Some Basic Concepts of Macroeconomics

The two main fields of study in economics are microeconomics and

macroeconomics. Now, as you already know, macroeconomics deals

with the economy as a whole. Microeconomics, on the other hand,

studies the behavior of organizations and individuals. Let us

understand a few concepts of Macroeconomics such as Monetary

Policy, Input and Output etc.

Basic Concepts of Macroeconomics

Consider a basic scenario of your school’s annual day celebrations.

You and your friends may either volunteer for backstage help or

participate in one or more events. Some of your friends may also be

involved in stage décor. In most cases, everyone is involved in one

activity or the other. And amidst all these preparations, there will be

someone or some committee overseeing or managing the entire event

at a large scale or macro level. Or in other words, the big picture.

Now, studying this big picture in terms of a country’s economy is

what is called macroeconomics. Wikipedia defines macroeconomics

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as a branch of economics that studies the structure, behavior,

performance, and decision-making of an economy as a whole.

Now that you are familiar with the basic idea of macroeconomics,

let’s understand a few concepts. Macroeconomics is a vast subject and

a field of study in itself. However, some quintessential concepts of

macroeconomics include the study of national income, gross domestic

product (GDP), inflation, unemployment, savings, and investments to

name a few. Let’s discuss a few concepts.

(Image Source: Wikipedia)

Income and Output

One of the most important concepts of macroeconomics is income and

output. The national output is the total amount of all goods and

services produced in a country during a specific period. And when

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production units or organizations sell everything they produce, they

generate an equal amount of income. Hence, you can measure output

by calculating the total income from the sale of all goods and services.

In relation to macroeconomics, economists usually measure national

income or output by gross domestic product or GDP. By measuring

GDP, economists can understand the market swings and changes.

They can identify what measures to take to improve the GDP of the

country. With technological advances, capital increase, and

acquisition of state-of-art equipment, production units and

organizations can increase national output and income. However,

income and output can be affected by the recession and other market

factors.

Unemployment

Another important component of macroeconomics is unemployment.

Economists measure the unemployment rate in an economy by

calculating the percentage of individuals without jobs. Unemployment

categories include classic unemployment, frictional unemployment,

and structural unemployment.

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Classical unemployment is when wages are too high for employers to

consider hiring more workers. Frictional unemployment occurs when

the time taken to search for an appropriate employee is too long.

Structural unemployment occurs when there is a mismatch between a

worker’s skills and the actual skill required for a job. Another

important category of unemployment is cyclical unemployment that

occurs when an economy’s growth is stagnant.

Inflation and Deflation

The study of inflation and deflation is another important aspect of

macroeconomics. The term inflation refers to an increase in the prices

of goods and services across the country. And the term deflation refers

to a decrease in the prices of goods and services. Economists measure

inflation and deflation by studying price indexes. A price index is the

weighted average of price for a class of products and services.

Inflation occurs when an economy grows too quickly. Deflation, on

the other hand, occurs when an economy declines over a period of

time. By studying the inflation and deflation trends, economists can

help curb inflation rates by taking appropriate measures. Too much

inflation can lead to negative consequences and continuous deflation

can cause low economic output.

Macroeconomic Policies

Now that you are familiar with some of the basic concepts of

macroeconomics, let’s try and understand some macroeconomic

policies. The two main macroeconomic policies that a government

may apply to bring about stability are the monetary policy and the

fiscal policy.

Monetary Policy

The monetary policy is an important process, which is under the

control of the monetary authority of a country. This monetary

authority is usually the central bank or the currency board. The

monetary policy is usually implemented by the central bank to

stabilize prices and to increase the strength of a country’s currency.

The monetary policy also aims to reduce unemployment rates and

stabilize GDP. It also controls the supply of money in an economy.

For example, the central bank of a country can pump money into an

economy by issuing money to buy bonds and other assets. On the

other hand, the central bank of a country can also sell bonds and take

money out of circulation.

Fiscal Policy

The fiscal policy is a process that makes use of a government’s

revenue generation and expenditure as tools to control economic

windfalls. The government uses the fiscal policy to stabilize the

economy during a business cycle. For instance, if production in an

economy does not match the required output, the government can

spend on idle resources and help in increasing output.

Usually, economists prefer the monetary policy over the fiscal policy.

This is because the monetary policy is under the control of the central

bank of a country, which is an independent organization. The fiscal

policy is under the control of the government, which can be affected

by political intentions.

