BASIC MACROECONOMICS

Microeconomics is the study of human behavior and choices as

they relate to relatively small units, such as an individual, a
firm, an industry, or a single market.
Macroeconomics is the study of human behavior and choices as
they relate to an entire economy.
Economic analysis attempts to explain why problems arise in
the economy and how these problems can be dealt with.
It is therefore indispensable for formulating and conducting
economic policy.
However, before studying macroeconomic theory and policy,
one must know the macroeconomic goals of the economy.
There is no point in formulating a policy without definite
objectives.
Macroeconomic policy operates within a framework of goals
and constraints.
The most important goals of economic policy are;
 BASIC MACROECONOMICS

i. Full employment full utilization of human and non-human

resources
ii. High living standards
iii. Price Stability
iv. Reduction of economic inequality and removal of poverty
v. Rapid economic growth
vi. External balance vs overall balance in economic relations with the
rest of the world.
 BASIC MACROECONOMICS
National Income
The most important aspects that shape the economy is the nations
capacity to produce goods and services and keep various factors of
production employed.
The GNP growth rate, the most important indicator of the nations
income, shows whether the nations income is expanding or
contracting, and thus, it is the broadest statistical aggregate of our
economic output and growth.
The estimates of GNP and national income provide the policy
makers and business community with the most useful tool for
analyzing an economys economic performance, both in the short
term and long term periods.
However, it is crucial to prepare the accurate and reliable estimates
of the nation product for purposes of meaningful economic analysis
and reliable forecasting.
In simple terms, GNP is the sum of all final goods and services
produced during a specified time period usually a year, with each
class of goods services measured at its market value i.e. at price
usually paid.
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If the same is estimated in terms of factor cost i.e. at the sum of all
income earned by factors of production (i.e. wages and salary, rents,
interest and profits), then the aggregate is GNP at factor cost.
In the definition stated above the term final is used to avoid the
possibility of double counting and to ensure that only the value of
final goods and services is counted in GNP. Why?
Because of the value of an intermediate class of goods is embodied
within the value of final goods and services.
The term gross refers to the fact that depreciation (or capital
consumption) of structures and equipment is not deducted from the
value of output.
Moreover, the aggregate GNP is a flow concept. It is typically
measured in terms of an annual rate i.e. over a period of time. For
instance, Indias GDP was Rs 14, 13,200 crore in 1997-98.
This means that Rs 14, 13,200 crore worth of final goods and services
were produced during 1997-98.
Thus GDP is a device designed to measure the market value of
production that flows through countries various industries and shops
per year.
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When measuring GNP, or any other aggregate of nation product, we

are interested in final value of goods and services.
In other words, we are only interested in value added in each stage of
production process.
Value added is difference between the value of goods and services as
they leave one stage of production and their cost when they entered
that stage.
We will consider one example- production of bread- to explain the
concept clearly.
As shown in the figure below, there are many stages in production of
wheat by the farmer to milling of wheat into the flour, the baking of
bread by the baker and its final sale to the customer by the retail shop
owner.
 BASIC MACROECONOMICS
Value added in different stages of bread production
Stage:1 Stage:2 Stage:3 Stage:4 Stage:5
Value added value added by value added by value added final value
by farmer= by Miller = by baker= by retailer= baked
bread=
Rs 0.80 Rs. 1.50 Rs. 1.80 Rs 0.20 Rs. 4.30

The final value of the bread is the sum total of value added at each
stage.
If we add up all the prices at each stage, it would be a gross mistake of
double counting.
This will distort the actual value of the product in a specified period.
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Relationship among eight variants of national product

The distinction between national product at market prices and national
product at factor cost, based on whether or not net indirect taxes have
been included and there is also a distinction between gross or net
national product according to which whether investment is inclusive
of capital consumption or not.
Further, a distinction has been drawn between domestic and national
product, according to whether we are measuring net factor income
from abroad or whether we are measuring what is produced within the
domestic economy.
This implies that there are eight combinations of national product
aggregates as shown below.
 BASIC MACROECONOMICS
Gross Domestic Product (GDP) at Market Price (MP)
at Factor Cost (FC)
Gross National Product (GNP) at Market Price (MP)
at Factor Cost (FC)
Net Domestic Product (NDP) at Market Price (MP)
at Factor Cost (FC)
Net National Product (NNP) at Market Price(MP)
at Factor Cost (FC)

The way that these national product aggregates are related to each
other be understood from the figure given below.
 =GNPMP
-net indirect
- Depreciation taxes
=NNPMP =GNPFC
- net income from Abroad

- Depreciation
=GDPMP
-net indirect
taxes
- net income from Abroad
- net income from Abroad

