MACRO ECONOMIC MACRO ECONOMIC

AGGREGATES & AGGREGATES &

CONCEPTSCONCEPTS

Rahul Pratap Singh KauravRahul Pratap Singh Kaurav1

NATIONAL INCOME "National income or product is the final figure

you arrive at when you apply the measuring rod of money to the diverse apples, oranges, battleships and machines that any society produces with its land, labour and capital resources."

Paul A. Samuelson

NATIONAL INCOME Calculation of national income requires adding

together all final goods and services produced in a country in a given year.

Various goods and services produced in the economy cannot be added together in their physical form; hence they need to be converted into monetary terms.

Thus National income is defined as the money value of all the final goods and services produced in an economy during an accounting period of time, generally one year.

CONCEPTS OF NATIONAL INCOME Gross Domestic Product (GDP)

Gross Domestic Product at factor cost Gross Domestic Product at market price

Gross National Product (GNP) Net Domestic Product (NDP) Net National Product (NNP) Per Capita Income Per Capita Disposable Income

GROSS DOMESTIC PRODUCT Gross Domestic Product (GDP): GDP is the sum of

money value of all final goods and services produced within the domestic territories of a country during an accounting year.

GDP (at market price)= C+I+G+(X-M) Gross Domestic Product at factor cost

= GDP at Market Prices –Indirect Taxes+ Subsidies

GROSS NATIONAL PRODUCT Gross National Product (GNP): GNP is the aggregate

final output of citizens and businesses of an economy in a year.

GNP may be defined as the sum of Gross Domestic Product and Net Factor Income from Abroad.

GNP = GDP + NFIAGNP = C+I+G+(X-M)+NFIA

Net Factor Income from Abroad: difference between income received from abroad for rendering factor services and income paid towards services rendered by foreign nationals in the domestic territory of a country

NET DOMESTIC PRODUCT AND NET NATIONAL PRODUCT Net Domestic Product

= GDP-Depreciation Net National Product (NNP)

= GDP–Depreciation +NFIAOr =GNP–Depreciation

Thus NNP is the actual addition to a year’s wealth and is the sum of consumption expenditure, government expenditure, net foreign expenditure, and investment, less depreciation, plus net income earned from abroad. = C+I+G+(X–M)–Depreciation + NFIA

NATIONAL INCOME NNP at Factor Cost is the sum total of income

earned by all the people of the nation, within the national boundaries or abroad

It is also called National Income. NNP at Factor Cost = NNP at Market Prices –

Indirect Taxes+ Subsidies

NET DOMESTIC PRODUCT AND NET NATIONAL PRODUCT

S.No. Item 2003-04 2004-05

1. National income (Net NationalProduct at factor cost)

2268576 2531223

2. Indirect taxes less subsidies 216828 277517

3. Net national product at marketPrices (1+2)

2485404 2808740

4 Other current transfers from rest of the world (Net)

104819 91736

5. Net factor income from abroad -18250 -17916

6. Net domestic product at market prices 2503654 286656

National Income Data for India (Rs Crore)

REAL AND NOMINAL NATIONAL INCOME National income estimated at the prevailing prices, is

called national income at current prices or Nominal National Income, or Money National Income or national income at current prices.

National income measured on the basis of some fixed price, say price prevailing at a particular point of time, or by taking a base year, is known as Real National Income or national income at constant prices

REAL NATIONAL INCOME Real GDP measures changes in the physical output in an

economy, between different time periods, by valuing all goods produced in the two periods at the same prices

deflator GDP

GDP Nominal=GDP Real

•GDP deflator is the ratio of nominal GDP in a year to real GDP of that year.

•GDP deflator measures the change in prices between the base

year and the current year.

PER CAPITAL INCOME The average income of the people of a country in a

particular year is called per capita income. In simple words it is income per head of a country for a year.

Population Total

Income National=Income CapitaPer

•Per capita income for the year 2006-07 may be calculated at the market price prevailing during the financial year 2006-07, i.e. current prices or at prices of a base year say 1999-2000, i.e. constant prices

PERSONAL DISPOSABLE INCOME Personal income is the total income received by the individuals of a

country from all sources before direct taxes in one year. Personal Income = National Income – Undistributed Corporate

Profits – Corporate Taxes – Social Security Contributions + Transfer Payments + Interest on Public Debt

Personal Disposable Income is the income which can be spent on consumption by individuals and families.

