Definition

Economics is the study of scarcity and choice.

Scarcity means that there is a finite amount of a good or service (Basically they are limited).
Because something is limited, we need to make decisions regarding how we use and allocate
our resources.
So studying economics helps use to better make decisions regarding how to deal with the
condition of scarcity.
Also, you should know the difference between scarcity and shortage. Shortage is a short term
condition of a limited amount of a resource. For example, if there is a frost in Florida and the
orange crop is destroyed, the supply of oranges will be limited, but only for that growing
season.

 Meaning of Economics:
The word Economics' originates from the Greek word ‘Oikonomikos’
(a) ‘Oikos’, which means ‘Home’, and
(b) ‘Nomos’, which means ‘Management’.
Thus, Economics means ‘Home Management’

 Economist:
Adam Smith, Known as ‘Father of Economics’
Book name- ‘An Enquiry into the Nature and Causes Wealth of Nation’, 1776.

 Basic Problems of an Economy:

(1) Unlimited human wants,
(2) Limited availability of resources to satisfy those wants, and
(3) Fulfilment of unlimited wants with limited resources.

 Problems come up:

Scarcity of resources: ‘want is a desire to acquire something with the willingness to put in
an effort to acquire it.’

 Opportunity Cost
One of the most important aspects of choice in Economics is the idea that every choice has
trade-off what didn’t you choose. This is related to the concept of opportunity cost.
Opportunity Cost is your second choice-what you give up when you make a decision. For
example, if you choose to go to college, you give up the salary you could have earned if you
go directly into the work force. The salary you would give-up is the opportunity cost of going
to college.
Another example, you spend time and money going to a movie, you cannot spend that time at
home reading a book, and you cannot spend the money on something else. If your next-best
alternative to seeing the movie is reading the book, then the opportunity cost of seeing the
movie is the money spent plus the pleasure you forgo by not reading the book
Remember that Economics is the study of scarcity and choice. The concept of opportunity
cost is an important element in economic choices.

 Basic Economic Problem:

Societies need to determine how to put all of the factors of production together to best deal
with the issue of scarcity. To do this they need to address these Basic Economic Questions:
1. What to Produce
What does a society do when the resources are limited? It decides which goods/service it
wants to produce. Further, it also determines the quantity required. For example, should we
produce more guns or more butter? Do we opt for capital goods like machines, equipment,
etc. or consumer goods like cell phones, etc.? While it sounds elementary, society must
decide the type and quantity of every single good/service to be produced.
2. How to Produce
The production of a good is possible by various methods. For example, you can produce
cotton cloth using handlooms, power looms or automatic looms. While handlooms require
more labour, automatic looms need higher power and capital investment.
Hence, society must choose between the techniques to produce the commodity. Similarly, for
all goods and/or services, similar decisions are necessary. Further, the choice depends on the
availability of different factors of production and their prices. Usually, a society opts for a
technique that optimally utilizes its available resources
3. For whom to Produce
Think about it – can a society satisfy each and every human wants? Certainly not. Therefore,
it has to decide on who gets what share of the total output of goods and services produced. In
other words, society decides on the distribution of the goods and services among the
members of society.
  The Factors of Production
In order to better understand how we make decisions regarding scarcity and choice, it is
important to understand how goods and services are produced. This is where the concept of
the factors of production comes in.
The Factors of Production are classified into four categories:
1. Land or Natural Resources
which are products used in the production of goods and services, come from the earth.
Examples could include lumber or oil. Natural resources can be characterized as either:
Renewable resources are resources that can be replenished, such as trees that can be
replanted. Nonrenewable resources are resources that cannot be replaced such as coal.
2. Labor or Human Resources
is the work that goes into the production of a good or service. When looking at this factor,
we usually look at the number or workers and the workers’ skills.
3. Capital
Capital is the term used for the items that are used to create a good or service. Examples of
this may include the building where a good is produced, or the tools utilized to create a good
or provide a service.
4. Entrepreneurship
Entrepreneurship is the putting together of land labor and capital to create a good or provide a
service. This is basically the ideas that go into the process of creating a good or providing a
service.

 Division of Economics

A. Micro Economics- the behavior of individual economic agents in the markets for
different goods and services and try to figure out how prices and quantities of goods
 and services are determined through the interaction of individuals in these markets.
Examples- demand, supply, factor pricing.

B. Macro Economics- an understanding of the economy as a whole by focusing our

attention on aggregate measures such as total output, employment and aggregate price
level.

 Difference between Economics and Economy

� Economics-Economics is the science and art of decision making, regarding the use of
scarce resources, under the conditions of scarcity, to attain maximum satisfaction.
� Economy- When a country or a geographical region is defined in the context of its
economic activities, it is known as economy or economic system.
  Economic System

1. Market Economy/ Capitalism- It is the economic system where all sorts of economic
problems are automatically solved through market mechanisms of supply and demand.
Capitalism or capitalist economy is referred to as the economic system where the factors of
production such as capital goods, labour, natural resources, and entrepreneurship are
controlled and regulated by private businesses.
� Features-
� Private property
� Freedom of enterprise
� Profit motive
� Price mechanism

2. Socialist Economy-If all the economic problems are corrected through economic
planning undertaken by the government, then that economic system is called centrally
planned economy or Socialist Economy .
� Features-
� Working class assumes the political power
� Restrictions on economic liberty
� Absence of market mechanism
� Absence of right to property

3. Mixed Economy-There is a type of economy which neither capitalistic nor socialistic

in nature but co-exist of both.
� Features-
� Partial restriction on individual liberty.
� Co-existence of private and public sector.
  Sectors of Economy
Tries to maximize return of Economic activities in which its in involved.

1. Primary Sector: In Primary sector of economy, activities are undertaken by directly using
natural resources. Agriculture, Mining, Fishing, Forestry, Dairy etc. are some examples
of this sector.
It is called so because it forms the base for all other products. Since most of the natural
products we get are from agriculture, dairy, forestry, fishing, it is also called Agriculture and
allied sector.
People engaged in primary activities are called red-collar workers due to the outdoor nature
of their work.
2. Secondary Sector: It includes the industries where finished products are made from
natural materials produced in the primary sector. Industrial production, cotton fabric,
sugar cane production etc. activities comes under this sector.
Hence its the part of a country's economy that manufactures goods, rather than producing raw
materials.
Since this sector is associated with different kinds of industries, it is also called industrial
sector.
People engaged in secondary activities are called blue collar workers.
3. Tertiary Sector: This sector’s activities help in the development of the primary and
secondary sectors. By itself, economic activities in tertiary sector do not produce a goods but
they are an aid or a support for the production.
Goods transported by trucks or trains, banking, insurance, finance etc. come under the
sector. It provides the value addition to a product same as secondary sector.
This sector jobs are called white collar jobs.
1. Demand
Demand is the amount of a product that consumers are willing and able to purchase at any
given price. It is assumed that this is effective demand, i.e. it is backed by money and an
ability to buy.
The law of demand states that the higher the price, the lower the quantity demanded; and the
lower the price, the higher the quantity demanded. Naturally, consumers are willing and able
to buy less as the price rises. This results in a downward sloping demand curve.

Determinants of Demand:
The factors that affect demand curve are as follows:
 Price.
 Income
 Teste and Preference
 Change in the price of other goods.
 Population

 Movement along the demand curve

Change in price effect

 Shifts in Demand curve

The demand curve can shift outward (to the right) or inward (to the left). If the demand curve
shifts out, this means that more is demanded at each price level. This increase in demand is
shown by the shift to a new demand curve, D1 in the diagram. An inward shift to a new curve
at D2 indicates a decrease in demand – this indicates that less is demanded at each price level.
Factors that affect shift in the demand curve
 Firstly, an increase in consumers’ incomes is likely to shift a demand curve to the
right for most normal and luxury goods. With more disposable income people buy
more of the things they want. So as incomes increase, the demand for cars, holidays,
consumer electronics etc. also increases. A fall in incomes will cause the demand
curve to shift inwards and to the left – demand decreases.
 A change in tastes and fashion can also shift the demand curve. If goods become
more fashionable the demand curve shifts to the right, increasing demand at all price
levels. If goods go out of fashion, the demand curve shifts to the left.
 Change in the price of other goods:
o Complimentary goods are those used alongside another good. For example, if
demand for holidays increases, demand for luggage or perhaps suntan lotion
will also increase. A change in the price of substitute goods will also shift the
demand curve.
o A substitute is a good used instead of another good. For example, if train
fares increase some people will switch to private transport and travel by car.
This may lead to an increase in the demand for petrol, shifting the demand
curve for petrol to the right. If the price of airline tickets were to increase, then
it is likely that demand for holidays at home in the UK would increase.
 A successful advertising campaign can cause the demand curve for a product to shift
to the right. However, bad publicity will have the opposite effect and cause a shift to
the left.
 Government legislation may also have an impact on the demand for certain products.
When legislation was passed making child seats compulsory in vehicles there was a
significant increase in demand at any given price.
 Technological changes: Better technology and innovations will lead to production of
new goods and services which are more efficient. Hence the demand for new goods
will increase. They will replace old goods and services.
  Number of Buyers and size of the market: The more the buyers in the market ,
larger is the demand; fewer buyers lead to decrease. A large market, spread over a
vast area ensures higher demand.
 Changes in the size of population : When the size of population increases the
demand for various goods and services will go up and vice versa. Growth in
population leads to higher demand for basic commodities like food, clothing and
shelter and over a period of time, for comfort goods like television sets and cars.

 Difference between types of goods

Normal goods-
Law of demand states that if price of product increases demand for this kind of goods
decreases, other things remaining unchanged.
Law of supply states that if price of product increases supply for this kind of goods increases,
other things remaining unchanged.
Substitute goods-
The goods which can be consumed alternatively having similar utility are called substitute
goods. In this case, If price of a product increases, demand for its substitute increases. For
example- Tea and Coffee are considered to be substitute goods of each other in Economics.
Complementary goods-
The goods which are usually consumed together are called complementary goods. For
example, Tea and coffee; Bread and Butter etc.

Exceptions to the law of demand

The law of demand does not apply in every case and situation. The circumstances when the
law of demand becomes ineffective are known as exceptions of the law. Some of these
important exceptions are as under.
 Giffen goods:
Some special varieties of inferior goods are termed as Giffen goods. Cheaper varieties of
this category like bajra, cheaper vegetable like potato come under this category. Sir Robert
Giffen of Ireland first observed that people used to spend more their income on inferior goods
like potato and less of their income on meat. But potatoes constitute their staple food. When
the price of potato increased, after purchasing potato they did not have so many surpluses to
buy meat. So the rise in price of potato compelled people to buy more potato and thus raised
the demand for potato. This is against the law of demand. This is also known as Giffen
paradox.
 Conspicuous Consumption – Goods of Snob Appeal:
 This exception to the law of demand is associated with the doctrine propounded by
Thorsten Veblen. A few goods like diamonds etc are purchased by the rich and wealthy
sections of the society. The prices of these goods are so high that they are beyond the reach of
the common man. The higher the price of the diamond the higher the prestige value of it. So
when price of these goods (also called as Veblen goods) falls, the consumers think that the
prestige value of these goods comes down. So quantity demanded of these goods falls with
fall in their price. So the law of demand does not hold good here.
 Change in fashion:
A change in fashion and tastes affects the market for a commodity. When a broad toe shoe
replaces a narrow toe, no amount of reduction in the price of the latter is sufficient to clear
the stocks. Broad toe on the other hand, will have more customers even though its price may
be going up. The law of demand becomes ineffective.
 Emergencies:
Emergencies like war, famine etc. negate the operation of the law of demand. At such
times, households behave in an abnormal way. Households accentuate scarcities and induce
further price rises by making increased purchases even at higher prices during such periods.
During depression, on the other hand, no fall in price is a sufficient inducement for
consumers to demand more.

2. Supply
Supply is the amount of a product which suppliers will offer to the market at a given price.

As the price of an item goes up, suppliers will attempt to maximize their profits by increasing
the quantity offered for sale. This means that the lower the price, the lower the quantity
supplied; and the higher the price, the higher the quantity supplied. At low price levels only
the most efficient suppliers can make a profit so supply is limited. As price increases, the
profit motive attracts new resources to supply and the higher price allows less efficient
producers to make a profit. So as price increases, supply increases.
Explaining the Law of Supply
There are three main reasons why supply curves for most products are drawn as sloping
upwards from left to right giving a positive relationship between the market price and
quantity supplied:
 The profit motive: When the market price rises (for example after an increase in
consumer demand), it becomes more profitable for businesses to increase their output.
Higher prices send signals to firms that they can increase their profits by satisfying
demand in the market.
 Production and costs: When output expands, a firm’s production costs rise, therefore a
higher price is needed to justify the extra output and cover these extra costs of
production.
 New entrants coming into the market: Higher prices may create an incentive for other
businesses to enter the market leading to an increase in supply.

Determinants of Supply:
 Price
 Change in costs
 Weather
 Introduction of New Technology
 Lagislation

 Movements along the supply curve

Change in Price effect

 Shifts in Supply Curve

Like demand, supply can also change – independent of any change in price. Supply at each
price level can increase (shift outwards to S2) or the amount supplied at each price level can
decrease (shift inwards to S1).
Factors that affect supply
 Change in costs: If producers’ costs fall resulting from a factor such as a fall in the
price of raw materials or cost of labour, this will increase supply, shifting the supply
curve outwards and to the right. Now at each price level more is supplied. Rising
costs will have the opposite effect and shift the supply curve inwards and to the left.
 Weather: can have a significant impact on the supply of agricultural products.
Increased output is likely to result from a good harvest – this again shifts the supply
curve outwards and to the right. Bad weather, of course, has the opposite effect.
 Introduction of new technology: especially in production techniques, also increases
supply: this increase in productivity shifts the supply curve outwards and to the right.
 Legislation: can also have a significant impact on the supply of some products.
Increasingly businesses find their costs are increasing because they have to comply
with new anti-pollution legislation introduced by the government. This shifts the
supply curve inwards and to the left. When the government imposes a tax on a good
or service, this too will cause the supply curve to shift to the left.
Exceptions to the law of supply
There are situations when the law of supply – that as price increases supply also crease- does
not hold.
 Backward bending labour supply curve:
The rise in the price of a good or service sometimes leads to a fall in its supply. The best
example is the supply of labor. A higher wage rate enables the worker to maintain his
existing material standard of living with less work, and he may prefer extra leisure to more
wages. The supply curve in such a situation will be ‘backward sloping’ SS 1 as illustrated in
figure.
Equilibrium in demand and supply:
The dictionary definition of 'equilibrium' is 'a state of physical balance', or put more simply,
'a state of rest'.
In microeconomics, supply and demand is an economic model of price determination in
a market.
It concludes that in a competitive market, the unit price for a particular good will vary until it
settles at a point where the quantity demanded by consumers (at current price) will equal the
quantity supplied by producers (at current price), resulting in an economic equilibrium for
price and quantity.

 In the diagram, the supply curve S and the demand curve D intersect at point E.
 Point E is thus the point at which both, the demand for the good and the supply of it
‘clears’.
 Point E corresponds a particular price (OP) and a particular quantity (OQ) at which
D=S
 Thus, ‘Equilibrium’ is defined to be the price-quantity pair where the quantity
demanded is equal to the quantity supplied, represented by the intersection of the
demand and supply curve.

Disequilibrium points..
  Equilibrium point E (where D=S), equilibrium price is P* and quantity, Q*.
 At any point other than point E where the curves intersect, there is a disequilibrium –
either surplus of supply in relation to demand or vice versa.
 When there is excess supply of a good in relation to demand, price will tend to fall
(from P1 to Pe)
 Converse when there is excess demand of a good in relation to its supply, price will
tend to rise (from P2 to Pe)
 The four basic laws of supply and demand are (A recap):
 If demand increases (demand curve shifts to the right) and supply remains unchanged,
a shortage occurs, leading to a higher equilibrium price.
 If demand decreases (demand curve shifts to the left) supply remains unchanged, a
surplus occurs, leading to a lower equilibrium price.
 If demand remains unchanged and supply increases (supply curve shifts to the right),
a surplus occurs, leading to a lower equilibrium price.
 If demand remains unchanged and supply decreases (supply curve shifts to the left), a
shortage occurs, leading to a higher equilibrium price.
3. Common Types of Market Structures
A market structure is an economic environment where a business operates. The market
structure can describe how competitive the industry is by considering factors like how
challenging it is to enter the industry and how many sellers participate. It also considers
relationships between companies and customers to show how prices fluctuate.
Features of market structures
 Some of the features that go into market structure consideration include:
 Seller entry barriers, or how hard it is for a new company to emerge within the market
 Seller exit barriers, or how hard it is for a new company to leave the market
 The degree to which company products are homogeneous or differentiated
 Number of companies in the market
 Number of customers who participate in the market
 Product prices
4 types of market structures
Here are the four main types of market structures:

A. Perfect Competition: Perfect competition is a unique form of the marketplace that allows
multiple companies to sell the same product or service. Many consumers are looking to
purchase those products. None of these firms can set a price for the product or service they
are selling without losing business to other competitors. There are no barriers to any firm that
is looking to enter or exit the market. The final output from all sellers is so similar that
consumers cannot differentiate the product or service of one company from its competitors.
o Features of Perfect Competition
The main features of perfect competition are as follows:
1. Many Buyers and Sellers
2. Homogeneity
3. Free Entry and Exit
4. Perfect Knowledge
5. Mobility of Factors of Production
6. Transport Cost
7. Absence of Artificial Restrictions
8. Uniform Price: Price taker.

B. Monopoly: A marketplace in which there is a lone vendor or seller is known as a

monopoly. However, there are certain conditions to be fulfilled for it. A monopolistic
competition market structure requires a lone manufacturer of a particular good.
There cannot be an alternative for this good, and for this situation to continue over time,
adequate constraints are maintained to stop any other enterprise from entering the
marketplace and start selling the good.
o Features of Monopoly Market
1. Maximise profit: It is an important reason why a company wants to be in a monopoly
market. The company strives to generate and secure not only the revenue but also to
maximise the profit.
2. Price maker: The monopoly players have the authority to fix and plan the price of goods.
In this market, the firm has the sole right to influence the market rate and has the pricing
power. Here, the price is modified according to the demand and supply of goods in the
market.
3. High competition: A monopoly market has high barriers for new players or participants to
enter. Sometimes, high competition makes it difficult for participants of the monopoly market
to make less profits.
4. No Free entry or exit.

C. Oligopoly: An oligopolistic market structure contains a few large sellers that sell to many
consumers. It's challenging to enter the industry because of factors like high startup costs and
patents, but an oligopoly is easier to enter than a monopoly.
Features of Monopoly Market
1. Interdependence: The foremost characteristic of oligopoly is interdependence of the
various firms in the decision making.
2. Advertising.
3.Competition.
4. Barriers to Entry of Firms.
5. Lack of Uniformity.
6. Existence of Price Rigidity.