Solved Question for You

Q: National Income of country is also known as _______________

a. GDP

b. GNP

c. NNP

d. All of the above

Ans; The correct option is “C”. The National income of a country is

the Net National Product or the NNP.We calculate it at either market

price or factor cost. When we calculate it at factor cost it is the

National Income.

Circular Flow of Income and Methods of Calculating National Income

What goes around comes around right? Have you ever wondered

where the money your parents earn comes from? And after you have

spent it, where will this money end up? As you may have figured it

out, money in our economy flows in circles. We call this the circular

flow of income. Let us learn more.

Flow of Money

In the course of your academic year, you are in constant need of

textbooks, notebooks, and stationery. And your family members

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usually fulfil these basic demands. But have you ever wondered how

they are able to do this? You must have seen your parents go to work

every day and receive salaries in return for their services. And this

salary is what they use to pay for your education and your basic needs.

Now in addition to your education, they also account for numerous

other expenses like household groceries, rent, and so on. And these

expenses, although small, affect the economy in some way or the

other. Let’s see how.

Now let’s take groceries as an example. When your parents purchase

groceries, it creates a demand for the same. An increase in demand

translates into an increase in production of goods and services. And to

meet this demand, manufacturers and industries hire more people in

exchange for their skills and services.

In this process of providing services, people earn more spendable

income. If you observe closely, there is a continuous flow of money

from households to industries and back to households. And that’s

exactly what is referred to as circular flow of income.

Browse more Topics under National Income Accounting

● Some Basic Concepts of Macroeconomics

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● Expenditure Method and Income Method

● Some Macroeconomic Identities

● Goods, Prices, GDP and Welfare

Circular Flow of Income

Let’s now understand this concept in economic terms. The circular

flow of income is a model that represents how money moves around

in an economy. In a simple economy, we have only two

components—households and industries. But it isn’t that simple.

In an open economy, there are a lot more factors that affect the

circular flow of income. In addition to household consumption and

business production, an open economy also takes into account the

government spending and foreign trade.

Money is injected into the economy when the government invests

money in infrastructure and welfare schemes. Similarly, industries and

businesses also earn income when they export goods. However, when

we import goods and services and pay taxes to the government, we

reduce our spendable income.

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Now government spending, exports, and investments together with

household income (wages) constitute the influx of money into an

economy. Similarly, business investments, taxes, and imports

constitute the total outflow. The national income will increase when

the total influx of money is more than the outflow of money. And the

circular flow of income will be in balance when the total influx

matches the total outflow.

(Image Source: Wikimedia)

Methods of Calculating National Income

Now that you are familiar with the concept of the circular flow of

income, let’s understand the methods of calculating national income.

Calculating and measuring national income is important because that’s

how we can assess an economy’s growth rate. There are several

methods of calculating national income. Let’s briefly look at each

method.

Income Method

The income method of calculating national income focuses on the

production perspective. Now production of goods and services

involves the use of land, labour, capital, and so on. And if we consider

these factors of production, income is generated via rent, wages and

salaries, profits, and interest.

We can then calculate the national income by adding all these types of

income. Another important source of income is mixed income. Mixed

income refers to the income generated by self-employed professionals

and sole proprietors.

According to the income method:

National Income = Rent + Wages + Interest + Profit + Mixed-Income

The income method, however, does not consider transfer payments,

prize money (lotteries), illegal money, profit tax, and sale of

second-hand goods.

Expenditure Method

The expenditure method of calculating national income focuses on the

expenditures. Now expenditure refers to all the purchases made by

residents, government, or business enterprises. The expenditure

method takes the following elements into consideration:

● Purchase of consumer goods and services by residents and

households (C)

● Government expenditure on goods and services (G)

● Business enterprises’ expenditure on capital goods and stocks

(I)

● Net exports (exports-imports) (NX)

Hence, according to the expenditure method:

National Income = C + G + I + NX

However, the expenditure method excludes expenditure on

second-hand goods and purchase of shares and bonds.

Value-Added Method

The value-added method of calculating national income focuses on the

value added to a product at each stage of production. To calculate the

national income using this method, we will have to first calculate the

net value added at factor cost (NVAFC). And to calculate the

(NVAFC), we will have to deduct the net indirect taxes.