- Depreciation -net indirect

=NNPFC taxes

=NDPMP - net income from Abroad =GDPFC

-net indirect - Depreciation

taxes
=NDPFC
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We can sum up the differences between gross and net marketing prices
and factor cost and national and domestic concepts in the following
way:
Gross = Net + Depreciation
Market Prices = factor cost + [indirect taxes subsidies]
National = Domestic + Net factor income from abroad.
There are some national product aggregates that are more frequently
met with and we have several ways to ordering them. One of these is as
follow:
Gross domestic product at market price + net factor income from
abroad
equals
Gross national product at market price net indirect taxes (indirect
taxes- Subsidies)
equals
Gross national product at factor cost capital consumption
(depreciation)
equals
Net national product at factor cost, which is popularly known as
national Income
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Real Vs. Nominal GNP
Its important to distinguish between real and nominal values of
macroeconomics aggregates.
When comparing data at different points in time, economists often use
terms such as real wage, real income or real GNP.
The real refers to the fact that data have been adjusted for change in
level of prices.
Thus real GNP is the GNP in current rupees deflated for changes in
the prices of the items included in the GNP.
In contrast, nominal GNP (or money GNP, as they are often called) is
expressed in current rupees.
It measures the value of output in given period in the price of that
period, or as it is some times put, in current rupees.
Over time, nominal values reflect changes both in a) the real size of
an economics variable and b) the general level of prices.
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In contrast, real values eliminate the impact changes in the price level.
Stated another way, real economic data are adjusted for changes in
purchasing power of the rupee.
Perhaps an example will clarify the difference between real and
nominal values.
In 1998-99 the nominal GNP in India was Rs 16, 01,065 crore,
compared to only Rs. 7, 69,265 crore in India was 1993-94.
Does this mean we produce two times as much output in 1993-94?
Not hardly.
In 1998-99 the general level of price was higher than the level of
prices in 1993-94.
Measured in terms of price level in 1993-94, real GNP in 1998-99 was
worth Rs. 10, 71,073.
Nominal GNP will increase either if a) more goods and services are
produced or if b) prices rise. Often both a) and b) contribute to an
increase in GNP.
Since we are really interested in comparing only the output or actual
production during two intervals, GNP must be adjusted for the
changes in prices.
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A price index called GNP deflator is constructed to a price index to
reveal the cost of purchasing the items included in GNP during the
period relative to the cost of purchasing those same items during a
base year (say 1993-94).
Since the base year is assigned the value of 100, as the GNP deflator
takes on values greater than 100, it indicates that prices have risen.
The central statistical organization (CSO) estimates how much of
each item included in GNP has been produced during a year.
This bundle of goods will include automobiles, houses, office
buildings, medical services, bread and all other goods included in
GNP, in qualities actually produced during the current year.
The agency then calculates the ratios of a) the cost of purchasing this
representative bundle of goods at current price divided by b) the cost
of purchasing the same bundle at the prices that were present during a
designated base year.
The base year chosen is given the value 100. The GNP deflator is
equal to the calculated ratio multiplied by 100.
If prices are, on average, higher during the current period than they
were during the base year, the GNP deflator will exceed 100.
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The relative size of the GNP deflator is measure of the current price
level compared to price level during the base year.
A change in nominal GNP tell us nothing about what is happening to
rate of real production unless we also know what is happening to
prices.
Money income could double while production actually declines, if
prices more than double.
On the other hand, money income could remain constant while real
GNP increases, if prices fall during a time period.
Data on money GNP and price changes are both essential for a
meaningful duration a time period.
Data on money GNP and price changes are both essential for a
meaningful comparison of real income between two time periods.
So we look at real rather than nominal GNP as basic measure for
comparing output in different years.
 BASIC MACROECONOMICS
The measurement of national income: output, expenditure and
income methods of measurement
There are three methods of calculating national income, and they are
all conceptually equivalent to each other.
These are: the output method, the income method and the expenditure
method.
These three measures give rise to several different ways of describing
the various macro-aggregates employed in compiling the national
accounts and these are described and illustrated in tables.
The output method: The output method is followed either by valuing
all final good and services produced during a year or by aggregating
the value imparted to the intermediate products at each stage of
production by the industries and productive enterprises in the
economy.
The sum of these values added gives the gross domestic product at
factor cost which after a similar adjustment to include net factor
income from abroad gives gross national product at factor cost.
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This approach is used to estimate gross and value added in the
primary sector- Ex. Agriculture and allied activities, forestry and
logging, fishing, registered manufacturing, etc.-of the Indian
Economy.
The output (value added) method
The agricultural and extractive industries 10
Plus Manufacturing industries 40
Plus Services and construction 40
----------------------------------------------------------------------
Equals Gross Domestic Product at factor cost 90
Plus Net factor income from abroad
(=income received from abroad- income paid abroad) 10
---------------------------------------------------------------------
Equal Gross National Product at factor cost 100
Less Capital consumption or depreciation -20
----------------------------------------------------------------------
Equals NNP at factor cost or national income 80
 BASIC MACROECONOMICS
The Expenditure method: The expenditure method
aggregates all money spent by private citizens, firms and the
government within the year, to obtain total domestic
expenditure at market prices.
This includes consumer spending and investment i.e. total
domestic spending.
It aggregates only the value of final purchases and excludes
all expenditures on intermediate goods.
However, since final expenditure at market price includes
both the effects of taxes and subsidies and our expenditures
on imports while excluding the value of our exports, all these
transactions have to be taken into account before we obtain
gross national product by this method.
For instance, in case of private consumption expenditure,
qualities of goods and services entering private consumptions
are estimated by deducting from qualities produced, qualities
used up in intermediate uses, purchased by government, etc.
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Similarly several items of machinery and equipment are identical and market values
of their output are together to estimate capital in from of machinery and equipment.
The Expenditure Method
Consumers expenditure(C) 70
Plus Government current expenditures on goods and services (G) 20
Plus Gross domestic fixed capital formation (I) 20
Plus Value of physical increase in stocks and work in progress (I) 10
----------------------------------------------------------------------------------------------
Equals Total domestic expenditure at market prices 120
Plus Exports and factor income from abroad (E) 20
Less Imports and factors income paid abroad (M) -30
-----------------------------------------------------------------------------------------------
Equals GNPMP 110
Less Indirect taxes -20
Plus Subsidies 10
-----------------------------------------------------------------------------------------------
Equals Gross national product at factor cost 100
 BASIC MACROECONOMICS
The Income Method: The income approach to measuring national
income does not simply aggregate all incomes.
It aggregates only those of those residents of the nation, corporate and

