of the Great Depression in1929. His monumental book of two exhaustive volumes, NationalIncome and its Composition, 1919-1938 (New York; NBER, 1941)

NATIONAL INCOME ACCOUNTING : CONCEPTS AND MEASUREMENT 19

earned him the worldwide recognition. This was followed by two of his landmarkcontributions, namely, National Product since 1869 (New York; NBER, 1947) andEconomic Growth of Nations : Total Output and Production Structure (Cambridge Mt,Harvard University Press, 1971). For his contributions, Kuznets was honouredwith the Nobel Prize in 1971 in recognition of his empirical interpretation ofeconomic growth.

in the final stage of the assembly line isthe final good.

Hence, the rationale for not takinginto account the value of intermediategoods in the measure of GDP is to avoidthe problem of double counting. That

is, no product should be counted twoor more times. Double counting willonly exaggerate or over-estimate thevalue of GDP.

The procedure by which we eliminatethe values of intermediate goods from GDP

Among these, the most systematic work was that of V.K.R.V. Rao in his bookNational Income in British India 1931-32 (London; MacMillan 1940), which formedthe basis of national income estimation in the post-independence period. In1949, the Government of India formed the National Income Committee underthe Chairmanship of P.C. Mahalanobis, with V.K.R.V. Rao and D.R. Gadgil asmembers. From then onwards the national income estimation has been steadilystrengthened. Now, the Central Statistical Organization (CSO) is entrusted withthe task of publishing National Accounts Statistics (NAS).

Richard Stone

Another important contribution in this field is that ofRichard Stone (1913-1991). Stone worked with JohnMaynard Keynes as a research assistant. Stone during theearly 1940s prepared a statistical profile of the Britisheconomy. After the World War II, Stone headed a UnitedNations project to develop standard national incomeaccounting model.

In India, prior to 1947, the estimation of national incomewas attempted by individual economists and scholars forspecific years.

D.R. GadgilV.K.R.V. Rao P.C. Mahalanobis
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is through the method of value added.This is discussed in the following section.

Concept and Measurement of ValueAdded

The concept of value added is very basicto the measure of GDP. Value-added isdefined as the difference between totalvalue of output of a firm and value ofinputs bought from other firms. It thusmeasures the value, which the firmconcerned has added by its processof production.

Most goods go through multiplestages of production. This means that

a goods value increases at each stageuntil its final value is obtained in thelast stage. It follows therefore that thevalue of final good will have to be equalto the sum of the value-added at eachstage of production. This is shown witha numerical illustration in Table 3.1.

Consider the production and saleof a cake to the Household sector forfinal consumption. The process ofproduction starts with a farmer raisingwheat crop and harvesting it. Since weare starting with the stage of wheatcultivation, let us not go into thebackward production linkages of the

Table 3.1 : Numerical Illustration of GNP Measurementusing Value Added Method

Stage I Stage II Stage III Stage IV(Wheat) (Flour) (Cake at Bakery) (Cake at Retailer)

FarmerBlacks Purchasesfrom other firms

None

Miller Whites Baker Browns Retailer Greens

Value Added Rs. 1.00 Purchasesfrom Farmer

Rs. 1.00 Rs. 2.00

ValueAdded

Purchasesfrom Miller

Rs. 1.50 Purchasesfrom Baker

ValueAdded

Rs.0.50

ValueAdded

Rs. 0.50

Break-up ofvalue added

Value of Finalgood = Rs.2.50

Profit 0.20 + 0.25 0.40 + 0.28 = 0.33Wages 0.60 + 0.10 + 0.70 + 0.05 = 1.45Rent 0.05 + None + None + None = 0.05Interest 0.05 + 0.10 + 0.01 + 0.02 = 0.18Depreciation 0.02 + 0.02 + 0.09 + 0.07 = 0.20Property andsales taxes

0.08 + 0.03 + 0.10 + 0.08 = 0.29Sum of valueadded

Total (in Rs.) 1.00 + 0.50 0.50 0.50 2.50+ +

======

Rs. 0.50
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farmer. Therefore, the farmers value-added in the cultivation stage will bejust the value of his output as such (thatis one rupee). In the second stage, themiller buys the wheat from the farmerand grinds it into flour, and sells it tothe baker for Rs.1.50. By this, he addsa value of 50 Paise. The baker makesthe cake and sells it to the retailer forRs. 2.00, thereby adding a value of 50paise. The retailer who buys the cakefrom the baker sells it to the finalconsumer for Rs. 2.50, thereby addinga value of 50 paise. This means that thevalue of the final good, namely, the cakeis Rs. 2.50 at the retail store. This finalvalue of the cake is the sum of the valueadded from the stage of cultivation tothat of retail sale at the shop, that is,total value added equals Rs.1.00 + 50Paise + 50 Paise + 50 Paise = Rs. 2.50.

On the other hand, if we hadincluded the value of all theintermediate stages, preceding the retailsale, cakes value would have increasedmanifold, due to the problem of double- counting. That is, wheat would havebeen counted four times, floor threetimes and baked items twice. This is thereason why we take the final value ofthe output as a sum of all values addedin producing a good.

This procedure of value addedmethod demonstrated for an individualproduct is applied at the aggregate levelfor the measurement of GDP.

Concepts of Value Added(i) Value of output by a Firm = Sales +

Change in Stock(ii) Value Added = Value of output

Intermediate goods cost

(iii) Net-value added at Market Price =Gross value added at Market price Consumption of fixed capital(Depreciation)

(iv) Net-value added at Factor Cost =Net value added at Market Prices Net indirect taxes (Net Indirect Taxes= Indirect Taxes subsidies)

(v) Net value added at factor cost = TotalFactor IncomeNow, let us look into the

computation of value added as shownin the illustration below:Example 1: From the following datacalculate the value added by Firm A andFirm B.