Usually, this method involves dividing the economy into various

industries such as agriculture, fishing, transport, communication, and

so on. Then by calculating the value added ((NVAFC) at each stage,

we can derive the national income. Now since this method

concentrates on the net value added by each component, we would

need to exclude or subtract the following elements from the output of

each enterprise:

● Consumption of raw materials

● Consumption of capital

● Net indirect taxes

Now if we add the NVAFC of all enterprises of an industry, we get the

net value added at factor cost for that industry. And by adding the

NVAFC of all industries, we get the net domestic product at factor

cost, which is represented as NDPFC. And to this, if we add the net

factor income from abroad, we get the national income.

Hence, according to the value-added method:

National Income = (NDPFC) + Net factor income from abroad

Solved Example for You

Q: Which of the following sources is an exception while calculating

national income using the income method.

a. Salaries

b. Rent

c. Profit from sale of second-hand goods

d. Mixed income

Correct Answer: C. The income method concentrates on the income

generated from the various factors of production such as land and

labour. This method does not consider the income generated from the

sale of second-hand goods.

Expenditure Method and Income Method

In your basic accounts lessons, you must have learned the concepts of

income and expenditure, assets and liabilities, profit and loss, and so

on. Now, these concepts are important because they set the financial

foundations for a successful business. However, it doesn’t stop there.

These concepts are equally important for an economy as a whole.

Let’s look at Income method and Expenditure Method of calculating

National Income.

National Income

National income or the gross national income is the total income

earned by all residents and enterprises of a country over a specific

period. You can also define national income as the total value of all

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goods and services produced over a specific period of time. Now,

there are several methods of calculating national income.

The three most common methods are the value-added method, the

income method, and the expenditure method. The value-added method

focuses on the value added to a product at each stage of its production.

Next, the income method focuses on the income received on the

factors of production such as land and labor. And finally, the

expenditure method focuses on the various types of expenditure based

on consumption and investment. Let’s look at the income and

expenditure methods in detail.

Browse more Topics under National Income Accounting

● Some Basic Concepts of Macroeconomics

● Circular Flow of Income and Methods of Calculating National

Income

● Some Macroeconomic Identities

● Goods, Prices, GDP and Welfare

Income Method

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The income method of calculating national income takes into account

the income generated from the basic factors of production. These

include the land, labor, capital, and organization. And in addition to

income accrued from these factors of production, another important

component of income is mixed income. Now let’s discuss all these

components in detail.

Rent from Land

Rent is the money you pay for the use of land. While calculating

income, rent refers only to the income earned from using any land.

Rent paid for the use of machinery and other equipment is not

accounted for as rent.

Now in addition to rent, another form of income is royalty. Royalty is

the amount you pay to an individual or a company in exchange for the

use of assets such as coal or gas.

Compensation for Labor

Compensation includes salaries and wages that you earn in exchange

for the services and skills that you provide for producing goods and

services. It also includes travel allowances, bonuses, accommodation

allowances, and medical reimbursements.

In addition to wages and salaries, another important component of

compensation is remuneration in the form of social security schemes

such as insurance, pensions, provident funds.

Interest on Capital

Interest refers to the charges you pay for using borrowed capital. Now,

this includes the interest paid when a company takes a loan for an

investment. Similarly, when a family invests in a property or a house,

they take a loan from a bank and pay an interest for the same while

repaying the loan over a period of time. However, while calculating

national income, economists consider only the interest paid by

production units.

Profits by Organizations

Profits refer to the money that organizations make while producing

goods and services. Now companies distribute the profits they make

by paying income tax to the government and dividends to

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shareholders. And the amount that is left over after paying tax and

dividends is called undistributed profit.

Mixed Income

Mixed income refers to the income of the self-employed individuals,

farming units, and sole proprietorships. Now, if you consider all these

components of income, national income can be represented as follows:

National Income = Rent + Compensation + Interest + Profit + Mixed

income

When economists calculated national income, they divide the

production units into different sectors. Then they calculate the income

for each sector and then derive the total national income. However,

while computing national income using the income approach,

economists exclude transfer payments such as gifts and donations and

profits from the sale of pre-owned goods. They also exclude income

from the sale of shares and debentures.

Expenditure Method

Now that you are familiar with the income approach of calculating

national income, let’s understand the expenditure approach. The final

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expenditure approach focuses on the expenditure involved in the

production of goods and services. Now you can classify expenditure

based on consumption and investment.

Consumption expenditure includes household consumption of goods

and services (C). It also includes government’s expenditure on goods

and services to fulfill social welfare needs (G). Investment

expenditure refers to the expenditure made by companies and

production units for raising capital (I). For instance, investment

expenditure includes the purchase of fixed capital assets such as

buildings and equipment. Expenditure also includes an addition to the

stock of raw materials.