Personal Disposable Income

= Personal Income – Personal Taxes

METHODS OF MEASURING NATIONAL INCOME

In equilibrium Output=Income=expenditure

Hence there are three approaches to the measurement of GDP:

Product (or Output) Method: National Income by Industry of Origin Final Product Method Value Added Method

Income Method or National Income by Distributive Shares Expenditure Method

PRODUCT (OR OUTPUT) METHOD The market value of all the goods and services produced in the

country by all the firms across all industries are added up together. Process

The economy is divided on basis of industries, such as agriculture, fishing, mining and quarrying, large scale manufacturing, small scale manufacturing, electricity, gas, etc.

The physical units of output are interpreted in money terms The total values added up. (GDP at market price) The indirect taxes are subtracted and the subsidies are added. (GDP at factor

cost) Net value is calculated by subtracting depreciation from the total value (NDP

at factor cost).

LIMITATIONS OF PRODUCT METHOD Problem of Double Counting:

unclear distinction between a final and an intermediate product.

Not Applicable to Tertiary Sector: This method is useful only when output can be

measured in physical terms Exclusion of Non Marketed Products

E.g. outcome of hobby or self consumption Self Consumption of Output

Producer may consume a part of his production.

INCOME METHOD The net income received by all citizens of a country in a particular year, i.e. total

of net rents, net wages, net interest and net profits. (GDP at factor cost). It is the income earned by the factors of production of a country. Add the money sent by the citizens of the nation from abroad and deduct the

payments made to foreign nationals (individuals and firms) (GNP at factor cost) or Gross National Income (GNI).

Process:• Economy is divided on basis of income groups, such as wage/salary earners,

rent earners, profit earners etc.• Income of all the groups is added, including income from abroad and

undistributed profits.• The income earned by foreigners and transfer payments made in the year

are subtracted. GNI = Rent + Wage + Interest +Profit + Net Income from Abroad- Transfer GNI = Rent + Wage + Interest +Profit + Net Income from Abroad- Transfer

paymentspayments

LIMITATIONS OF INCOME METHOD

Exclusion of non monetary income: Ignores the non-monetized section of economic activities. Economic activities that contribute to national income, but due

to their non monetary nature, they go unrecorded. For e.g. a farmer and family working in their own field.

Exclusion of Non Marketed Services: People undertake a particular activity that are difficult to ascertain in money value. E.g. mother’s services to the family.

EXPENDITURE METHOD OF MEASURING NATIONAL INCOME

The total expenditure incurred by the society in a particular year is added together to get that year’s national income.

Components of Expenditure: personal consumption expenditure net domestic investment government expenditure on goods and services, and net foreign investment

Limitations Ignores Barter System Affected by Inflation

USES OF NATIONAL INCOME DATA National income is the most dependable indicator of a

country’s economic health. Difference between GDP and GNP indicates the

contribution of net income earned abroad Necessary for Economic planning: useful aid in judging

which sectors should be given more emphasis A measure of economic welfare.

higher aggregate production implies more and more goods and services being available to people

Helps in determining the regional disparities, income inequality and level of poverty in a country.

Helps in comparing the situations of economic growth in two different countries.

DIFFICULTIES IN MEASUREMENT OF NATIONAL INCOME

Non monetized transactions: Exchange of goods and services which have no monetary payments, like services rendered out of love, courtesy or kindness are difficult to include in the computation of national income.

Unorganized sector: Contribution of unorganized sector are unrecorded. It is very difficult to identify income of those who do not pay income tax.

Multiple sources of earnings: Part time activity goes unrecognized and such income is not included in national income.

Categorization of goods and services: In many cases categorization of goods and services as intermediate and final product is not very clear.

Inadequate data: Lack of adequate and reliable data is a major hurdle to the measurement of national income of underdeveloped countries.