(Rs. in Lakhs)(i) Closing stock of Firm A 20(ii) Closing stock of Firm B 15(iii) Opening stock of Firm A 5(iv) Opening stock of Firm B 10(v) Sales by Firm A 300(vi) Purchases by Firm A from 100

Firm B(vii) Purchases by Firm B from 80

Firm A(viii) Sales by Firm B 250(ix) Import of raw material 50

by Firm A(x) Exports by Firm B 30

As first step calculate the value ofoutput for each Firm. Then find thevalue added.Step 1. Value of output of Firm A

= Sales + Change in stock(Closing stock Opening stock)= 300 + (20 5)= Rs. 315 lakhs

Step 2. Value added by Firm A= Value of output purchases
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from Firm B imports byFirm A= 315 100 50= Rs. 165 lakhs

Repeat the same procedure for Firm B

Step 3. Value of output of Firm B= Sales + Change in stock(Closing stock Opening stock)+ Exports by Firm B= 250 + (15 10) + 30= Rs. 285 lakhs

Step 4. Value added by Firm B= Value of output purchasesfrom Firm A= 285 80= Rs. 205 lakhs

Gross Domestic Product : As Sum ofExpenditure

GDP can be measured by taking intoaccount all final expenditures in theeconomy. There are three distinct typesof expenditure as they are committedby Households, Firms and Governmentrespectively. These expenditures areclassified into following types :

(i) Private Consumption (C)Expenditure

(ii) Investment Expenditure (I)

(iii) Government Purchases of (G)Goods and Services

(iv) Net Exports (X M)

Let us discuss these items of finalexpenditures with respect to the sectorsconcerned.

(i) Private Consumption expenditure

The private consumption component ofGDP measures the money value of

goods and services that are purchasedby households and non-profitinstitutions for current use during atime period. Considering the fact thatconsumption expenditure is asignificant part of GDP, it requiresspecial attention by economists andgovernment. Private consumption is thedemand for consumer goods andservices. While goods are tangibles,(that is, you can see a car) the servicesare intangibles (that is, you cannot seea service such as car insurance).Further in the case of goods,consumption or use of a good can beseparated from the place of itsproduction and can be separated intime, that you can consume or use agood at your convenient place or time.But services should necessarily be usedat the time and place in which they areproduced. For instance, banking servicewill take place at the place and timespecified by the banker and customersutilise their banking facilities accordingly.

Consumption can be divided intothree sub-categories such as,consumer services, consumer non-durable goods and consumer durablegoods. Non-durable goods are used upimmediately or within a short span oftime. Durable goods in contrast couldbe used for a longer period of time.Food items are non-durableconsumption goods whereas furniture,stereo equipment, washing machinesare durable consumption goods. Butusually this distinction is based onlyon the given length of time within whichconsumer goods are used. Durabilitydoes not imply a state of permanence.
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Durable goods also have their limitedperiod of use value, after which they aregiven up. Private final consumption willinclude expenditure on all these threecategories mentioned here.

(ii) Investment

Investment is an addition to the stock ofcapital during a period. The GrossPrivate Domestic Investment shows theaggregate value in this regard. Unlikethe intermediate goods which are usedup entirely in the process of makingother goods, capital is only partiallydepleted in making other goods. Thatis, a steel mill may have a useful life ofsay, 50 years. In providing steel in anyone year, only a small portion (1/50th)of the mill is used. This using up ofcapital is called depreciation.Depreciation is the value of the existingcapital stock that has been consumedor used up in the process of producingoutput. Usually an asset is depreciatedat a predetermined rate and monetaryvalue is assigned to the rate ofdepreciation of a physical asset inone year. This is also described ascapital consumption allowance1. Wheninvestment is expressed as GrossInvestment or Net Investment it meanswhether investment has or has not beenadjusted against depreciation. Grossterm includes depreciation while Netterm is obtained after deducting thedepreciation amount.

Investment component could beclassified under four categories : they are(a) Business fixed investment

(b) Inventory investment(c) Residential construction investment(d) Public investment

(a) Business Fixed Investment (BFI) isthe amount spent by business units onpurchase of newly produced plant andequipment. The two measures of BFI areGross Business Fixed Investment (GBFI)and Net Business Fixed Investment(NBFI). Gross Business Fixed investmentis the gross amount spent on newlyprovided plant and equipment, that is,capital goods. If depreciation isdeducted from it, then we obtain NetBusiness Fixed Investment.

The inclusion of capital goods in thefinal product along with the goods andservices produced by them wouldinvolve double counting. For this reasonit is important to make provision fordepreciation. If in every year we deductfrom investment (and therefore fromdomestic product) the amount by whichcapital stock has been used up over theyear, then over the whole lifespan of thecapital good, we will have deductedfrom the domestic product the wholevalue of the capital good. In this waywe will have avoided counting in thedomestic product both the asset andthe goods produced by it and so shallhave avoided double counting. BFI isusually the result of a consciousdecision by firms to augment theirproductive capacity.

(b) Inventory Investment is the netchange in inventories of final goods

1 The usage of fixed assets lead to their wear and tear; so, we must provide for consumption offixed capital as a prerequisite in accounting the product.
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awaiting sale, semi-finished goods, orof materials used in the productionprocess (inputs). These must beincluded since they represent currentlyproduced output not included in thecurrent sales of final output.

Changes in inventory are usuallythe result of unintentional short rundeviations between supply anddemand. Stock changes play a crucialrole in income determination. Forexample, if there is a sudden doublingof the demand for television sets, it isunlikely that the production of them willalso double overnight. So, the first effectof the increase in demand relative tosupply will be a fall in the inventory oftelevision sets normally held in theeconomy (inventory that is held by theproducer, wholesaler or retailer), in theattempt to satisfy the sudden increasein demand. This process will continueuntil production is augmented tomatch the increased demand.Conversely, a sudden fall in demand willlead to a rise in inventories of televisionsets until production adjusts itself tothe lower level of demand.

