MACROECONOMICS 1.1 Meaning 1.2 Schools of Thought 1.3 Scope/ Subject Matter 1.4 Importance 1.1 MEANING India is a fast growing economy, recording a growth of about 7 percent per annum. It ranks among the few high growth economies of the world. Our current account deficit [CAD] in balance of payments is about 2.1 percent of GDP. The foreign exchange reserves are substantial at 400 billion US $. Foreign investment is encouraging. Many multinational corporations (MNCs) find Indian market is encouraging and attractive. Our money and capital markets are sufficiently active. Monetary authorities (RBI) and the Government, through monetary and fiscal policies are playing a positive role in controlling inflation and promoting economic growth. , Agriculture, it is reported has registered a higher growth in 2016-17. At the same time growth in industrial output is low. Unemployment is increasing. We have a large number of people below poverty line (BPL) and also a large number of illiterates. Income inequality is a serious problem to deal with. Economy in recent months is slowing down leading towards recession. All the above issues are macroeconomic problems which are the subject matter of this book. Macroeconomics deals with the behaviour and changes in the macro fundamentals of an economy. .™ Economics - II (SYBMS, BFM, BBI: SEM-IV) Macroeconomics studies the economy as a whole and analyses its “functioning. It deals with the behaviour of aggregates such as national income, employment level, general price level, investment level and balance of payments. These aggregates are the result of activities in different sectors of the economy and they form the collective behaviour pattern of different decision makers such as consumers, governments, firms and industries. 2 According to K. E. Boudling*, “Macro economics is that part of economics which studies the overall averages and aggregates of the economic system. It does not deal with individual incomes but with national income, not with individual prices but with the general price level, not with individual output, but with national output”. In other words, while microeconomics is the study of individual units of aneconomy, macroeconomics is the study of the economy as a whole and in its totality. 1.2 SCHOOLS OF THOUGHT The following are the main schools of thought in macroeconomics: (a) Classical Macroeconom ics (b) Keynesian Theory (c) Post-Keynesian Developments (a) Classical Macroeconomics: The classical school of thought is composed of certain assumptions and postulates. The main idea of the classical school is that(markets work best when they are left alone, without any government intervention. This is termed as “laissez faire” capitalism-Adam Smith, David Ricardo, J.S. Mill, J.B. Say are some of the well known economists of this school. (b) Keynesian** Theory: During the Great Depression in the USA, policymakers could not find a solution to the problem of mass unemployment in the classical economic principles that said the markets will correct themselves on their own. During, this time, Keynes questioned the classical model and provided an explanation to why markets can fail and why the government needs to play a role in * Kenneth Boulding, British Economist (1910-1993). ** John Mayanard Keynes - British Economist (1883-1946), considered as th greatest economist of 20th century.— | B order to reduce the effects of economic fluctuations through fiscal and monetary policies. This led to the development of the Keynesian school of thought or the Keynesian theory. Macroeconomics <) Post Keynesian Developments: Later in 1950s, economists like Paul Samuelson, James Tobin, Robert Solow, Franco Modigilani, combined Kenesian economic theories with neo-classical microeconomics to evelop theories of consumption, itvestment and money. Another important post-Keynesian development in macroeconomics was the emergence Of. Monetarism,| led by Milton Friedman*.| Monetarists focus on the role of money supply and central bank in determining price level in an economy. es Allof these, along with Keynesian models, form the subject matter of modern macroeconomics. 1.3 SCOPE/SUBJECT MATTER OF MACROECONOMICS The following is the scope of macroeconomics: 1. Determination of National Income: The primary focus of macroeconomics is the study of the factors that determine a country’s national output and income. These factors include consumption, investment, government expenditure and net exports. Macroeconomics analyses each of these factors. National income provides a quantitative basis for choosing and evaluating economic policies. Several concepts of national income accounting are used in macroeconomics, such as, gross domestic product (GDP), gross national product (GNP), net national product (NNP), per capita income. All these measures are used to analyse the performance of an economy. Economic Fluctuations or Business Cycles: Free-market economies experience business cycles which refer to fluctuations in national income and employment with alternating periods of prosperity and recession. Such fluctuations cause large scale involuntary unemployment as well as inflation. Analysis of the effects of economic fluctuations has been the main focus of macroeconomics, particularly since the Great Depression. * Milton Friedman (1912-2006), American Economist Nobel Laureate - 1976.Economics - 11 (SYBMS, BFM, BBI: SEM-IV) Aggregate Demand and Aggregate Suppl and employment explains what determines the national income and what causes fluctuations in the level of national income over time. The focus of macroeconomics then shifted to analysing components of aggregate demand like, consumption, investment, government expenditure and net exports Aggregate supply can be increased in the long run through improvement in productivity, investments, technological changes and policies. nt: Macroeconomics studies the level an economy. Employment level isa function of economic activities, state of technology, level of productivity, wage rate and government policies. During recession, due to lack of aggregate demand, the economy experiences large scale involuntary unemployment. This is cyclical unemployment experienced by developed economies. In developing economies the problem of unemployment is different from that of developed economies. In such economies disguised unemployment, underemployment and mass unemployment takes place due to low level of economic activities. Macroeconomics studies the causes of unemployment and provides the basis for employment policies. ly: The theory of income Employment and Unemployme of and nature of employment in Money and Price Level: Macroeconomics studies the role of money in an economy by analysing the demand for and supply of money. Related to money is the issue of general price level and changes in it. Thus, macroeconomics is concerned with the study of inflation, deflation and more recently, stagflation. Economic Growth and Development: Theories of economic growth and development have been a recent area of interest in macroeconomics. The problem of economic growth is a long term problem and Keynesian economics did not deal with it. The focus of Keynesian economics is dealing with short term problems associated with business cycles. Therefore, in