Macroeconomics

Course Introduction
Uses of Studying Macroeconomics
Understanding Economic Performance:
• Analyze indicators like GDP, inflation, and unemployment to assess a
country's economic health.
Policy Formulation:
• Assist in creating fiscal and monetary policies to manage growth,
stabilize inflation, and reduce unemployment.
Global Economic Insights:
• Understand international trade, exchange rates, and global economic
dynamics.
Uses of Studying Macroeconomics
Business Strategy:
• Help businesses anticipate economic cycles and adjust strategies
accordingly.
Forecasting and Planning:
• Predict future economic trends for investment, policymaking, and
resource allocation.
Addressing Economic Challenges:
• Develop solutions to issues like inequality, poverty, and climate
change.
Careers in Macroeconomics
Economist:
• Work in government agencies, think tanks, or international organizations
analyzing economic trends and policies.
Policy Analyst:
• Develop and evaluate public policies in areas like taxation, trade, or employment.
Banking and Finance:
• Roles in investment analysis, risk management, or central banking (e.g., RBI,
Federal Reserve).
Academia and Research:
• Teach and conduct research in universities or research institutes.
Careers in Macroeconomics
Consultant:
• Advise businesses or governments on economic strategies and
decision-making.
International Organizations:
• Positions at IMF, World Bank, or UN focusing on global economic
issues.
Corporate Sector:
• Work in roles like market analysis, strategic planning, or economic
forecasting for companies.
How Ordinary People Can Use
Macroeconomics in Daily Life
Understanding Inflation and Prices:
• Track inflation rates to understand why the cost of living is rising.
• Helps individuals adjust their budgets, savings, and spending habits.
• Example: Knowing how inflation erodes the value of money can
encourage timely investments.
Evaluating Employment Opportunities:
• Learn how economic conditions, like recessions or booms, affect job
markets.
• Helps individuals plan careers and upskill during economic downturns.
Managing Savings and Investments:
• Use knowledge of interest rates (influenced by monetary policy) to
decide on loans or savings.
• Example: Understanding how rising interest rates can make borrowing
more expensive.
Making Sense of Government Policies:
• Analyze how fiscal policies, such as tax changes or stimulus packages,
affect household income.
• Example: Knowing how tax cuts might increase disposable income or
government spending might create jobs.
Understanding Economic News:
• Interpret GDP growth rates, trade deficits, or stock market trends in
the news.
• Helps individuals make informed decisions about future
opportunities.
Navigating Business Cycles:
• Recognize patterns in economic growth or downturns to prepare for
uncertainties like layoffs or price hikes.
• Example: Saving more during economic expansions in anticipation of
potential recessions.
Global Perspective:
• Understand how global events (e.g., oil price shocks, trade wars)
impact local economies and daily life.
Planning Major Life Decisions:
• Consider economic conditions when making decisions like purchasing
a house, starting a business, or pursuing education.
• Example: Opting for fixed-rate loans during periods of expected rising
interest rates.
Module I: Macroeconomics and
National Income (12 Hours)
• Introduction to Macroeconomics; Integration of Micro and Macro
Analysis and their importance.

• National Income -
• Concepts; Measurement of Gross Domestic Product
• Significance and Problems in Measurement
• Distinction between Nominal and Real GDP - GDP Deflator;
• National Income and Economic Wellbeing;
• Circular flow of Income - 4 sector model;
• Concept of Social Accounting.
Introduction to Macroeconomics:
• Understand how macroeconomics differs from microeconomics.
• Learn the importance of integrating micro-level decisions (e.g.,
individual consumer choices) with macro-level phenomena (e.g.,
national inflation rates).
• Example: How household savings (micro) influence national
investment levels (macro).
National Income Concepts and Measurement:
• Learn key terms like GDP (Gross Domestic Product), GNP (Gross
National Product), and NNP (Net National Product).
• Explore methods of GDP measurement:
• Expenditure method: Adding consumption, investment, government
spending, and net exports.
• Income method: Summing all incomes earned in production.
• Production method: Summing the value-added at each production stage.
Challenges in Measurement:
• Understand issues like informal sectors, unrecorded activities, and
data reliability.
Nominal vs. Real GDP:
• Nominal GDP measures output at current prices, while real GDP
adjusts for inflation.
• Learn about the GDP deflator as a tool to calculate real GDP.
Economic Well-being and National Income:
• Discuss whether higher GDP correlates with better living standards.
Circular Flow of Income:
• Study the 4-sector model: households, businesses, government, and
foreign trade.Example: How household consumption drives business
production.
Social Accounting:
• Learn how national income accounts are compiled to assess economic
performance.
Definition of Macroeconomics
• John Maynard Keynes: Macroeconomics is the study of
the economy as a whole, focusing on aggregate measures
such as total output, employment, and inflation.

• Milton Friedman: Macroeconomics involves the analysis of

aggregate economic variables and the relationships
among them.

• Paul Samuelson: Macroeconomics is the branch of

economics that deals with the performance, structure,
and behavior of an economy as a whole.
Key concepts in Macroeconomics
• Gross Domestic Product (GDP): The total value of all
goods and services produced within a country over a
specific period.

• Inflation: The rate at which the general level of prices

for goods and services rises, eroding purchasing power.

• Unemployment: The measure of the number of people

who are actively looking for work but aren’t currently
employed.
• Fiscal Policy: Government spending and tax policies
used to influence economic conditions.

• Monetary Policy: Central bank actions that determine

the size and rate of growth of the money supply.
 Integration of Micro and Macro
Analysis
Microfoundations of Macroeconomics:
• Macroeconomic models often rely on microeconomic
principles to explain aggregate behavior. For example,
consumer behavior (micro) influences aggregate demand
(macro).

• Example: The Pradhan Mantri Jan Dhan Yojana (PMJDY)

aimed at financial inclusion can be analyzed
• at the micro level by studying individual savings behavior and
• at the macro level by assessing its impact on national savings
rates and economic growth.
Policy Implications:
• Effective economic policies require an understanding
of both micro and macro perspectives. For instance,
tax policies (micro) can affect overall economic
growth (macro).

