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
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
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.
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
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
 ● 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.
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 (NVA​FC​). And to calculate the
(NVA​FC​), 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 ((NVA​FC​) 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 NVA​FC​ of all enterprises of an industry, we get the

net value added at factor cost for that industry. And by adding the
NVA​FC​ of all industries, we get the net domestic product at factor
cost, which is represented as NDP​FC​. 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 = (NDPF​ C)​ + 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
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
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
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
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
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
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
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

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
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)

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
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.