the 1950s and 1960s, a branch of economics called Development Economics emerged to study the development process in low-income economies. Balance of Payments and Exchange Rate: As foreign income is a determinant of national income, macroeconomics studies the impact of trade on national income. Macroeconomics explains the factors which determine a country’s balance of payments and identifies the causes of deficit. It suggests policy measures to correct such deficits. Exchange rate between different currencies is one of determinants of balance of payments position of an economy. The central bank plays a role in managing exchange rates. This is a subject matter of macroeconomics.o a Macroecorionics The study of macroeconomics is of great significance to policy makers, researchers and academicians, business firms, international agencies like the World Bank, IMF, WTO and individual citizens. The following are some of the reasons why a good understanding of macroeconomics is important: 1 Understanding the functioning of an economy: The study of macroeconomics helps one to understand the general functioning of anecononyy. It helps to study the interaction between different sectors of an economy like, households, business and government and analyse how different markets interact with each other. Macroeconomics also focuses on the study of economic systems that exist, like different forms of capitalism, socialism and mixed economy systems. Understanding and evaluating economic performance: Economic growth and development are considered to be the most important indicators of an economy’s performance. The analysis of national and per capita income forms the basis for evaluating and comparing different economies on their performance. Countries are ranked on the basis of the size of their national income and per capita income to provide a perspective on the state of the global economy. v 3. Formulating government policies: Macroeconomic analysis and models form the base on which governments formulate their economic and social policies. Keynesian theory has been the foundation of counter-cyclical fiscal and monetary policies that were put in place by most developed economies to deal with recession, unemployment and inflation. The developing economies have formulated long term plans and policies to promote growth and development on the basis of the development models. Understanding the economic environment of business: Business units are affected by the macroeconomic environment. Rate of interest, the general price level, the phase of business cycle, exchange rate, level of employment, investment and expenditure levels, all have major impact on performance of business units. Businesses have to be prepared to face challenges that arise out of changes in the macroeconomic environment. Understanding of macroeconomics is extremely important in taking effective business decisions. Forecasting future trends: Macroeconomics provides the foundation to economic analysts to forecast future trends in different economic indicators like interest rate, exchange rate, growth rate, price level,7. 6 Economics - I (SYBMS, BFM, BBI: SEM-Iv) income and employment levels. Such trend forecasts are used by governments as well as businesses to formulate policies. 6 Making political choices: Economics and politics have very strong inter-linkages. In most cases, people make political choices on the basis of macroeconomic indicators and judge governments on the basis of their achievements in areas like employment generation, control of inflation and welfare generation. Political parties and leaders in democracies try to win votes by promising economic benefits like employment, income, price control and social welfare. One can make a good and wise political choice if one has an understanding of the functioning of an economy. Study of macroeconomics becomes important for making good political choices. _ REVIEW QUESTIONS 1. Define macroeconomics. Discuss the various schools of thought of macroeconomics. 2. Discuss the scope of macroeconomics. 3. Discuss the importance of the study of macroeconomics. OBJECTIVE QUESTIONS A. Choose the correct answer from the alternatives provided : 1. The following is not a subject matter of macroeconomics: (a) National income accounting , {by Law of demand and supply (c) Business cycle (d) General price level 2. One of the major assumptions of the classical school is (a) Lack of aggregate demand causes involuntary unemployment (b) Government's fiscal operations can reduce unemployment (c) Unemployment and inflation can exist together (dy Economy will be in full employment equilibrium in the long run 3. Keynesian theory is not based on which of the following assumptions? fa) Supply creates its own demand (b) Markets can fail (c) Government intervention can reduce the impact of recession (d) Aggregate demand determines national outputMacroeconomics 7 4. Which of the following schools of thought in macroeconomics focuses on the role of money supply and central bank? (a) Development Economics (b) Classical School (O) Monetarism (d) Keynesian School of macroeconomics specifically focuses on the problems 5. Which brane! of developing economies? (a) Development Economics — (b) Public Finance (c) Monetary Economics (d) Trade Cycle Theory 6. Which of the following measurements indicate how national income is distributed? : (a) GDP (b) GNP (cy Per Capita Income (d) NNP ‘Ans.: (1) - (b), (2) - (@), (3) - (a), (4) - (0), (5) - (a), (6) - () B. State whether the following statements are True or False: nomics deals with individual industry. 1. Macroeco nomics based on market 2, Classical economics deals with macroec: economy. a: Monetarism is the par' 4, Macroeconomics expl t of macroeconomics. ains the change in price of individual goods or services. 5, Macroeconomics doesnot deal with performance of the entire economy. 46. Individual business unit is affected by macroeconomic changes. ‘Ans.: True: 2,3, 6; False:1,4,59 CIRCULAR FLOW OF INCOME 21 Introduction 2.2 Circular Flow in a Closed Econ 2.3 Circular Flow in an Open Econ of Income omy omy or Four Sector Economy 24 Importance of Circular Flow 21 INTRODUCTION ; diture explains the process that \ The circular flow of income and expen: u ' determines national income and national output simultaneously] The overall economic activity can be represented in the form of circular low of income, output and expenditure] In an economy consumers spend their income on goods and services pr duced by production units. They pay to the factors in the forms of wages, rent, interest and profits. This forms the income of the factor owners which is spent again. The functioning of the economy consists of the production of goods and services by the production units (Whatare "costs" to business units are "incomes" to the factor owners, On the other hand,\consumers' expenditure is income to business units: Expenditure of constimers determines the income of the producers. More expenditure means more income and greater production of goods and services, The economy is in equilibrium when income equals output equals expenditu Cond As explained inthe beginning, an economy performs certain economic activities which enables it to function smoothly. The important activitiesCircular