• Example: The Goods and Services Tax (GST) reform

unified the tax structure across states,
• at the micro level impacting individual businesses and
• at the macro level improving overall economic efficiency
Market Failures and Government Intervention:
• Microeconomic analysis helps identify market failures
such as monopolies or externalities, which can then be
addressed through macroeconomic policies.

• Example: Pollution control measures in Delhi involve

micro-level regulations on industries and vehicles,
while macro-level policies include national
environmental standards and subsidies for cleaner
technologies.
Importance of Integration
Comprehensive Policy Making:
• Integrating micro and macro analysis ensures that
policies are well-rounded and address both individual
and aggregate economic issues.

• Example: The Mahatma Gandhi National Rural

Employment Guarantee Act (MGNREGA) provides
micro-level employment opportunities while
contributing to macro-level goals of reducing
rural poverty and stimulating rural economies.
Better Economic Predictions:
• Combining insights from both fields leads to more
accurate economic forecasts and better preparedness
for economic fluctuations.

• Example: Understanding the micro-level impact of

monsoon rains on agriculture helps predict
macro-level outcomes like food inflation and GDP
growth.
Enhanced Economic Stability:
• Policies that consider both micro and macro aspects
can help stabilize the economy by addressing root
causes of economic issues.

• Example: The Reserve Bank of India’s (RBI)

monetary policy decisions are informed by micro-
level data on banking sector health and macro-
level indicators like inflation and growth rates.
 Economics and Non-Economic
Production
Economic Production: Activities that involve creating goods or
services for monetary gain, contributing to national income.

Example: A factory producing cars for sale.

Non-Economic Production: Activities that do not involve monetary

transactions or are for personal use.

Example: A person growing vegetables for their own family.

Intermediate and Final Goods
• Intermediate Goods: Goods used as inputs to produce final goods;
not counted in GDP to avoid double counting.
• Example: Steel used to make cars.

• Final Goods: Goods consumed directly by end-users and counted in

GDP.
• Example: A car purchased by a consumer.
Transfer Payments
• Transfer payments are non-productive payments made by the
government or institutions where no goods or services are
exchanged.

• Example: Pensions, unemployment benefits, or scholarships.

These payments are excluded from national income calculations as
they do not reflect production.
Consumer and Producer Goods
• Consumer Goods: Goods meant for direct consumption by
individuals.
• Example: Food, clothing, or smartphones.

• Producer Goods: Goods used by businesses to produce other goods

or services.
• Example: Machinery, tools, or raw materials.
 Macroeconomic Goals
Full Employment
• Full employment occurs when all those willing and able to work at prevailing
wage rates are employed, with only natural unemployment (e.g., frictional or
structural unemployment).

• Importance: It ensures that a country's resources are fully utilized, reducing

poverty and increasing income levels.

• Example :
• Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA) provides
guaranteed employment to rural households, aiming to reduce unemployment and
underemployment in rural India.
• Unemployment challenges persist, but programs like this help improve labor force
Price Stability:
• Price stability refers to
• maintaining a low and stable rate of inflation,
• preventing excessive price fluctuations that can harm purchasing power and economic
stability.

• Importance: Stable prices build confidence in the economy, helping

households and businesses plan better.

• Example:
• The Reserve Bank of India (RBI) targets an inflation rate of 4% (±2%) under its
monetary policy framework.
• During the COVID-19 pandemic, RBI used measures like reducing interest rates to
control inflation while supporting growth.
Economic Growth:
• Economic growth signifies an increase in the economy's productive capacity
over time, typically measured by GDP growth.

• Importance: Growth raises income levels, reduces poverty, and improves

living standards.

• Example:
• India achieved a high GDP growth rate of 8.7% in FY2021-22 after recovering from the
pandemic-induced contraction.
• Government initiatives like Make in India and Startup India promote industrial growth
and innovation.
Balance of Payments Equilibrium and Exchange Rate Stability
• A balance of payments (BoP) equilibrium ensures that a country's imports
and exports, along with other financial flows, are balanced, avoiding
excessive deficits or surpluses.
• Stable exchange rates help maintain trade competitiveness and reduce
uncertainty.

• Importance: Stability attracts foreign investment and ensures the country's

ability to meet international obligations.

• Example:
• India faced a BoP crisis in 1991 due to excessive imports and low foreign reserves.
• Reforms like opening up the economy and controlling exchange rates brought stability.
Today, RBI intervenes in the foreign exchange market to manage rupee volatility.
Social (Welfare) Objective
• This goal focuses on reducing inequality and improving social welfare through
equitable distribution of wealth and resources. It includes access to
education, healthcare, and basic needs for all.

• Importance: Social welfare ensures inclusive development and reduces social

tensions.

• Example:
• Programs like Ayushman Bharat aim to provide health insurance to vulnerable
populations, improving access to healthcare.
• Schemes like PM-Kisan Samman Nidhi provide direct income support to small and
marginal farmers.
Macroeconomic Policy Instruments
Fiscal Policy
• Fiscal policy involves government spending and taxation to influence
the economy. By increasing spending or cutting taxes, the government
can boost demand and stimulate growth. Conversely, reducing
spending or raising taxes helps control inflation.

• Example: India's 2020 stimulus package to support businesses during

COVID-19.
Macroeconomic Policy Instruments
Monetary Policy
• Monetary policy is managed by the central bank (e.g., RBI) to control
money supply and interest rates. It aims to stabilize inflation,
promote growth, and manage employment.

• Example: RBI reducing repo rates during economic downturns to

make loans cheaper and boost demand.
Aspect Monetary Policy Fiscal Policy
Refers to the central bank's control over money Refers to the government's use of taxation and
Definition
supply and interest rates. spending to influence the economy.