D. Monopolistic Competitive: A monopolistic competition market structure features many

sellers, meaning that it's easy to enter the industry. Combining aspects of a monopoly and
competitive market, companies within a monopolistic structure can sell products that are
similar but feature slight differences. This allows them to have a small amount of market
power based on how they differentiate products.
Features of Monopolistic Competitive Market:
 Large Number of Buyers and Sellers.
 Free Entry and Exit of Firms.
 Product Differentiation.
 Selling Costs.
 Lack of Perfect Knowledge.
 Less Mobility.
 More Elastic Demand.
 Chapter 1
Introduction
You must have already been introduced to a study of basic
microeconomics. This chapter begins by giving you a
simplified account of how macroeconomics differs from the
microeconomics that you have known.
Those of you who will choose later to specialise in
economics, for your higher studies, will know about the
more complex analyses that are used by economists to
study macroeconomics today. But the basic questions of
the study of macroeconomics would remain the same and
you will find that these are actually the broad economic
questions that concern all citizens – Will the prices as a
whole rise or come down? Is the employment condition of
the country as a whole, or of some sectors of the economy,
getting better or is it worsening? What would be reasonable
indicators to show that the economy is better or worse?
What steps, if any, can the State take, or the people ask
for, in order to improve the state of the economy? These
are the kind of questions that make us think about the
health of the country’s economy as a whole. These
questions are dealt within macroeconomics at different
levels of complexity.
In this book you will be introduced to some of the basic
principles of macroeconomic analysis. The principles will
be stated, as far as possible, in simple language.
Sometimes elementary algebra will be used in the
treatment for introducing the reader to some rigour.
If we observe the economy of a country as a whole it will
appear that the output levels of all the goods and services
in the economy have a tendency to move together. For
example, if output of food grain is experiencing a growth, it
is generally accompanied by a rise in the output level of
industrial goods. Within the category of industrial goods
also output of different kinds of goods tend to rise or fall
simultaneously. Similarly, prices of different goods and
services generally have a tendency to rise or fall
simultaneously. We can also observe that the employment
level in different production units also goes up or down
together.
If aggregate output level, price level, or employment
level, in the different production units of an economy,

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 bear close relationship to each other then the task of analysing the
entire economy becomes relatively easy. Instead of dealing with the
above mentioned variables at individual (disaggregated) levels, we
can think of a single good as the representative of all the goods and
services produced within the economy. This representative good will
have a level of production which will correspond to the average
production level of all the goods and services. Similarly, the price or
employment level of this representative good will reflect the general
price and employment level of the economy.
In macroeconomics we usually simplify the analysis of how the
country’s total production and the level of employment are related to
attributes (called ‘variables’) like prices, rate of interest, wage rates,
profits and so on, by focusing on a single imaginary commodity and
what happens to it. We are able to afford this simplification and thus
usefully abstain from studying what happens to the many real
commodities that actually are bought and sold in the market because
we generally see that what happens to the prices, interests, wages and
profits etc. for one commodity more or less also happens for the others.
Particularly, when these attributes start changing fast, like when prices
are going up (in what is called an inflation), or employment and
production levels are going down (heading for a depression), the general
directions of the movements of these variables for all the individual
commodities are usually of the same kind as are seen for the aggregates
for the economy as a whole.
We will see below why, sometimes, we also depart from this useful
simplification when we realise that the country’s economy as a whole
may best be seen as composed of distinct sectors. For certain purposes
the interdependence of (or even rivalry between) two sectors of the
economy (agriculture and industry, for example) or the relationships
between sectors (like the household sector, the business sector and
2 government in a democratic set-up) help us understand some things
happening to the country’s economy much better, than by only looking
Introductory Macroeconomics

at the economy as a whole.

While moving away from different goods and focusing on a
representative good may be convenient, in the process, we may be
overlooking some vital distinctive characteristics of individual goods.
For example, production conditions of agricultural and industrial
commodities are of a different nature. Or, if we treat a single category
of labour as a representative of all kinds of labours, we may be unable
to distinguish the labour of the manager of a firm from the labour of the
accountant of the firm. So, in many cases, instead of a single
representative category of good (or labour, or production technology),
we may take a handful of different kinds of goods. For example, three
general kinds of commodities may be taken as a representative of all
commodities being produced within the economy: agricultural goods,
industrial goods and services. These goods may have different production
technology and different prices. Macroeconomics also tries to analyse
how the individual output levels, prices, and employment levels of these
different goods gets determined.
From this discussion here, and your earlier reading of
microeconomics, you may have already begun to understand in what

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way macroeconomics differs from microeconomics. To recapitulate briefly,
in microeconomics, you came across individual ‘economic agents’ (see
box) and the nature of the motivations that drive them. They were
‘micro’ (meaning ‘small’) agents – consumers choosing their respective
optimum combinations of goods to buy, given their tastes and incomes;
and producers trying to make maximum profit out of producing their
goods keeping their costs as low as possible and selling at a price as
high as they could get in the markets. In other words, microeconomics
was a study of individual markets of demand and supply and the ‘players’,
or the decision-makers, were also individuals (buyers or sellers, even
companies) who were seen as trying to maximise their profits (as
producers or sellers) and their personal satisfaction or welfare levels
(as consumers). Even a large company was ‘micro’ in the sense that it
had to act in the interest of its own shareholders which was not
necessarily the interest of the country as a whole. For microeconomics
the ‘macro’ (meaning ‘large’) phenomena affecting the economy as a
whole, like inflation or unemployment, were either not mentioned or
were taken as given. These were not variables that individual buyers or
sellers could change. The nearest that microeconomics got to
macroeconomics was when it looked at General Equilibrium, meaning
the equilibrium of supply and demand in each market in the economy.

Economic Agents
By economic units or economic agents, we mean those individuals
or institutions which take economic decisions. They can be
consumers who decide what and how much to consume. They may
be producers of goods and services who decide what and how much
to produce. They may be entities like the government, corporation,
banks which also take different economic decisions like how much
to spend, what interest rate to charge on the credits, how much to 3
tax, etc.

Introduction
Macroeconomics tries to address situations facing the economy as a
whole. Adam Smith, the founding father of modern economics, had
suggested that if the buyers and sellers in each market take their
decisions following only their own self-interest, economists will not need
to think of the wealth and welfare of the country as a whole separately.
But economists gradually discovered that they had to look further.
Economists found that first, in some cases, the markets did not or
could not exist. Secondly, in some other cases, the markets existed
but failed to produce equilibrium of demand and supply. Thirdly, and
most importantly, in a large number of situations society (or the State,
or the people as a whole) had decided to pursue certain important
social goals unselfishly (in areas like employment, administration,
defence, education and health) for which some of the aggregate effects
of the microeconomic decisions made by the individual economic agents
needed to be modified. For these purposes macroeconomists had to
study the effects in the markets of taxation and other budgetary
policies, and policies for bringing about changes in money supply, the
rate of interest, wages, employment, and output. Macroeconomics has,

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 Adam Smith

Adam Smith is regarded as the founding

father of modern economics (it was known
as political economy at that time). He was
a Scotsman and a professor at the
University of Glasgow. Philosopher by
training, his well known work An Enquiry
into the Nature and Cause of the Wealth
of Nations (1776) is regarded as the first
major comprehensive book on the subject.
The passage from the book. ‘It is not from
the benevolence of the butcher, the brewer,
of the baker, that we expect our dinner,
but from their regard to their own interest.
We address ourselves, not to their
humanity but to their self-love, and never talk to them of our own
necessities but of their advantage’ is often cited as an advocacy for
free market economy. The Physiocrats of France were prominent
thinkers of political economy before Smith.

therefore, deep roots in microeconomics because it has to study the

aggregate effects of the forces of demand and supply in the markets.
However, in addition, it has to deal with policies aimed at also
modifying these forces, if necessary, to follow choices made by society
outside the markets. In a developing country like India such choices
have to be made to remove or reduce unemployment, to improve
4 access to education and primary health care for all, to provide for
good administration, to provide sufficiently for the defence of the
Introductory Macroeconomics

country and so on. Macroeconomics shows two simple characteristics

that are evident in dealing with the situations we have just listed.
These are briefly mentioned below.
First, who are the macroeconomic decision makers (or ‘players’)?
Macroeconomic policies are pursued by the State itself or statutory
bodies like the Reserve Bank of India (RBI), Securities and Exchange
Board of India (SEBI) and similar institutions. Typically, each such
body will have one or more public goals to pursue as defined by law
or the Constitution of India itself. These goals are not those of
individual economic agents maximising their private profit or welfare.
Thus the macroeconomic agents are basically different from the
individual decision-makers.
Secondly, what do the macroeconomic decision-makers try to do?
Obviously they often have to go beyond economic objectives and try
to direct the deployment of economic resources for such public needs
as we have listed above. Such activities are not aimed at serving
individual self-interests. They are pursued for the welfare of the
country and its people as a whole.

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1.1 EMERGENCE OF MACROECONOMICS
Macroeconomics, as a separate branch of economics, emerged after the
British economist John Maynard Keynes published his celebrated book
The General Theory of Employment, Interest and Money in 1936. The
dominant thinking in economics before Keynes was that all the labourers
who are ready to work will find employment and all the factories will be
working at their full capacity. This school of thought is known as the
classical tradition.

John Maynard Keynes

John Maynard Keynes, British
economist, was born in 1883.
He was educated in King’s
College, Cambridge, United
Kingdom and later appointed
its Dean. Apart from being a
sharp intellectual he actively
involved in international
diplomacy during the years
following the First World War.
He prophesied the break down
of the peace agreement of the
War in the book The Economic
Consequences of the Peace
(1919). His book General
Theory of Employment,
Interest and Money (1936) is
regarded as one of the most 5
influential economics books of the twentieth century. He was

Introduction
also a shrewd foreign currency speculator.

However, the Great Depression of 1929 and the subsequent years

saw the output and employment levels in the countries of Europe
and North America fall by huge amounts. It affected other countries
of the world as well. Demand for goods in the market was low, many
factories were lying idle, workers were thrown out of jobs. In USA,
from 1929 to 1933, unemployment rate rose from 3 per cent to
25 per cent (unemployment rate may be defined as the number of
people who are not working and are looking for jobs divided by the
total number of people who are working or looking for jobs). Over the
same period aggregate output in USA fell by about 33 per cent. These
events made economists think about the functioning of the economy
in a new way. The fact that the economy may have long lasting
unemployment had to be theorised about and explained. Keynes’ book
was an attempt in this direction. Unlike his predecessors, his approach
was to examine the working of the economy in its entirety and examine
the interdependence of the different sectors. The subject of
macroeconomics was born.

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 1.2 CONTEXT OF THE PRESENT BOOK OF MACROECONOMICS
We must remember that the subject under study has a particular
historical context. We shall examine the working of the economy of a
capitalist country in this book. In a capitalist country production
activities are mainly carried out by capitalist enterprises. A typical
capitalist enterprise has one or several entrepreneurs (people who
6 exercise control over major decisions and bear a large part of the risk
associated with the firm/enterprise). They may themselves supply the
Introductory Macroeconomics

capital needed to run the enterprise, or they may borrow the capital. To
carry out production they also need natural resources – a part consumed
in the process of production (e.g. raw materials) and a part fixed (e.g.
plots of land). And they need the most important element of human
labour to carry out production. This we shall refer to as labour. After
producing output with the help of these three factors of production,
namely capital, land and labour, the entrepreneur sells the product in
the market. The money that is earned is called revenue. Part of the
revenue is paid out as rent for the service rendered by land, part of it is
paid to capital as interest and part of it goes to labour as wages. The
rest of the revenue is the earning of the entrepreneurs and it is called
profit. Profits are often used by the producers in the next period to buy
new machinery or to build new factories, so that production can be
expanded. These expenses which raise productive capacity are examples
of investment expenditure.
In short, a capitalist economy can be defined as an economy in
which most of the economic activities have the following characteristics
(a) there is private ownership of means of production (b) production
takes place for selling the output in the market (c) there is sale and
purchase of labour services at a price which is called the wage rate (the

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labour which is sold and purchased against wages is referred to as
wage labour).
If we apply the above mentioned four criteria to the countries of
the world we would find that capitalist countries have come into
being only during the last three to four hundred years. Moreover,
strictly speaking, even at present, a handful of countries in North
America, Europe and Asia will qualify as capitalist countries. In many
underdeveloped countries production (in agriculture especially) is
carried out by peasant families. Wage labour is seldom used and
most of the labour is performed by the family members themselves.
Production is not solely for the market; a great part of it is consumed
by the family. Neither do many peasant farms experience significant
rise in capital stock over time. In many tribal societies the ownership
of land does not exist; the land may belong to the whole tribe. In
such societies the analysis that we shall present in this book will
not be applicable. It is, however, true that many developing countries
have a significant presence of production units which are organised
according to capitalist principles. The production units will be called
firms in this book. In a firm the entrepreneur (or entrepreneurs) is
at the helm of affairs. She hires wage labour from the market, she
employs the services of capital and land as well. After hiring these
inputs she undertakes the task of production. Her motive for
producing goods and services (referred to as output) is to sell them
in the market and earn profits. In the process she undertakes risks
and uncertainties. For example, she may not get a high enough price
for the goods she is producing; this may lead to fall in the profits
that she earns. It is to be noted that in a capitalist country the
factors of production earn their incomes through the process of
production and sale of the resultant output in the market.
In both the developed and developing countries, apart from the
7
private capitalist sector, there is the institution of State. The role of
the state includes framing laws, enforcing them and delivering justice.

Introduction
The state, in many instances, undertakes production – apart from
imposing taxes and spending money on building public infrastructure,
running schools, colleges, providing health services etc. These
economic functions of the state have to be taken into account when
we want to describe the economy of the country. For convenience we
shall use the term “Government” to denote state.
Apart from the firms and the government, there is another major
sector in an economy which is called the household sector. By a
household we mean a single individual who takes decisions relating
to her own consumption, or a group of individuals for whom decisions
relating to consumption are jointly determined. Households also save
and pay taxes. How do they get the money for these activities? We
must remember that the households consist of people. These people
work in firms as workers and earn wages. They are the ones who
work in the government departments and earn salaries, or they are
the owners of firms and earn profits. Indeed the market in which the
firms sell their products could not have been functioning without the
demand coming from the households. Moreover, they can also earn
rent by leasing land or earn interest by lending capital.

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 So far we have described the major players in the domestic economy.
But all the countries of the world are also engaged in external trade.
The external sector is the fourth important sector in our study. Trade
with the external sector can be of two kinds
1. The domestic country may sell goods to the rest of the world. These
are called exports.
2. The economy may also buy goods from the rest of the world. These
are called imports. Besides exports and imports, the rest of the
world affects the domestic economy in other ways as well.
3. Capital from foreign countries may flow into the domestic country,
or the domestic country may be exporting capital to foreign countries.
Summary

Macroeconomics deals with the aggregate economic variables of an

economy. It also takes into account various interlinkages which may
exist between the different sectors of an economy. This is what
distinguishes it from microeconomics; which mostly examines the
functioning of the particular sectors of the economy, assuming that
the rest of the economy remains the same. Macroeconomics emerged
as a separate subject in the 1930s due to Keynes. The Great Depression,
which dealt a blow to the economies of developed countries, had provided
Keynes with the inspiration for his writings. In this book we shall
mostly deal with the working of a capitalist economy. Hence it may not
be entirely able to capture the functioning of a developing country.
Macroeconomics sees an economy as a combination of four sectors,
namely households, firms, government and external sector.
Key Concepts

Rate of interest Wage rate

Profits Economic agents or units
Great Depression Unemployment rate
Four factors of production Means of production
8
Inputs Land
Introductory Macroeconomics

Labour Capital
Entrepreneurship Investment expenditure
Wage labour Capitalist country or capitalist
economy
Firms Capitalist firms
Output Households
Government External sector
Exports Imports

? 1. What is the difference between microeconomics and macroeconomics?

Exercises

2. What are the important features of a capitalist economy?

3. Describe the four major sectors in an economy according to the

? macroeconomic point of view.

4. Describe the Great Depression of 1929.

Suggested Readings
1. Bhaduri, A., 1990. Macroeconomics: The Dynamics of Commodity Production,
pages 1 – 27, Macmillan India Limited, New Delhi.
2. Mankiw, N. G., 2000. Macroeconomics, pages 2 – 14, Macmillan Worth
Publishers, New York.

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 National Income Accounting
In this chapter we will introduce the fundamental functioning of a
simple economy. In section 2.1 we describe some primary ideas
we shall work with. In section 2.2 we describe how we can view
the aggregate income of the entire economy going through the
sectors of the economy in a circular way. The same section also
deals with the three ways to calculate the national income; namely
product method, expenditure method and income method. The
last section 2.3 describes the various sub-categories of national
income. It also defines different price indices like GDP deflator,
Consumer Price Index, Wholesale Price Indices and discusses the
problems associated with taking GDP of a country as an indicator
of the aggregate welfare of the people of the country.

2.1 SOME BASIC CONCEPTS OF MACROECONOMICS

One of the pioneers of the subject we call in economics today,
Adam Smith, named his most influential work – An Enquiry into
the Nature and Cause of the Wealth of Nations. What generates
the economic wealth of a nation? What makes countries rich or
poor? These are some of the central questions of economics. It is
not that countries which are endowed with a bounty of natural
wealth – minerals or forests or the most fertile lands – are naturally
the richest countries. In fact the resource rich Africa and Latin
America have some of the poorest countries in the world, whereas
many prosperous countries have scarcely any natural wealth.
There was a time when possession of natural resources was the
most important consideration but even then the resource had to
be transformed through a production process.
The economic wealth, or well-being, of a country thus does
not necessarily depend on the mere possession of resources; the
point is how these resources are used in generating a flow of
production and how, as a consequence, income and wealth are
generated from that process.
Let us now dwell upon this flow of production. How does this
flow of production arise? People combine their energies with
natural and manmade environment within a certain social and
technological structure to generate a flow of production.
In our modern economic setting this flow of production arises
out of production of commodities – goods and services by millions
of enterprises large and small. These enterprises range from giant

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 corporations employing a large number of people to single entrepreneur
enterprises. But what happens to these commodities after being produced? Each
producer of commodities intends to sell her output. So from the smallest items
like pins or buttons to the largest ones like aeroplanes, automobiles, giant
machinery or any saleable service like that of the doctor, the lawyer or the financial
consultant–the goods and services produced are to be sold to the consumers.
The consumer may, in turn, be an individual or an enterprise and the good or
service purchased by that entity might be for final use or for use in further
production. When it is used in further production it often loses its characteristic
as that specific good and is transformed through a productive process into
another good. Thus a farmer producing cotton sells it to a spinning mill where
the raw cotton undergoes transformation to yarn; the yarn is, in turn, sold to a
textile mill where, through the productive process, it is transformed into cloth;
the cloth is, in turn, transformed through another productive process into an
article of clothing which is then ready to be sold finally to the consumers for
final use. Such an item that is meant for final use and will not pass through any
more stages of production or transformations is called a final good.
Why do we call this a final good? Because once it has been sold it passes out
of the active economic flow. It will not undergo any further transformation at the
hands of any producer. It may, however, undergo transformation by the action
of the ultimate purchaser. In fact many such final goods are transformed during
their consumption. Thus the tea leaves purchased by the consumer are not
consumed in that form – they are used to make drinkable tea, which is consumed.
Similarly most of the items that enter our kitchen are transformed through the
process of cooking. But cooking at home is not an economic activity, even though
the product involved undergoes transformation. Home cooked food is not sold
to the market. However, if the same cooking or tea brewing was done in a
restaurant where the cooked product would be sold to customers, then the
same items, such as tea leaves, would cease to be final goods and would be
10 counted as inputs to which economic value addition can take place. Thus it is
not in the nature of the good but in the economic nature of its use that a good
Introductory Macroeconomics

becomes a final good.