Investment expenditure also includes an acquisition of valuables such

as precious metals or jewelry. Expenditure also includes imports and

exports made by companies and the government. And while

calculating national income, you need to calculate the net exports

(NX). That is the total exports minus total imports.

Now while calculating national income using the expenditure

approach, you need to also deduct depreciation on capital assets and

indirect taxes. Using the expenditure approach, national income can be

represented as follows:

National Income = C (household consumption) + G (government

expenditure) + I (investment expense) + NX (net exports).

Again, you while determining income using the expenditure approach,

you need to exclude expenditure on second-hand goods, purchase of

shares and bonds, expenditure of transfer payments (unemployment

benefits, pension), and purchase of intermediate products.

Solved Question for You

Question: Identify whether the following statement is true or false.

“Royalty received by an organization for the use of its coal mines can

be considered as a source of income while computing national income

using the income approach.”

● True

● False

Correct Answer: True. Royalty is a form of income and it should be

accounted for while calculating national income using the income

approach.

Some Macroeconomic Identities

You must have gone through several articles that discuss various

macroeconomic concepts such as foreign trade, exports and imports,

and goods and services. Now, these concepts are important as they

affect the gross domestic product or GDP of the economy as a whole.

However, in addition to GDP, there are several other very important

macroeconomic identities that measure economic growth. These

include the gross national product or GNP and the net national product

or NNP.

Gross National Product

Now, the GNP measures the total value of all final goods and services

produced within a specific period of time by a country’s residents and

enterprises. While calculating GNP, economists deduct the income

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earned domestically by foreign individuals and companies and add the

income earned by residents and companies working abroad.

And that is the basic difference between GNP and GDP. While Gross

National Product considers the ownership, GDP measures the total

value of all goods and services produced in a country regardless of

foreign or domestic ownership. Let’s now understand the various

components of Gross National Product.

GNP is the sum of household consumption expenditure, private

investment, government expenditure, and net exports. And to this

value, economists add the income earned by overseas residents and

enterprises and deduct the income earned by foreign residents and

enterprises. Let’s look at each component in detail.

First, household consumption expenditure includes the expenditure on

durable goods, non-durable goods, and services. The next component,

private investment, includes the capital expenditure or investment on

new capital for producing consumer goods. Government expenditure

refers to the total expenditure by federal, state, or local governments

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on final goods and services. And finally, net exports refers to the

difference between the total imports and exports.

Net National Product

Now let’s understand the net national product or the NNP. The NNP

takes into account the depreciation factor. What is depreciation?

Depreciation is the wear and tear of fixed assets. And in this context, it

also refers to capital used to maintain existing stock.

And NNP is the total value of all final goods and services produced by

the factors of production of a country within a given specific time

minus depreciation. In other words, NNP is GNP – depreciation. Now

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while calculating the NNP, economists take into consideration two

very important factors—indirect taxes and subsidies.

The market price of any product includes taxes, which go to the

government. Hence, while calculating the NNP, economists need to

deduct the taxes. Similarly, the government also provides subsidies to

encourage production of certain goods and services. And with that

being the case, we need to add these subsidies while calculating the

NNP. The NNP after considering taxes and subsidies is called the

NNP at factor cost or national income.

Browse more Topics under National Income Accounting

● Some Basic Concepts of Macroeconomics

● Circular Flow of Income and Methods of Calculating National

Income

● Expenditure Method and Income Method

● Goods, Prices, GDP and Welfare

National Disposable Income and Private Income

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Apart from the GNP and the NNP, two other macroeconomic

identities that you should be familiar with are the national disposable

income and the private income. The national disposable income refers

to the total value of all goods and services a country has at its disposal.

The national disposable income also includes current transfers from

the rest of the world (for example, gifts and aids received from other

countries). Basically, the national disposable income refers to the

income an economy has for its consumption expenditure without

having to sell off any assets for the same. And that’s the reason why it

is an important economic indicator.

Private income is the final value of all incomes received by the private

sector. In this context, the private sector refers to the residents and

enterprises of a country. Private income also includes the national debt

interest, the net factor income from abroad, the current transfers from

the government, and the net transfers from the rest of the world.

Solved Question for You

Q: Identify whether the following statement is true or false.