Government of India, specifically the Ministry of

Authority Responsible Reserve Bank of India (RBI).
Finance.
Aims to boost economic growth, reduce
Ensures price stability, controls inflation, and
Primary Goals unemployment, and ensure equitable income
promotes economic growth.
distribution.

- Repo rate, reverse repo rate, CRR (Cash - Government spending, taxation policies, and public
Key Tools/Instruments
Reserve Ratio), SLR (Statutory Liquidity Ratio). debt management.

Focus Mainly short-term economic stabilization. Often long-term development and social welfare.

- The 2020 Atmanirbhar Bharat package allocated

- RBI reduced repo rates during COVID-19 to
Examples in India ₹20 lakh crore to boost the economy during the
make loans cheaper and stimulate demand.
pandemic.

Nature Focused on monetary and credit control. Focused on public revenue and expenditure.

Easier to adjust due to regular policy reviews by Takes time to implement due to parliamentary
Flexibility
the RBI. approvals and budget cycles.

Primarily businesses, investors, and financial Affects all citizens directly through public spending
Target Audience
institutions. and taxation.
National Income
• National income refers to the total monetary value of all goods and
services produced by a country's residents over a specific time period
(usually a year). It includes income earned both domestically and
abroad, and is often measured using indicators like Gross Domestic
Product (GDP), Gross National Product (GNP), or Net National Product
(NNP).
Importance of National Income to
the Health of an Economy
Indicator of Economic Performance:
• National income helps assess whether an economy is growing or
shrinking.
• Example: A rising GDP indicates economic expansion, while a
declining GDP signals a recession.
Policy Formulation:
• Governments and central banks use national income data to design
fiscal and monetary policies.
• Example: A country with sluggish GDP growth might increase public
spending to stimulate the economy.
Living Standards Assessment:
• Higher national income generally means better living standards for
citizens (though it doesn’t account for income inequality).
• Example: Comparing GDP per capita between countries shows
relative wealth and development levels.
Investment Decisions:
• National income trends help businesses and investors decide where
and when to allocate resources.
• Example: If GDP growth in India is strong, foreign investors may
increase their investments in Indian industries.
International Comparisons:
• Enables comparisons of economic performance between countries.
• Example: Comparing India's GDP with China's helps evaluate
competitiveness.
Why Measuring National Income is
Important
• Economic Planning: Accurate national income data helps governments
set realistic goals for growth, employment, and development.
• Budgeting and Resource Allocation: Determines how resources should
be allocated across sectors like health, education, and infrastructure.
• Monitoring Economic Progress: Helps track progress over time and
adjust policies to meet long-term objectives.
• Evaluating Welfare Programs: National income provides insights into the
effectiveness of welfare programs in reducing poverty and inequality.
 Difficulties in Measuring National
Income
• Underground Economy: Informal activities like unregistered businesses or illegal
trade are hard to track.
Example: Street vendors or black-market transactions often go unrecorded.
• Non-Monetary Transactions: Bartering or home-produced goods/services are
not included in official estimates.
Example: A farmer growing food for their family may not report this output.
• Data Collection Challenges: Collecting reliable data from all sectors, especially
rural and informal ones, is difficult.
Example: Small businesses in remote areas may not report income
accurately.
• Double Counting: Counting the same output multiple times during production
stages inflates national income.
• Example: Including both the value of raw cotton and the final shirt produced from it.

• Environmental Costs Ignored: National income measures like GDP often exclude
negative externalities like pollution or resource depletion.
• Example: Logging a forest increases GDP but damages environmental health.

• Income Inequality: A high GDP might mask disparities in income distribution.

• Example: GDP may rise due to profits concentrated in a few industries while most citizens
remain poor.

• Accounting for Foreign Earnings: Distinguishing between domestic production

and income earned abroad by citizens or foreigners can be complex.
 National Income Concepts
Gross National Product (GNP)
• GNP is the total market value of all final goods and services produced by a country's residents
(both domestically and abroad) within a given time period, typically a year.
• Formula:

OR

• Example:
If the GDP of India is ₹100 trillion and the income earned by Indian citizens from abroad is ₹5 trillion
while foreigners (in India) earn ₹2 trillion from India, GNP = ₹100T + (₹5T - ₹2T)
= ₹103T.
Gross Domestic Product (GDP):
• GDP is the total market value of all final goods and services produced within a
country's borders in a given time period, regardless of the nationality of the
producers.
• Formula:

• where:
C = Consumption
I = Investment
G = Government spending
(X−M) = Net exports (Exports - Imports)
Example:
• If a country’s consumption is ₹60T, investment is ₹20T, government spending is ₹10T,
exports are ₹15T, and imports are ₹5T, then
GDP = ₹60T + ₹20T + ₹10T + (₹15T - ₹5T)
Net National Product (NNP):
• NNP is GNP minus depreciation (the reduction in the value of capital
goods due to wear and tear).
• Formula:

• Example:
If the GNP is ₹103T and depreciation is ₹3T,
NNP = ₹103T - ₹3T
= ₹100T.
• NNP is particularly useful in environmental economics. It provides a more
accurate measure of a nation's economic performance by accounting for
the depreciation of natural resources and capital goods. This helps in
assessing the sustainability of economic growth and the long-term health
of the economy
Net Domestic Product (NDP):
• NDP is GDP minus depreciation. It reflects the actual
productivity after accounting for capital wear and tear.
• Formula:

• Example:
If the GDP is ₹100T and depreciation is ₹3T, NDP = ₹100T - ₹3T
= ₹97T.
Per Capita Income:
• Per capita income is the average income earned per person in a given
area in a specified year.
• Formula:

• Example:
• If the national income of a country is ₹100T and the population is 1
billion,
per capita income = ₹100T / 1 billion
= ₹100,000.
Personal Disposable Income (PDI):
• Personal disposable income is the income that individuals have left
after paying personal taxes. It is the income available for spending
and saving.
• Formula:

• Example:
• If personal income is ₹86T and personal taxes are ₹10T,
PDI = ₹86T - ₹10T
= ₹76T
NNP at Factor Cost:
• NNP at factor cost is NNP adjusted for indirect taxes and
subsidies. It represents the income received by the factors
of production (labor, capital) in the economy.
• Formula:

• Example:
If NNP at market price is ₹100T, indirect taxes are ₹10T, and
subsidies are ₹5T,
NNP at factor cost = ₹100T - ₹10T + ₹5T
= ₹95T.
GDP at Factor Cost:
• GDP at factor cost is the measure of the value of output produced by
factors of production in a country, adjusted for taxes and subsidies.
• Formula:

• Example:
If GDP at market price is ₹100T, indirect taxes are ₹10T, and subsidies
are ₹5T,
GDP at factor cost = ₹100T - ₹10T + ₹5T
= ₹95T.
Gross Value Added (GVA):
• GVA is the measure of the value of goods and services produced in an
economy, minus the cost of inputs and raw materials used in production.
• Formula:

GVA = Gross output – Intermediate Consumption

• Example:
If Gross output is ₹100T and intermediate consumption is ₹5T,
GVA = ₹100T - ₹5T
= ₹95T.

• particularly useful for assessing the contribution of specific sectors or

industries to the overall economy.
GDP at Market Price:
• This is the total value of goods and services produced within a
country's borders, measured at the prices actually paid by
consumers (including taxes).
• Formula:

• Example:
If GDP at factor cost is ₹95T, indirect taxes are ₹10T, and subsidies are
₹5T,
GDP at market price = ₹95T + ₹10T - ₹5T
= ₹100T.
GNP at Market Price:
• GNP at market price is the total value of goods and services
produced by a country's residents, regardless of where they are
produced, measured at market prices.
• Formula:

• Example:
• If GDP at market price is ₹100T and net factor income from abroad is
₹3T,
GNP at market price = ₹100T + ₹3T
= ₹103T.
Personal Income (PI):
• Personal income is the total income received by individuals and households from all sources,
including wages, salaries, investments, and government transfers, before taxes.
• Formula:
Personal Income = NNP – UDP – SPU – RPP

Where
NNP – Net national product
UDP – undistributed company profits
SPU – surplus of public undertakings
RPP – rent from public properties

• Example:
If NNP is ₹90T, undistributed profits are ₹5T, surplus of public undertakings are ₹2T, and rent from
public properties are ₹3T, then,
PI = ₹90T - ₹5T - ₹2T - ₹3T
= ₹80T.
 From To Adjustment

Domestic National Add Net Factor Income from Abroad (NFIA)

Net Gross Add depreciation

Factor Cost Market Price Add Indirect Taxes and Subtract Subsidies

Gross Net Subtract depreciation

Market Factor cost Subtract Indirect Taxes and Add Subsidies

price
GDP GNP Add Net Factor Income from Abroad (NFIA)
 Term Formula
GNP GDP + NFIA
GDP C + I + G + (X - M)
NNP GNP - Depreciation
NDP GDP - Depreciation
Personal income (PI) NNP – UDP – SPU – RPP

Per capita income National Income / Population

Personal disposable Personal Income - Personal Taxes
income (PDI)
NNP at factor cost NNP at Market Price - Indirect Taxes + Subsidies
GDP at factor cost GDP at Market Price - Indirect Taxes + Subsidies
Gross value added GVA = Gross output – Intermediate Consumption
GDP at market price GDP at Factor Cost + Indirect Taxes - Subsidies
GNP at market price GDP at Market Price + NFIA
Real GDP, Nominal GDP, and GDP
Deflator
• Nominal GDP:
• Measures the value of all goods and services produced in a country at
current market prices (prices of the year in which goods are
produced).
• Includes changes in output and inflation.

• Example: If a country produces goods worth ₹100 trillion in 2024, its

nominal GDP is ₹100 trillion (at 2024 prices).
• Real GDP:
• Measures the value of all goods and services produced in a country at
constant prices (adjusted for inflation, using base-year prices).
• Reflects the actual growth in production, excluding price changes.

• Example: If 2024 output is valued using 2020 prices, and it amounts

to ₹90 trillion, the real GDP for 2024 is ₹90 trillion.
• GDP Deflator:
• A measure of the level of price inflation or deflation in the economy,
calculated as the ratio of nominal GDP to real GDP.
• Formula:

• GDP Deflator > 100 --------> Inflation

• GDP Deflator < 100 --------> Deflation
Relationship Between Nominal GDP, Real GDP, and GDP Deflator

• Nominal GDP reflects both changes in output and prices, while real
GDP isolates the effect of output by holding prices constant.

• The GDP deflator shows the extent to which the nominal GDP is
influenced by changes in prices.
• Nominal GDP: ₹100 trillion (2024 prices).
• Real GDP: ₹90 trillion (2020 base-year prices).
• GDP Deflator Calculation:

• Interpretation: A GDP deflator of 111.11 means prices have increased

by 11.11% since the base year (2020).
• This relationship helps distinguish whether changes in GDP are due
to higher production or price levels.
 Exercises
A country has the following data: A country's GNP is ₹920 billion, and
• Value of consumption: ₹500 billion depreciation (consumption of fixed capital)
is ₹70 billion. Calculate NNP. (Ans:
• Investment: ₹200 billion ₹850billion)
• Government expenditure: ₹150 billion
• Exports: ₹100 billion The GNP of a country is ₹920 billion.
• Imports: ₹50 billion Depreciation is ₹70 billion. Net factor
income from abroad is ₹20 billion.
Calculate the GDP using the expenditure Calculate NDP. (Ans: ₹830billion)
method. (Ans: ₹900billion)