Of the final goods, we can distinguish between consumption goods and
capital goods. Goods like food and clothing, and services like recreation that
are consumed when purchased by their ultimate consumers are called
consumption goods or consumer goods. (This also includes services which are
consumed but for convenience we may refer to them as consumer goods.)
Then there are other goods that are of durable character which are used in
the production process. These are tools, implements and machines. While they
make production of other commodities feasible, they themselves don’t get
transformed in the production process. They are also final goods yet they are
not final goods to be ultimately consumed. Unlike the final goods that we have
considered above, they are the crucial backbone of any production process, in
aiding and enabling the production to take place. These goods form a part of
capital, one of the crucial factors of production in which a productive enterprise
has invested, and they continue to enable the production process to go on for
continuous cycles of production. These are capital goods and they gradually
undergo wear and tear, and thus are repaired or gradually replaced over time.
The stock of capital that an economy possesses is thus preserved, maintained
and renewed partially or wholly over time and this is of some importance in the
discussion that will follow.

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 We may note here that some commodities like television sets, automobiles
or home computers, although they are for ultimate consumption, have one
characteristic in common with capital goods – they are also durable. That is,
they are not extinguished by immediate or even short period consumption;
they have a relatively long life as compared to articles such as food or even
clothing. They also undergo wear and tear with gradual use and often need
repairs and replacements of parts, i.e., like machines they also need to be
preserved, maintained and renewed. That is why we call these goods
consumer durables.
Thus if we consider all the final goods and services produced in an economy
in a given period of time they are either in the form of consumption goods (both
durable and non-durable) or capital goods. As final goods they do not undergo
any further transformation in the economic process.
Of the total production taking place in the economy a large number of
products don’t end up in final consumption and are not capital goods either.
Such goods may be used by other producers as material inputs. Examples are
steel sheets used for making automobiles and copper used for making utensils.
These are intermediate goods, mostly used as raw material or inputs for
production of other commodities. These are not final goods.
Now, to have a comprehensive idea of the total flow of production in the
economy, we need to have a quantitative measure of the aggregate level of final
goods produced in the economy. However, in order to get a quantitative
assessment – a measure of the total final goods and services produced in the
economy – it is obvious that we need a common measuring rod. We cannot
add metres of cloth produced to tonnes of rice or number of automobiles or
machines. Our common measuring rod is money. Since each of these
commodities is produced for sale, the sum total of the monetary value of
these diverse commodities gives us a measure of final output. But why are
we to measure final goods only? Surely intermediate goods are crucial inputs
to any production process and a significant part of our manpower and capital
11
stock are engaged in production of these goods. However, since we are dealing
with value of output, we should realise that the value of the final goods already

National Income Accounting

includes the value of the intermediate goods that have entered into their
production as inputs. Counting them separately will lead to the error of double
counting. Whereas considering intermediate goods may give a fuller description
of total economic activity, counting them will highly exaggerate the final value
of our economic activity.
At this stage it is important to introduce the concepts of stocks and flows.
Often we hear statements like the average salary of someone is Rs 10,000 or the
output of the steel industry is so many tonnes or so many rupees in value. But
these are incomplete statements because it is not clear whether the income which
is being referred to is yearly or monthly or daily income and surely that makes
a huge difference. Sometimes, when the context is familiar, we assume that the
time period is known and therefore do not mention it. But inherent in all such
statements is a definite period of time. Otherwise such statements are
meaningless. Thus income, or output, or profits are concepts that make sense
only when a time period is specified. These are called flows because they occur
in a period of time. Therefore we need to delineate a time period to get a
quantitative measure of these. Since a lot of accounting is done annually in an
economy, many of these are expressed annually like annual profits or production.
Flows are defined over a period of time.

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 In contrast, capital goods or consumer durables once produced do not wear
out or get consumed in a delineated time period. In fact capital goods continue
to serve us through different cycles of production. The buildings or machines in
a factory are there irrespective of the specific time period. There can be addition
to, or deduction from, these if a new machine is added or a machine falls in
disuse and is not replaced. These are called stocks. Stocks are defined at a
particular point of time. However we can measure a change in stock over a
specific period of time like how many machines were added this year. Such
changes in stocks are thus flows, which can be measured over specific time
periods. A particular machine can be part of the capital stock for many years
(unless it wears out); but that machine can be part of the flow of new machines
added to the capital stock only for a single year when it was initially installed.
To further understand the difference between stock variables and flow
variables, let us take the following example. Suppose a tank is being filled with
water coming from a tap. The amount of water which is flowing into the tank
from the tap per minute is a flow. But how much water there is in the tank at a
particular point of time is a stock concept.
To come back to our discussion on the measure of final output, that part
of our final output that comprises of capital goods constitutes gross
investment of an economy1. These may be machines, tools and implements;
buildings, office spaces, storehouses or infrastructure like roads, bridges,
airports or jetties. But all the capital goods produced in a year do not
constitute an addition to the capital stock already existing. A significant part
of current output of capital goods goes in maintaining or replacing part of
the existing stock of capital goods. This is because the already existing capital
stock suffers wear and tear and needs maintenance and replacement. A part
of the capital goods produced this year goes for replacement of existing capital
goods and is not an addition to the stock of capital goods already existing
and its value needs to be subtracted from gross investment for arriving at the
measure for net investment. This deletion, which is made from the value of
12 gross investment in order to accommodate regular wear and tear of capital,
is called depreciation.
Introductory Macroeconomics

So new addition to capital stock in an economy is measured by net investment

or new capital formation, which is expressed as
Net Investment = Gross investment – Depreciation
Let us examine this concept called depreciation a little more in detail. Let us
consider a new machine that a firm invests in. This machine may be in service for
the next twenty years after which it falls into disrepair and needs to be replaced.
We can now imagine as if the machine is being gradually used up in each year’s
production process and each year one twentieth of its original value is getting
depreciated. So, instead of considering a bulk investment for replacement after
twenty years, we consider an annual depreciation cost every year. This is the
usual sense in which the term depreciation is used and inherent in its conception
is the expected life of a particular capital good, like twenty years in our example of
the machine. Depreciation is thus an annual allowance for wear and tear of a

1
This is how economists define investment. This must not be confused with the commonplace
notion of investment which implies using money to buy physical or financial assets. Thus use of the
term investment to denote purchase of shares or property or even having an insurance policy has
nothing to do with how economists define investment. Investment for us is always capital formation,
a gross or net addition to capital stock.

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capital good.2 In other words it is the cost of the good divided by number of years
of its useful life.3
Notice here that depreciation is an accounting concept. No real expenditure
may have actually been incurred each year yet depreciation is annually
accounted for. In an economy with thousands of enterprises with widely varying
periods of life of their equipment, in any particular year, some enterprises are
actually making the bulk replacement spending. Thus, we can realistically
assume that there will be a steady flow of actual replacement spending which
will more or less match the amount of annual depreciation being accounted
for in that economy.
Now if we go back to our discussion of total final output produced in an
economy, we see that there is output of consumer goods and services and
output of capital goods. The consumer goods sustain the consumption of
the entire population of the economy. Purchase of consumer goods depends
on the capacity of the people to spend on these goods which, in turn, depends
on their income. The other part of the final goods, the capital goods, are
purchased by business enterprises. They are used either for maintenance of
the capital stock because there are wear and tear of it, or they are used for
addition to their capital stock. In a specific time period, say in a year, thetotal
production of final goods can thus be either in the form of consumption or
investment. This implies that there is a trade-off. If an economy, produces
more of consumer goods, it is producing less of capital goods and vice-
versa.
It is generally observed that more sophisticated and heavy capital goods
raise the ability of a labourer to produce goods. The traditional weaver would
take months to weave a sari but with modern machinery thousands of pieces of
clothing are produced in a day. Decades were taken to construct the great
historical monuments like the Pyramids or the Taj Mahal but with modern
construction machinery one can build a skyscraper in a few years. More
production of newer varities of capital goods therefore would help in the greater
13
production of consumer goods.
But aren’t we contradicting ourselves? Earlier we have seen how, of the total

National Income Accounting

output of final goods of an economy, if a larger share goes for production of
capital goods, a smaller share is available for production of consumer goods.
And now we are saving more capital goods would mean more consumer goods.
There is no contradiction here however. What is important here is the element of
time. At a particular period, given a level of total output of the economy, it is
true if more capital goods are produced less of consumer goods would be
produced. But production of more capital goods would mean that in future the
labourers would have more capital equipments to work with. We have seen that
this leads to a higher capacity of the economy to produce with the same number
of labourers. Thus total input itself would be higher compared to the case when
less capital goods were produced. If total output is higher the amount of
consumer goods that can be produced would surely be higher.

2
Depreciation does not take into account unexpected or sudden destruction or disuse of
capital as can happen with accidents, natural calamities or other such extraneous circumstances.
3
We are making a rather simple assumption here that there is a constant rate of depreciation
based on the original value of the asset. There can be other methods to calculate depreciation in
actual practice.

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 Thus the economic cycle not only rolls on, higher production of capital goods
enables the economy to expand. It is possible to find another view of the circular
flow in the discussion we have made so far.
Since we are dealing with all goods and services that are produced for the
market, the crucial factor enabling such sale is demand for such products backed
by purchasing power. One must have the necessary ability to purchase
commodities. Otherwise one’s need for commodities does not get recognised by
the market.
We have already discussed above that one’s ability to buy commodities comes
from the income one earns as labourer (earning wages), or as entrepreneur
(earning profits), or as landlord (earning rents), or as owner of capital (earning
interests). In short, the incomes that people earn as owners of factors of production
are used by them to meet their demand for goods and services.
So we can see a circular flow here which is facilitated through the market.
Simply put, the firms’ demand for factors of production to run the production
process creates payments to the public. In turn, the public’s demand for goods
and services creates payments to the firms and enables the sale of the products
they produce.
So the social act of consumption and production are intricately linked and,
in fact, there is a circular causation here. The process of production in an economy
generates factor payments for those involved in production and generates goods
and services as the outcome of the production process. The incomes so generated
create the capacity to purchase the final consumption goods and thus enable
their sale by the business enterprises, the basic object of their production. The
capital goods which are also generated in the production process also enable
their producers to earn income – wages, profits etc. in a similar manner. The
capital goods add to, or maintain, the capital stock of an economy and thus
make production of other commodities possible.

2.2 CIRCULAR FLOW OF INCOME AND METHODS

14
OF CALCULATING NATIONAL INCOME
Introductory Macroeconomics

The description of the economy in the previous section enables us to have a

rough idea of how a simple economy – without a government, external trade or
any savings – may function. The households receive their payments from the
firms for productive activities they perform for the latter. As we have mentioned
before, there may fundamentally be four kinds of contributions that can be
made during the production of goods and services (a) contribution made by
human labour, remuneration for which is called wage (b) contribution made by
capital, remuneration for which is called interest (c) contribution made by
entrepreneurship, remuneration of which is profit (d) contribution made by fixed
natural resources (called ‘land’), remuneration for which is called rent.
In this simplified economy, there is only one way in which the households
may dispose off their earnings – by spending their entire income on the goods
and services produced by the domestic firms. The other channels of disposing
their income are closed: we have assumed that the households do not save, they
do not pay taxes to the government – since there is no government, and neither
do they buy imported goods since there is no external trade in this simple
economy. In other words, factors of production use their remunerations to buy
the goods and services which they assisted in producing. The aggregate
consumption by the households of the economy is equal to the aggregate
expenditure on goods and services produced by the firms in the economy. The

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entire income of the economy,
therefore, comes back to the
producers in the form of sales
revenue. There is no leakage
from the system – there is no
difference between the amount
that the firms had distributed in
the form of factor payments
(which is the sum total of
remunerations earned by the
four factors of production) and
the aggregate consumption
expenditure that they receive as
sales revenue.
In the next period the firms
will once again produce goods Fig. 2.1: Circular Flow of Income in a Simple Economy
and services and pay
remunerations to the factors of production. These remunerations will once
again be used to buy the goods and services. Hence year after year we can
imagine the aggregate income of the economy going through the two sectors,
firms and households, in a circular way. This is represented in Fig. 2.1. When
the income is being spent on the goods and services produced by the firms, it
takes the form of aggregate expenditure received by the firms. Since the value
of expenditure must be equal to the value of goods and services, we can
equivalently measure the aggregate income by “calculating the aggregate value
of goods and services produced by the firms”. When the aggregate revenue
received by the firms is paid out to the factors of production it takes the form
of aggregate income.
In Fig. 2.1, the uppermost arrow, going from the households to the firms,
represents the spending the households undertake to buy goods and services 15
produced by the firms. The second arrow going from the firms to the households

National Income Accounting

is the counterpart of the arrow above. It stands for the goods and services which
are flowing from the firms to the households. In other words, this flow is what
the households are getting from the firms, for which they are making the
expenditures. In short, the two arrows on the top represent the goods and services
market – the arrow above represents the flow of payments for the goods and
services, the arrow below represents the flow of goods and services. The two
arrows at the bottom of the diagram similarly represent the factors of production
market. The lower most arrow going from the households to the firms symbolises
the services that the households are rendering to the firms. Using these services
the firms are manufacturing the output. The arrow above this, going from the
firms to the households, represents the payments made by the firms to the
households for the services provided by the latter.
Since the same amount of money, representing the aggregate value of goods
and services, is moving in a circular way, if we want to estimate the aggregate
value of goods and services produced during a year we can measure the annual
value of the flows at any of the dotted lines indicated in the diagram. We can
measure the uppermost flow (at point A) by measuring the aggregate value of
spending that the firms receive for the final goods and services which they produce.
This method will be called the expenditure method. If we measure the flow at
B by measuring the aggregate value of final goods and services produced by all

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 the firms, it will be called product method. At C, measuring the sum total of all
factor payments will be called income method.
Observe that the aggregate spending of the economy must be equal to the
aggregate income earned by the factors of production (the flows are equal at A
and C). Now let us suppose that at a particular period of time the households
decide to spend more on the goods and services produced by the firms. For the
time being let us ignore the question where they would find the money to finance
that extra spending since they are already spending all of their income (they
may have borrowed the money to finance the additional spending). Now if they
spend more on the goods and services, the firms will produce more goods and
services to meet this extra demand. Since they will produce more, the firms
must also pay the factors of production extra remunerations. How much extra
amount of money will the firms pay? The additional factor payments must be
equal to the value of the additional goods and services that are being produced.
Thus the households will eventually get the extra earnings required to support
the initial additional spending that they had undertaken. In other words, the
households can decide to spend more – spend beyond their means. And in the
end their income will rise exactly by the amount which is necessary to carry out
the extra spending. Putting it differently, an economy may decide to spend more
than the present level of income. But by doing so, its income will eventually rise
to a level consistent with the higher spending level. This may seem a little
paradoxical at first. But since income is moving in a circular fashion, it is not
difficult to figure out that a rise in the flow at one point must eventually lead to
a rise in the flow at all levels. This is one more example of how the functioning of
a single economic agent (say, a household) may differ from the functioning of
the economy as a whole. In the former the spending gets restricted by the
individual income of a household. It can never happen that a single worker
decides to spend more and this leads to an equivalent rise in her income. We
shall spend more time on how higher aggregate spending leads to change in
aggregate income in a later chapter.
16 The above mentioned sketchy illustration of an economy is admittedly a
simplified one. Such a story which describes the functioning of an imaginary
Introductory Macroeconomics

economy is called a macroeconomic model. It is clear that a model does

not describe an actual economy in detail. For example, our model assumes
that households do not save, there is no government, no trade with other
countries. However models do not want to capture an economy in its every
minute detail – their purpose is to highlight some essential features of the
functioning of an economic system. But one has to be cautious not to simplify
the matters in such a way that misrepresents the essential nature of the
economy. The subject of economics is full of models, many of which will be
presented in this book. One task of an economist is to figure out which model
is applicable to which real life situation.
If we change our simple model described above and introduce savings,
will it change the principal conclusion that the aggregate estimate of the
income of the economy will remain the same whether we decide to calculate it
at A, B or C? It turns out that this conclusion does not change in a
fundamental way. No matter how complicated an economic system may be,
the annual production of goods and services estimated through each of the
three methods is the same.
We have seen that the aggregate value of goods and services produced in an
economy can be calculated by three methods. We now discuss the detailed steps
of these calculations.

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2.2.1 The Product or Value Added Method
In product method we calculate the aggregate annual value of goods and services
produced (if a year is the unit of time). How to go about doing this? Do we add
up the value of all goods and services produced by all the firms in an economy?
The following example will help us to understand.
Let us suppose that there are only two kinds of producers in the economy.
They are the wheat producers (or the farmers) and the bread makers (the bakers).
The wheat producers grow wheat and they do not need any input other than
human labour. They sell a part of the wheat to the bakers. The bakers do not
need any other raw materials besides wheat to produce bread. Let us suppose
that in a year the total value of wheat that the farmers have produced is Rs 100.
Out of this they have sold Rs 50 worth of wheat to the bakers. The bakers have
used this amount of wheat completely during the year and have produced
Rs 200 worth of bread. What is the value of total production in the economy? If
we follow the simple way of aggregating the values of production of the sectors,
we would add Rs 200 (value of production of the bakers) to Rs 100 (value of
production of farmers). The result will be Rs 300.
A little reflection will tell us that the value of aggregate production is not Rs
300. The farmers had produced Rs 100 worth of wheat for which it did not need
assistance of any inputs. Therefore the entire Rs 100 is rightfully the contribution
of the farmers. But the same is not true for the bakers. The bakers had to buy Rs
50 worth of wheat to produce their bread. The Rs 200 worth of bread that they
have produced is not entirely their own contribution. To calculate the net
contribution of the bakers, we need to subtract the value of the wheat that they
have bought from the farmers. If we do not do this we shall commit the mistake
of ‘double counting’. This is because Rs 50 worth of wheat will be counted twice.
First it will be counted as part of the output produced by the farmers. Second
time, it will be counted as the imputed value of wheat in the bread produced by
the bakers.
Therefore, the net contribution made by the bakers is, Rs 200 – Rs 50 = Rs 150. 17
Hence, aggregate value of goods produced by this simple economy is Rs 100 (net

National Income Accounting

contribution by the farmers) + Rs 150 (net contribution by the bakers) = Rs 250.
The term that is used to denote the net contribution made by a firm is
called its value added. We have seen that the raw materials that a firm buys
from another firm which are completely used up in the process of production
are called ‘intermediate goods’. Therefore the value added of a firm is, value of
production of the
fir m – value of Table 2.1: Production, Intermediate Goods and Value Added
intermediate goods
used by the firm. The Farmer Baker
value added of a firm Total production 100 200
is distributed among Intermediate goods used 0 50
its four factors of Value added 100 200 – 50 =150
production, namely,
labour, capital,
entrepreneurship and land. Therefore wages, interest, profits and rents paid
out by the firm must add up to the value added of the firm. Value added is a
flow variable.
We c a n r e p r e s e n t t h e e x a m p l e g i v e n a b o v e i n t e r m s o f
Table 2.1.