(c) Residential Construction Investmentis the account spent on the building ofhousing units. This is also expressedin terms of either gross or net dependingon whether depreciation has beensubtracted or not.

(d) Public Investment includes allcapital formation carried out by thegovernment such as building of roads,hospitals, schools etc. This is also givenin gross or net value depending onwhether depreciation has beensubtracted or not.

Now the investment component asa whole can be thought of in thefollowing two ways :

Gross Investment = Gross BusinessFixed Investment + Gross ResidentialConstruction Investment + Gross PublicInvestment + Inventory Investment

Net Investment = Net Business FixedInvestment + Net ResidentialConstruction Investment + Net PublicInvestment + Inventory Investment

As pointed out earlier, the differencebetween gross investment and netinvestment is depreciation.

(iii) Government Purchases ofGoods and Services

This component summarises thegovernment spending on goods andservices. Remember that governmentpurchases is a proxy measure forgovernment output.

As a matter of fact, governmentpurchases from private producerswould be intermediate goods andgovernment wages and salaries wouldbe part of the income side of thenational accounts. Instead of doing thiswe take the government purchases aspart of the final product.

In the above we have understoodgovernment as a producer of goods andservices. This is an important functionof the government. At the same time weshould also be aware of another functionof government that is, makingpayments to certain categories of peopleor firms to compensate them as a matterof its social obligation. This is calledGovernment Transfers, which refer to the
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total value of payments made bygovernment sector towards householdsand firms as income supplements andsubsidies respectively. This is also knownas Transfer Payments, and they are notcounted in the GDP because there is noproduction of goods due to them.Transfer Payments are basically welfare-oriented expenditures of theGovernment.

(iv) Net Exports

This is the difference between Exports (X)and Imports (M) of a country, that is(X M).

Based on the expenditure flowsin the economy, Gross DomesticProduct is the total value of the sumof consumption and investmentexpenditure along with governmentpurchases and net exports.

In other wordsGDP = C + I + G + (X M)

Where,C = Consumption expenditure by

households

I = Investment expenditure by firms

G = Government purchases of goodsand services.

X-M = Net Exports.

Gross Domestic Product : A Measureof Income

The third approach to the measurementof GDP is to compute it by addition of allfactor incomes generated in theproduction of goods and services.Because each rupee of goods andservices produced is matched by a rupeeof income, we can arrive at the samefigure for GDP on the income side as we

did on the product side. While measuringGDP we must include only those incomeflows that originate with the productionof the goods and services within theparticular time period.

The components of factor income are:

1. Employee compensation2. Profits

3. Rent

4. Interest

5. Mixed income

Now let us look into the details ofeach one of these.

1. Employee Compensation

Compensation to employees in the formof wages, salaries and benefits makesup the largest single component ofincome generated with production ofGDP. Wages and salaries are payablein cash, kind or both.

2. Profits

Profits are the reward the owners offirms receive for being in business.Firms desire to earn profits is the mainmotivating force behind production ina market economy.

3. RentRental income is, for example, incomeearned by owners of rental housing. Themeaning of rent in the national incomeaccounts is that it is a charge for thetemporary use of some capital asset.4. InterestHouseholds both receive and payinterest. We include in GDP only the netinterest, that is the difference betweeninterest amount paid and the interestincome received by households.
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5. Mixed Income

Mixed income will include the income ofown account workers and profits anddividends of unincorporated enterprises.In other words, it may be called as mixedincome of the self employed.

All the above mentioned componentsof income measure of the GDP have animportant implication for the economyas such. Their relative share in GDPshows the manner in which each ofthese income flows changes overtime.

It is possible to show by way of anillustration as to how the sum of valueadded is equal to the total of the abovetypes of income earned during theprocess of production. This is shownin Table 3.1

GDP as measured by theaggregation of factor incomes is alsocalled as Gross Domestic Income (GDI).

Gross National Product

After getting GDP we can add Net FactorIncome from abroad to estimate thevalue of Gross National Product (GNP).How is Net Factor Income from Abroaddefined? What are included in it?

Net Factor Income from Abroad isthe difference between the factor incomereceived from the rest of the world, i.e.abroad for rendering factor services, andthe income paid for factor servicesrendered by non-residents inside thedomestic territory of the country. As weknow that factor incomes includecompensation to employees and incomefrom property and entrepreneurship,then Net Factor Income from abroad isthe difference with respect to these itemsreceived by residents abroad and given

to non-residents working in thedomestic territory during a givenaccounting year. Hence, the componentsof Net Factor Income from abroad are :

(i) Net compensation to employees(ii) Net income from property and

entrepreneurship, which includesrent, interest, dividends, etc.

(iii) Net retained earnings of residentcompanies abroad

Hence,

Gross Domestic Product + Net FactorIncome from abroad = Gross NationalProduct

Now we may distinguish betweenGross National Product and GrossDomestic Product. The differencebetween the two arises from Net FactorIncome from Abroad. Note that the(X M) component of GDP representsonly goods and services other thanfactor incomes.

Real and Nominal GNP

Having presented the measurement ofGNP it remains to be seen as how thechanges in the GNP value are expressedin relation to price level changes as pricechanges affect the value of the nationalincome aggregates. For this we mustexplain the two ways of computingnational income data at current marketprices and constant prices.

Current Market Prices

If the GNP (or any other relatedaggregates) is measured in terms ofcurrent market prices, then it is referredto as Nominal GNP. Since the nominalGNP measures the value of currentlyproduced goods and services at market
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prices, GNP will change when either theoverall price level changes or when theactual volume of production changesor when both change simultaneously.