The NNP at factor cost of a country is ₹800

• The GDP of a country is ₹900 billion. billion. Indirect taxes are ₹100 billion,
Income earned by Indian citizens abroad subsidies are ₹20 billion, $20 billion NFIA
is ₹50 billion, and income earned by and depreciation is ₹60 billion. Calculate
foreigners within India is ₹30 billion. GDP at market prices. (Ans: ₹920billion)
Calculate GNP. (Ans: ₹920billion)
 Advance
dA country produces the following goods
A country has the following data (in ₹ and services:
billion):
• Agriculture Sector: Output = ₹400
• GDP at Market Prices: 1,500 billion, Intermediate Consumption =
• Net Factor Income from Abroad: ₹100 billion
100 • Manufacturing Sector: Output = ₹800
• Depreciation: 200 billion, Intermediate Consumption =
₹300 billion
• Indirect Taxes: 150 • Service Sector: Output = ₹600 billion,
• Subsidies: 50 Intermediate Consumption = ₹200
billion
Calculate:
Net Factor Income from Abroad: ₹50
1.GNP at Market Prices billion
(₹1,600billion) Depreciation: ₹100 billion
2.NNP at Factor Cost (₹1,300billion) 1.Calculate GDP (Value Added Method)
(₹1,200billion)
Circular Flow Model
• A circular flow diagram is a visual representation of
how money, goods, and services flow through an
economy.
• It shows the interactions between the two primary
sectors: households and firms, as well as the roles
played by the government and foreign trade in more
advanced models.
 How is it Useful?
1.Understanding the Economy’s Functioning:
It helps visualize how resources, goods, services, and money move within the economy,
providing insights into the interdependence of economic agents.
2.Shows the Role of Different Sectors:
By including the government (taxes and public spending) and the foreign sector
(exports and imports), it provides a more realistic picture of a modern, open economy.
3.Identifying Leakages and Injections:
Leakages (savings, taxes, imports) and injections (investment, government spending,
exports) influence the size of the economy and help policymakers address issues like
unemployment or inflation.
4.Basis for Economic Analysis:
It serves as a framework for understanding concepts like GDP, national income, and
fiscal and monetary policies.
Circular Money Flow with Savings
and investment
• Savings reduce the flow of money expenditure to the firms and will
cause a fall in economy’s total income. Economists therefore call
savings a leakage from the money expenditure flow

• Firms borrow money from banks (deposits of households). Thus,

money is reintroduced back into the expenditure stream, resulting in
no decrease in flow of spending.
• Savings are withdrawals from the income flow.
• Investments are injections into the income flow.

• Planned investment = Planned savings (to maintain constant income

money flow)

• If planned investment is less, then income, output and employment

will fall and the circular flow of money will contract
Two-Sector Model (Households and Firms Only)

• In the simplest form of an economy, households provide factors of

production (labor, capital) to firms, and firms pay households in
the form of income (wages, rent, profits). Households then spend
this income on goods and services produced by firms.
• Equation:
Y=C … (1)
Where:
• Y = Total income/output
• C = Consumption expenditure by households

• There are no savings, government, or trade in this model, so the

total income (Y) equals total consumption (C).
 Three-Sector Model (Including
Government)
• When the government sector is added, taxes and government expenditure
come into play. Households pay taxes, and the government spends on public
goods and services. Some income is saved by households.
• Equation:
Y=C+S+T …(2)
Where:
• S = Savings
• T = Taxes
• On the expenditure side:
Y=C+I+G …(3)
Where:
• I = Investment by firms
• G = Government expenditure
• In equilibrium:
C+S+T=C+I+G …(4)
By canceling C, we get:
S+T=I+G …(5)

• This means savings and taxes fund investment and government spending.
• By rearranging S + T = I + G, we get
S–I=G–T
…(6)
• This equation is important as it shows what happens
when government spending exceeds the taxes it
receives. To balance it out, there will be a shortfall in
private investment (I).

• In other words, Government borrowings reduce private

investment in an economy
• Now rearrange (3), we get
Y =C+I+G
Y–C–G=I
LHS is the savings component, keeping the identity S = I

We break up the LHS into private savings (Y – T – C) and public savings

(T – G), we get

S=Y–C–G
= (Y – T – C) + (T – G)
Note that Y – T is disposable income (Personal income minus personal
taxes)
• For the economy to remain in steady state, flows into the financial
sector needs to equal flows out of the financial sector.
• Therefore, condition for steady state
(Y – T – C) + (T – G) = I …(7)
i.e., sum of private saving and public saving must equal investment
Saving and investment identity in
the Open Economy
• In an open economy, exports (X) and imports (M) are included. Exports represent
income from foreign countries, while imports represent spending on foreign
goods.
Equation for National Income:
Y=C+S+T …Same as (2)
Equation for Expenditure:
Y = C + I + G + (X - M) …(8)
In equilibrium:
C + S + T = C + I + G + (X - M)
By canceling C, we get:
S+T+M=I+G+X …(9)
• This equation shows that savings, taxes, and imports fund investment,
government spending, and exports.

• Rewriting as Net exports we get

S + T = I + G + NX …(10)
Relation of Aggregate Domestic
Output and Expenditure with Trade
Balance
• The national income account identity of the open economy can be used to
further show how aggregate domestic output and aggregate expenditure (C
+ I + G) and net exports are related.

• Rearranging Y = C + I + G + NX, we get,

NX = Y - (C + I + G) …(11)
Where, (C + I + G) is aggregate domestic expenditure
Thus,
Net exports = National Domestic Product (Y) – Aggregate Domestic
Expenditure
• If Y > (C + I + G), then we export the excess (surplus)
• If Y < (C + I + G), then we import the deficit
Foreign capital flows and trade
balance
• Rearranging Y = C + I + G + NX, we get,
Y – C – G = I + NX …(12)
Where, Y – C – G is the savings component, or Y – C – G = S

Substituting in (12), we get,

S = I + NX
S – I = NX …(13)
The economy’s Net Exports (NX) must be equal to the difference
between savings and investment.
• The key concept here is the linking of International Capital flows and the
goods market.