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 Here all the variables are expressed in terms of money. We can think of the
market prices of the goods being used to evaluate the different variables listed
here. And we can introduce more players in the chain of production in the
example and make it more realistic and complicated. For example, the farmer
may be using fertilisers or pesticides to produce wheat. The value of these inputs
will have to be deducted from the value of output of wheat. Or the bakers may
be selling the bread to a restaurant whose value added will have to be calculated
by subtracting the value of intermediate goods (bread in this case).
We have already introduced the concept of depreciation, which is also known
as consumption of fixed capital. Since the capital which is used to carry out
production undergoes wear and tear, the producer has to undertake replacement
investments to keep the value of capital constant. The replacement investment
is same as depreciation of capital. If we include depreciation in value added
then the measure of value added that we obtain is called Gross Value Added. If
we deduct the value of depreciation from gross value added we obtain Net Value
Added. Unlike gross value added, net value added does not include wear and
tear that capital has undergone. For example, let us say a firm produces Rs 100
worth of goods per year, Rs 20 is the value of intermediate goods used by it
during the year and Rs 10 is the value of capital consumption. The gross value
added of the firm will be, Rs 100 – Rs 20 = Rs 80 per year. The net value added
will be, Rs 100 – Rs 20 – Rs 10 = Rs 70 per year.
It is to be noted that while calculating the value added we are taking the
value of production of firm. But a firm may be unable to sell all of its produce. In
such a case it will have some unsold stock at the end of the year. Conversely, it
may so happen that a firm had some initial unsold stock to begin with. During
the year that follows it has produced very little. But it has met the demand in the
market by selling from the stock it had at the beginning of the year. How shall we
treat these stocks which a firm may intentionally or unintentionally carry with
itself? Also, let us remember that a firm buys raw materials from other firms. The
part of raw material which gets used up is categorised as an intermediate good.
18 What happens to the part which does not get used up?
In economics, the stock of unsold finished goods, or semi-finished goods,
Introductory Macroeconomics

or raw materials which a firm carries from one year to the next is called
inventory. Inventory is a stock variable. It may have a value at the beginning
of the year; it may have a higher value at the end of the year. In such a case
inventories have increased (or accumulated). If the value of inventories is less
at the end of the year compared to the beginning of the year, inventories have
decreased (decumulated). We can therefore infer that the change of inventories
of a firm during a year ≡ production of the firm during the year – sale of the
firm during the year.
The sign ‘≡’ stands for identity. Unlike equality (‘=’), an identity always holds
irrespective of what variables we have on the left hand and right hand sides of it.
For example, we can write 2 + 2 ≡ 4, because this is always true. But we must
write 2 × x = 4. This is because two times x equals to 4 for a particular value of
x, (namely when x = 2) and not always. We cannot write 2 × x ≡ 4.
Observe that since production of the firm ≡ value added + intermediate
goods used by the firm, we get, change of inventories of a firm during a year
≡ value added + intermediate goods used by the firm – sale of the firm during
a year.
For example, let us suppose that a firm had an unsold stock worth of Rs
100 at the beginning of a year. During the year it had produced Rs 1,000

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worth of goods and managed to sell Rs 800 worth of goods. Therefore, the
Rs 200 is the difference between production and sales. This Rs 200 worth of
goods is the change in inventories. This will add to the Rs 100 worth of
inventories the firm started with. Hence the inventories at the end of the year
is, Rs 100 + Rs 200 = Rs 300. Notice that change in inventories takes place
over a period of time. Therefore it is a flow variable.
Inventories are treated as capital. Addition to the stock of capital of a firm
is known as investment. Therefore, change in the inventory of a firm is treated
as investment. There can be three major categories of investment. First is the
rise in the value of inventories of a firm over a year which is treated as
investment expenditure undertaken by the firm. The second category of
investment is the fixed business investment, which is defined as the addition
to the machinery, factory buildings and equipment employed by the firms.
The last category of investment is the residential investment, which refers to
the addition of housing facilities.
Change in inventories may be planned or unplanned. In case of an unexpected
fall in sales, the firm will have unsold stock of goods which it had not anticipated.
Hence there will be unplanned accumulation of inventories. In the opposite
case where there is unexpected rise in the sales there will be unplanned
decumulation of inventories.
This can be illustrated with the help of the following example. Suppose a
firm produces shirts. It starts the year with an inventory of 100 shirts. During
the coming year it expects to sell 1,000 shirts. Hence, it produces 1,000
shirts, expecting to keep an inventory of 100 at the end of the year. However,
during the year, the sales of shirts turn out to be unexpectedly low. The firm
is able to sell only 600 shirts. This means that the firm is left with 400 unsold
shirts. The firm ends the year with 400 + 100 = 500 shirts. The unexpected
rise of inventories by 400 will be an example of unplanned accumulation of
inventories. If, on the other hand, the sales had been more than 1,000 we 19
would have unplanned decumulation of inventories. For example, if the sales

National Income Accounting

had been 1,050, then not only the production of 1,000 shirts will be sold,
the firm will have to sell 50 shirts out of the inventory. This 50 unexpected
reduction in inventories is an example of unexpected decumulation of
inventories.
What can be the examples of planned accumulation or decumulation of
inventories? Suppose the firm wants to raise the inventories from 100 shirts
to 200 shirts during the year. Expecting sales of 1,000 shirts during the year
(as before), the firm produces 1000 + 100 = 1,100 shirts. If the sales are actually
1,000 shirts, then the firm indeed ends up with a rise of inventories. The new
stock of inventories is 200 shirts, which was indeed planned by the firm. This
rise is an example of planned accumulation of inventories. On the other hand
if the firm had wanted to reduce the inventories from 100 to 25 (say), then it
would produce 1000 – 75 = 925 shirts. This is because it plans to sell 75
shirts out of the inventory of 100 shirts it started with (so that the inventory at
the end of the year becomes 100 – 75 = 25 shirts, which the firm wants). If the
sales indeed turn out to be 1000 as expected by the firm, the firm will be left
with the planned, reduced inventory of 25 shirts.
We shall have more to say on the distinction between unplanned and
planned change in inventories in the chapters which follow.

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 Taking cognizance of change of inventories we may write
Gross value added of firm, i (GV Ai) ≡ Gross value of the output produced by
the firm i (Qi) – Value of intermediate goods used by the firm (Zi)
GV Ai ≡ Value of sales by the firm (Vi ) + Value of change in inventories (Ai ) –
Value of intermediate goods used by the firm (Zi) (2.1)
Equation (2.1) has been derived by using: Change in inventories of a firm
during a year ≡ Production of the firm during the year – Sale of the firm
during the year.
It is worth noting that the sales by the firm includes sales not only to
domestic buyers but also to buyers abroad (the latter is termed as exports). It
is also to be noted that all the above mentioned variables are flow variables.
Generally these are measured on an annual basis. Hence they measure value
of the flows per year.
Net value added of the firm i ≡ GVAi – Depreciation of the firm i (Di)
If we sum the gross value added of all the firms of the economy in a year, we
get a measure of the value of aggregate amount of goods and services produced
by the economy in a year (just as we had done in the wheat-bread example).
Such an estimate is called Gross Domestic Product (GDP). Thus GDP ≡ Sum
total of gross value added of all the firms in the economy.
If there are N firms in the economy, each assigned with a serial number
from 1 to N, then GDP ≡ Sum total of the gross value added of all the firms in
the economy
≡ GVA1 + GVA2 + ..... + GVAN
Therefore
N
GDP ≡ ∑ i =1
GVAi (2.2)

20
The symbol is a notation – it is used to denote summation. Suppose, there
Introductory Macroeconomics

are 3 students, having pocket money of Rs. 200, 250 and 350 respectively.
We can say, if ith student has pocket money X i , then,
X 1 = 200, X 2 = 250, X 3 = 300 . The total pocket money will be given by
X1 + X 2 + X 3 . The summation notation given above is useful in writing it in
a shorter form: X 1 + X 2 + X 3 can be written as , which means that
there are three values of X corresponding to the three individuals 1 to 3,
and we are referring to the sum of the values of X for individuals 1 to 3.
This notation is particularly useful in macroeconomics since we deal with
aggregates. For instance, suppose there are 1000 consumers in the economy,
having consumption c1 , c2 ,...., c1000 . If we want to compute the aggregate
consumption for this economy, we have to add up all these values, which
means aggregate consumption for this economy will be given by
C = c1 + c2 + ... + c1000 . The summation notation, however, allows us to write
it in a much shorter form. Since we are summing up the values of
consumption for individual 1 to individual 1000, where the value of

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 consumption for the individual i is ci, aggregate consumption will be

In general, if we are taking sum of a quantity xi over individuals 1 to n ,

it will be denoted by .

2.2.2 Expenditure Method

An alternative way to calculate the GDP is by looking at the demand side of the
products. This method is referred to as the expenditure method. In the farmer-
baker example that we have described before, the aggregate value of the output
in the economy by expenditure method will be calculated in the following way.
In this method we add the final expenditures that each firm makes. Final
expenditure is that part of expenditure which is undertaken not for intermediate
purposes. The Rs 50 worth of wheat which the bakers buy from the farmers
counts as intermediate goods, hence it does not fall under the category of final
expenditure. Therefore the aggregate value of output of the economy is Rs 200
(final expenditure received by the baker) + Rs 50 (final expenditure received by
the farmer) = Rs 250 per year.
Firm i can make the final expenditure on the following accounts (a) the final
consumption expenditure on the goods and services produced by the firm. We
shall denote this by Ci. We may note that mostly it is the households which
undertake consumption expenditure. There may be exceptions when the firms
buy consumables to treat their guests or for their employees (b) the final
investment expenditure, Ii , incurred by other firms on the capital goods produced
by firm i. Observe that unlike the expenditure on intermediate goods which is
not included in the calculation of GDP, expenditure on investments is included. 21
The reason is that investment goods remain with the firm, whereas intermediate

National Income Accounting

goods are consumed in the process of production (c) the expenditure that the
government makes on the final goods and services produced by firm i. We shall
denote this by Gi . We may point out that the final expenditure incurred by the
government includes both the consumption and investment expenditure (d) the
export revenues that firm i earns by selling its goods and services abroad. This
will be denoted by Xi .
Thus the sum total of the revenues that the firm i earns is given by
RVi ≡ Sum total of final consumption, investment, government and exports
expenditures received by the firm i
≡ Ci + Ii + Gi + Xi
If there are N firms then summing over N firms we get
N
∑ i =1
RVi ≡ Sum total of final consumption, investment, government and
exports expenditures received by all the firms in the economy
N N N N
≡ ∑ i =1
Ci + ∑ I +
i =1 i ∑ i =1
Gi + ∑ i =1
Xi (2.3)

Let C be the aggregate final consumption expenditure of the entire

economy. Notice that a part of C is spent on imports of consumption goods C

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 N
= ∑ i =1 Ci + Cm. Let Cm denote expenditure on the imports of consumption goods.
Therefore C – Cm denotes that part of aggregate final consumption expenditure
that is spent on the domestic firms. Similarly, let I – I m stand for that part of
aggregate final investment expenditure that is spent on domestic firms, where
I is the value of the aggregate final investment expenditure of the economy and
out of this I m is spent on foreign investment goods. Similarly
G – Gm stands for that part of aggregate final government expenditure that is
spent on the domestic firms, where G is the aggregate expenditure of the
government of the economy and Gm is the part of G which is spent on imports.
N
Therefore, ∑ i =1
Ci ≡ Sum total of final consumption expenditures
N
received by all the firms in the economy ≡ C – Cm; ∑ i =1 I i ≡ Sum total of final
investment expenditures received by all the firms in the economy ≡ I – Im;
N
∑ Gi ≡ Sum total of final government expenditures received by all the firms
i =1
in the economy ≡ G – Gm. Substituting these in equation (2.3) we get
N N
∑ i =1
RVi ≡ C – Cm + I – Im + G – Gm + ∑ i =1
Xi
N
≡C+I+G + ∑ i =1
X i – (Cm + Im + Gm)

≡C+I+G+X– M
N
Here X ≡ ∑ i = 1 X i denotes aggregate expenditure by the foreigners on the
exports of the economy. M ≡ Cm + Im + Gm is the aggregate imports expenditure
incurred by the economy.
We know, GDP ≡ Sum total of all the final expenditure received by the firms
in the economy.
In other words
N
GDP ≡ ∑ i =1
RVi ≡ C + Ι + G + X – M (2.4)
22 Equation (2.4) expresses GDP according to the expenditure method. It may
be noted that out of the five variables on the right hand side, investment
Introductory Macroeconomics

expenditure, I, is the most unstable.

2.2.3 Income Method

As we mentioned in the beginning, the sum of final expenditures in the economy
must be equal to the incomes received by all the factors of production taken
together (final expenditure is the spending on final goods, it does not include
spending on intermediate goods). This follows from the simple idea that the
revenues earned by all the firms put together must be distributed among the
factors of production as salaries, wages, profits, interest earnings and rents. Let
there be M number of households in the economy. Let Wi be the wages and
salaries received by the i-th household in a particular year. Similarly, Pi, Ini, Ri
be the gross profits, interest payments and rents received by the i-th household
in a particular year. Therefore, GDP is given by

M M M M
GDP ≡ ∑ i =1
Wi + ∑ i =1
Pi + ∑ i =1
In i + ∑ i =1
Ri ≡ W + P + In + R (2.5)

M M M M
Here, ∑ i =1
Wi ≡ W, ∑ i =1
Pi ≡ P, ∑ i =1
In i ≡ In, ∑ i =1
Ri ≡ R.

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 Taking equations (2.2), (2.4) and (2.5) together we get
N
GDP ≡ ∑ i =1
GV Ai ≡ C + I + G + X – M ≡ W + P + In + R (2.6)
It is to be noted that in identity (2.6), I stands for sum total of both planned
and unplanned investments undertaken by the firms.
Since, the identities (2.2), (2.4) and (2.6) are different expressions of the same
variable, namely GDP, we may represent the equivalence by Fig. 2.2.
Now, let us look at
X–M P N
a numerical example åi =1GVA i
to see how all the three G In
methods of estimating I R
GDP give us the same C W
answer. GDP
Example: There are
two firms, A and B.
Suppose A uses no
raw material and Expenditure Income Product
produces cotton worth Method Method Method
Rs. 50. A sells its cotton Fig. 2.2: Diagramtic Representation of GDP by the Three Methods
to firm B, who uses it
to produce cloth. B sells the cloth produced to consumers for Rs. 200.
1. GDP in the phase of production or the value added method:
Recall that value added (VA) = Sales – Intermediate Goods
Thus,
VAA = 50 - 0 = 50
VAB = 200 - 50 = 150
Thus,
GDP = VAA + VAB = 200.

Table 2.2: Distributions of GDPs for firms A and B 23

National Income Accounting

Firm A Firm B

Sales 50 200
Intermediate
0 50
consumption

Value added 50 150

2. GDP in the phase of disposition or the expenditure method:

Recall that GDP = Sum of final expenditure or expenditures on goods
and services for end use. In the above case, final expenditure is
expenditure by consumers on cloth. Therefore, GDP = 200.
3. GDP in the phase of distribution or Income method
Let us look at the firms A and B again.
Now, of this 50 received by A, the firm gives Rs. 20 to the workers as wages,
and keeps the remaining 30 as its profits. Similarly, B gives 60 as wages and
keeps 90 as profits.

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 Table 2.3: Distributions of factor incomes of firms A and B

Firm A Firm B
Wages 20 60

Profits 30 90

Recall that GDP by income method = sum total of factor incomes, which is
equal to total wages received (workers of A and B) and total profits earned (by A
and B), which is equal4 to 80 + 120 = 200.

2.2.4 Factor Cost, Basic Prices and Market Prices

In India, the most highlighted measure of national income has been the GDP at
factor cost. The Central Statistics Office (CSO) of the Government of India has
been reporting the GDP at factor cost and at market prices. In its revision in
January 2015 the CSO replaced GDP at factor cost with the GVA at basic prices,
and the GDP at market prices, which is now called only GDP, is now the most
highlighted measure.
The idea of GVA has already been discussed: it is the value of total output
produced in the economy less the value of intermediate consumption (the output
which is used in production of output further, and not used in final consumption).
Here we discuss the concept of basic prices. The distinction between factor cost,
basic prices and market prices is based on the distinction between net production
taxes (production taxes less production subsidies) and net product taxes (product
taxes less product subsidies). Production taxes and subsidies are paid or received
in relation to production and are independent of the volume of production such
as land revenues, stamp and registration fee. Product taxes and subsidies, on
the other hand, are paid or received per unit or product, e.g., excise tax, service
tax, export and import duties etc. Factor cost includes only the payment to factors
24 of production, it does not include any tax. In order to arrive at the market prices,
we have to add to the factor cost the total indirect taxes less total subsidies. The
Introductory Macroeconomics

basic prices lie in between: they include the production taxes (less production
subsidies) but not product taxes (less product subsidies). Therefore in order to
arrive at market prices we have to add product taxes (less product subsidies) to
the basic prices.
As stated above, now the CSO releases GVA at basic prices. Thus, it includes
the net production taxes but not net product taxes. In order to arrive at the GDP
(at market prices) we need to add net product taxes to GVA at basic prices.
Thus,

GVA at factor costs + Net production taxes = GVA at

basic prices
GVA at basic prices + Net product taxes = GVA at
market prices
Table 2.5 at the end of the chapter gives the figures for GDP (at market prices)
and GVA at basic prices, while Table 2.6 gives the composition of GDP from
expenditure side.
4
In this example, we have left out factor payments in the form of rent and interest. But this
will not make any difference to the basic result, because after paying wages the remainder of value
added by a firm will be distributed between rent, interest and profits (together called operating
surplus).