Flow of Income 9 are (i) production (ii) exchange (iii) consumption and (iv) distribution/The above activities are based on decisions of economic agents. They are primarily the households and firms. We can add government also as a decision taking agent since its functioning involves economic activities. (Households are the owners of factors of production - land, labour, capital ‘5nd entrepreneur. They supply the services of these factors to those who make use of these services to produce goods and services. Firms are the business concerns or the entrepreneurs who decide what, where, how and for whom to produce the goods and services by using the services of factors of production which are supplied by households. } Supply of factors of production by households and demand for them by the firms determine prices of factor services in the factor market. Factor prices in the form of rent, wages, interest and profits are paid by the firms and received by the households. | Exchange of goods and services take place in the commodity market where \they are sold by the firms and purchased by the harp ae Prices - rent, wages/salaries, interest and profit are decided in factor market) Money received by the households as factor income is spent in the ‘commodity market paying for the goods and services supplied by the firms) The above explanation shows us that an economy functions in such a way, where households supply factor services and receive income in the form of factor prices paid by the firms. The households spend the factor income in the commodity market by purchasing goods and services supplied by the firms. The entire operation takes place in a circular manner which is explained below in detail. 2.2. CIRCULAR FLOWIN A CLOSED ECONOMY a cs (A) TWO SECTOR ECONOMY I. Circular Flow without Saving The circular flow of income is explained by considering a simple economy in which there are only two sectors, that is, households and firms, The circular flow is explained with the help of the following assumptions.TT 10 Economics - I (SYBMS, BEM, BBI: SEM-IV) Assumptions v1. The economy consists of two sectors (i) households and (ii) firms. 2, Production takes place only in the firms. 3. Households spend their entire income received in the form of rent, wages, interest and profits on goods and services. 4. Income not spentis saved, which is invested through financial market. 5. Firms supply goods and services as per demand, thus do not maintain any inventory. 6. There areno government operations, i.e., NO government expenditure and taxes in the economy. 7. Thereisno international economic relations. There is no outflow and The circular flow of economic activity in inflow of goods and services, making the economy a closed one. a two sector economy is explained in the Fig. 2.1. 7 é Households Fir Factor Owners Ss Financi or Us al |! Factor U ae of Goods Market and Producers of rvices eS Goods and Services Py 2y) ace? ents for Goods at 4 ger h Co, MMoprty MARK Fi °W of Goods and service Fig. 2.1eaeessesueerua r Flow of Income i re 2.1 the factor owners and consumers of goods and services, are he left side rectangle and the right side rectangle represents firms which are factor users and producers of goods and services. Factor services flow from households to firms and factor income from the firms to the pousehold. The upper half shows this flow through factor market. The lower half shows the flow of goods and services and payment for the same through commodity market. The Fig. 2.1 indicates two types of flow, real and money. Factors of production and goods and services represent real flow whereas factor payments and payments for goods and services represept money flow \The real flow and money flow occur in opposite directions) When we combine the flow of factors and goods market we get a circular flow.) Circula In Figu shownin tl circular flow and it gets injected back into the circular flow in the form of investment. The saving and investment flows between households and firms take place through the financial market or financial sector which consists of commercial banks, stock market and non- banking financial institutions. saving is a leakage in the The closed economy is in equilibrium when S =I. It is because ina closed economy, Y=C+S or Y=C+I S=I (B) THREESECTOR ECONOMY Ina modern economy the Government plays a major role in the functioning and governing of the economic system of a country. Governments decide policy measures, spend on economic and administrative activities by collecting money from its citizens in the form of taxes. | Government receives income in the form of taxes, Tax payments reduce “The disposable income of households and firms which in turn reduce their expenditure and also savings. Governments expenditure comprises spending on goods and services and, transfer payments in the form of pension payments, subsidies, unemployment allowance, etc. Money spent by the government is an injection of income into the economy which in turn is received by the households and firms. \In our simple three sector economy consisting of households, firms and government, we do not consider the government's direct economic activities in the form of investment, production, sale, etc.12 The circular flow (SYBMS, BFM, BBI : SEM-IV) Economics - IT ee onomy is shown in Fig. 2.2. of income ina three sector ec Government Fig. 2.2 The income of the government through taxes paid by both households and firms is spent by the government in the form of transfer payments, salaries to government employees, purchases of goods and services, etc. Transfer Payments are made in the form of pension payments, unem ployment allowances, subsidies, etc. Money spent by the government is received by the firms and households. The leakages in the form of saving and taxes arise in the circular flow of income. They get injected back to the circular flow in the form of investment and government expenditure. When the leakages in the form of sav ing and taxes are equal to injections in the form of investment and government expenditure the flow of economy activities 80es on smoothly. The introduction of the government sector affects the overall economic activity. The total expenditure is now the sum of consumption expenditure (C), investment expenditure (1) and government expenditure (G). Thus, Total Expenditure (E)=C+1+G acecsseseeee (1) The total income (Y) received is allocated to consumption, saving and taxes (T). Thus,Circular Flow of Income 2B NO eee Q) The economy is in equilibrium when the expenditure is equal to income. Thus we have, CHIFG=CHStT i eeenenneenns () Since C is common in both sides of the identity, we have I+G=S+T By rearranging we obtain, Ces Ne f= 2e)) gad Ee EH Ee EEE RA a ©) The equation 5 shows that if G > T, we have a deficit budget. To finance this government need to borrow from financial market. For this purpose, investment by business firms should be less than saving (I < S). Thus, government borrowing reduces private investment in the economy. In other words, government borrowing crowds out private investment. 