• In (13), if S – I is positive, we will be lending the excess funds to foreigners (net

capital outflow)

• If S – I is negative, we will be borrowing from foreigners to fund our expenses

(net capital inflow)
National Income and Economic
Welfare
• Individual welfare is the sum of all satisfactions experienced by an
individual and social welfare is the sum of total individual welfares.

• Economic Welfare is that part of social welfare which can be directly

or indirectly measured in terms of money.

• According to Pigou, a rise in NI leads to an increase in economic

welfare and hence total welfare also increases.
• However, that is not always true, the causes that increase economic
welfare may reduce non-economic welfare, therefore, the increase in
total welfare may be less that the anticipated one.
Why GDP/GNP is not a good
measure of welfare
• GNP is a measure of National Income and not a satisfactory measure
of welfare of the nation.

• Other than money there are factors like leisure, quality of life,
standard of living, externalities etc, that affect the human wellbeing.
• Leisure: Longer working hours increases output and national income
but it implies less leisure enjoyed by people which makes them
unhappy. GNP does not include the value of leisure.

• Quality of Life: Better the quality of life, happier is the individual. But
GNP does not include the indices that measure quality of life.
• Non market transactions: Services of housewives at home affect the
welfare of people but is not a part of GNP as it involves non-market
transactions.

• Environmental quality and resource depletion: Establishment of

industrial plants increase the income of the national but at the cost of
pollution which affect the local people adversely. This negative
impact is not counted in GNP, it is only concerned about increase in
income.
• Nature of Production: In an economy some amount of money can be
spent to produce nuclear weapons or to build bridges, roads and
dams. The former has no impact on welfare whereas the latter
increases welfare though both the production processes increase
national income.

• Standard of Living: If more national expenditure is incurred on the

production of capital goods compared to the production of consumer
goods, it will increase the national income of the country but not the
standard of living of the people.
New Economic Welfare - Tobin
• Tobin in 1972 had constructed ‘Measure of Economic Welfare’ (MEW)
or ‘New Economic Welfare’ (NEW) according to Samuelson which is
an attempt
• to supplement GNP in order to include non-market activities relating to
economic welfare.
• to improve upon traditional measures of economic progress, such as Gross
National Product (GNP) or Gross Domestic Product (GDP)
• Tobin's concept of NEW aimed to provide a more accurate
measure of national welfare by:
• Adjusting for negative externalities (e.g., environmental
degradation, pollution).
• Excluding defensive expenditures (i.e., expenditures that don't
improve welfare, like spending on crime prevention or pollution
control).
• Incorporating social factors such as income distribution, health,
education, and overall quality of life.
• Thus, the NEW adjusts GDP by focusing not just on
production but also on the overall quality and sustainability
of economic growth.
 Key Adjustments in NEW
• Exclusion of "regrettables":
• These are expenditures that do not contribute directly to human welfare
(e.g., defense spending, pollution cleanup). In the GDP framework, these
expenses are included as productive activities, but Tobin argued they don 't
directly improve welfare.
• Inclusion of non-market activities:
• Traditional GDP ignores certain activities that enhance well-being but are not
traded in the market, such as household work or leisure time. NEW seeks to
include the value of these activities.
• Adjustment for inequality:
• NEW considers the distribution of income, as more equal societies often
report higher levels of subjective well-being.
Example to Illustrate NEW
• Let’s consider a country, "EcoLand," with a GDP of $500 billion.

• GDP-based Measurement:
• EcoLand’s GDP includes all goods and services produced, even spending on
pollution control and healthcare due to industrial pollution.
Application of NEW Adjustments
• Exclusion of Regrettables:
• Suppose EcoLand spends $50 billion on pollution control and crime
prevention. Under Tobin's concept of NEW, these expenditures would be
excluded, as they do not contribute to actual welfare.

• NEW-adjusted GDP
= GDP − Spending on regrettables
= $500B − $50B
= $450B
• Inclusion of Non-Market Activities:
• If unpaid household work and leisure time were valued at $30 billion, this
would be added to GDP to reflect their contribution to welfare.

• NEW-adjusted GDP,
= $450B + $30B
= $480B
• 3. Adjustment for Inequality:
• If EcoLand has significant income inequality, the welfare impact might
be reduced. For example, a downward adjustment of $20 billion could
reflect the negative welfare effects of inequality.
• Final NEW-adjusted GDP
= $480B − $20B
= $460B

• In this case, although EcoLand's traditional GDP is $500 billion, its

New Economic Welfare (NEW) after adjustments is only $460 billion.
This shows that while EcoLand is producing a lot, its actual welfare,
when accounting for pollution, inequality, and other factors, is lower
than what GDP suggests.
Why is Tobin's NEW Important?
• Tobin’s concept is significant because it emphasizes that economic
growth alone is not enough to ensure improvements in the well-being
of citizens.
• By adjusting for factors that traditional measures like GDP overlook,
NEW offers a more comprehensive view of economic progress,
focusing on quality of life, environmental sustainability, and fair
distribution of wealth.
Measurement of National Income
• Income Method (Factor Income Method)
• Expenditure Method
• Product Method (Value Added Method)
 Income Method (Factor Income
Method)
• The Income Method calculates a country’s GDP by summing the incomes earned by
factors of production (labor, capital, land, entrepreneurship) within the country. This
method focuses on the incomes received by individuals and firms, assuming that
production generates income.

• Formula:
NDP (FC) = Wages + Rent + Interest + Profits + Mixed Income

• Wages/Salaries: Payment to labor for their contribution to production.

• Rent: Income received from the use of land or property.
• Interest: Earnings from the capital invested in production.
• Profits: Earnings of firms or businesses.
• Mixed Income: Income of self-employed individuals (combination of wages, profits,
Example:

Suppose a country has the following incomes:

• Wages: ₹500 billion
• Rent: ₹100 billion
• Interest: ₹150 billion
• Profits: ₹200 billion
• Mixed income: ₹50 billion

Thus, GDP = ₹500B + ₹100B + ₹150B + ₹200B + ₹50B

= ₹1000 billion.
 Expenditure Method
• The Expenditure Method measures GDP by summing up all the expenditures made on final
goods and services produced within a country during a specific period. It assumes that what is
produced is consumed, invested, or exported.