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2.3 SOME MACROECONOMIC IDENTITIES
Gross Domestic Product measures the aggregate production of final goods and
services taking place within the domestic economy during a year. But the whole
of it may not accrue to the citizens of the country. For example, a citizen of India
working in Saudi Arabia may be earning her wage and it will be included in the
Saudi Arabian GDP. But legally speaking, she is an Indian. Is there a way to take
into account the earnings made by Indians abroad or by the factors of production
owned by Indians? When we try to do this, in order to maintain symmetry, we
must deduct the earnings of the foreigners who are working within our domestic
economy, or the payments to the factors of production owned by the foreigners.
For example, the profits earned by the Korean-owned Hyundai car factory will
have to be subtracted
from the GDP of India.
The macroeconomic
variable which takes
into account such
additions and
subtractions is
known as Gross
National Product
The foreigners have a share in your domestic economy.
(GNP). It is, therefore,
Discuss this in the classroom.
defined as follows
GNP ≡ GDP + Factor income earned by the domestic factors of production
employed in the rest of the world – Factor income earned by the factors of
production of the rest of the world employed in the domestic economy
Hence, GNP ≡ GDP + Net factor income from abroad
(Net factor income from abroad = Factor income earned by the domestic factors
of production employed in the rest of the world – Factor income earned by the
factors of production of the rest of the world employed in the domestic economy).
We have already noted that a part of the capital gets consumed during the 25
year due to wear and tear. This wear and tear is called depreciation. Naturally,

National Income Accounting

depreciation does not become part of anybody’s income. If we deduct
depreciation from GNP the measure of aggregate income that we obtain is called
Net National Product (NNP). Thus
NNP ≡ GNP – Depreciation
It is to be noted that all these variables are evaluated at market prices.
Through the expression given above, we get the value of NNP evaluated at
market prices. But market price includes indirect taxes. When indirect taxes
are imposed on goods and services, their prices go up. Indirect taxes accrue to
the government. We have to deduct them from NNP evaluated at market prices
in order to calculate that part of NNP which actually accrues to the factors of
production. Similarly, there may be subsidies granted by the government on
the prices of some commodities (in India petrol is heavily taxed by the
government, whereas cooking gas is subsidised). So we need to add subsidies
to the NNP evaluated at market prices. The measure that we obtain by doing
so is called Net National Product at factor cost or National Income.
Thus, NNP at factor cost ≡ National Income (NI ) ≡ NNP at market prices –
(Indirect taxes – Subsidies) ≡ NNP at market prices – Net indirect taxes (Net
indirect taxes ≡ Indirect taxes – Subsidies)

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 We can further subdivide the National Income into smaller categories. Let us try
to find the expression for the part of NI which is received by households. We shall
call this Personal Income (PI). First, let us note that out of NI, which is earned by
the firms and government enterprises, a part of profit is not distributed among the
factors of production. This is called Undistributed Profits (UP). We have to deduct
UP from NI to arrive at PI, since UP does not accrue to the households. Similarly,
Corporate Tax, which is imposed on the earnings made by the firms, will also have
to be deducted from the NI, since it does not accrue to the households. On the other
hand, the households do receive interest payments from private firms or the
government on past loans advanced by them. And households may have to pay
interests to the firms and the government as well, in case they had borrowed money
from either. So, we have to deduct the net interests paid by the households to the
firms and government. The households receive transfer payments from government
and firms (pensions, scholarship, prizes, for example) which have to be added to
calculate the Personal Income of the households.
Thus, Personal Income (PI) ≡ NI – Undistributed profits – Net interest
payments made by households – Corporate tax + Transfer payments to
the households from the government and firms.
However, even PI is not the income over which the households have complete
say. They have to pay taxes from PI. If we deduct the Personal Tax Payments
(income tax, for example) and Non-tax Payments (such as fines) from PI, we
obtain what is known as the Personal Disposable Income. Thus
Personal Disposable Income (PDI ) ≡ PI – Personal tax payments – Non-tax
payments.
Personal Disposable Income is the part of the aggregate income which
belongs to the households. They may decide to consume a part of it, and
save the rest. In Fig. 2.3 we present a diagrammatic representation of the
relations between these major macroeconomic variables.

NFIA D
26
GDP GNP NNP ID - Sub
Introductory Macroeconomics

(at
Market NI UP + NIH
Price) (NNP at + CT –
FC) TrH
PI PTP +
NP
PDI

Fig. 2.3: Diagrammatic representation of the subcategories of aggregate income. NFIA: Net
Factor Income from Abroad, D: Depreciation, ID: Indirect Taxes, Sub: Subsidies, UP: Undistributed
Profits, NIH: Net Interest Payments by Households, CT: Corporate Taxes, TrH: Transfers recived
by Households, PTP: Personal Tax Payments, NP: Non-Tax Payments.

National Disposable Income and Private Income

Apart from these categories of aggregate macroeconomic variables, in India, a
few other aggregate income categories are also used in National Income
accounting
• National Disposable Income = Net National Product at market prices
+ Other current transfers from the rest of the world
The idea behind National Disposable Income is that it gives an idea of

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 what is the maximum amount of goods and services the domestic economy
has at its disposal. Current transfers from the rest of the world include
items such as gifts, aids, etc.
• Private Income = Factor income from net domestic product accruing to
the private sector + National debt interest + Net factor income from abroad
+ Current transfers from government + Other net transfers from the rest of
the world.

Table 2.4: Basic National Income Aggregates5

1. Gross Domestic • GDP is the market value of all final goods
Product at Market and services produced within a domestic
Prices (GDPMP) territory of a country measured in a year.
• All production done by the national
residents or the non-residents in a
country gets included, regardless of
whether that production is owned by a
local company or a foreign entity.
• Everything is valued at market prices.
GDPMP = C + I + G + X − M
2. GDP at Factor Cost • GDP at factor cost is gross domestic
(GDPFC) product at market prices, less net
product taxes.
• Market prices are the prices as paid by
the consumers Market prices also include
product taxes and subsides. The term
factor cost refers to the prices of products
as received by the producers. Thus, factor
cost is equal to market prices, minus net
indirect taxes. GDP at factor cost 27
measures money value of output produced

National Income Accounting

by the firms within the domestic
boundaries of a country in a year.
GDPFC = GDPMP − NIT
3. Net Domestic • This measure allows policy-makers to
Product at Market estimate how much the country has to
Prices (NDPMP) spend just to maintain their current GDP.
If the country is not able to replace the
capital stock lost through depreciation,
then GDP will fall.
NDPMP = GDPMP − Dep.

4. NDP at Factor Cost • NDP at factor cost is the income earned

by the factors in the form of wages, profits,
(NDPFC)
rent, interest, etc., within the domestic
territory of a country.
NDPFC = NDPMP - Net Product Taxes - Net ProductionTaxes

5
Following the System of National Accounts 2008 (SNA2008) given by the United Nations in
partnership with some other agencies, countries are now switching to new aggregates. India shifted
to these aggregates a few years back.

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 5. Gross National • GNPMP is the value of all the final goods
and services that are produced by the
Product at Market
normal residents of India and is
Prices (GNPMP) measured at the market prices, in a year.
• GNP refers to all the economic output
produced by a nation’s normal residents,
whether they are located within the
national boundary or abroad.
• Everything is valued at the market prices.
GNPMP = GDPMP + NFIA

6. GNP at Factor Cost • GNP at factor cost measures value of

(GNPFC) output received by the factors of
production belonging to a country in a
year.
GNPFC =GNPMP - Net Product Taxes - Net ProductionTaxes

7. Net National • This is a measure of how much a country

can consume in a given period of time.
Product at Market
NNP measures output regardless of where
Prices (NNPMP) that production has taken place (in
domestic territory or abroad).
NNPMP = GNPMP − Depreciation
NNPMP = NDPMP + NFIA

8. NNP at Factor Cost • NNP at factor cost is the sum of income

28 (NNPFC) earned by all factors in the production in
the form of wages, profits, rent and
Introductory Macroeconomics

interest, etc., belonging to a country

Or during a year.
• It is the National Product and is not bound
National Income by production in the national boundaries.
It is the net domestic factor income added
(NI)
with the net factor income from abroad.
NI = NNPMP − Net Product Taxes - Net ProductionTaxes
= NDPFC + NFIA = NNPFC

9. GVA at Market Prices • GDP at market prices

10. GVA at basic prices • GVAMP - Net Product Taxes

11. GVA at factor cost • GVA at basic prices - Net Production Taxes

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2.4 NOMINAL AND REAL GDP
One implicit assumption in all this discussion is that the prices of goods and
services do not change during the period of our study. If prices change, then
there may be difficulties in comparing GDPs. If we measure the GDP of a country
in two consecutive years and see that the figure for GDP of the latter year is
twice that of the previous year, we may conclude that the volume of production
of the country has doubled. But it is possible that only prices of all goods and
services have doubled between the two years whereas the production has
remained constant.
Therefore, in order to compare the GDP figures (and other macroeconomic
variables) of different countries or to compare the GDP figures of the same country
at different points of time, we cannot rely on GDPs evaluated at current market
prices. For comparison we take the help of real GDP. Real GDP is calculated in
a way such that the goods and services are evaluated at some constant set of
prices (or constant prices). Since these prices remain fixed, if the Real GDP
changes we can be sure that it is the volume of production which is undergoing
changes. Nominal GDP, on the other hand, is simply the value of GDP at the
current prevailing prices. For example, suppose a country only produces bread.
In the year 2000 it had produced 100 units of bread, price was Rs 10 per bread.
GDP at current price was Rs 1,000. In 2001 the same country produced 110
units of bread at price Rs 15 per bread. Therefore nominal GDP in 2001 was Rs
1,650 (=110 × Rs 15). Real GDP in 2001 calculated at the price of the year 2000
(2000 will be called the base year) will be 110 × Rs 10 = Rs 1,100.
Notice that the ratio of nominal GDP to real GDP gives us an idea of how the
prices have moved from the base year (the year whose prices are being used to
calculate the real GDP) to the current year. In the calculation of real and nominal
GDP of the current year, the volume of production is fixed. Therefore, if these
measures differ it is only due to change in the price level between the base year
and the current year. The ratio of nominal to real GDP is a well known index of
prices. This is called GDP Deflator. Thus if GDP stands for nominal GDP and 29
GDP

National Income Accounting

gdp stands for real GDP then, GDP deflator = gdp .
Sometimes the deflator is also denoted in percentage terms. In such a case
GDP
deflator = gdp × 100 per cent. In the previous example, the GDP deflator is
1,650
= 1.50 (in percentage terms this is 150 per cent). This implies that the
1,100
price of bread produced in 2001 was 1.5 times the price in 2000. Which is true
because price of bread has indeed gone up from Rs 10 to Rs 15. Like GDP
deflator, we can have GNP deflator as well.
There is another way to measure change of prices in an economy which is
known as the Consumer Price Index (CPI). This is the index of prices of a
given basket of commodities which are bought by the representative consumer.
CPI is generally expressed in percentage terms. We have two years under
consideration – one is the base year, the other is the current year. We calculate
the cost of purchase of a given basket of commodities in the base year. We also
calculate the cost of purchase of the same basket in the current year. Then we
express the latter as a percentage of the former. This gives us the Consumer
Price Index of the current year vis-´a-vis the base year. For example let us take
an economy which produces two goods, rice and cloth. A representative
consumer buys 90 kg of rice and 5 pieces of cloth in a year. Suppose in the

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 year 2000 the price of a kg of rice was Rs 10 and a piece of cloth was Rs 100.
So the consumer had to spend a total sum of Rs 10 × 90 = Rs 900 on rice in
2000. Similarly, she spent Rs 100 × 5 = Rs 500 per year on cloth. Summation
of the two items is, Rs 900 + Rs 500 = Rs 1,400.
Now suppose the prices of a kg of rice and a piece of cloth has gone up to Rs
15 and Rs 120 in the year 2005. To buy the same quantity of rice and clothes
the representative will have to spend Rs 1,350 and Rs 600 respectively (calculated
in a similar way as before). Their sum will be, Rs 1,350 + Rs 600 = Rs 1,950. The
1,950
CPI therefore will be
1,400 × 100 = 139.29 (approximately).
It is worth noting that many commodities have two sets of prices. One is
the retail price which the consumer actually pays. The other is the wholesale
price, the price at which goods are traded in bulk. These two may differ in
value because of the margin kept by traders. Goods which are traded in
bulk (such as raw materials or semi-finished goods) are not purchased by
ordinary consumers. Like CPI, the index for wholesale prices is called
Wholesale Price Index (WPI). In countries like USA it is referred to as
Producer Price Index (PPI). Notice CPI (and analogously WPI) may differ
from GDP deflator because
1. The goods purchased by consumers do not represent all the goods which
are produced in a country. GDP deflator takes into account all such goods
and services.
2. CPI includes prices of goods consumed by the representative consumer, hence
it includes prices of imported goods. GDP deflator does not include prices of
imported goods.
3. The weights are constant in CPI – but they differ according to production
level of each good in GDP deflator.

2.5 GDP AND WELFARE

30
Can the GDP of a country be taken as an index of the welfare of the people of
Introductory Macroeconomics

that country? If a person has more income he or she can buy more goods and
services and his or her material well-being improves. So it may seem reasonable
to treat his or her income level as his or her level of well-being. GDP is the sum
total of value of goods and services created within the geographical boundary of
a country in a particular year. It gets distributed among the people as incomes
(except for retained earnings). So we may be tempted to treat higher level of GDP
of a country as an index of greater well-being of the people of that country (to
account for price changes, we may take the value of real GDP instead of nominal
GDP). But there are at least three reasons why this may not be correct.
1. Distribution of GDP – how uniform is it: If the GDP of the country is rising,
the welfare may not rise as a consequence. This is because the rise in GDP may
be concentrated in the hands of very few individuals or firms. For the rest, the
income may in fact have fallen. In such a case the welfare of the entire country
cannot be said to have increased. For example, suppose in year 2000, an
imaginary country had 100 individuals each earning Rs 10. Therefore the GDP
of the country was Rs 1,000 (by income method). In 2001, let us suppose the
same country had 90 individuals earning Rs 9 each, and the rest 10 individual
earning Rs 20 each. Suppose there had been no change in the prices of goods
and services between these two periods. The GDP of the country in the year 2001
was 90 × (Rs 9) + 10 × (Rs 20) = Rs 810 + Rs 200 = Rs 1,010. Observe that

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 compared to 2000, the GDP of the country in 2001 was higher by Rs10. But
this has happened when 90 per cent of people of the country have seen a drop in
their real income by 10 per cent (from Rs 10 to Rs 9), whereas only 10 per cent
have benefited by a rise in their income by 100 per cent (from Rs 10 to Rs 20). 90
per cent of the people are worse off though the GDP of the country has gone up.
If we relate welfare improvement in the country to the percentage of people who
are better off, then surely GDP is not a good index.
2. Non-monetary exchanges: Many activities in an economy are not evaluated
in monetary terms. For example, the domestic services women perform at
home are not paid for. The
exchanges which take place in the
informal sector without the help
of money are called barter
exchanges. In barter exchanges,
goods (or services) are directly
exchanged against each other.
But since money is not being used
here, these exchanges are not
registered as part of economic
activity. In developing countries,
where many remote regions are
underdeveloped, these kinds of
exchanges do take place, but they
are generally not counted in the
GDPs of these countries. This is
a case of underestimation of GDP.
Hence, GDP calculated in the
standard manner may not give us How uniform is the distribution of GDP? It still
a clear indication of the seems that a majority of the people are poor and
productive activity and well-being a few benefited.
31
of a country.
3. Externalities: Externalities refer to the benefits (or harms) a firm or an

National Income Accounting

individual causes to another for which they are not paid (or penalised).
Externalities do not have any market in which they can be bought and
sold. For example, let us suppose there is an oil refinery which refines
crude petroleum and sells it in the market. The output of the refinery is
the amount of oil it refines. We can estimate the value added of the refinery
by deducting the value of intermediate goods used by the refinery (crude
oil in this case) from the value of its output. The value added of the refinery
will be counted as part of the GDP of the economy. But in carrying out
the production the refinery may also be polluting the nearby river. This
may cause harm to the people who use the water of the river. Hence their
well being will fall. Pollution may also kill fish or other organisms of the
river on which fish survive. As a result, the fishermen of the river may be
losing their livelihood. Such harmful effects that the refinery is inflicting
on others, for which it will not bear any cost, are called externalities. In
this case, the GDP is not taking into account such negative externalities.
Therefore, if we take GDP as a measure of welfare of the economy we shall
be overestimating the actual welfare. This was an example of negative
externality. There can be cases of positive externalities as well. In
such cases, GDP will underestimate the actual welfare of
the economy.

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 At a very fundamental level, the macroeconomy (it refers to the economy that we

Summary
study in macroeconomics) can be seen as working in a circular way. The firms
employ inputs supplied by households and produce goods and services to be sold to
households. Households get the remuneration from the firms for the services
rendered by them and buy goods and services produced by the firms. So we can
calculate the aggregate value of goods and services produced in the economy by
any of the three methods (a) measuring the aggregate value of factor payments
(income method) (b) measuring the aggregate value of goods and services produced
by the firms (product method) (c) measuring the aggregate value of spending received
by the firms (expenditure method). In the product method, to avoid double counting,
we need to deduct the value of intermediate goods and take into account only the
aggregate value of final goods and services. We derive the formulae for calculating
the aggregate income of an economy by each of these methods. We also take note
that goods can also be bought for making investments and these add to the productive
capacity of the investing firms. There may be different categories of aggregate income
depending on whom these are accruing to. We have pointed out the difference between
GDP, GNP, NNP at market price, NNP at factor cost, PI and PDI. Since prices of goods
and services may vary, we have discussed how to calculate the three important
price indices (GDP deflator, CPI, WPI). Finally we have noted that it may be incorrect
to treat GDP as an index of the welfare of the country.
Key Concepts

Final goods Consumption goods

Consumer durables Capital goods
Intermediate goods Stocks
Flows Gross investment
Net investment Depreciation
Wage Interest
32 Profit Rent
Circular flow of income Product method of calculating
Introductory Macroeconomics

National Income
Expenditure method of calculating Income method of calculating
National Income National Income
Macroeconomic model Input
Value added Inventories
Planned change in inventories Unplanned change in inventories
Gross Domestic Product (GDP) Net Domestic Product (NDP)
Gross National Product (GNP) Net National Product (NNP)
(at market price)
NNP (at factor cost) or Undistributed profits
National Income (NI)
Net interest payments made Corporate tax
by households
Transfer payments to the Personal Income (PI)
households from the government
and firms
Personal tax payments Non-tax payments
Personal Disposable Income (PDI) National Disposable Income

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 Private Income Nominal GDP
Real GDP Base year
GDP Deflator Consumer Price Index (CPI)
Wholesale Price Index (WPI) Externalities

1. What are the four factors of production and what are the remunerations to
? each of these called?
2. Why should the aggregate final expenditure of an economy be equal to the
Exercises

aggregate factor payments? Explain.