2.3 CIRCULAR FLOW IN AN OPEN ECONOMY OR FOUR SECTOR ECONOMY Every economy has foreign economic relations involving exports and imports of goods and services, foreign investments, lending and borrowing. These activities bring in a fourth sector wherein we can express all the activities in the form of inflow and outflow of money. Though such monetary flows are in foreign exchange, we can convert them into domestic currencies. Exports of goods and services as well as foreign investments and borrowings result in the inflow of money. Similarly all the imports, investment abroad and lending to other countries lead to outflow of money. All the above activities are grouped under foreign sector, that is, the fourth sector, which is added to the existing three sector model. pm Four sector economy is an open economy where it deals with the rest of “the world. For the sake of simplicity we assume that only households and firms deal with the rest of the world. Both the sectors have exports and imports. The households export labour services and receive remittances. Similarly the firms export and import goods and services. Both households and firms will have a net export (X - M) showing the balance between the Teceipts and payments involved. Net exports could be positive or negative.14 Economics - Il (SYBMS, BFM, BBI : SEM-IV) i he magnitude of circular Taking net exports of both households and firms, tl gn Pe eal be tore if X > M, it will be less if X < M and the volume of circular flow will be left unaffected if X = M. The circular flow of income in a four sector (or open) economy is shown in Fig. 2.3. X-M HOUSEHOLDS Savings FINANCIAL MARKETS Factor Income Consumption Investment Fig. 2.3 The Fig. 2.3 explains a four sector, open economy model, where households and firms, financial markets, government and foreign sector have their activities. The circular flow of economic activities among the four sectors is shown in Fig. 2.3. If saving equals investment (S = I), government expenditure equals taxes (G =T) and exports equals imports (X = M), there will be equilibrium in all the sectors. Inan economy with government sector and foreign sector, the fundamental identity in an open economy will be Y=C+I+G+Nx sseseeseeneees (6) where G is government spending on purchases of goods and services and NX is net exports [exports (X) minus imports (M)] Since national income (Y) is either consumed (C), saved (S) or paid as taxes (T) to government, we have C+I+G+NX=C+S+T (7) In reality, however, in an economy there are numerous markets and several leakages, therefore it is almost impossible to have a simultaneous equilibrium in all the markets.circu ular Flow of Income 1 IMPORTANCE OF CIRCULAR FLOW ie | INCOME as os 1, Shows smooth functioning of the economy : The concept of circular flow gives a clear cut picture of the economy. From it we can know whether the economy is functioning efficiently or whether there is any disturbance in the smooth functioning of the economy. 2. Helps to know the problem of disequilibrium : With the help of circular flow we can study the problems of disequilibrium. It can also guide us in the restoration of equilibrium. 3. Helps to find out the leakages in the circular flow : The concept of circular flow enables us to find out the leakages in the form of saving, imports and taxes and their effects on income and expenditure. 4. Highlights the importance of monetary and fiscal policies : The study of circular flow highlights the importance of monetary and fiscal policies to bring about equality between income and expenditure. REVIEW QUESTIONS 1. Explain the concept of circular flow of income and expenditure in a closed economy. 2. Analyse the circular flow of income and expenditure in an open economy. 3. Write short notes on: (a) Circular flow of income in a two-sector economy (b) Circular flow of income in a three-sector economy (c) Circular flow of income in an open economy. 4. Explain the circular flow of income and bring out its importance. OBJECTIVE QUESTIONS A. Select the correct answer and rewrite the statement : 1. Which of the following type of economy deals with the rest of the world ? (a) Closed (b) Open (c) Only developed (d) Only developing2 16 Economics - II (SYBMS, BFM, BBI: SEM-IV) 2. Which of the following economy is in equilibrium when investment is equal to saving ? a) Closed (b) Open (c) Developing (d) Developed 3. Inwhich of the economy the leakages in the form of saving and taxes arise in the circular flow of income ? (a) Two-sector (b) Three-sector (c) Open (d) One-sector 4. Inacircular flow economy, firms supply (a) Labour (b) Goods and services (c) Land 5. Ina three sector economy, we do not include income expenditure of (a) Government (b) External sector (c) Household 6. The four sector circular flow economy does not include (a) World economy (b) Financial market (c) Crude oil reserves in oil wells Ans.: (1) - (b), (2) - (a), (3) - (b), (4) - (b), (5) - (b), (6) - () B. State whether the following statements are True or False : 1. Ina two sector economy there are no economic activities by the government. 2. Inacircular flow economy, $= I. 3. Households are the producers of goods and services. 4. Ina three sector economy, C+1+G=C+S4T. 5. Inthe open economy, the magnitude of circular flow is more if X P) then GNI will be greater than GDP. On the other hand, if net factor income from abroad is negative (that is R < P) then GNI will be less than GDP. GNI and GDP The distinction between the two measures is significant because incomes earned by domestic factors abroad are part of a country's GNI and not its GDP. Eventhough GNI is considered as a better measure of the welfare of citizens, most countries are interested in knowing how domestic policies and programmes lead to effects within national borders and therefore GDP is the measure of output that is generally used.Measurement of National Product 1 The distinction between GNI and GDP is given below. GNI GDP 1) It is the total money value IC is the total money value of of goods and services produced goods and services produced py the nationals during a given in the domestic territory of a ¢ country during a given year. ar. yes - 2) The income earned by It does not include the nationals whether inside or income earned by the outside the country is included nationals outside the country. inGNI. (3) The part of income All the income produced in the produced in the country but country by nationals or earned by foreigners is foreigners working in the excluded from GNI. country are included in GDP. (4) GNI will be larger than GDP will be larger than GNI if GDP if the people or firms of a much of the income froma country hold large amounts of country's production flows out the stocks and bonds of firms of the country, i.e., R< P. or governments of other countries and derive income from them, i.e., R > P. (6) GNI=C+1+G+(X-M) (Ge) GDP =C+1+G+(X-M) (3) Net National Product (NNI) and Net Domestic Product (NDP) The NNI and NDP are calculated by subtracting depreciation from GNI and GDP respectively. Depreciation is an allowance for the amount of capital that has been used up for the production of national output. Capital depreciation : In the process of production some capital such as equipment etc. are worn out, which is called depreciation or capital Consumption. Thus, in the calculation of national income some allowance should be made to replace the equipment worn out during the process of Peon (ie. depreciation). The investment made for the replacement ca a output capital does not lead to an increase in the productive recat in the economy. When no allowance is made for depreciation the a ing total is referred to as gross output, income or expenditure, and en an allowance is made for depreciation we arrive at net amount.os 22 ci Economics - Il (SYBMS, BFM, BBI: SEM-IV) Thus, NNI = GNI - Depreciation, and NDP = GDP - Depreciation. GNI NNI (1) It is the sum of money value of final goods and services produced by the country's factors during a given year. (2) GNI = GDP + net factor income from abroad. It is the net money value of final goods and services produced by the country's factors during a given period. NNI is calculated by subtracting depreciation from GNI. Thus, NNI =GNI - Depreciation. It gives the correct picture of the wealth of a nation. (3) It does not give the correct picture of the wealth of a nation. Real Vs Nominal GNI Real GNI refers to GNI at constant prices. It helps to capture the real growth of the economy. On the other hand, nominal GNI refers to GNI at current prices. When prices rise even if there is no real increase in the production of goods and services, the nominal GNI i.e. GNI at current prices will rise. Such an increase in GNI is not real growth. Thus, in order to know the real change inGNI, GNI at current prices is deflated (brought down) by using a price deflator (price index) or national income deflator. The deflated GNI is called GNI at constant prices. Nominal GNI GNI Deflator = —RealGNI x 100 (4) Gross Value Added (GVA) GVA is defined as the value of output less the value of intermediate consumption. Value added represents the contribution of labour and capital to production process. The gross value added (GVA) from different sectors was given at factor cost. Now the sectorwise estimates of gross value added (GVA) is givenat basic prices instead of factor cost. The relationship between GVA at basic prices, GVA at factor. cost and GDP at market prices is given below.—_—_ Measurement of National Product 23 GVA at Basic Prices =CE+OS/ MI + CFC + (Production taxes - Production subsidies) where, CE= Compensation of employees OS= Operating surplus MI= Mixed income CFC = Consumption of fixed capital Production taxes or subsidies are paid or received with relation to roduction and are independent of the volume of actual production. Some examples of production taxes are land revenues, stamps and registration fees and tax on profession. Some examples of production subsidies are subsidies to railways, input subsidies to farmers, subsidies to village and ‘small industries, etc. GvVAat Factor Cost =GVA at basic prices - (Production taxes - Production subsidies) CDP = 2 GVAat basic prices + Product taxes - Product subsidies where GDP refers to GDP at constant market prices. Product taxes or subsidies are paid or received on per unit of product. Some examples of product taxes are excise tax, sales tax, service tax and import and export duties. Many of them are now merged into GST. Examples of product subsidies are food, petroleum and fertilizer subsidies, interest subsidies given to farmers, households, etc. through banks, and subsidies for providing insurance to households at lower rates. 3.3 GREEN NATIONAL INCOME Meaning: ‘Green National Income measured as Green Gross Domestic Product or DP is an index of economic growth that measures the environmental effects on the growth of conventional GDP.’ It takes into account the environmental impact on a country’s economic srowth. For example, it measures, in terms of money, the loss of bio- diversity, the cost of climate change and pollution in the process ofSy 2 : Economics - II (SYBMS, BFM, BBI : SEM-Iv) Production of goods and services that are accounted for in the calculation : GDP. In other words, GGDP is conventional gross domestic product lgures adjusted for the environmental costs of economic activities. It is a Measure of how much a country is prepared for sustainable economic development. The concept of GGDP finds its origin in the works of economists like James Tobin and William Nordhaus* who were among the earliest to develop a growth model incorporating environmental changes. Eventually, the concept of GGDP got accepted as a policy initiative by many governments, Notable among these are the USA, Norway, China and India. In China, the first green GDP accounting report, for 2004, was published in September 2006. It showed that the financial loss caused by pollution was $66.3 billion or 3.05 percent of the GDP. These efforts of incorporating GGDP took a backseat during the financial crisis of 2007-08 and have not yet been Tevived. India began its GGDP initiative in 2009. The Ministry of Statistics and Programme Implementation set up an expert group in 2011 to work outa framework for green national accounts in India. The committee presented its report in 2013. Need for Green GDP: 1. Conventional measurements of national income, like GDP and GNP suffer from many limitations. These measurements can only calculate the gross output produced in an economy but do not evaluate the wealth and assets that a nation has. 2. A nation’s wealth and assets are used up in the process of output production, resulting in changes in the country’s future potential to produce. With the help of conventional measurements, there is no way of knowing whether the income generated in an economy is sustainable in the future or not. 3. Natural capital, that includes geology, soil, air, water and living beings, are not adequately considered as economic assets in traditional GDP measurement. The cost of using these resources is not accounted for. The positive externalities (benefits) of maintaining natural capital are also not considered, partly because it is very difficult to give monetary value to these assets and partly because governments fear that the resulting GDP data will reflect poorly on them. For example, the benefits of maintaining forest land or coastal resources to the "Is Growth Obsolete" : William D. Nordhaus and James Tobin, NBER, 1972.Measure ement of National Product 25 economy cannot be easily given money value and hence are not accounted for in the calculation of GDP. It is argued that Governments and firms generally do not make adequate provisions for the interest of the future generation in the srocess of creating national wealth. In order to achieve rapid growth and short-term profits, they cause rapid depletion of natural capital. Green GDP measurement can be used to bring in accountability towards the interest of the future generations. Due to several drawbacks of the conventional national income measurement, it has become necessary to have a more comprehensive macroeconomic indicator to indicate an economy’s potential in sustainable development and social well being. Conventional GDP has limited scope for indicating the state of social well being of the people. Calculation : The calculation of GGDP involves natural capital accounting. It is the process of calculating the total stocks and flow of natural resources and services in a given ecosystem of a region. The process of production results in consumption of natural capital (Net natural capital consumption). Therefore, in the calculation of GGDP, natural