• Formula:
GDP (MP) = C + I + G + (X−M)
Where
• C = Consumption: Household consumption of goods and services. (Private final consumption
expenditure)
• I = Investment: Business investments in capital goods (factories, machinery), plus residential
construction. (Gross domestic capital formation)
• G = Government Spending: Government expenditures on goods and services. (Government final
consumption expenditure)
• X = Exports: Goods and services sold to other countries.
• M = Imports: Goods and services purchased from other countries.
Example:
If a country has the following expenditures:
• Consumption (C): ₹400 billion
• Investment (I): ₹300 billion
• Government spending (G): ₹200 billion
• Exports (X): ₹150 billion
• Imports (M): ₹100 billion

Thus, GDP = ₹400B + ₹300B + ₹200B + (₹150B - ₹100B)

= ₹950 billion.
Product Method (Value Added
Method)
• The Product Method calculates GDP by adding up the value added at each
stage of production for all goods and services produced within a country
during a specific period. It measures the value of output and avoids
double-counting by focusing on the value added at each production stage.
Value Added:
• Value added refers to the difference between the value of output (sales
revenue) and the value of intermediate goods (inputs used to produce the
final product).
• Formula:
GVA (MP) or GDP (MP) = ∑ (Value of Output − Value of Intermediate
Goods)
Example:
Let’s say a country has the following value-added across different sectors:
• Agriculture: Value of output = ₹200 billion, Intermediate goods = ₹50 billion
• Manufacturing: Value of output = ₹400 billion, Intermediate goods = ₹150
billion
• Services: Value of output = ₹300 billion, Intermediate goods = ₹100 billion
Thus, GDP = (₹200B - ₹50B) + (₹400B - ₹150B) + (₹300B - ₹100B)
= ₹150B + ₹250B + ₹200B
= ₹600 billion.
Method Focus Key Components
Income Method Income earned by factorsWages, Rent, Interest, Profits,
of production Mixed Income
Expenditure Expenditures made on final
Consumption (C), Investment
Method goods and services (I), Government Spending (G),
Exports (X), Imports (M)
Product Method Value added at each stage Value of Output - Value of
of production Intermediate Goods
 Practice
A country’s income data is as follows (in ₹ billion):

• Wages and Salaries: ₹800

• Rent: ₹150
• Interest: ₹200
• Profits: ₹300
• Mixed Income: ₹250
• Net Factor Income from Abroad (NFIA): ₹50
• Depreciation: ₹100
• Indirect Taxes: ₹120
• Subsidies: ₹20
A country’s expenditure data is as follows (in ₹ billion):

• Private Consumption Expenditure: ₹1,200

• Government Expenditure: ₹400
• Gross Investment: ₹500
• Net Exports (Exports - Imports): ₹50

Calculate GDP at Market Prices using the expenditure method.

An economy has the following sectoral data (in ₹ billion):

• Agriculture Output = ₹400; Intermediate Consumption = ₹100

• Industry Output = ₹800; Intermediate Consumption = ₹400
• Service Output = ₹600; Intermediate Consumption = ₹200

Calculate GDP using the value-added method.

Income Method: Product Method:
 Wages paid to workers: ₹50,000  Value of output of bicycles:
 Rent for land: ₹10,000 ₹120,000
 Interest on capital: ₹5,000  Value of intermediate goods (raw
 Profits earned by producers: ₹35,000 materials): ₹20,000
Expenditure Method:
 Consumption of bicycles: ₹60,000
 Investment in new factories: ₹20,000
 Government purchases of bicycles:
₹10,000
 Exports of bicycles: ₹15,000

 Example to Compare All Methods
Let’s assume a small country produces 100 bicycles. The total income,
expenditure, and value-added are summarized below:
Income Method:
 Wages paid to workers: ₹50,000
 Rent for land: ₹10,000
 Interest on capital: ₹5,000
 Profits earned by producers: ₹35,000

GDP by Income Method = ₹50,000 + ₹10,000 + ₹5,000 + ₹35,000

= ₹100,000
Expenditure Method:
 Consumption of bicycles: ₹60,000
 Investment in new factories: ₹20,000
 Government purchases of bicycles: ₹10,000
 Exports of bicycles: ₹15,000
 Imports of bicycle parts: ₹5,000

GDP by Expenditure Method = ₹60,000 + ₹20,000 + ₹10,000 +

(₹15,000 - ₹5,000)
= ₹100,000
Product Method:
 Value of output of bicycles: ₹120,000
 Value of intermediate goods (raw materials): ₹20,000

GDP by Product Method = ₹120,000 - ₹20,000

= ₹100,000
Problems in Measuring National
Income Using the Income Method
• Goods produced for self consumption: In most of the underdeveloped or
developing countries the producers (mainly in production) keeps some produce
for self-consumption. The value of the product for self consumption must be
included in national income calculation but it is very difficult to get that value.