Constant Prices

However, for certain purposes we maywant to have a measure of output thatchanges only when the quantity of goodsproduced changes. This measure of onlyquantity change, not prices, is the methodof using constant prices. Accordingly,GNP that is computed at constant priceswill be called the Real GNP. Usually,under this method GNP value isexpressed in terms of prices prevailing ina year chosen to be the base year.

Real GNP has the followingadvantages:(a) It is useful in finding out the effect of

increased production of goods andservices on the real developmentcapacity of the economy in general.But the nominal GNP cannot showthis as we cannot segregate thechange in output alone, since, thecurrent market prices in terms ofwhich it is measured prevent suchan exercise;

(b) Real GNP also enables one to makea year-to-year comparison of thechanges in the growth of output ofgoods and services. An expansionphase of the economy is a period ofrising real GNP. On the contrary arecession is a period in which realGNP falls consecutively; and

(c) Real GNP is also often used inmaking international comparisonsof economic performance across thecountries.Having explained the concepts of

Nominal and Real GNP, let us proceedto know the method by which we obtainthe value of Real GNP through theconstant prices.

The purpose of using constantprices is to eliminate the effect of pricechanges. For this, we are supposed toexpress the value of current years GNP(Nominal GNP) in terms of pricesprevailing during a reference year in thepast, which is called the Base year. Thatis, the account for the value of currentyears GNP as if the price level is sameas that of the base year. As you may beaware that the price level is usuallymeasured by the Wholesale Price Indexor the Consumer Price Index Number.2

If the GNP in the current year isvalued at current market prices, it willnot be possible for us to find out howmuch of the increase in GNP is due toincrease in prices (inflation) and howmuch of the increase is due to anincrease in the production of goods andservices. To know whether GNPincrease actually means an increase inthe output of goods and services, wemust eliminate the effect of priceincreases.

We shall explain, through thefollowing illustration, the calculation of

2 An index number is a representative number to decode the changes in price level. The consumerprice index number is used to represent the average change over time in the prices paid by thefinal consumer of a specified group of goods or services.


nominal GNP and real GNP as well asGNP deflator (Table 3.2).

Let us assume that our imaginaryeconomy has only three final goods :

Oranges - Consumption good

Computers - Capital goodand Government purchases of cloth.

Let us take up the calculationof nominal GNP through theexpenditure approach. Let us thereforefind out the expenditure on each goodand obtain the total expenditure atcurrent prices.

Consumption expenditure (oranges)is Rs. 4452, investment (computers) is

Table 3.2: Nominal GNP, Real GNP and the GNP Deflator

Current Period Base Period

Item Quantity Price Expenditure Price Expenditure(Rs) (Rs) (Rs) (Rs)

Oranges 4,240 Kgs. 1.05 per kg. 4,452 1 per Kg 4,240Computers 5 2100 each 10,500 2000 each 10,000Government 1,060 1 per 1,060 1 per meter 1,060Purchases meters meterof Cloth

Nominal GNP 16,012 Real GNP 15,300

Deflators for the current period

104.7100Rs.15300Rs.16012

GNPReal

100GNPNominalDeflatorGNP ==

=

Consumption Expenditure Deflator

105.0100

Rs.4240

4452Rs.100

eexpenditurnconsumptioperiodBase

eexpenditurnconsumptioperiodCurrent

===

105.0100Rs.1000005001Rs.

100investment period Base

investmentperiodCurrentDeflatorInvestment ===

100.0100Rs.1060

0601Rs.100

urchasespGovernment period Base

urchasespGovernmentperiodCurrent

PurchasesGovernment ===


GNPMP

(-)net in

come from

abroa

d

() net indirect taxes




GDPMPGNP

FC

()net in

come

from a

broa

d

GDPFC

-depreciation

(-)depreciation

()depreciation

NNPFC

NDPFC

NNPMP

()net in

come

from a

broa

d

NDPMP

()net in

come

from a

broa

d

(-) depreciation

Rs. 10,500, and government expenditureis Rs. 1,060, so the nominal GNP is Rs.16012.

Now, let us calculate real GNP. Thisis, as mentioned before, calculated byvaluing the current period quantities atthe base period prices. Accordingly, theconsumption expenditure is Rs. 4240,investment is Rs.10,000 and governmentexpenditure is Rs.1,060. So the realGNP is Rs.15,300.

Finally, the concept of GNP deflatorrequires explanation. The GNP deflator

measures the average level of the prices ofall the goods and services that make upGNP. It is calculated as the ratio of nominalGNP to real GNP, multiplied by 100.

In the above example, we dividenominal GNP (Rs.16,012) by real GNP(Rs. 15,300) and multiply the results by100. We obtain GNP deflator as 104.7.

It is also possible to calculatedeflator for specific expenditures as wewould like to know the real value ofthese expenditures. This is also shownin Table 3.2.

Fig 3.1: Relationships between Different aggregates of National Income3

3 Wilfred Beckerman, An Introduction to National Income Analysis, 3rd Edition, Universal BookStall, New Delhi, 1999.


Important National AccountsAggregates

Gross National Product is the coreconcept of national income accounting.From this several other measures arederived, each having its specific purposeto interpret the performance of a giveneconomy. All these concepts andmeasures are interrelated which isshown in Figure 3.1. From this, we mayobserve eight major national accountsconcepts as given below and they maybe derived following the direction givenin the diagram.