“The gross national product or GNP takes into account the

depreciation cost incurred in the production of goods and services.”

Answer: The statement is False. The net national product or NNP is

the macroeconomic identity that accounts for the depreciation cost.

NNP = GNP – Depreciation.

Goods, Prices, GDP and Welfare

In your everyday routine, there are several things that you need to get

through the day. As a student, you may require your subject books,

your art equipment, or your mechanical drawing set. Needs are

different for different people and what satisfies these needs are goods

and services. And you pay a price for these goods. Consequently, you

create a market for these goods and help in contributing towards the

GDP of your country’s economy. And all these put together affect the

economy in many ways. So, let’s try and understand these concepts in

detail.

Goods

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Now, we already know that goods are products that satisfy human

wants and needs. In the context of economics, we can define goods as

materials that provide a utility. Now, you can classify goods into

different categories such as tangible and intangible goods and

intermediary and final goods.

Tangible and Intangible Goods

Tangible goods are the goods that you see and touch. You can transfer

these goods from one place to another. Examples of tangible goods

include automobiles, garments, and grocery items. Intangible goods,

on the other hand, are goods that you can’t feel or touch. Medical,

architectural, law or engineering services are all examples of

intangible goods.

(Image Source: Wikipedia)

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You can further divide tangible goods into categories such as

economic and non-economic goods and consumer and producer

goods. Goods that you buy are economic goods. They come with a

price and are affected by demand and supply factors. Non-economic

goods are free.

Consumer goods are goods that directly satisfy human needs. These

include durable (fuel, bread, milk, rice) and non-durable goods

(garments, cars, fans). Producer goods include goods that you can

further use to produce other goods. These include goods such as

machines and agricultural raw materials.

Intermediate and Final Goods

Intermediate goods are goods that one production unit sells to another

for resale or further production. For instance, a farmer may sell wheat

to a company. A company may then buy that wheat and further

process it to create bread. Here wheat is an intermediary product.

Final goods are goods that are produced for final consumption or

investment and not for resale. It is very important for you to

understand the difference between an intermediary product and a final

product. When a municipal corporation provides electricity to a

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production unit or a company, then it is an intermediary good.

However, when the same electricity is supplied to households for

direct consumption, it becomes a final good.

Prices

Now that you are familiar with the concept of goods in economics,

let’s try and understand the concept of price. You can define price as

the compensation you pay to another party in return for one unit of

goods or services. The price of a product or a service usually depends

on its supply and demand. And the demand and supply factors in an

open economy usually balance on their own.

When a product’s supply is excessive, then the prices are usually low.

This causes the production to decrease to a point where there is a

balance between the demand and supply. When the demand for the

same product increases and doesn’t match the supply, the price of the

product increases. This entire system of price based on demand and

supply factors is also referred to as the price theory.

Although in a free economy the demand and supply factors balance

out themselves, sometimes these forces are affected by government

subsidies or industrial manipulation. Consequently, the prices also

change.

(Image Source: Wikipedia)

Gross Domestic Product (GDP) and Welfare

Now that you have understood the concepts of goods and prices, let’s

see how they affect the GDP of an economy. Let’s first understand

what’s GDP? You can define GDP as the total value of goods and

services produced in a country within a specific period. The GDP is

usually calculated on an annual basis.

You can calculate an economy’s GDP using the income and

expenditure methods. After computing the GDP, you can measure it

with the GDP of the previous year. Usually, GDP is used as a tool to

the indicate economic performance of a country.

Although the GDP is an important indicator of economic growth, a

country’s good GDP doesn’t necessarily translate to good welfare and

well-being. Let’s see why. First, if a country’s GDP rises, it may not

consequently increase the well-being of its people. The GDP rise may

be distributed among a handful of companies. For others, the income

may have fallen.

Second, there are several transactions and activities that are

non-monetary. Money does not matter in such transactions. For

instance, volunteer work is a non-monetary activity as there is no

income generated.

Finally, there are black markets in several developing countries. In

black markets, trading generally involves swapping of goods and

services and money isn’t involved. Consequently, as money may or

may not be exchanged, GDP cannot be calculated. So, although the

GDP is an effective tool to measure economic growth, it doesn’t really

measure the well-being or the welfare of the people.

Solved Question for You

Q: Identify whether the following statement is true or false.

“The sand on a beach shore comes under the category of an economic

good.”

Correct answer: False. Beach sand is freely available. It does not have

a monetary value associated with it and is hence a non-economic

good.