 Example: A farmer in rural India grows vegetables and consumes a portion of

the harvest. While the vegetables have value, they are not sold in the market,
making it difficult to estimate their value and include it in national income
calculations. Estimating the equivalent market price is challenging without
proper data.
• Wages and salaries paid in kind: The value of wages and salaries paid
in the form of free food, lodging, dress and other facilities should be
included in national income but again it is not always possible to
calculate the wages and salaries paid in kind.
 Example: A worker at a construction site is provided free meals and
accommodation as part of their wages. While these benefits have
economic value, calculating their monetary worth is difficult since
they are not direct cash payments and may vary in quality or
quantity.
• Second hand goods and assets: Sale and purchase of second hand
assets like houses, machinery, cars, furniture etc. and old shares,
bonds, are not included in national income because they are already
included when they were produced. If the second hand goods and
assets are included in current national income, the national income
would increase many times. But in this case, the brokerage fees and
commissions in the repurchase of second hand goods and assets are
included in national income.
 Example: If someone sells a second-hand car, the car itself is not
added to national income again, as it was already counted when it
was first sold. However, the commission earned by the car dealer in
facilitating the sale is counted as part of national income.
• Illegal activities: Income earned through illegal activities like
gambling, illicit extraction of mine, etc, it not included in national
income. Though these activities have value and they satisfy the wants
of a group of people, they are not considered productive from the
point of view of society.
 Example: Income generated from illegal drug trade or gambling is not
included in the calculation of national income, even though it
represents a significant amount of economic activity in some regions.
These activities are considered non-productive from a societal
perspective and thus excluded.
• Consumers’ service: Actors, dancers, doctors, singers, teachers do not
produce any tangible product therefore there is a problem regarding
the inclusion of their services. Their services are included as final
goods in national income accounting because they satisfy human
wants and receive payment for that.
 Example: A doctor provides medical services and earns fees for these
services, which are included in national income because they
represent payment for satisfying a need, even though no tangible
good is produced. Similarly, a singer earns money by performing in
concerts, and this income is included.
• Depreciation calculation: Depreciation reduces the value of national
income, but a correct estimation of depreciation value in a given
period is very difficult.
 Example: A factory buys machinery for ₹1 million, which loses value
over time due to wear and tear. Estimating the exact depreciation
over time can be complex because it depends on factors like usage,
maintenance, and technological obsolescence. If depreciation is
overestimated or underestimated, it can distort national income
calculations.
• Changes in Price Level: National income by product method measures the
value of goods and services at the current price. Therefore, this method
does not reflect any price change. Economists therefore calculate real
national income at a constant price level by the consumer price index.
 Example: If a country’s nominal GDP increases from ₹1 trillion to ₹1.2
trillion, but inflation was 20%, the real GDP remains unchanged. Without
adjusting for inflation, the national income might seem to have grown,
even though the actual quantity of goods and services produced has
stayed the same.
Problems in Measuring National
Income Using the Product Method
Double Counting:
• If intermediate goods (goods used to produce final goods) are not
correctly accounted for, it can lead to double counting, artificially
inflating the GDP.
 Example: If the value of steel is counted separately and then counted
again as part of the value of cars made from the steel, GDP will be
overstated.
Valuing Non-Market Activities:
• Many non-market activities that contribute to the economy, such as
household work, childcare, and volunteer work, are not included in
national income.
 Example: A stay-at-home parent’s contribution in terms of childcare
and household chores is valuable, but it’s not captured in GDP
because it’s not part of the formal market.
Underground Economy:
• The black market and informal sectors (where goods and services are
produced but not officially recorded) are difficult to measure and
often omitted.
 Example: A mechanic who repairs cars without issuing receipts
operates in the informal economy, meaning their output is not
captured in the product method.
Difficulty in Measuring Services:
• While manufacturing output is easy to measure, services like
education, healthcare, and consulting are harder to quantify,
especially when their value is intangible.
 Example: The contribution of a lawyer or a consultant to the
economy is harder to measure compared to a factory producing
tangible goods like cars or computers.
 Problems in Measuring National
Income Using the Expenditure
Method
Government services: There is a debate on the inclusion of govt expenditure on military, police
protection, administrative and legal services in calculation of national income. If there above
mentioned services facilitate the smooth functioning of production by maintaining peace then
they are intermediate goods and the govt expenditure must not be included in national income.
On the other hand, if these services protect the lives and property of people then they are final
goods and govt expenditure should be included in national income. In order to avoid all this
confusion expenditure on government services are considered as expenditure on final goods and
included in national income.
• Example: The Indian Armed Forces and the Indian Police Service (IPS) provide protection
and ensure law and order. The debate is whether these services should be counted as
intermediate goods (facilitating production by maintaining peace) or final goods
(protecting citizens and their property). In India’s national income calculations,
Transfer payments: There are some govt expenditures, for example,
pensions, unemployment allowance, subsidies, interest on national
debt, which are not included in national income because they are paid
without increasing the output of the national in the current year.
These types of government expenditure is known as transfer payment.
• Example: The Mahatma Gandhi National Rural Employment
Guarantee Act (MGNREGA) provides unemployment allowances
to rural households. Similarly, the PM-Kisan Scheme gives direct
income support to farmers. These are transfer payments and are
not included in the calculation of national income, as they do not
result in the production of goods or services in the current
period.
Public Expenditure: It is very difficult to find out the difference between
public expenditure on consumption (expenses on police, parks, street
lighting, civil and judicial administration, museum, etc) and public
expenditure on investment (canals, buildings, roads). Public expenditure
on consumption do not generate any additional output in the current
period.
• Example: The Delhi Metro Rail Project represents investment
expenditure as it increases infrastructure and productivity in the
long term. In contrast, spending on the maintenance of public parks
like Lodhi Garden in Delhi or Cubbon Park in Bengaluru is
consumption expenditure, as it does not directly lead to additional
economic output in the short term. Accurately categorizing these
types of expenditure remains a challenge.
Durable use of consumer goods: The expenditure on durable consumer
goods like TV, fridge, furniture etc. are considered as expenditure on final
goods and can be easily included in national income accounting but these
goods are used for a number of years. It is not possible to calculate their
used up value for subsequent years. One of the exceptions is ‘new house’.
Expenditure on new house is investment expenditure and not
consumption expenditure.
• Example: When a family in India buys a new refrigerator or a new
television, it is counted as a final good in the year of purchase.
However, the refrigerator or television may be used for 10 years,
and its value decreases over time. This depreciation is not reflected
in subsequent national income calculations. On the other hand,
buying a new apartment in a housing complex in Mumbai or
Bengaluru is considered investment expenditure, not