capital accounting is necessary. This process involves three steps: de Physical accounting determines the state, type and extent of resources over space and time. Both quantitative and qualitative accounting is done. For example, measuring forest cover and water resources in both quantitative and qualitative terms is a part of natural capital accounting. Monetary valuation of the natural capital is the next process. It is often a difficult process because many components of natural capital are not traded. For example, how does one put a monetary value tc the bio-diversity existing in mangroves located in urban areas? The net change in natural capital in monetary terms is then incorporated into the GDP to arrive at the GGDP. GGDP is measured using the following formula: GGDP = GDP - Cost of Net Natural Capital Consumption Cost of Natural Capital Consumptn includes: (i) Costs of natural resource consumption (ii) Costs of environmental depletionEconomics - II (SYBMS, BFM, BBI: SEM-IV) 26 Drawbacks / Criticisms emely important concept t fevery country, the concep These drawbacks make its practical applic It may be difficult to assign monetary values to some of the natural capital components. However, with advancement of technology, more and more accurate measurement is becoming possible. e to capture the economic and has it gives too much importance hat needs to be incorporated by tt of GGDP has some drawbacks, Though an extr ation somewhat difficult. policy makers 0! ks GGDP measures are often not abl social welfare aspect of GDP growt to environment factors alone. Some critics believe that the GGDP measures only account for depletion of natural resources but these measures cannot indicate the sustainability of the growth rate. nN 3.4 NATIONAL INCOME AND ECONOMIC WELFARE } ar “Economic welfare is the level of prosperity and standard of living of @ither an individual or a group of people. [It is also defined as the utility gained through achievement of material goods and services. Conventional measurements of national income accounting have been traditionally used to measure economic welfare. Economic welfare depends upon efforts made by governments to improve people's quality of life. This is done through spending on welfare through subsidies, investment in health, education, infrastructure and rural development. Around 1960s, the world began to face problems of environmental degradation, global inequality and economic underdevelopment in many countries. During this time many economists began to question the importance given by governments and agencies to national income accounting for estimating generation of economic welfare. In 1972, William Nordhaus and James Tobin introduced their Measure of Economic Welfare (MEW)* as an alternative to GDP. MEW adjusted national income to include the value of leisure time and the amount of unpaid work in an economy, hence increasing the welfare value of GDP. They also included the value of the environment damage caused by ———_—SSSSSSSSSSSSSSSSSSSSsssssseS * "Ig Growth Obsolete" : William D. Nordhaus and James Tobin, NBER, 1972.Measurement of National Product 27 industrial production and consumption, which reduced the welfare value of GDP. Relationship Between National Income and Welfare Economic welfare increases with increase in welfare spending by the overnment, provided the spending is distributed in the desired manner. ‘Anincrease in national income will generally lead to increased capacity of wernments to raise welfare spending and thus increase economic welfare. But direct relationship between national income and economic welfare is subject to the following conditions: Change in size of national income: When the size of the national income increases, people earn more income and consume more goods and services. This has a positive impact on welfare. On the other hand, a decrease in the size of the national income will have the opposite effect. Change in price level: National income is the market value of final goods and services produced. If the value of the national income rises due to inflation, it becomes difficult to measure the real changes in economic welfare. If prices rise without an increase in output, economic welfare will reduce because real income or purchasing power will fall. 1 3. Per capita income: The analysis of national income is incomplete without considering per capita income. If national income and population size change at the same rate, then the per capita income willremain the same. In sucha situation, there may not be any increase in welfare spending by the government. Thus, even though the national income has increased, economic welfare may not increase. 4. Expenditure pattern: With increase in national income, if peoplespend their rising income to acquire necessities like food, essentials, housing, education, transport services, then economic welfare will increase. If the increased income is used to spend on unproductive investments or for speculative investments, then welfare generation will be negatively impacted. 5. Production pattern: An increase in national income should be analysed by examining the production pattern. If the national income has increased due to increased defence production or production of luxury goods as compared to the production of essential goods and Services, then economic welfare will be negatively affected. 6. Changes in income distribution: Changes in national income bring about changes in income distribution. Income is transferred from theEconomics ~ 1 (SYBMS, BFM, BBI: SEM-IV) ec s ag and from the government to ant through taxes a a nle to the gov ernmer ding, If the rich are eae peor elfare spene a4 ' the people through ee it rill have a positive effect on economic a spending, se welfare spencing, increase We ae tionalising essential uusinesses, Na Dee slfare. Checks on monopoly be on luxury goods will increase services imposing een if most of the share of nationa| ‘ ‘ Onthe other 100 fit and the rich enj < generated through private oo Perecatively ae. era hen economic welfare W! lance between taxation a oe rmment has to maintain a ba ane eee ation ever, e govel ‘4 iV. y a" ea ue ending. Ifthe rich are taxed very He ee at aie and welfar ae and take their wealth outside. His in ie invetion and job creation and will oe ya =. less produc high-income groups need to meni welfare. Therefore, taxes on hig} 8) i i , production ani be rational in order to increase savings, investment, p d economic welfare. economic welfare. t ; Economies may experience growth Growth and employment ara promoting employment. It happens due to new and better technology which requires less labour. Currently India is growing at around 7 percent per annum but a slow increase in employment. Absence of employment leaves people with no income which reduces economic welfare. REVIEW QUESTIONS Ne Explain the meaning and features of national income. Explain the following concepts : (i) GNI (ii) GDP (iii) NNT Distinguish Between : (i) GNlIand GDP (ii) GNI and NNI Write notes : (i) Real and Nominal GNI (ii) GreenGDP (iii) National income and economic welfare Explain the concept of green national income. Discuss the need for green national income. Explain the calculation of GGDP and discuss its drawback Bring out the relationship between national income and economic—_ Meas? ement of National Product 29 OBJECTIVE QUESTIONS _ —_———————— i Select the correct answer and rewrite the statement : . 