KEY EQUATIONS AD = C+I AS=C+S AD=AS=C+S=C+I Y=E=O Y=O=C+I Y=E=C+S C+I=Y=C+S Total Expenditure (E) = C + I + G National Income=C+I+G+(X-M) GDP at Market Price = C+I+G+(X-M) GDP at Factor Cost = GDP at Market

Prices –Indirect Taxes+ Subsidies   GNP = GDP + NFIA GNP = C+I+G+(X-M) +NFIA

• NNP = C+I+G+(X–M)–Depreciation + NFIA

• NNP=GDP–Depreciation +NFIA• NNP at Market Price = GNP –

Depreciation • NNP at Factor Cost = NNP at Market

Prices –Indirect Taxes+ Subsidies • NNP at Factor Cost = National

Income= FID+NFIA• NNP at Factor Cost = Rent + Wage +

Interest +Profit + Net Income from Abroad- Transfer payments

• Personal Income =National Income–Undistributed Corporate Profits–Corporate Taxes–Social Security Contributions+ Transfer Payments+ Interest on Public Debt

• Personal Disposable Income=Personal Income – Personal Taxes

INFLATION

it is a state of “too much money chasing too few goods”. Two broad categories:

price inflation money inflation

Both have cause and effect relationship, i.e. money inflation leads to price inflation.

Money inflation is increase in the amount of currency in circulation.

Foreign exchange inflows in the form of capital, tourism and other incomes from abroad.

Coulborn

CONCEPTS OF INFLATION Headline Inflation:

Measure of the total inflation within an economy Affected by the areas of the market which may experience sudden

inflationary spikes such as food or energy. Inflationary Spikes occurs when a particular section

of the economy experiences a sudden price rise, possibly due to external factors.

Hyperinflation: Prices increase at such a speed that the value of money erodes

drastically and the economy is trapped between rising prices and wages.

This is also known as galloping inflation or runaway inflation.

CONCEPTS OF INFLATION Stagflation:

A typical situation when stagnation and inflation coexist. Suppressed Inflation:

When inflationary conditions exist, but the government makes such policies which temporarily keep prices under check

as soon as these checks are removed, inflation bursts out.

Deflation: just opposite to inflation; a state when prices fall persistently.

Disinflation It is a well planned process to bring down prices moderately from a

very high level.

INFLATION

Inflationary Gap represents rise in price due to a gap

between effective demand and supply. The term was coined by KeynesKeynes to

describe a situation when there is an ‘excess of anticipated expenditure over available output at base prices’.

Wage Price Spiral Wages chase prices and prices chase

wages and thus create a wage price spiral.

Prices

Wages

Prices

Wages

CAUSES OF INFLATION

Excess Money Supply. Demand Pull Inflation.

Increase in money supply Increase in disposable income Increase in aggregate spending Increase in population of the country

Cost Push Inflation: An increase in price of any of the inputs, will increase in the cost of production.

Any inflationary pressure created i.e. prices pushed up by cost.

CAUSES OF INFLATION Low Increase in Supply: if supply falls short of

demand, prices will increase. Obsolete technology Deficient machinery Scarcity of resources Natural calamities Industrial disputes and external aggressions

Built in Inflation: Built in inflation is a type of inflation that has resulted from past events and persists in the present.

It is also known as hangover inflation.

INFLATION AND DECISION MAKING

Impact on Consumers: Increase in price of one commodity affects purchase decisions for

many other things of daily need. Changes in consumer prices upset daily budget. Increase in price of eatables may force a cut down on purchase of

many other items.

 Impact on Producers (or Suppliers): Higher the prices, higher are their profits. The critical aspect is that producers gain as sellers of the final (or

intermediate) goods but when they have to buy raw material, hire workforce, buy technology or machine, they are adversely affected by inflation.

INFLATION AND DECISION MAKING

Impact on Government: Government is committed to take the economy to higher levels of

growth by encouraging production and investment, It is duty bound to see that taxpayers’ money is not eroded by

hyperinflation. It acts as the balancing force between consumers and sellers.

Indexation: It is automatic linkage between monetary obligations and price

levels. It applies to wages, interest and taxes.

MEASURING INFLATION A price index is a numerical measure designed to help

to compare how the prices of some class of goods and/or services, taken as a whole, differ between time periods or geographical locations.

Price Index= Various Measures

Producer Price Index (PPI): measures average changes in prices received by domestic producers for their output.

Wholesale Price Index (WPI): inflation is calculated on the basis of wholesale prices of a wide variety of goods (including consumer and capital goods),

Consumer Price Index (CPI): measures the price of a selection of goods purchased by a "typical consumer.“

100Price sYear' Base

Price sYear'Current ×

MEASURING INFLATION Cost of Living Indices (COLI): are similar to the CPI;

these are often used to adjust fixed incomes and contractual incomes to maintain the real value of such incomes.