1. GNP at Market Prices (GNPMP

)4 =Value of all the final goods andservices produced in the economy+ Net Factor Income from Abroad

2. NNP at Market Prices (NNPMP) =GNPMP Depreciation

3. GDP at Market Prices (GDPMP

) =GNPMP Net Factor Income fromAbroad

4. NDP at Market Prices (NDPMP

) =GDPMP Depreciation

5. GNP at Factor Cost (GNPFC) = GDPMP+ Net Factor Income from Abroad Net Indirect taxes

6. NNP at Factor Cost (NNPFC

) =GNP

FC Depreciation

7. GDP at Factor Cost (GDPFC) = GDPMP Net Indirect taxes

8. NDP at Factor Cost (NDPFC)= GDPFC Depreciation

National5 Disposable Income

In addition to the above, we may alsoinclude the concept of NationalDisposable Income. National DisposableIncome is the income from all sources tothe residents of a nation for spending onconsumption as well as saving during ayear. It is given by the following :

National Disposable Income= NNPMP + Other Current Transfersfrom the rest of the world6

This is the maximum available incomefor a country. National DisposableIncome for a country is what thePersonal Disposable Income (PersonalIncome Personal Taxes) is for anindividual.

4 A particular value may be expressed at Market Prices or at Factor Cost. If a quantity is expressedin terms of its current prices it is referred to as market price. Suppose the total value added iscomputed on the basis of current prices of inputs then we may call this as value added at MarketPrices. On the other hand, if the value added is arrived at by adding the payments to factors(land, labour, capital and entrepreneurship) such as rent, wages, interest and profit, (as wasdone in Table 3.1) then it is described as value added at Factor Cost. In the same manner, all theconcepts of national income may be shown either at market prices or at factor costs.

5 It may be necessary to give the meaning of Domestic and National used in National Incomeaggregates. Domestic here simply means domestic territory. So, domestic product would implythe value of all goods and services produced by the normal residents of a country. Nationalrefers to the addition of the net factor income from abroad to the domestic product.

6 Current transfers from the rest of the world may include gifts, cash, consumer goods and evenmilitary equipment.
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The above definitions may beunderstood as general principles of howthese measures are conceptualised. Inpractice each country follows its ownmethod of compilation and hencedefinition of specific items, whichconstitute an aggregate measure, willbe different from others. In India, thenational accounts are prepared inaccordance with System of NationalAccounts (SNA) since 1975.Subsequently, there has been asignificant improvement in thestatistical statements in terms ofdatabase and coverage. Presently theSNA 1993 is being used.

Concepts of National Product andNational Income: A Summary

GNPMP = Value of all final goods andservices produced in theeconomy+Net factor incomefrom abroad

NNPMp

= GNPMp

DepreciationGDPMp = GNPMp Net factor income

from abroadNDP

Mp= GDP

Mp Depreciation

GNPFc = GNPMp Net indirect taxesNNPFc = GNPFc Depreciation =

National incomeGDPFc = GDPMp Net indirect taxesNDPFc = GDPFc Depreciation

Three Methods of Measurement ofNational Product

(i) Expenditure MethodGNPMp = Personal consumptionexpenditure + Gross Investment(Gross business fixed investment +Inventory investment + Grossresidential construction investment+ Gross public investment) +

Government purchases of goods andservices + Net exports (Exports imports)+ Net factor income from abroad.

(ii) Income MethodGNPMp = Employee compensation(wages and salaries + employerscontribution towards socialsecurity schemes) + profits + rent +interest + mixed income +depreciation + net indirect taxes(Indirect taxes Subsidies) + Netfactor income from abroad.

(iii) Value Added MethodGNPMp = (Value of output in primarysector intermediate consumptionof primary sector) + (value of outputin secondary sector intermediateconsumption of secondary sector)+ (value of output in tertiary sector intermediate consumption oftertiary sector) + Net factor incomefrom aboard.

The following numerical examples willhelp us to understand various nationalincome aggregates.Example 1: From the following datacalculate the Gross National Product atMarket Price through the ExpenditureMethod

(Rs. in crores) i. Inventory Investment 10 ii. Exports 20 iii. Net factor income from abroad (5) iv. Personal consumption 350

expenditure v. Gross residential 30

construction investment vi. Government purchases of

goods and services 100 vii. Gross public investment 20viii. Gross business fixed 30

investment ix. Imports 10


Solution:

GNPMp =Personal consumption = 350expenditure+ Gross Investment = 90which include:

Gross Business Fixed = 30InvestmentGross Residential = 30Construction InvestmentGross public Investment = 20Inventory Investment = 10

+ Government purchases of = 100goods and services+ Net exports = 10which include:

Exports = 20Imports = 10

+Net Factor Income From Abroad = 5GNPMp = 545

So, GNPMp is Rs. 545 crores.Example 2: From the following datacalculate the Gross National Product atMarket Price via the Income method

(Rs. in crores) i. Wages and Salaries 700 ii. Rent 100 iii. Depreciation 50 iv. Net factor income from abroad 10 v. Mixed income 400 vi. Subsidies 100 vii. Profits 400viii. Indirect taxes 300 ix. Employers contribution 50

to social security schemes x. Interest 40

Solution:Employee Compensation whichinclude = 750

Wages & Salaries = 700Employers contribution to = 50social security schemes+ Profits = 400+ Rent = 100+ Interest = 40

+ Mixed Income = 400+ Depreciation = 50+ Net Indirect taxes which = 200includeIndirect taxes = 300Subsidies = 100

+ Net Factor Income from Abroad = 10GNP

Mp=1930.

So the GNPMp is Rs.1930 crores

Example 3: From the following datacalculate the Gross National Product atMarket Price via the Value Added method

(Rs. in croroes) i. Value of output in primary 1,000

sector ii. Net factor income from abroad 20 iii. Value of output in tertiary sector 700 iv. Intermediate consumption 400

in secondary sector v. Value of output in secondary 900

sector vi. Intermediate consumption in 500

primary sector vii. Intermediate consumption in 300

tertiary sector

Solution:Value of output in primary sector = 1,000 Intermediate consumption of primary sector = 500+ Value of output in secondary = 900 sector Intermediate consumption in = 400 secondary sector+ Value of output in tertiary = 700 sector Intermediate consumption = 300 of tertiary sector+ Net factor income from abroad = 20GNPMP = 1380So, GNPMp is Rs. 1380 crores.