3. 4. J. What is the total money value of final goods and services produced within the domestic territory of the country during a given year ? (ay GDP (b) GNI (c) NNI (d) None of the above What is the total money value of the goods and services produced by the nationals during a given year ? ya) GNI (b) GDP («) NDP (d) None of the above GNI inan open economy is equal to (a) GDP +(X-M) by” GDP + (X-M) +R-P () GDP +(R-P) Which of the following formulas is used to calculate GGDP? (a) GDP + Net factor income from abroad (os) GDP+C+I+G (c) GDP- Depreciation (a) GDP - Net Natural Capital Consumption Which of the following will not result in increase in economic welfare when the national income increases? (a) Increase in subsidy spending by the government (b) Increased production in the defence sector at the cost of other sectors (c) Reduction in price level (d) Rational increase in taxes on the rich Which of the following is not a drawback of GGDP? (a) Provides an alternative to the conventional measures of national income (b) Cannot measure economic sustainability (c) Difficult to measure natural capital in terms of money (d) Not able to capture the economic welfare aspects of GDP Ans. (1) - (a), (2) - (a), (3) - (b), (4) - (a), (5) - (b), (6) - (a) B. State whether the following statements are True or False : X GDPis equal to the value of all final goods and services produced in 2. an economy ina given year. GDP ina eloséd economy is equal to C +1 + G + (X- M). 3. Inanopen economy GNI = C +1 + G+ (X- M) + (R- P).30 Economics - II (SYBMS, BFM, BBI : SEM-IV) 4. Income earned by foreigners is included in GNI. 5. GGDP=GDP - Cost of Net Natural Capital Consumption. 6. Environment damage reduces economic welfare. Ans.: True: 1, 3, 5,6; False: 2,4 Cc. Match the columns: Group A Group B 1. GDPinaclosed economy | (a) C+Il+G+(X-M) 2. GDP in open economy (b) GNlatconstant prices 3. NDP (c) GDP - Cost of Net Natural 4. R-P Capital Consumption 5. GGDP (d) GDP - Depreciation 6. Real GNI ~—|-(e) Net factor income from abroad i). C+I+G (g) GNI deflator Ans.; (1) - (Pp, (2) - (a), (3) - (d), (4) - (e), (5) - (0), (6) - (b)TRADE CYCLES 4.1 Meaning 4.2 Features of Trade Cycle 4.3 Phases of Trade Cycles 41 MEANING Trade cycle or business cycle is a part of economic system. The term trade cycle has been defined in various ways by different economists. According to Professor Estey: “Cyclical fluctuations are characterised by alternating waves of expansion and contraction. They do not have fixed rhythm, but they are cycles in that the phases of contraction and expansion recur frequently and in fairly similar patterns”. According to Keynes, “A trade cycle is composed of periods of good trade, characterised by rising prices and low unemployment percentages, altering with periods of bad trade characterised by falling prices and high unemployment percentages”. According to Burns and Mitchell, "Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organise their work mainly in business enterprises. A cycle consists of expansions occuring at about the same time in many economic activities, followed by similarly Seneral recessions, contractions and revivals which merge into the expansion phase of the next cycle; this sequence of changes is recurrent butoc 32 Economics - Il (SYBMS, BFM, BBI: SEM-Iv) not periodic; in duration business cycles vary from more than one year to ten or twelve years." A very simple definition is given by Samuelson and Nordhaus. According to them, "A business cycle is a swing in total national output, income anq employment, usually lasting for a period of 2 to 10 years, marked by widespread expansion or contraction in most sectors of the economy." As per above definitions, business conditions vary from time to time i.e, a period of prosperity is followed by recession and so on affecting GNP, employment, real incomes, price level, profits, etc. So in simple words trade cycles are upward and downward movements in output, prices, interest rates, employment, profits, real incomes, etc. They are essentially short. term phenomenon. It may be noted that the pattern of cycles is irregular. Any two trade cycles are not the same. 4.2 FEATURES OF TRADE CYCLE Generally economists divide trade cycles into two main phases, recession and expansion. Peaks and troughs mark the turning points of the cycles, The successive phases of the trade cycle is shown in Fig. 4.1. The downturn of a trade cycle is called a contraction or recession which is a period when economic activity is declining. The recession begins at a peak and ends at a trough. This is followed by expansion which begins at a trough and ends ata peak. The expansion is a period in which the level of economic activity is rising. The trough is the turning point where economic activity is at its lowest. On the other hand the peak is upper turning point where the level of economic activity is at its highest. 1. Burns and Mitchell, Measuring Business Cycles, National Bureau of Economic Research, New York, 1946, P. 1. 2. P. A. Samuelson and W. D. Nordhaus : Macroeconomics, 16th Edition, Irwit McGraw - Hill, 1998, P. 125.ee Trade CHE ‘les 33 ~< Level of Economic Activity ° i 2 4 Fig. 4.1 The important features of trade cycles are the following : Fluctuations in Aggregate Economic Activity : Trade cycles are fluctuations in the level of "aggregate economic activity" rather than fluctuations ina single, specific economic variable. It involves changes in many variables such as GDP, employment, investment, profits as well as financial market variables. 1, 2. Expansions and Contractions : Trade cycles are accompanied by expansions and contractions (or recession). The important characteristics of an expansion are : (i) Rising Consumption, Production and Real GDP : During expansion consumption expenditures rise sharply. As businessmen react with raising production, real GDP rises. Asa consequence, business investment in plant and machinery also rises sharply. (ii) Increase in Employment : The demand for labour increases during expansion. This leads to higher employment. (iii) Rise in Prices : As demand for goods and materials rise, their prices start rising. This may be accompanied by rise in wages and prices of services. Hence prices tends to rise during expansion. (iv) Rise in profits, demand for credit and stock prices : Business profits rise sharply during expansion. Anticipating this, stock prices rise as investors expect a business upturn. Since the™ Economics - Il (SYBMS, BFM, BBL: SEM-Iy, demand for credit rises sharply the interest rates may also Tise during expansion. The important features of a contraction (recession) are the opposite of that of expansion. They are : (i) Falling consumption, production and Read GDP : During recession consumer purchases decline sharply, while inventories of consumer durables increase unexpectedly. As businessmen react by cutting down production, real GDP falls. Consequently, business investment in plant and equipment also falls sharply (ii) Increase in unemployment: The demand for labour falls during contraction. This is followed