Service Price Index (SPI): With the growing importance of service sector across the world, many countries have started developing services price indices (SPI).

Inflation Rate 100Index sYear'Current

Index sYear'Current -Index syear'Last ×=

MEANING OF BUSINESS CYCLE

The business cycle or economic cycle refers to the fluctuations of economic activity about its long term growth trend.

The cycle involves shifts over time between periods of relatively rapid growth of output (recovery and prosperity), and periods of relative stagnation or decline (contraction or recession).

Phases of Business Cycle Prosperity Recession Depression Recovery

PROSPERITY PHASE

Unemployment rate declines Income tends to rise Investment increases Investors become more optimistic Consumption tends to rise Share price index tends to rise Money Supply increases

RECESSIONARY PHASE

Recession is turning point ie when prosperity ends recession begins

Liquidation in stock market, fall in prices are symptoms

Banks & People try to gain greater liquidity so credit sharply contracts

Business expansion stops

DEPRESSION PHASE

Shrinkage in volume output Rise in level of unemployment Fall in aggregate demand Contraction of Bank credit Fall in prices

RECOVERY PHASE

Rise in demand for consumption goods which in turn lead to demand for capital goods and new investment is induced

This will give rise to increase in income and employment

PHASES OF BUSINESS CYCLE

10-4

Year

ProsperityPeak

Trough Trough

Peak

Peak

2005 2010 2015

PROFIT CONCEPT & THEORIES OF PROFIT

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PROFIT

Profit = Revenue-Total Cost

ACCOUNTING PROFIT Accounting profit = Total Revenue – The cost

involved in producing and selling

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ECONOMIC PROFIT Economic profit = Total Revenue – Explicit costs + imputed costs. Economic profit = Accounting profit - Imputed cost.

PROFIT AS A REWARD FOR MARKET IMPERFECTION AND FRICTION IN ECONOMY (DYNAMIC THEORY OF PROFIT)

In a static economy neither demand nor supply changes. The demand for a commodity depends upon the size of population, incomes, consumer's tastes, substitutes of commodities, price and the price of related goods.

In a static equilibrium, the supply of the commodity does not change. When demand and supply do not change, the price as well as the cost of production remain constant.

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PROFIT AS A REWARD FOR MARKET IMPERFECTION AND FRICTION IN ECONOMY (DYNAMIC THEORY OF PROFIT) (CONTD…)

According to Prof. Clark, profits belong essentially to economic dynamics and not to economic statics where the economy is frictionless and full competition pervades. In a static economy, pure profit would be eliminated as fast as they could be created.

A war, an inflation, a business depression are all factors in a modern economy which lead to profit or losses. 43

INNOVATION THEORY OF PROFITS Prof. J A Schumpeter's theory of profits is almost

akin to the theory of profits enunciated by Prof. J B Clark.

Prof. Schumpeter, in his innovation theory, attributed profits to dynamic changes in the productive process due to the introduction of modern science and technology of production techniques.

Risk plays no part in this theory and profits are solely attributed to dynamic development.

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PROFIT AS A REWARD FOR ORGANISING OTHER FACTORS OF PRODUCTION

A proportionate combination of the various infrastructures, men, material, money, machinery, marketing is quite indispensable to produce the desired output.

Entrepreneur takes this responsibility to coordinate these infrastructures to produce products. He not only takes unforeseen risks but also, in the midst of uncertainties, combines the factors of production to produce output. 45

A disproportionate combination of factors only increases cost of production and reduces profits.

It is here that the entrepreneurial skill and wisdom play a very important part.

All profits, in a sense, are complementary, since many factors like risk, uncertainty, innovation and monopoly powers, etc., affect every business activity in profit earning.

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In general, it could be argued that under perfect competition, when the price is equal to the average and marginal costs, the entrepreneur gets only "normal profits" and not supernormal profits.

Under imperfect competition, which includes monopoly, duopoly, oligopoly and monopolistic competition the entrepreneur, by exercising control over the supply and price of his product and by creating artificial scarcity in the availability of products, can earn supernormal profits.

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SUMMARY OF PROFIT THEORY In the real world, there is imperfect competition. No single theory is capable of explaining the

cause for the emergence of profit. All the theories are interrelated.