Example 4: From the following datacalculate the GNP, GDP, NNP, NDP at bothfactor cost and market prices.

(Rs. in crores) i. Gross Investment 90 ii. Net exports 10 iii. Net indirect taxes 5 iv. Depreciation 15 v. Net factor income from abroad 5 vi. Personal consumption 350

expenditurevii. Government purchases of 100

goods and services

Solution:

a) GNPMP =Personal consumption expenditure = 350+ Gross investment = 90+ Government purchases of = 100 goods and services+ Net exports = 10+ Net factor income from abroad = 5

GNPMP = 545

So, GNPMP is Rs. 545 croresb) NNPMP = GNPMP Depreciation

= 545 15 = 530So, NNPMP = Rs. 530 croresc) GDPMP = GNPMP Net Factor

Income from Abroad= 545 (5) = 545 + 5= 550

So, GDPMP = Rs. 550 croresd) NDPMP = GDPMP Depreciation

= 550 15 = 535So, NDPMP = Rs. 535 crorese) GNPFC = GNPMp Net indirect

taxes= 545 5 = 540

So, GNPFC = Rs. 540 croresf) NNPFC = GNPFC Depreciation

= 540 15 = 525So, NNPFC = Rs. 525 croresg) GDPFC = GDPMp Net indirect

taxes= 550 5 = 545

So, GDPFC = Rs. 545 croresh) NDP

FC= GDP

FC

Depreciation

= 545 15 = 530So, NDP

FC= Rs. 530 crores

Items that are Excluded from GNPMeasurement

It may be recalled that GNP is themeasure of the value of the final goodsand services produced in one year. Butin reality many transactions occur inthe economy that have either nothingto do with the final goods and servicesproduced or that they are non-marketactivities or illegal activities whosemeasurement has its own limitations,both conceptual and empirical. We shallnow enumerate a few of thesetransactions that are excluded in theestimation of GNP.1. Purely Financial TransactionsThere are three generate types of purelyfinancial transactions. They are(a) Buying and Selling of securities(b) Government Transfer Payments(c) Private Transfer Payments

Now, let us examine thesetransactions in detail.

(a) Buying and selling of securities

In the financial markets as shownearlier in circular flow model, potentialsavers and investors buy and sellfinancial assets such as shares andbonds. While someone buys a sharethere is only a transfer of ownershipright. It is a claim to ownership of assets.In the case of bonds, it isacknowledging a debt transaction.There is no production activity but onlyexchange of funds for financial claims.Trading in financial instruments does
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not imply production of final goods andservices. As such these are not includedin the GNP.

(b) Government Transfer Payments

As defined earlier, transfer paymentsare payments for which no goods orservices are provided in exchange.Pension payments, Employees socialsecurity measures, adhoc assistancedue to certain exigencies like floods,drought, etc. and subsidies areexamples for government transferpayments. As there is no production offinal goods and services in response totransfer payments, the transferpayments are not included in the GNP.

(c) Private Transfer Payments

Items such as pocket money given byparents to their children, elders giftingmoney to the young ones are privatetransfer payments. This is merely atransfer of money from one individualto another. Hence this is also notincluded in the GNP.

2. Transfer of Used Goods

GNP refers to the value of the final goodsand services produced in a given year.Hence, goods produced in the previoustime period cannot be included in theGNP. For instance, when a person buysa used car, it cannot be recognized inGNP measurement as the car wasproduced in an earlier year. Spendingon a used car simply reflects a change inthe ownership of a pre-existing output.

3. Non-market Goods and ServicesMany final goods and services are notacquired through regular market

transaction vegetables can be grownin the backyard instead of bought inthe super market, or an electrical faultcan be repaired by the house ownerhimself or herself instead of hiring anelectrician. These are examples of non-marketed goods and services that havebeen consumed without usingorganised markets. But GNP includesonly those transactions that occurthrough market activities. Bartertransactions and production for self-consumption by household are notincluded in the GNP. It is in this context,there is a debate as to whetherhousewives services should be includedor not. If so, how do we value theirservices at current market prices?

4. Illegal Activities

GNP does not include trade in illegalgoods and services even though theyare final products and are purchasedin market transactions. Activities suchas smuggling, gambling, crime for hire,drug trafficking, illegal arms sale aresome cases in point.

These illegal activities create anunderground economy whereinproduction is unreported orunaccounted either because it isunlawful or those involved want toevade the government tax-net. As aresult these illegal and concealedtransactions create a huge volume ofunaccounted money that is popularlycalled the black money. Black moneyis the main driving force ofunderground economy or paralleleconomy. As in the case of non-marketgoods, it is difficult to fix exact market
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value for transactions in theunderground economy. Technically, asper the law of the land, these activitiesare classified under economic offenses.Hence their exclusion from GNP.

5. The Value of LeisureLeisure is regarded as an economicgood. It may be that, other things beingequal, more leisure is better than lessleisure. When the levels of incomeincrease, the resultant state of affluencewould induce people to prefer moreleisure than less of it. This means thatwith higher economic security the richersegment of our society would cut downtheir work effort, which in turn meansproducing less GNP. But that would notimply or suggest that people becomeworse off than before. In fact, choice ofmore leisure is simply an increase inutility. However, it would be verydifficult to measure the intangible itemlike leisure and include it in the GNP.

Nevertheless, in a modern economy,there is wide range of businessopportunities to provide for leisure timeactivities. So, though leisure as suchcannot be measured, the servicesprovided by the business sector tocapture the demand for leisure-timeactivities could be brought under finalservices for inclusion in the GNP.Leisure-time activities are in greatdemand from the middle and richerclasses of society.

However, leisure per se cannot bebrought within the treatment of nationalaccounts mainly because there is novaluation possible and imputing valueis both difficult and not useful for anyanalysis.