by layoffs and higher unemployment. (iii) Fall in prices : As demand for goods and materials declines, their prices tumble. Wages and prices of services are not likely to decline, but they tend to rise less rapidly during economic downturns. Fall in profits, demand for credits and stock prices : Business profits fall sharply during recession. On the anticipation of this, stock prices fall usually. Since the demand for credit falls, the interest rates also fall during recession. (iv Peak : The expansionary process reaches a very high level of production known as the peak. It is a symptom of the end of the prosperity phase and the beginning of the contraction or the recession Trough : The trough is the tuning point where the economic activity is at its lowest. The contractionary forces come to a standstill known as trough. It is the end of the contractionary phase. The trough may be short-lived or may continue at the bottom for sometime. The forces at the trough pave the way for the revival of the economy. Comovement of Variables : The tendency of many economic variables to move together ina predictable way over the business cycle is called comovement of variables. Many economic variables such as output, employment, prices, investment, profits, stock prices, etc. have regular and predictable patterns of behaviour over the course of the business cycle. Generally, they tend to fall during recession and rise during expansions. Recurrent but not Periodic : The business cycle is not periodic. It does not occur at regular, predictable intervals and does not last fora fixed or predetermined length of time. Eventhough the pattern of cycleTrade Cycles 35 is irregular, it is recurrent, that is, the standard of pattern of contraction - trough - expansion - peak recurs again and again in industrial economies. ations / The ups and downs in the economy are reflected by the vari fluctuations in macro-economic variables suchas GNP, investments, profits, employment, wages etc. The variations in these magnitudes show hases of a business cycle. Generally expansion and recession are inacycle. But considering the intermediate stages between, ig. 4.2 shows the prices, different p' only two phases there are various phases, which are discussed below. Fi; different phases of trade cycles. Y: i Recession Steady Growth Path Level of Economic Activity 7 <— Time > Fig. 4.2 In Fig, 4.2 the line S is the steady growth path. A typical business cycle is greraly divided into four phases. The Fig. 4.2 shows that the cycle starts at the trough or low point and then it passes through a recovery and te ati phase, reaches to the peak. It then declines through a recession depression phase and reaches to trough. The four phases of the trade cycleas shown in Fig. 4.2 are : (1) Depression (2) Recovery (3) Prosperity and (4) Recession ‘complete cycle is measured from peak to peak or trough to trough. The T phases of a business cycle are explained below.36 Economics - Il (SYBMS, BFM, BBI: SEM-IV) 1. Depression A depression is a period of low economic activity. Growth rate Boss rele the steady growth. There is considerable reduction * he aes cen employment, income, investment, demand and price uring this Pt ase, Bank deposits and credit shrink due to general decline in economic ac ivity. Investment in stock becomes less profitable and least attractive. Business profits would be low or even negative. At the depth of depression all economic activities touch the bottom point called trough. The trough may be short lived or itmay continue fora long time. But gradually limiting forces are set in motion which tends to bring this to an end. Sometimes a major depression may last for nearly a decade and in some cases it may last for 3-4 years as The Great Depression of 1929. How is the process reversed ? The exact nature of the factors reversing the depression varies from cycle to cycle. Some of the factors are discussed below. i) The producers may offer jobs to workers anticipating better future. They try to maintain their capital stock. ii) Consumers may start purchasing - postponed consumption items expecting no further decline in prices leading to gradual increase in demand. ili) Banks and private investors start investing in securities and bonds from accumulated excess liquidity so stock prices begin to rise. iv) It should be noted that generally prices of inputs fall faster than that of finished products. Therefore, some profitability always remains there. It increases after the trough. As a result investment and employment increase which in turn increases output, income, demand etc. and the phase of recovery starts. v) Monetary and fiscal policies also lead to recovery. 2. Recovery Various exogenous and/or endogenous factors are responsible for reviving the economy. When the economy enters the phase of recovery, the economy registers upward trend in output, income, employment, etc. But the growth rate may still remain below the steady growth rate (see Fig. 4.2).—_ 37 Trade Cycles There may be a replacement of se i-durable goods or capital stock which iI] lead to increase in the demand. To meet this increased demand w d employment increase. Asaresult output and income also ‘ es cumulative. estment an Once the revival starts, the process becom of the recovery phase, output inv! 2 start to rise. be noted that in the early stages au Sigoa proportionate increase in the total costs a to eae capacity inthe economy. But later costs rise and output becomes less el Or yhich may result into rise in prices and profits. Business optimism pre : LA the recovery gathers momentum, some firms plan additional ty and some undertake renovation programme. This tends to raise the oe : for bank credits which leads to credit expansion. When the cumu ati come, employment, consumption expenditure, investment, ansion of ins prices etc. exceed the steady rate, the economy enters the phase of prosperity. It sh increa 3. Prosperity ee Increases in output, employment, investment demand, profits, bank loans, prices, standard of living, etc. are main features of the phase of prosperity. We can observe the following important features during this phase. i) Bankcredits grow rapidly eventhough rate of interest is higher. There is a general expansion of credit. ii) Idle funds are channelised into productive areas since stock prices are higher due to high profitability. iii) Money supply increases and it continues to flow in all kinds of economic activities. iv) Excess capacity gradually disappears creating shortage of labour and raw materials. After the full employment is achieved, a further increase in demand leads to an increase in prices. But factor remuneration like wages, interest rates, rents, taxes etc. do not rise in proportion to the rise in prices so business continues to remain profitable. This increases investment especially of inventories. Demand for bank credit increases. Inthis way, the expansionary process becomes cumulative and the economy reaches the Peak. an Peak point is generally characterised by stagnation in demand. This is hae of the highest level of prosperity in which increase in demand is i led. It is the end of prosperity and beginning of the recession. Factors e Shortage of inputs, rise in prices, rise in interest rate, stagnant demand