Innovations cause dynamic changes leading to economic progress. Uncertainty is the hallmark of dynamic changes and innovation is uncertainty tied up with risk. Thus, all the causes of profit are interrelated and interdependent. The result is that profit is always uncertain, profits are non-calculable and cannot be accurately estimated.

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THEORIES OF PROFIT Lack of agreement Profits as Residual Income left after payment of

contractual rewards to other factors of production Risk bearing theories:

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PROFITS AS DYNAMIC SURPLUS

1. J. B. Clarke’s Dynamic Theory of ProfitsIn competitive long run equilibrium, P= AC

(including normal profits) and therefore, there is no pure profit.

But profits will emerge if P > AC due to changes(disequilibrium) either in demand or supply

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1. CLARKE’S DYNAMIC THEORY

5 changes that occur in a dynamic economy and give rise to profits:

Changes in- Quantity & quality of human wants- Methods of production- Amount of capital- Forms of organization- Growth of population

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CLARKE’S DYNAMIC THEORY In addition, 2 more changes:

Innovation and External change According to Knight, it is not change which leads to

profits, but dynamic changes give rise to profits ONLY if changes and their consequences are unpredictable- because of uncertainty of Future.

“In an economy where nothing changes, there can be no profits; there is no uncertainty about the future, so there is no risk and no profit”- Stonier & Hague

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2. SCHUMPETER’S INNOVATIONS THEORY OF PROFITS

Main function of entrepreneur is to introduce innovations in the economy and profits are a reward for this function.

2 types:A. Innovations that reduce cost of production

( those which change the production function)Include new machinery, new processes and

techniques of production, new source of raw material, new ways of organising business

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SCHUMPETER’S INNOVATIONS THEORY

B. Innovations that increase the demand for the product ( those which change the demand or utility function- to sell more or at a better price)

Include:New product, new variety, new design of product,

new method of advertising, discovery of new market

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SCHUMPETER’S INNOVATIONS THEORY Profits accrue not to those who conceived the

innovation or financed it or to the one who introduced it

Profits from a particular innovation are temporary- (He is in a monopoly position for sometime- transitional unless he can construct a permanent monopoly)

With patents, he can continue to make profits for a long time

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SCHUMPETER’S INNOVATIONS THEORY

In a competitive economy without patents, existing competitors will soon adopt any successful innovation and profits disappear.

In a progressive, competitive economy entrepreneurs continue to introduce new innovation and earn profits.

“The successful innovator can continuously seek new equilibrium profits since the horizon of conceivable innovations is unlimited”- Stigler

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3. KNIGHT: RISK, UNCERTAINTY &PROFITS

Uncertainty is a permanent feature of the economic system“So long as entrepreneurs start production with

imperfect knowledge of the market, anticipated marginal product of hired factors deviate from their actual product, so long a surplus would persist”

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KNIGHT: RISK, UNCERTAINTY & PROFITS Causes of Uncertainty

Changes in fashions & taste Changes in incomes Changes in Government policies (Taxation, wage and

labor laws, export policies) Movement of prices as a result of inflation and deflation Changes in production technology Competition from new firms

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KNIGHT: RISK, UNCERTAINTY & PROFITS

Insurable & Non insurable Risks Insurable: fire, theft, accident etc- may cause

huge losses but by paying premium, can insure- Premium becomes part of cost of production

Non Insurable Risks: Relate to the outcome of price-output/product design/advertisement expenditure decisions made by the entrepreneur -Can’t be insured- Involve uncertainty and give rise to economic profits, positive or negative

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KNIGHT: RISK, UNCERTAINTY & PROFITS The theory explains why supernormal (economic)

profits arise in fields like petroleum exploration (have higher risks)

Expected returns on stocks is higher than the interest on bonds because of higher risks.

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4. MANAGERIAL EFFICIENCY THEORY Some firms are more efficient than others in

terms of productive operations/ higher managerial skills- Hence need to be compensated with supernormal profits.

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5. MONOPOLY THEORY OF PROFIT Due to Monopoly

Through Patents Licenses Economies of scale Exclusive control over raw materials which prevent

competitors from entering

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6. FRICTIONAL THEORY

In the long run, in a perfectly competitive equilibrium , firms tend to earn only a normal return or zero profit.

At any time firms are not likely to be in such long run equilibrium and earn profit or loss

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