3. Distinguish between stock and flow. Between net investment and capital which
is a stock and which is a flow? Compare net investment and capital with flow of
water into a tank.
4. What is the difference between planned and unplanned inventory
accumulation? Write down the relation between change in inventories and value
added of a firm.
5. Write down the three identities of calculating the GDP of a country by the
three methods. Also briefly explain why each of these should give us the same
value of GDP.
6. Define budget deficit and trade deficit. The excess of private investment over saving
of a country in a particular year was Rs 2,000 crores. The amount of budget deficit
was ( – ) Rs 1,500 crores. What was the volume of trade deficit of that country?
7. Suppose the GDP at market price of a country in a particular year was Rs 1,100 crores.
Net Factor Income from Abroad was Rs 100 crores. The value of Indirect taxes –
Subsidies was Rs 150 crores and National Income was Rs 850 crores. Calculate
the aggregate value of depreciation.
8. Net National Product at Factor Cost of a particular country in a year is
Rs 1,900 crores. There are no interest payments made by the households to the
firms/government, or by the firms/government to the households. The Personal 33
Disposable Income of the households is Rs 1,200 crores. The personal income

National Income Accounting

taxes paid by them is Rs 600 crores and the value of retained earnings of the
firms and government is valued at Rs 200 crores. What is the value of transfer
payments made by the government and firms to the households?
9. From the following data, calculate Personal Income and Personal Disposable
Income.
Rs (crore)
(a) Net Domestic Product at factor cost 8,000
(b) Net Factor Income from abroad 200
(c) Undisbursed Profit 1,000
(d) Corporate Tax 500
(e) Interest Received by Households 1,500
(f) Interest Paid by Households 1,200
(g) Transfer Income 300
(h) Personal Tax 500
10. In a single day Raju, the barber, collects Rs 500 from haircuts; over this day,
his equipment depreciates in value by Rs 50. Of the remaining Rs 450, Raju

?
pays sales tax worth Rs 30, takes home Rs 200 and retains Rs 220 for
improvement and buying of new equipment. He further pays Rs 20 as income
tax from his income. Based on this information, complete Raju’s contribution
to the following measures of income (a) Gross Domestic Product (b) NNP

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 ?
at market price (c) NNP at factor cost (d) Personal income (e) Personal
disposable income.
11. The value of the nominal GNP of an economy was Rs 2,500 crores in a particular
year. The value of GNP of that country during the same year, evaluated at the
prices of same base year, was Rs 3,000 crores. Calculate the value of the GNP
deflator of the year in percentage terms. Has the price level risen between the
base year and the year under consideration?
12. Write down some of the limitations of using GDP as an index of welfare of a
country.

Suggested Readings
1. Bhaduri, A., 1990. Macroeconomics: The Dynamics of Commodity Production, pages
1 – 27, Macmillan India Limited, New Delhi.
2. Branson, W. H., 1992. Macroeconomic Theory and Policy, (third edition), pages
15 – 34, Harper Collins Publishers India Pvt Ltd., New Delhi.
3. Dornbusch, R and S. Fischer. 1988. Macroeconomics, (fourth edition) pages 29–
62, McGraw Hill, Paris.
4. Mankiw, N. G., 2000. Macroeconomics, (fourth edition) pages 15–76, Macmillan
Worth Publishers, New York.
Appendix 2.1

Table 2.5: GVA and GDP for India at constant (2011-12) prices6

34 PE (Provisional Estimates)
S.No. Item 2020–21
Introductory Macroeconomics

(Rs. Lakh Crore)

1. GVA at basic prices 124.53

2. Net production taxes 10.59

3. GDP (1+2) 135.13

Source: Annual Report, Reserve Bank of India, 2020–21
(Handbook of Statistics on Indian Economy)

6
These are provisional estimates released by the CSO in 2018.

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Appendix 2.2

Table 2.6: Composition of GDP: expenditure side (2011–12 prices)

S.No. Item (Provisional

Estimates)
2017–18
(Rs. In Crore)

1. Private Final Consumption Expenditure (PFCE) 7560985

2. Government Final Consumption Expenditure 1586745

(GFCE)

3. Gross Fixed Capital Formation (GFCF) 4220508

4. Change in Stocks 154276

5. Valuables 167784

Investment (3+4+5) 4542568

6. Exports of Goods and Services 2694386

7. Imports of Goods and Services 2865827

Net Exports (6-7) 5560213

8. Discrepancies 6117

9. GDP (1+2+3+4+5+6-7+8) 19244394

Source: Annual Report, Reserve Bank of India, 2020–21 (Handbook of Statistics on
Indian Economy)
35

National Income Accounting

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 CHAPTER 2: ECONOMICS

 National Income

National Income is defined as the sum total of the monetary value of all final goods and services produced
in a country, i.e., the incomes earned by the citizens of the country in a particular period (generally, one
year).

There are 5 measures of the national income, and these measures are GDP (Gross Domestic Product),
GNP (Gross National Product), NNP (Net National Product), P.I. (Personal Income), and DPI
(Disposable Personal Income).

Transfer Income:

 Transfer income/payment refers to those income or payment originates with no current goods
and service produced. These are not included in national income estimation.

 Example: Old age pension, Scholarship, Bonus, Prize money etc.

Non-Economic production:

 Includes the production of goods and services that are not meant to be sold , nor there is any
market for them , nor do they have a market price.

 Example: Services rendered to self. These are also not included in national income
accounting.

 GDP (Gross Domestic Product): The total monetary value of all final goods and services produced
within the geographical boundary of the country during a particular period (Generally one year). In
GDP, we consider all goods/ services produced by both resident citizens and foreign nationals who
reside in India and the income of Indians abroad are excluded.
 GNP (Gross National Product): The total value of the final goods and services produced by Indians
in India and abroad during a particular period. GNP includes the value of goods produced by resident
and non-resident citizens of a country, whereas the income of foreigners who reside in India is
excluded.
o GNP= GDP+ receipt from nonresidents – payment to foreigners
o i.e GNP= GDP+ Net income from abroad (NFIA)
o Net export is alternatively known as net income from abroad / net foreign income.
o GDP= GNP possible when 1) receipt= payment2) receipt= payment= 0
o (It is possible in a closed economy)
o Net Factor Income from Abroad (NFIA)
It refers to the difference between factor income received from the rest of the world and factor income
paid to the rest of the world.
 a) „Factor income from abroad‟- the income earned by the normal residents of a country from the rest
of the world (in the form of wages and salaries, rent, interest, dividend and retained earnings.)
b) „Factor income to abroad‟- the factor income paid to the normal residents of other countries (i.e.,
non-residents) for their factor services within the economic territory.

 Net National Product (NNP): It is calculated by deducting depreciation from Gross National
Product (GNP),
i.e., NNP = GNP – Depreciation.
 Net Domestic Product (NDP):It is calculated by deducting depreciation from Gross Domestic
Product (GNP),
i.e., NDP = GDP – Depreciation
 Personal income (P.I.): The sum of all the income received by the people of the country in one year.
Personal Income = National Income – (Undistributed Corporate Profits+ Corporate Taxes + Social
Security Contribution) + (Transfer Payments). Transfer Payments are payments that are not against
any productive work. (Example- Old Age Pension, Unemployment compensation etc.).
 Disposable Personal Income (DPI): Income available to individuals after deducting direct taxes.
Disposable Personal Income = Personal Income – Direct Taxes.

Some Definition

 Factor cost: It is the total cost of all the factors of production consumed or used in producing a good
or service.

 Basic price: Basic price is the amount receivable by the producer from the purchaser for a unit of a
good or service produced as output minus any tax payable, plus any subsidy receivable, on that unit as
a consequence of its production or sale.

 Market price: Market price is the price at which a product is sold in the market. It includes the cost
of production in the form of wages, rent, interest, input prices, profit, etc. It also includes the taxes
imposed by the government and the subsidies provided by the government for the producers.

 Relation between Market Price and factor cost

Market Price = {Factor cost + Taxes (Indirect tax)} – Subsidies

Or,

Factor cost = Market Price – Taxes (Indirect tax) + Subsidies

GDP at Factor Cost

  The factor cost does not include the taxes that are paid to the government since taxes are not
directly involved in the production process and, therefore, are not a part of the direct production
cost.
 However, subsidies received are included in the factor cost as subsidies are direct inputs into
production.
Factor Cost = Cost of Production + Subsidies – Taxes
GDP at Factor Cost= Sum of all Gross Value Added (GVA) at factor cost
Thus, GDP at Factor Cost= GDP at market price - Indirect Taxes + Subsidy

GDP at Market Price

 GDP at market price is the price which is set after all the levels of value additions and at which
goods and services are sold or offered in the marketplace.
 Conventionally, the market price is the sum of the cost of production and indirect taxes.
Market Price (MP) = Cost of Production or factor cost + Net Indirect Taxes
Net Indirect Taxes = Indirect Taxes – Subsidy
GDP at Market Price= GDP at factor cost+ Indirect Taxes – Subsidy

Some Formulas:

 GVA at factor cost + (Production taxes less production subsidies) = GVA at basic prices

 GDP at market prices = GVA at basic prices + Product taxes – Product subsidies

 Basic price = Factor cost + Production taxes – Production subsidy

 Market price = Basic price + Product taxes – Product subsidy

Or, Market Price = Factor cost + Net indirect taxes

Where,

 Net indirect taxes = Indirect taxes – Subsidy

 GDP at factor cost= GDP at market price – indirect tax+ Subsidies

 GNP at Market Price = GNP at factor cost+ indirect taxes – subsidies
 GNP at market price – Depreciation = NNP at market price
 NNP at market price- indirect taxes + Subsidies = NNP at factor cost
 Difference between Factor Cost and Market Price

Aspect Factor Cost Market Price

The actual cost incurred to hire factors of The price at which goods and services are sold to
Definition
production. consumers.
Producer's viewpoint, focusing on cost of
Perspective Consumer's viewpoint, reflecting willingness to pay.
production.

Includes payments to land, labor, capital, and Represents the final price inclusive of production
Components
entrepreneurship. cost, taxes, and profit margin.

Role in Decision- Affects resource allocation, production Influences consumer purchasing decisions and overall
making methods, and income distribution. demand.
Income Determines the income earned by factors of
Does not directly impact factor incomes.
Distribution production.
Determines production costs and profit Reflects both production costs and profit margin
Impacton Pricing
margins. desired by producers.

Economic Influences investment decisions and sectoral

Drives demand and influences supply behavior.
Impact growth.

Reflects the cost side of economic

Comparison Represents the revenue side of economic transactions.
transactions.

If labor costs increase, factor cost rises for If demand for a product increases, market price may
Example
businesses. rise due to higher consumer willingness to pay.

 Per Capita Income-is the average income of the people of an economy in a specified year. It is
calculated by dividing the national income by its total population.

i.e. Per capita income = National income/population

Methods of Measuring

National Income of a country is calculated by Simon Kuznets in the following methods:

• Income Method

• Production (Value-Added) Method

• Expenditure Method

 Although in recent time “Social accounting method” of measuring national income is developed
by Richard Stone.

 Export import method, Input output, Investment method etc. are not the any method of National
income estimation.

 In India National income is estimated by a combination of product and income method.

 Combination of product method and income method was first time utilized for national income
estimation in 1931-32 by Mr V.K.R.V Rao.

 First Scientifically National income was estimated by Mr V.K.R.V Rao in 1931-32.

1. Income Method of Calculating National Income

The National income is estimated by adding the mixed income of self-employed and all the production
factors like profit, interest, wages, rents, etc. Almost 1/3rd of the Indian population is self-employed.
Thus, the self-employed income is considered the domestic income, which is related to production within
the country‟s border.

The income method is also known as the Factor Income method, which includes adding the trading
surplus of the public sector corporations and undistributed benefits of the private actor.
 2. Production Method of National Income

According to the Production Method, the National income is estimated by adding the value added by all
the firms. The value added is equal to the difference between the Value of Output and the Value of (non-
factor) inputs. The production method gives the Gross Domestic Product at the Market Price. To calculate
the National Income,

• Add Net Factor Income from Abroad: GNP at M.P. = GDP at M.P. + NFIA

• Subtract Depreciation: NNP at M.P. = GNP at M.P. – Dep

• Subtract Net Indirect Taxes: NNP at F.C. = NNP at M.P. – NIT

In this method national income is measured as a flow of goods and services ,i.e in product method , we
calculate money value of all final goods and services produced by the citizen in an economy during a
year.

Final goods – refer to those goods which are directly consumed and not used in further production
processing.

Double counting or multiple counting error problem which means counting of the value of same product
more than once, is arising at the time of estimation of national income thorough product method.

To avoid the error of double counting or multiple counting in the calculating of the national income , we
shall concentrate on value added method (VAM) as employed in the product method.

So, in national income estimation, the product method is also known as value added method (VAM).

3. Expenditure Method of Measuring National Income

The expenditure method is used to measure the domestic economic expenditure and consists of two
elements, i.e., Investment expenditure and Consumption expenditure. According to the expenditure, the
method to measure national income by: Y= C + I + G + (X - M)

Here, X - M = Net Exports, X = Exports, M = Imports, I = Investment or Capital Formation, G = Govt‟s

expenditure on final consumer goods, C = Private Sector‟s Expenditure on final consumer goods, and Y =
GDP at M.P. The investment expenditure is the expenditure on the construction of fixed capital like
buildings, machinery, etc., while the Consumption expenditure includes goods and services.
Estimation of National Income in India

In 1868, Dadabhai Naoroji wrote a book „Poverty and Un British Rule in India.‟ It was the first attempt at
the calculation of National Income. The first person to estimate National Income scientifically was Dr V.
K. R. V. Rao, who estimated national income for 1925-29. After Independence, the National Income
committee was formed in 1949 under the chairmanship of P.C. Mahalanobis. And Central Statistical
Organisation (CSO) was formed after some years.

Importance of National Income Accounting

National Income Accounting gives a clear idea of the country‟s economy. It helps the government to form
new policies and to come up with better economic models for planning the economic model of the
country. The significance of National Income Accounting is explained as follows-

• For the Economy: In regard to economic accounting, the National Income data is considered an
important tool as it depicts the output and product results from an individual‟s income, international trade
transactions, and industrial products.

• National Policies: These form the basis for forming national policies. It helps in knowing the direction
of the investment and the output of these policies, which will help in changing the policies and coming up
with proper measures for a stable economy.

• Economic Planning: Knowing the data of the gross income, output, saving, and consumption of the
different sources is important for economic planning.

• Research: The data collected by the Ministry of Statistics and Programme Implementation is used by
economics scholars to conduct research.

• Economic Models: Economists come up with long-run and short-run economic and investment models
using the data of the national income.
• Per Capita Income: Calculation of National Income is essential for calculating the per capita income of
the country. The greater value of Per capita income, the greater the country‟s economic welfare.

Issues related to National Income Accounting in India

The problems related to the different methods used for National Income Accounting in India includes the
following-

• Problems in Income Method involves Owner-occupied houses, self-employed persons, goods meant
for Self-consumption, and wages and salaries paid in kind.

• Problems in Product Method involves services of housewives, Intermediate and Final Goods, Second-
hand goods assets, illegal activities, consumer‟s services, capital gains, inventory changes, depreciation,
price changes, etc.

• Problems in Expenditure Method involves Government services, transfer payments, durable-use of

Consumers‟ goods, and public expenditure.

Circular Flow of Income

The circular flow means the unending flow of production of goods and services, income, and expenditure
in an economy. It shows the redistribution of income in a circular manner between the production unit and
households.

These are land, labour, capital, and entrepreneurship.

o The payment for the contribution made by fixed natural resources (called land) is known as rent.
o The payment for the contribution made by a human worker is known as wage.
o The payment for the contribution made by capital is known as interest.
o The payment for the contribution made by entrepreneurship is known as profit.

Circular Flow of Income in a Two-Sector Economy

It is defined as the flow of payments and receipts for goods, services, and factor services between the
households and the firm sectors of the economy.
Explanation

 The outer loop of the diagram shows the flow of factor services from households to firms and the
corresponding flow of factor payments from firms to households.
 The inner loop shows the flow of goods and services from firms to households and the
corresponding flow of consumption expenditure from households to firms.
 The entire amount of money, which is paid by firms as factor payments, is paid back by the factor
owners to the firms.

Real GDP and Nominal GDP

Poverty
Poverty is a state or condition in which a person or community lacks the
financial resources and essentials for a minimum standard of living. Poverty
means that the income level from employment is so low that basic human
needs can't be met.

The UN Human Rights Council has defined poverty as “A human condition

characterized by the sustained or chronic deprivation of the resources,
capabilities, choices, security and power necessary for the enjoyment of an
adequate standard of living and other civil, cultural, economic, political and
social rights”.

According to World Bank, Poverty is pronounced deprivation in well-being,

and comprises many dimensions. It includes low incomes and the inability to
acquire the basic goods and services necessary for survival with dignity.
Poverty also encompasses low levels of health and education, poor access to
clean water and sanitation, inadequate physical security, lack of voice, and
insufficient capacity and opportunity to better one's life.

Types of poor:

There are multiple ways to describe poverty-stricken people.

• Chronic poor: People who are leading constant lives of poverty and who
are normally poor but may have a small amount of money with them
(for example, casual workers) are classified collectively as the chronic
poor.

• Churning poor: The churning poor are the people who go in and out of
poverty (for example, small farmers and seasonal workers).

• Transient poor: The poor who are well off most of the time but may be
subject to bad luck or difficult times at times. They are known as the
transient poor.

Types of Poverty:

• There are two main classifications of poverty:

 Absolute Poverty:
 • A condition where household income is below a necessary level to
maintain basic living standards (food, shelter, housing). This concept is
based on absolute needs of the people and people are defined as poor
when some absolute needs are not sufficiently satisfied.

• This condition makes it possible to compare between different countries

and also over time.

• It was first introduced in 1990, the “dollar a day” poverty line measured
absolute poverty by the standards of the world's poorest countries. In
October 2015, the World Bank reset it to $1.90 a day.

• In India, these basic needs are measured in terms of calorie intake of

2400 in rural areas per person per day and 2100 in urban areas per
person per day.

Measures of Absolute Poverty

• Poverty Line: Poverty line is referred to as that amount of money that is

required by a person to meet their basic needs such as food, shelter and
clothing or it can be defined as the level of income that is required to
sustain a minimum standard of living.

The current poverty line in rural regions is 1,059.42 Indian rupees (62 PPP
USD) per month, while in urban areas it is 1,286 Indian rupees (75 PPP
USD) per month.

Note: Dadabjai Naoroji was the first person who discuss the concept of
poverty line.

• Head Count Ratio: It indicates the percentage of people living below the
poverty line. HCR indicates the incidence of poverty in a nation. Hence, it
is also termed as poverty incidence ratio.

HCR = Total no. of BPL people / Total population x 100

 Relative Poverty:

• It is defined from the social perspective that is living standard

compared to the economic standards of population living in
surroundings.
• Hence it is a measure of income inequality.

• This concept is related to the general standard of living in a society.

Thus, according to this concept, people are poor because they are
deprived of the opportunities, comforts and self-respect regarded as
normal in the community to which they belong.

• In relative poverty, poor are defined as, a person or family whose

incomes are less than the average income of the community.

The concept of relative poverty is used to indicate the level of income inequality in
a nation. It is measured through:
a. Gini co efficient (In mathematical terms).
b. Lorenz Curve (In graphical terms).
Gini Co-efficient or Gini Index

• It is developed by the Italian statistician and sociologist Corrado Gini in

1912.
• The value of Gini Coefficient varies from 0 and 1.
• 0 represents perfect equality i.e. a situation where every resident has the
same income.
• 1 represents perfect inequality i.e. one resident earns all the income and the
others have no income.
• The higher the Gini coefficient, the more is the gap between rich & poor in
a country.

Lorenz Curve

• It is a curve that measures the relationship between the percentage of

income earned and percentage of people who earned that particular
percentage of Income.
• Perfect equality is represented by a straight 45 degree line.
• Curve below the perfect equality line represents the Lorenz curve.
• The closed the Lorenz curve to the perfect equality line, the less is the
level of income inequality and vice versa.
CAUSES OF POVERTY

• Population Explosion: India’s population has steadily increased through

the years. During the past 45 years, it has risen at a rate of 2.2% per
year, which means, on average, about 17 million people are added to
the country’s population each year. This also increases the demand for
consumption goods tremendously.