Does GNP Measure EconomicWelfare?For a very long period of timeeconomists have used GNP quiteuncritically as the principal measure ofeconomic growth and development.Maximisation of national income wastaken synonymous with maximisationof growth; hence rising GNP is good anddeclining GNP is bad for the economy.But a whole range of questionsconcerning it are being raised thesedays. They are such as, what is or oughtto be growth? What happens todistribution of income and wealth withan increase of GNP? What does anincreasing GNP do to the use of non-renewable natural resources? Is therea necessary association betweenincrease in national income andnational welfare? Can the increase innational income accomplish goodquality of life and human development?All these and other questions have beenresearched into in the recent past andat present GNP measure is under closescrutiny by economists and policymakers. In recent times more and moreeconomists have shown keen interest tocritically look at GNP as the indicator ofgrowth and development of a nation.

Measurement of GNP is subject tothe rules of national income accounting.These rules may rigidly classifyproduction activities to be included inor excluded from GNP. Hence GNP as astatistic can be misleading as the basisof overall development of an economy.Therefore, the main question that needsto be discussed is : Does the GNPmeasure economic welfare?
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J.R. Hicks once wrote that, Thepurpose of income calculation... is togive people an indication of theamount they can consume withoutimpoverishing themselves7.

In the contemporary economies,particularly in the developingcountries, we are confronted with theserious issue of inequality in theincome distribution, environmentaldegradation, and deterioration in thequality of life. All these and relatedproblems have not only introducedgaps between different classes of peoplein terms of their social and economicstatus but also between nations,involving categorisation such asdeveloped, developing, less developedand least developed countries.

It is beyond the scope of thischapter to probe into the developmentdebates over the questions narratedabove. Suffice it to say that increase in

7 J.R.Hicks, Value and Capital, Oxford University Press, 1975, Page 172.

GNP as the sole objective of developmentwill be counter productive. It isimportant to test whether growth inGNP results in equitable distribution ofincome, sustainable development andgood quality of life for people. Theprocess of development must createsustainable societies withoutendangering the natural resources andecological systems.

Therefore, attempts to enhance GNPat any cost may create economic badssuch as poverty and pollution. Thisrequires an alternate measure, whichwould allow GNP to measure humanwelfare. Some economists have suggestedthe concept of green GNP. Such a greenGNP would help attain a sustainable useof the natural environment and equitabledistribution of the benefits ofdevelopment. It may be useful to debatethese issues related to GNP.

SUMMARY

Circular flow of income forms the basis for measurement of macroeconomicactivities.

Product approach, Income approach and Expenditure approach are threeways in which Gross National Product can be measured.

In the product approach, only the final goods and services are included tofacilitate the aggregation of the value added by the producing units.

Income approach is concerned with summation of factor incomes which inturn must equal to total value added. Hence product is also income innational accounts.

Aggregate expenditure is obtained by adding all expenditures onconsumption, investment and government purchases of goods and services.

Real GNP and Nominal GNP are outlined by taking the value of nationalproduct at constant prices and current prices respectively.

GNP deflator is used to measure the average level of the prices of all goodsand services.

Purely financial transactions, government and private transfers, used goods,illegal activities, non-market goods, etc. do not get included in the GNP.


EXERCISES

Section I

1. Define:(i) GNP at market prices(ii) NNP at market prices(iii) GNP at factor cost(iv) NNP at factor cost.

2. Define the concept of value added.3. Show how the sum of value added is equal to sum of factor incomes.4. What is the difference between final good and intermediate good?5. What is depreciation?6. What are the components of aggregate expenditure?7. What are factor incomes?8. What is meant by double counting? Why should it be avoided?9. What are transfer payments?

10. Explain the meaning of non-market activities.11. What is called Green GNP?12. Differentiate between national income at current price and constant

price.13. Define: (a) Nominal GNP and (b) Real GNP14. What is a GNP deflator?15. Give reasons for not including leisure in GNP.

Section II

16. Explain product and income approaches to measure national income.17. Explain the value-added method with the help of an example.18. What are the items that are excluded from GNP? Give reasons.19. Does GNP measure national welfare?20. Explain the components of factor income.21. Explain the following terms:

(a) Business fixed investment(b) Inventory investment(c) Residential construction investment(d) Public investment.

Section III

22. Calculate the value added by Firm A and Firm B from the followingdata:

(Rs. in lakhs)

(i) Purchase by Firm A from the Rest of the world 30(ii) Sales by Firm B 90(iii) Purchases by Firm A from Firm B 50


(iv) Sales by Firm A 110(v) Exports by Firm A 30(vi) Opening stock of Firm A 35(vii) Closing stock of Firm A 20(viii) Opening stock of Firm B 30(ix) Closing stock of Firm B 20(x) Purchases by Firm B from Firm A 50

23. Calculate value added by Firm X and Firm Y from the following data:(Rs. in lakhs)

(i) Sales by Firm X 100(ii) Sales by Firm Y 500(iii) Purchases by households from Firm Y 300(iv) Exports by Firm Y 50(v) Change in stock of Firm X 20(vi) Change in stock of Firm Y 10(vii) Imports by Firm X 70(viii) Sales by Firm X to Firm Y 250(ix) Purchases by Firm Y from X 200

24. From the following data calculate the Net National Product at MarketPrices by (a) Expenditure Method (b) Income Method:

(Rs. in Crores)(i) Personal consumption expenditure 700(ii) Wages and salaries 700(iii) Employers contribution to social security schemes 100(iv) Gross Business fixed investment 60(v) Gross Residential construction investment 60(vi) Gross public investment 40(vii) Inventory investment 20(viii) Profits 100(ix) Government purchases of goods and services 200(x) Rent 50(xi) Exports 40(xii) Imports 20(xiii) Interest 20(xiv) Mixed income 100(xv) Net factor income from abroad 10(xvi) Depreciation 20(xvii) Subsidies 10(xviii) Indirect taxes 20