• Low Agricultural Productivity: A major reason for poverty in the low

productivity in the agriculture sector. The reason for low productivity is
manifold. Chiefly, it is because of fragmented and subdivided land
holdings, lack of capital, illiteracy about new technologies in farming, the
use of traditional methods of cultivation, wastage during storage, etc.

• Inefficient Resource utilisation: There is underemployment and

disguised unemployment in the country, particularly in the farming
sector. This has resulted in low agricultural output and also led to a dip
in the standard of living.

• Low Rate of Economic Development: Economic development has been

low in India especially in the first 40 years of independence before the
LPG reforms in 1991.

• Price Rise: Price rise has been steady in the country and this has added
to the burden the poor carry. Although a few people have benefited
 from this, the lower income groups have suffered because of it, and are
not even able to satisfy their basic minimum wants.

• Unemployment: Unemployment is another factor causing poverty in

India. The ever-increasing population has led to a higher number of job-
seekers. However, there is not enough expansion in opportunities to
match this demand for jobs.

• Lack of Capital and Entrepreneurship: The shortage of capital and

entrepreneurship results in low level of investment and job creation in
the economy.

• Colonial Exploitation: The British colonization and rule over India for
about two centuries de-industrialised india by ruining its traditional
handicrafts and textile industries. Colonial Policies transformed india to
a mere raw-material producer for european industries.

• Climatic Factors: Most of india’s poor belong to the states of Bihar, UP,
MP, Chhattisgarh, odisha, Jharkhand, etc. Natural calamities such as
frequent floods, disasters, earthquake and cyclone cause heavy damage
to agriculture in these states

Poverty Estimation in India

• Poverty estimation in India is carried out by NITI Aayog’s task force

through the calculation of poverty line based on the data captured by
the National Sample Survey Office under the Ministry of Statistics and
Programme Implementation (MOSPI).
• Poverty line estimation in India is based on the consumption
expenditure and not on the income levels.

• Alagh Committee (1979) determined a poverty line based on a minimum

daily requirement of 2400 and 2100 calories for an adult in Rural and
Urban area respectively.

• Subsequently different committees; Lakdawala Committee (1993),

Tendulkar Committee (2009), Rangarajan committee (2012) did the
poverty estimation.

• As per the Rangarajan committee report (2014), the poverty line is

estimated as Monthly Per Capita Expenditure of Rs. 1407 in urban
areas and Rs. 972 in rural areas

Poverty Alleviation Programs in India

• Integrated Rural Development Programme (IRDP):

• It was introduced in 1978-79 and universalized from 2nd October, 1980,

aimed at providing assistance to the rural poor in the form of subsidy
and bank credit for productive employment opportunities through
successive plan periods.

• Jawahar Rozgar Yojana/Jawahar Gram Samridhi Yojana: The JRY was

meant to generate meaningful employment opportunities for the
unemployed and underemployed in rural areas through the creation of
economic infrastructure and community and social assets.

• Rural Housing – Indira Awaas Yojana: The Indira Awaas Yojana (LAY)
programme aims at providing free housing to Below Poverty Line (BPL)
families in rural areas and main targets would be the households of
SC/STs.

• Food for Work Programme: It aims at enhancing food security through

wage employment. Food grains are supplied to states free of cost,
however, the supply of food grains from the Food Corporation of India
(FCI) godowns has been slow.
• Annapurna Scheme: This scheme was started by the government in
1999– 2000 to provide food to senior citizens who cannot take care of
themselves and are not under the National Old Age Pension Scheme
(NOAPS), and who have no one to take care of them in their village. This
scheme would provide 10 kg of free food grains a month for the eligible
senior citizens. They mostly target groups of ‘poorest of the poor’ and
‘indigent senior citizens’.

• Sampoorna Gramin Rozgar Yojana (SGRY): The main objective of the

scheme continues to be the generation of wage employment, creation
of durable economic infrastructure in rural areas and provision of food
and nutrition security for the poor.

• Mahatma Gandhi National Rural Employment Guarantee Act

(MGNREGA) 2005: The Act provides 100 days assured employment
every year to every rural household. One-third of the proposed jobs
would be reserved for women. The central government will also
establish National Employment Guarantee Funds. Similarly, state
governments will establish State Employment Guarantee Funds for
implementation of the scheme. Under the programme, if an applicant is
not provided employment within 15 days s/he will be entitled to a daily
unemployment allowance.

• National Rural Livelihood Mission: Aajeevika (2011): It evolves out the

need to diversify the needs of the rural poor and provide them jobs with
regular income on a monthly basis. Self Help groups are formed at the
village level to help the needy.

• Pradhan Mantri Kaushal Vikas Yojana: It will focus on fresh entrant to

the labour market, especially labour market and class X and XII dropouts.
Unemployment
• Disguised Unemployment:

 It is a phenomenon wherein more people are employed than actually

needed.

 It is primarily traced in the agricultural and the unorganized sectors of

India.

Marginal Productivity of Labor=0.

• Seasonal Unemployment:

 It is an unemployment that occurs during certain seasons of the year.

 Agricultural labourers in India rarely have work throughout the year.

• Structural Unemployment:

 It is a category of unemployment arising from the mismatch between

the jobs available in the market and the skills of the available workers in
the market- Insufficient skill

 Many people in India do not get job due to lack of requisite skills and
due to poor education level, it becomes difficult to train them.

• Cyclical Unemployment:

 It is result of the business cycle, where unemployment rises during

recessions and declines with economic growth (with Boom and Bust).

 Cyclical unemployment figures in India are negligible. It is a

phenomenon that is mostly found in capitalist economies.

• Technological Unemployment:

 Man/ Woman replaced by machines

 It is loss of jobs due to changes in technology.

 In 2016, World Bank data predicted that the proportion of jobs

threatened by automation in India is 69% year-on-year.
  (Acc. To World Economic Forum, by 2025 75 million jobs will be lost but
133 million jobs will be created also)

• Frictional Unemployment:

 The Frictional Unemployment also called as Search Unemployment,

refers to the time lag between the jobs when an individual is searching
for a new job or is switching between the jobs (transitional time).

 In other words, an employee requires time for searching a new job or

shifting from the existing to a new job, this inevitable time delay causes
the frictional unemployment. It is often considered as a voluntary
unemployment because it is not caused due to the shortage of job, but
in fact, the workers themselves quit their jobs in search of better
opportunities.

• Under Unemployment:

 Underemployment is a measure of employment and labor utilization in

the economy that looks at how well the labor force is being used in
terms of skills, experience, and availability to work. It refers to a
situation in which individuals are forced to work in low-paying or low-
skill jobs.

• According to NSSO, a person is either employed or unemployed based

on whether he/she belongs to the Labour Force or not. This depends on
the activity status of the individual.

• According to NSSO, the Activity Status is classified into two broad

categories:

 Employed i.e., working during the time when the survey was conducted.

 Unemployed i.e., available to work but is not recruited by any of the

sectors within the economy.

 Neither seeking nor is available for work.

 All those individuals belonging to the employed and unemployed

categories of the Activity status belong to the labour force.
  Labor Force Participation Rate (LFPR)= (Labor Force/ Total
Population)*100

 The unemployment rate is the percentage of people who are unable to

find work.

 Unemployment rate =

(Number of people unemployed/total labour force) x 100.

 According to the Periodic Labour Force Survey (PLFS) of NSSO, the

unemployment rate was at 5.3% in rural India and 7.8% in Urban India.

 The unemployment rate as of April 2019 has risen by 7.6%. This is the
highest in two years. This is based on the data provided by the State of
India’s Environment (SOE) in Figures released by Delhi based non-profit
organization – Centre for Science and Environment.

 Work force participation age 15-60 years.

Types of Workers in India

According to NSO:

 Self employed- Own self

 Regular/ Salaried employed- under some organization regularly.

 Casual Workers- very short time period on daily or monthly basis.

According to Census 2011:

 Main Worker- workers employed more than 183 days

 Marginal Worker- workers employed less than 6 months.

Measurement of Unemployment in India

• National Sample Survey Office (NSSO), measures unemployment in India

on following approaches:
 • Usual Status Approach: This approach estimates only those persons as
unemployed who had no gainful work for a major time during the 365
days preceding the date of survey.

• Weekly Status Approach: This approach records only those persons as

unemployed who did not have gainful work even for an hour on any
day of the week preceding the date of survey.

• Daily Status Approach: Under this approach, unemployment status of a

person is measured for each day in a reference week. A person having
no gainful work even for 1 hour in a day is described as unemployed for
that day.

Causes of Unemployment

• Large population.

• Low or no educational levels and vocational skills of working population.

• Inadequate state support, legal complexities and low infrastructural,

financial and market linkages to small/ cottage industries or small
businesses, making such enterprises unviable with cost and compliance
overruns.

• Huge workforce associated with informal sector due to lack of required

education/ skills, which is not captured in any employment data. For ex:
domestic helpers, construction workers etc.

• The syllabus taught in schools and colleges, being not as per the
current requirements of the industries. This is the main cause of
structural unemployment.

• Inadequate growth of infrastructure and low investments in

manufacturing sector, hence restricting employment potential of
secondary sector.

• Low productivity in agriculture sector combined with lack of

alternative opportunities for agricultural worker which makes
transition from primary to secondary and tertiary sectors difficult.

• Regressive social norms that deter women from taking/continuing

employment.
 CHAPTER
22
UNEMPLOYMENT AND FULL EMPLOYMENT

INTRODUCTION

Unemployment has been one of the most persistent and unmanageable

problems facing all industrial countries of the world. At the same time, the
goal of public policy has been to remove unemployment and to achieve
full employment in such countries. We attempt below the various types of
causes of unemployment for an understanding of the meaning of the term
full employemnt.

TYPES OF UNEMPLOYMENT

Before explaining the various types of unemployment, it is necessary to

define the term unemployment. Everyman’s Dictionary of Economics
defines unemployment as “involuntary idleness of a person willing to
work at the prevailing rate of pay but unable to find it.” It implies that
only those persons are to be regarded as unemployed who are prepared to
work at the prevailing rate of pay but they do not find work. Voluntarily
unemployed persons who do not want to work like the idle rich, are not
considered unemployed. We now analyse the various causes or types of
unemployment.

1. Frictional Unemployment. Frictional unemployment exists when there

is lack of adjustment between demand for and supply of labour. This may
be due to lack of knowledge on the part of employers about the
availability of workers or on the part of workers that employment is
available at a particular place. It is also caused by lack of necessary skills
for a particular job, labour immobility, breakdowns of machinery,
shortages of raw materials, etc. The period of unemployment between
losing one job and finding another is also included under frictional
unemployment.

2. Seasonal Unemployment. Seasonal unemployment results from

seasonal fluctuations in demand. Employment in ice factories is only for
the summer. Similarly ice-cream sellers remain unemployed during winter
and chestnut-sellers during summer. The same is the case with agricultural
workers who remain employed during harvesting and sowing seasons and
remain idle for the rest of the year.

3. Cyclical Unemployment. Cyclical unemployment arises due to

cyclical fluctuations in the economy. They may also be generated by
international forces. A business cycle consists of alternating periods of
booms and depressions. It is during the downswing of the business cycle
that income and output fall leading to widespread unemployment.

4. Structural Unemployment. Structural unemployment results from a

variety of causes. It may be due to lack of the co-operant factors of
production, or chages in the economic structure of the society. The word
structural implies that “the economic changes are massive, extensive,
deep-seated, amounting to transformation of an economic structure, i.e.,
the production functions or labour supply distribution. More specifically,
it refers to changes which are large in the particular area, industry or
occupation.” Shifting patterns in the demand for the products of various
industries have also been responsible for this type of unemployment.
There are, however, economists who argue that the higher unemployment
in America since 1957 has been due to causes other than inadequae
demand: (1) A faster rate of technological change; (2) a displaced worker
remains unemployed for a number of days in finding a new job; and (3)
most of the unemployed workers belong to blue-collar groups. The
supporters of the structural transformation thesis hold that the number of
vacancies is greater than or equal to the number of displaced workers due
to structural changes in a particular area, industry or occupation, and that
unemployment is not due to inadequacy of demand.

5. Technological Unemployment. Keynes failed to take into account

technological unemployment that has taken place more rapidly in the post-
war period. Modern prodution process is essentially dynamic where
innovations lead to the adoption of new machineries and inventions
thereby displacing existing workers leaving behind a trail of
unemployment. When there is automation or displacement of old
technology by a new one requiring less workers than before, there is
technological unemployment. A special case of technological
unemployment is that “which is not due to improvements in the technique
of production but in the technique of organisation.” It pertains to making
management more efficient which may decide upon modernising existing
facilities or closing down obsolete plants. In all such cases unemployment
is bound to decrease.

In fact, there is little to distinguish between structural and technology

unemployment. One of the causes of structural unemployment is
technological change. Technological change itself causes obsolesence of
skills thereby leading to structural unemployment. Further, both structural
and technological unemployment are related to inadequate demand.
Technological change tends to increase output per man-hour which has
the effect of raising the potential total output in the economy. If this
potential growth in output is not matched by the actual growth in output,
there will be unemployment in the economy due to deficiency in demand.
Therefore, modern economists are of the view that unemployment is
caused by structural changes, technological changes and by inadequacy of
demand taken together.

6. Disguised Unemployment. Disguised or concealed unemployment or

underemployment is a notable feature of underdeveloped countries. Such
unemployment is not voluntary but involuntary. People are prepared to
work but they are unable to find work throughout the year due to the lack
of complementary factors. Such unemployment is found among rural
landless and small farmers due to the seasonal nature of farm operations
and inefficient land and equipment to keep them fully employed. A person
is said to be disguised unemployed if his contribution to output is less than
what he can produce by working for normal hours per day. His marginal
productivity is nil or negligible, and by withdrawing such labourers, farm
output can be increased.
 There are also other types of underemployed persons in such countries. A
person is considered to be underemployed if he is forced by
unemployment to take a job that he thinks is not adequate for his purpose,
or not commensurate with his training. Further, there are those who work
full time in terms of hours per day but earn very little to rise above the
poverty level. They are hawkers, petty traders, rickshaw pullers, workers
in hotels and restaurants and in repair shops, etc. in urban areas. Open and
disguised unemployed in urban and rural areas are estimated at 30-35 per
cent of the labour force in underdeveloped countries.

MEANING OF FULL EMPLOYMENT

Right from the classicals to the modern economists, there is no unanimity

of views on the meaning of ‘full employment’. It is a very “slippery
concept”, according to Professor Ackley. But the credit for popularising it
goes to Keynes, and since the end of the Second World War it has been
accepted as one of the important goals of public policy. Though “full
employment is not definable nor should it be defined,” according to
Professor Henry Hazlitt, yet it is worth-while analysing the various views
of economists on full employment.

The Classical View1

The classical economists always believed in the existence of full

employment in the economy. To them full employment was a normal
situation and any deviation from this was regarded as something
abnormal. According to Pigou, the tendency of the economic system was
to automatically provide full employment in the labour market.
Unemployment resulted from the rigidity in the wage structure and
interference in the working of free market system in the form of trade
union legislation, minimum wage legislation, etc. Full employment exists
“when everybody who at the running rate of wages wishes to be
employed.” Those who are not prepared to work at the existing wage rate
are not unemployed in the Pigovain sense because they are voluntarily
unemployed. There is, however, no possibility of involuntary
unemployment in the sense that people are prepared to work but they do
not find work. According to Pigou, “With perfectly free competition—
 there will always be at work a strong tendency for wage rates to be so
related to demand that everybody is employed.” However, this classical
view on full employment is consistent with some amount of frictional,
voluntary, seasonal or structural unemployment.

1. For figures and detailed explanation refer to Ch. 6.

The Keynesian View

According to Keynes, full employment means the absence of involuntary

unemployment. In other words, full employment is a situation in which
everybody who wants to work gets work. Full employment so defined is
consistent with frictional and voluntary unemployment. Keynes assumes
that “with a given organisation, equipment and technique, real wages and
the volume of output (and hence of employment) are uniquely co-related,
so that, in general, an increase in employment can only occur to the
accompaniment of a decline in the rate of wages.” To achieve full
employment, Keynes advocates increase in effective demand to bring
about reduction in real wages. Thus the problem of full employment is one
of maintaining adequate effective demand. “When effective demand is
deficient,” writes Keynes, “there is underemployment of labour in the
sense that there are men unemployed who would be willing to work at less
than existing real wage. Consequently, as effective demand increases,
employment increases, though at a real wage equal to, or less than, the
existing one, until a point comes, at which there is no surplus of labour
available at the then existing real wage.” Keynes gives an alternative
definition of full employment at another place in his General Theory thus:
“It is a situation in which aggregate employment is inelastic in response to
an increase in the effective demand for its output.” It means that the test of
full employment is when any futher increase in effective demand is not
accompained by any increase in output. Since the supply of output
becomes inelastic at the full employment level, any further increase in
effective demand will lead to inflation in the economy. Thus the
Keynesian concept of employment involves three conditions: (i) reduction
in the real wage rate, (ii) increase in effective demand, and (iii) inelastic
supply of output at the level of full employment.2
Other Views on Full Employment

According to Professor W.W. Hart, attempting, to define full employment

raises many people’s blood pressure. Rightly so, because there is hardly
any economist who does not define it in his own way.

Lord Beveridge in his book Full Employment in a Free Society defined it

as a situation where there were more vacant jobs than employed men so
that normal lag between losing one job and finding another will be very
short. By full employment he does not mean zero employment which
means that full employment is not always full. There is always a certain
amount of frictional unemployment in the economy even when there is
full employment. He estimated frictional unemployment of 3% in a full
employment situation for England. But his pleading for more vacant jobs
than the unemployed cannot be accepted as the full employment level.

According to the American Economic Association Committee, “Full

employment means that qualified poeple who seek jobs at prevailing rates
can find them in productive activities without considerable delay. It means
full time jobs for people who want to work full time. It does not mean
people like house-wives and students are under pressure to take jobs when
they don’t want jobs or that workers are under pressure to put in undesired
overtime. It does not means unemployment is ever zero” This is not a
definition but a description of full employment situation where all
qualified persons who want jobs at current wage rates find full-time jobs.
Here again, like Beveridge, the Committee considered full employment to
be consistent with some amount of unemployment.

2. See Figure 2 of Ch. 20 and its explanation.

Individual economists may, however, continue to differ over the definition

of full employment, but the majority has veered round the view expressed
by the U.N. Experts on National and International Measures for Full
Employment that “full employment may be considered as a situation in
which employment cannot be increased by an increase in effective
demand and unemployment does not exceed the minimum allowances that
must be made for the effects of frictional and seasonal factors.” This
 definition is in keeping with the Keynesian and Beveridgian views on full
employment. It is now agreed that full employment stands for 96 to 97 per
cent employment, with 3 to 4 per cent unemployment existing in the
economy due to frictional factors.