25. From the following data calculate the Gross Domestic Product at FactorCost by (a) Expenditure Method (b) Income Method:

(Rs. in Crores)(i) Personal consumption expenditure 700(ii) Wages and salaries 700


(iii) Employers contribution to social security schemes 100(iv) Gross business fixed investment 60(v) Profits 100(vi) Gross residential construction investment 60(vii) Government purchases of goods and services 200(viii) Gross public investment 40(ix) Rent 50(x) Inventory investment 20(xi) Exports 40(xii) Interest 20(xiii) Imports 20(xiv) Net factor income from abroad 10(xv) Mixed income 100(xvi) Depreciation 20(xvii) Subsidies 10(xviii) Indirect taxes 20

26. From the following data calculate the Gross Domestic Product at MarketPrices:

(Rs. in crores)(i) Value of output in primary sector 2,000(ii) Intermediate consumption of secondary sector 800(iii) Intermediate consumption of primary sector 1000(iv) Net factor income from abroad 30(v) Net indirect taxes 300(vi) Value of output of tertiary sector 1,400(vii) Value of output of secondary sector 1,800(viii) Intermediate consumption of tertiary sector 600

DETERMINATION OF INCOME ANDEMPLOYMENT

UNIT-III

IntroductionIt is an established principle inmacroeconomics that the aggregatedemand and the aggregate supplytogether determine the level of aggregateoutput of goods and services, aggregateemployment and the general price levelin an economy. Therefore, as the firststep, the meaning of the concepts ofaggregate demand and aggregatesupply are explained below.

Aggregate Demand

Aggregate demand is the total demandfor goods and services in the economy.The aggregate demand is usuallyrelated to the price level. An inverserelationship could be assumed betweenthese two variables. That is, the greaterthe price level the lower the aggregatedemand and vice versa.1 Figure 4.1shows the aggregate demand curve.

In the Figure 4.1, the curve AD is theaggregate demand curve. The X-axis

CHAPTER 4

1 Explanation of specific reasons for the downward sloping nature of the aggregate demand curveis beyond the scope of this book. It may be dealt with during higher studies in economics.

2 The Classical school of economics ranged from Adam Smith in the 18th century to A. C. Pigou in20th century. The Classical approach to macroeconomics (all writings on macroeconomics priorto that of John Maynard Keynes) believed that the economy would normally be in a state of full-employment equilibrium. The reason for this belief was their acceptance of Says law of markets.Says law, in brief, maintained the impossibility of any deficiency in aggregate demand.

measures the output of goods andservices. The Y-axis measures theprice level.

Aggregate Supply

Aggregate supply is the total supply ofgoods and services in the economy. Inrespect of aggregate supply there is nosuch clear-cut relationship with theprice level. In macroeconomics we havetwo different kinds of aggregate supplyconcepts based on two different sets ofassumptions. They are: (a) the Classicalconcept of aggregate supply, and (b) theKeynesian concept of aggregate supply.We shall take up these two concepts oneby one.

Classical Concept of AggregateSupply

In the Classical2 concept, the aggregatesupply is perfectly inelastic withrespect to the price level. This meansthat changes in the price level have no


effect on the aggregate supply. Theclassical aggregate supply curve isshown in Figure 4.2.

The X-axis measures the output.The Y-axis measures the price level.The curve AS is the aggregate supplycurve. Q* is the full-employment levelof output of goods and services. Theaggregate supply curve is a verticalline at the full-employment level ofoutput. This means that changes in theprice level have no effect on theaggregate supply.

The full-employment level of outputof goods and services is the largestoutput that the economy is capable ofproducing, when all resources are fullyemployed. However, under the state offull-employment, there could be asituation of temporary unemploymentwhich is known as frictionalunemployment.3

The long tradition of the Classicalschool of economics believed that the

aggregate supply would always be atthe full-employment level. Thetheoretical foundation of this conceptof aggregate supply was based uponthe assumptions of (a) Says law ofmarkets and (b) wage-price flexibility.

Says Law of Markets

Says law of markets (named after the 18th

century French economist Jean BaptisteSay) was one of the main propositions ofClassical theory (Clip 4.1). Says law statesthat supply creates its own demand. Ifgoods are produced then there willautomatically be a market for them. Thismeans that there cannot be a generaloverproduction or glut in aneconomy that is based on a marketsystem of production and exchange.4

Correspondingly, there cannot be adeficiency in aggregate demand.

Say felt that people do not work forthe sake of doing work, because workis considered to be unpleasant. People

Fig 4.1: Aggregate Demand Curve Fig 4.2: Classical Aggregate Supply Curve

Price level

OutputQ*

3 Frictional unemployment is a temporary unemployment of people who move between jobs. Sinceit takes time for a person to switch from one job to another, at any one point of time, there willbe a short period of temporary unemployment, which is called frictional unemployment.

4 Gardner Ackley, Macroeconomics, Collier Macmillan, 1978

AS

Output

AD

Price level
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AGGREGATE DEMAND AND AGGREGATE SUPPLY IN MACROECONOMICS 43

work only in order to obtain goods andservices that yield satisfaction or utility.

In an economy that is characterisedby division of labour and exchange ofgoods and services, people do notproduce all the goods and services theywish to consume. Instead, they produceonly those goods and services in whichthey are relatively the most proficient,and exchange the surplus (over theirown needs) for the produce of others.

In such a system, the very act ofproduction is itself the demand for othergoods. The amount demanded of othergoods is equal to the value of thesurplus goods (that is the quantity ofgoods over and above that required forself-consumption) that each man

produces. Therefore, each personsproduction constitutes his or herdemand for other goods; hence, for theentire community, aggregate demandequals aggregate supply. Says lawimplies that an increase in output willgenerate an equal increase in incomeand spending. Thus, income andpr

ncert xii macro economics

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