MEASURES TO ACHIEVE AND MAINTAIN FULL EMPLOYMENT

Since underemployment is caused by deficiency in effective demand, full

employment can be achieved by increasing effective demand either by
stimulating investment or consumption, or both. Full employment is thus
sought to be achieved and maintained by monetary, fiscal and direct
measures which are discussed in the chapters on Monetary and Fiscal
Policies.

EXERCISES

1. What do you mean by full employment ? Explain measures to

achieve full employment.
2. Distinguish between structural unemployment and technological
unemployment.
3. Write notes on : frictional, cyclical and disguised unemployment.
UNIT 6 INFLATION AND UNEMPLOYMENT 
Structure
6.0 Objectives
6.1 Introduction
6.2 Types of Unemployment
6.3 Phillips Curve
6.4 Natural Rate of Unemployment
6.5 Expectation-Augmented Phillips Curve
6.5.1 Phillips Curve under Adaptive Expectations
6.5.2 Phillips Curve under Rational Expectations
6.6 Let Us Sum Up
6.7 Answers/ Hints to Check Your Progress Exercises

6.0 OBJECTIVES
After going through this unit you should be able to
 identify various types of unemployment;
 explain the concept of natural rate of unemployment;
 establish a relationship between unemployment and inflation;
 explain how the short-run Phillips curve shifts; and
 reconcile the difference in shape of the Phillips curve in short-run and long-
run.

6.1 INTRODUCTION
In Units 7 and 8 of BECC 103 we gave some preliminary ideas of inflation – its
definition, causes and effects. In this Unit we describe the relationship between
inflation and unemployment. In the process, we discuss various types of
unemployment and its measurement. Recall that classical economists believed in
dichotomy of real and monetary variables. Thus, inflation being a monetary
variable should not have any effect on a real variable such as unemployment.
Keynesian economists, however, believed that change in monetary variables
could affect real variables.
Inflation, as you know, is defined as a persistent rise or, a tendency towards
persistent rise in the general level of prices. As and when there will be


Prof. Kaustuva Barik, Indira Gandhi National Open University, New Delhi and Dr. Tarun
Manjhi, Sri Ram College of Commerce, University of Delhi.
Expectations, Inflation increase in the general price level, purchasing power of households decline.
and Unemployment
Increase in inflation is likely to reduce the value of national currency and it’s vice
versa. Although there are many types of inflation, it can be mainly classified into
three types of inflation- demand pull (caused by increase in demand), cost push
(cause by increase in cost of production) and built-in inflation (mainly caused by
past events). The rate of inflation could vary from a low level to a very high
level. As of 2021, Venezuela for example has an inflation rate of nearly 10,000
per cent per year.
Unemployment is a state in which healthy person fails to get employment at
prevailing wage. It is caused by various factors that are concerned with demand
and supply. There are broadly six types of unemployment- structural (arises due
to change in structure of economy, frictional (arises due to time gap between
changing jobs), cyclical (arises due to change in cycle of economy i.e. boom,
recession, etc.), seasonal (arises due to change in season), disguised
unemployment (it is also called hidden unemployment where marginal product of
labour is very much close to zero) and under employment in which better
qualified person end with low quality, low paid jobs because of excess supply of
labour and lower availability of job opportunity.

6.2 TYPES OF UNEMPLOYMENT

‘Labour force’ as a concept includes all persons in the age group of 16 years to
64 years who are willing to work. Thus it includes both employed and
unemployed persons. The persons not included in the labour force include those
who are retired, too ill to work, keeping the house, or simply not looking for
work.
‘Work force’ as a concept is somewhat narrower – it includes the employed
persons only. Thus the difference between the labour force and the work force
gives us the number of unemployed.
By employed persons we mean those who perform any paid work (thus
homemakers are not included) and those who have jobs. On the other hand, the
unemployed as a category includes people who are not employed but are actively
looking for work. While considering unemployment we do not take into account
those who are not in the labour force. We define unemployment rate as the
number of unemployed divided by the total labour force. You should remember
that the concept of unemployment implies ‘involuntary unemployment’. This
concept implies that a person is willing to work at the prevailing wage rate, but
cannot find work.

80
There are three types of unemployment, viz., frictional, structural and cyclical. Inflation and
Unemployment
We explain the differences below.
(i) Frictional unemployment: It takes place because people switch over from one
job to another. In many cases the tenure of job gets over and workers remain
unemployed till they get another job. In other cases workers migrate from one
region to another in search of better jobs or opt to remain out of job for short time
periods. Frictional unemployment takes place because in an economy with
imperfect information, job search and matching is not smooth and there are
frictions in the economy.
(ii) Structural unemployment: It results from the mismatch between supply and
demand for different kinds of jobs. For example, in recent years, the number of
engineers and management professionals looking for jobs in India has been much
higher than available jobs. This has resulted in a number of persons with
technical qualification opting for low qualification jobs. Structural
unemployment takes place largely due to structural shifts in an economy and
adjustments to such shifts take time. A large number of educational institutions in
India have discontinued their engineering education programmes.
(iii) Cyclical unemployment: It arises due to fluctuations in aggregate demand,
which is a part of business cycles. When aggregate demand declines, there is
simultaneous decline in the demand for labour and consequent increase in
unemployment. On the other hand, a general boom in the economy increases the
demand for labour and unemployment decreases. Thus cyclical unemployment is
pro-cyclical in nature.
Empirical data shows that the labour force in an economy is much less than the
total population. Total labour force in India, according to certain sources, is about
50 crores compared to an estimated population of 138 crores in 2020. Persons
above 65 years and children below 15 years of age however should not be taken
into consideration while comparing the size of the labour force to total
population. A relevant ratio in this context is the ‘Labour Force Participation
Rate (LFPR)’. It is defined as follows:
Size of the labour force
LFPR =
Size of population in the age group of 16 − 64 years
The labour force participation rate (LFPR) varies across countries, and over time
for the same country. If we take gender into account, there could be male labour
force participation rate and female labour force participation rate. Usually, there
is a gap between male LFPR and female LFPR. In India, for example, female
LFPR is much lower compared to male LFPR. Further, there is a sharp decline in
female LFPR in recent years. Such a decline could be due to cultural and
structural issues.
The rate of unemployment u is defined as the ratio of unemployed persons to
total labour force. The rate of unemployment varies across countries and for a
country over time.
81
Expectations, Inflation
and Unemployment
6.3 PHILLIPS CURVE
The Phillips curve, named after A W Phillips, describes the relationship between
unemployment and inflation. In 1958 Phillips, then professor at London School
of Economics, took time series data on the rate of unemployment and the rate of
increase in nominal wage rate for the United Kingdom for the period 1861-1957
and attempted to establish a relationship. He took a simple linear equation of the
following form:
𝑤̇ = 𝑎 − 𝑏𝑢
where 𝑤̇ is the rate of wage increase, a and b are constants and u is the rate of
unemployment. Phillips found that there exists a stable and inverse relationship
between 𝑤̇ and u, with the implication that lower rate of unemployment is
associated with higher rate of wage increase.
Subsequent to the publication of the results by Phillips, many economists
followed suit and attempted similar exercises for other countries. Subsequently, it
was established that there is a stable relationship between rising wage rate and
rising price level. This led some economists to refine the simple equation
estimated by Phillips and use of inflation (the rate of increase in prices) instead of
wage rate increase. In many cases the scatter of plot of variables appeared to be a
curve, convex to origin. As empirical studies reinforced the inverse relationship
between the rate of inflation and the rate of unemployment the Phillips curve
soon became an important tool of policy analysis.
The policy implication of such a result was astounding – an economy cannot
have both low inflation and low unemployment simultaneously. In order to
contain unemployment an economy has to tolerate a higher rate of wage increase
and vice versa. Thus the Phillips curve justifies the discretionary stabilization
policy of a government.
In Fig. 6.1 we depict a typical Phillips curve. Suppose the economy is operating
at point A with inflation rate of 𝜋 and unemployment rate of u1. If the
government wants to reduce the rate of inflation to u2, the economy has to
tolerate a higher rate of inflation (𝜋 ).

Inflation rate

B
𝜋

𝜋 A

u2 u1 Unemployment rate

Fig. 6.1: Phillips Curve

82
During the 1960s and early 1970s the Phillips curve was considered to be an Inflation and
Unemployment
important tool of policy analysis. The prescription was simple and straight
forward: During periods of high unemployment the government could follow an
expansionary monetary policy which leaves more money in the hands of people.
Such a policy may accelerate the rate of inflation while lowering unemployment.
Conversely, during periods of high inflation the government could follow a
contractionary economic policy so as to reduce inflation rate; the cost of such a
policy however was supposed to be higher rate of unemployment. Thus,
economists believed that there was a trade-off between inflation and
unemployment. The government could choose any combination of inflation rate
and unemployment rate depending upon the slope and position of the Phillips
curve.
During the late 1970s and early 1980s, however, such a belief got shattered. The
prescriptions of the Phillips curve did not work at all. Economies suffered from
both high inflation and high unemployment. As unemployment increased, there
was a lower level of output implying stagnation in economic growth. When
governments tried to follow Keynesian policy prescription of higher government
expenditure so as to increase aggregate demand, the rate of inflation accelerated.
Thus, what most countries experienced was ‘stagflation’ – a combination of
stagnation and inflation. The reason for stagflation was found to be supply shocks
due the ‘oil crisis’ of 1973 and 1979 (refer to Unit 6). Stagflation prompted
economists to explore further into the reasons for stagflation.
Check Your Progress 1
1. Write a brief note on the various types of unemployment.
………………………………………………………………………………
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2. Explain how the Phillips curve could offer policy options before the
government.
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83
Expectations, Inflation 3. Define the following concepts:
and Unemployment
a) Involuntary Unemployment
b) Natural Rate of Unemployment
c) Labour Force Participation Rate
d) Inflation-Unemployment Trade-Off
……………………………………………………………………………….
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6.4 NATURAL RATE OF UNEMPLOYMENT

You might have come across the term full employment, which implies that all
workers in the economy are employed. Have you ever thought of such a
situation? Can it be attained? When we say that an economy is operating at ‘full
employment’ level, we do not mean that there is zero unemployment. Because of
imperfections in markets, rigidities in wages and prices, and various frictions in
the economy it is not possible to obtain zero unemployment.
For example, at any point of time, some workers are in the transition process
from one job to another (frictional unemployment). Similarly, a fraction of
workers cannot be employed because of mismatch between the skill they possess
and the skill required (structural unemployment).
In view of the above, a new concept termed ‘natural rate of unemployment’ was
introduced in the 1960s independently by Milton Friedman and Edmund Phelps.
Natural rate of unemployment takes into account the frictions and imperfections
in the economy and assumes that it is natural for an economy to have certain
fraction of its labour force unemployed, at any point of time. We observe that any
unemployment that is not natural could be due to business cycle, or policy
related.
For empirical purposes natural rate of unemployment is the total of frictional
unemployment and structural unemployment in an economy.
It varies across countries, and over time for the same country. For the US
economy, for example, natural rate of unemployment is estimated to be between
3.5 per cent and 4.5 per cent. Many countries do not report any estimate of
natural rate of unemployment.
The concept of natural rate of unemployment reshaped macroeconomic analysis
in subsequent years. As we will see later in this Unit, expectations of economic
agents (such as households, firms and government) about future economic
environment play a major role in the shape and position of the Phillips curve.

84
6.5 EXPECTATION-AUGMENTED PHILLIPS Inflation and
Unemployment
CURVE
The Phillips curve discussed earlier could not explain stagflation in an economy.
For explaining stagflation we need to bring in expectations into our analysis. In
fact, Phillips curve given in Fig. 6.1 holds true if there is no change in
expectations in the minds of people. In case people perceive that there is a change
in expectations, then the Phillips curve will shift. Both adaptive expectations and
rational expectations have important implications for Phillips curve.
6.5.1 Phillips Curve under Adaptive Expectations
You know from microeconomics that workers and employers take decisions
regarding employment on the basis of real wage; not nominal wage. According to
Friedman and Phelps, expectations do matter. Thus the ‘expected real wage’
should be looked into account for determining equilibrium output and wage rate.
Workers usually enter into a contract with the employer regarding their salary for
certain time period. During contract period, salary cannot be re-negotiated; it can
be changed only after the contract period is over. As the workers are aware of
these conditions, they incorporate expected inflation into the contract. For
example, if the workers expect that inflation rate would be 3 per cent in the
coming year, they will negotiate the wage rate in such a manner that the real
wage rate does not decline due to price increase.
For an expected inflation rate of 𝜋 per cent, suppose the Phillips curve is given
by SRPC1 (see Fig. 6.2). Suppose the economy is at point A. At this point the
expected inflation rate is 𝜋 (say 3 per cent) and unemployment rate is at the
natural rate u* (say 6 per cent). At point A, the workers and firms expect an
inflation rate of 3 per cent and they are getting it. Thus there is no pressure on the
economy for a change.
There is a possibility of trade-off between inflation and unemployment along the
curve SRPC1. If there is higher inflation, then real wage will decline (because
nominal wage cannot be increased due to existing contracts). Consequently, firms
will employ more labour thereby leading to a decline in unemployment.
Suppose the government pursues an expansionist fiscal policy (government
expenditure increases or tax rate decreases), which will boost aggregate demand.
As a result, there is an increase in prices (means higher inflation rate). An
expansionist monetary policy, such as increase in money supply or decrease in
interest rate, will also have the same effect. It will lead to an increase in
investment which will, to some extent, increase the demand for labour also. In
either case, there is an increase in inflation rate to 𝜋 (say 6 per cent). The rate of
unemployment reduces to u2 (below the natural rate). It implies that more
workers are employed, as a result of which output will be higher than potential
output. In Fig. 6.2 we have shown this situation as point B.

85
Expectations, Inflation Equilibrium at point B, however, is temporary. Workers very soon realize that
and Unemployment
there is an unexpected increase in inflation rate. In order to compensate for the
price rise, workers will demand a higher wage rate. It will lead to a shift in the
Phillips curve from SRPC1 to SRPC2. Equilibrium in the economy will be at
point C in Fig. 6.2. Consequently, inflation will be at 𝜋 while unemployment
will be at the natural rate, i.e., u*.

LRPC
Interest Rate

𝜋3 C

B
𝜋2
A
SRPC2
𝜋1
SRPC1

u2 u*
Unemployment Rate
Fig. 6.2: Shift in Phillips Curve

Notice that unemployment in the economy is back at the natural rate (6 per cent).
The inflation rate however is much higher ( 𝜋 ). Thus the attempt of the
government to reduce unemployment rate below the natural rate inflation rate,
results in higher and higher inflation. In view of this, the natural rate of inflation
is often termed as the ‘non-accelerating inflation rate of unemployment’
(NAIRU). It means that there is no acceleration in inflation if unemployment is
maintained at this. Further, the term natural rate of unemployment indicates that
it is inflexible, but social optimal. The term NAIRU, on the other hand, does not
indicate any social optimality or desirability.

When unemployment is at the natural rate or NAIRU, there will be stability in the
rate of inflation. When unemployment departs from the natural rate, there is
acceleration or deceleration in inflation rate. Thus if actual unemployment is less
than u*, inflation will continue to accelerate – higher and higher in subsequent
years. The concept of NAIRU and expectations formation explains the
hyperinflation witnessed by many countries. Unless unemployment returns to its
natural rate the inflation spiral will keep on accelerating.

The above analysis brings us to an important conclusion. Under adaptive

expectations, the short run the Phillips curve is downward-sloping. In the long
run however, it is vertical. In Fig. 6.2, the vertical line LRPC depicts the long run
Phillips curve. Thus there is no trade-off between inflation and unemployment in
the long run.
86
6.5.2 Phillips Curve under Rational Expectations Inflation and
Unemployment
Under rational expectations economic agents such as firms and households are
forward looking. They take into account all available information – past
experience as well as present and future developments in the economy. There is
no perfect foresight under rational expectations, but the errors cancel out on the
whole.

An implication of the above is that actual inflation rate is equal to expected

inflation rate. Thus workers and firms do not commit any error regarding wage
rate during negotiations. Thus, there is no trade-off between inflation and
unemployment under rational expectations. Unemployment rate in the economy
is at the natural rate.

Suppose unemployment in the economy is at the natural rate. Firms and workers
expect inflation to be at the rate of 𝜋 . Suppose, the government pursues an
expansionary policy as a result of which there is an increase in aggregate
demand. Consequently, there is an increase in the rate inflation. If this policy was
expected by the economic agents, they would have factored in the increase in
inflation rate into their decision-making. If the policy is unexpected, then it
would have the desired effect, that is, reduction in unemployment. This brings us
to an important issue: how effective is government policy under rational
expectations? If government policy is expected, it will not have any impact.
Check Your Progress 2
1. In 2019 the expected rate of inflation was 7 per cent while actual rate of
inflation was 5 per cent. If ʎ = 0.5, find out the expected inflation rate for
2020.
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2. How do you reconcile the vertical long run Phillips curve with the
downward sloping short run Phillips curve? Explain through a diagram.
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87
Expectations, Inflation 3. Explain the following concepts:
and Unemployment
a) Adaptive Expectations
b) Rational Expectations
c) Non-Accelerating Inflation Rate of Unemployment (NAIRU)
d) Long-Run Phillips Curve
………………………………………………………………………….……
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6.6 LET US SUM UP

Unemployment results in loss of not only potential output at the macro level but
also in income at the individual level. Many a time unemployment culminates
into a crisis situation when there is widespread unemployment in the economy.
The social sigma and psychological trauma associated with unemployment often
compels policy makers to cut down on the rate of unemployment.
The classical economists assumed flexibility in real wage and prices which
ensured full employment in the economy all the time. Keynesian economists,
however, contest such an assumption and speak about rigidities in wage rate and
prices. In case of sticky prices there is a possibility of unemployment as per the
Keynesian model.
Phillips curve describes the inverse relationship between inflation and
unemployment. It shows the possibility that unemployment can be reduced at the
cost of higher inflation.
During the 1970s most economies in the world passed through a phase of
stagflation. The trade-off between inflation and unemployment was proved to be
false. In order to explain such a situation we bring in expectations into our
analysis. There are two models of expectations: adaptive and rational.
According to adaptive expectations, the Phillips curve is stable in the short-run
but in the long run it shifts. The long run Phillips curve is vertical. Thus there
could be some trade-off between inflation and unemployment in the short-run,
but in the long-run there is no trade-off. We explained the process through which
the shift in the Phillips curve takes place. According to rational expectation, there
is no trade-off between inflation and unemployment. Any policy of the
government to reduce unemployment becomes ineffective, as people can forecast
the expected changes correctly.
88
6.7 ANSWER/HINTS TO CHECK YOUR PROGRESS Inflation and
Unemployment
EXERCISES
Check Your Progress 1
1. Your answer should include frictional, structural and cyclical
unemployment. Go through Section 6.2 for details.
2. Go through Section 6.3 and refer to Fig. 6.1.
3. These concepts are discussed in Sections 6.2 and 6.3.
Check Your Progress 2
1. Refer to the text in Section 6.5. You should explain Fig. 6.2.
2. These concepts are defined in Sections 6.5.

89