individual, that obtain income directly from the current production of

goods and services.
It aggregates money payments made to the different factors of production

i.e. factors income and excludes all incomes which cannot be concerned as
payment for current services to production (i.e. Transfer incomes and
which therefore do not enter national income).
What is factor payment for the producers is factor income for factor

owners. It includes wages and salaries (W), rent (R), interest (I) and
profits (P).
The last includes the profits of companies and surpluses of public

corporations.
Thus, the total of all factor income gives total domestic income which once

adjusted stock appreciation gives gross domestic product at factor cost.

If we then add on net factor income from abroad we have obtained one

measure of gross national income or more properly known as gross

national product.
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The Income Method
Income from employment 50
Plus Income from self-employment 10
Plus Gross Trading profits of companies 10
Plus Gross Trading surplus of public corporations 10
Plus Rent 10
---------------------------------------------------------------------------------
Equals Gross domestic product at factor cost 90
Plus Net factor income from abroad 10
----------------------------------------------------------------------------------
Equals Gross national product at factor cost 100
According to above table, conceptually whatever may be the method
followed for the measurement of national income, with appropriate
adjustments all three methods will give the same result.
Hence, the three methods give rise to estimates of GNP which once
adjusted to take account of capital consumption (depreciation) provides the
measurement of national income by different methods, the consistency and
accuracy of the national income estimates can be cross checked.
 BASIC MACROECONOMICS
Other measures of national output
There are five alternative measures of national product and income:
i) Gross national product
ii) Net National income
iii) National income
iv) Personal income
v) Disposable income
The alternatives range from GNP, which is the broadest measure of
output, to disposable income, which indicates the funds available to
households for either personal consumption or saving.
GNPs measured through expenditure method is the sum of consumption
(C), Gross Private Domestic Investment (I), Government Purchases (G),
and Net Export (E-M).
Exports include factor income received from abroad and factor income
paid abroad is included in imports. Therefore, net exports include net
factor income from abroad (NFIA). By deducting depreciation from abroad
net indirect taxes from NNPMP, we get NNPFC, widely known as National
Income.
 BASIC MACROECONOMICS

Through income method, national income can also be

calculated by summing up payments to all factors production:
Land, Labor, Capital and Entrepreneurship.
Factor payments to land are rents, to labor wages, to capital
interest payments and to entrepreneurship profits.
Therefore national income computed through income method is
equally to sum of rents, wages, interests and profits.
Total profits can be either from incorporated business or
unincorporated business.
Profits of incorporated are corporate profits and profits of
unincorporated business (like self-employment, small scale
industries, etc.) are proprietors income.
 BASIC MACROECONOMICS
Personal income is the total income received by individuals that
is available for consumptions, saving and payment of personal
taxes.
When we subtract income that is earned but not directly
received from and add income that is received but not earned
during the current period to national income we get personal
income.
Thus, corporate profits which are equal to corporate profit
taxes plus retained earnings plus dividends and social insurance
taxes are deducted and transfer payments, net interest and
dividends are added to national income to get personal income.
Disposable income is the income available to individuals after
personal taxes i.e. Disposable income = personal income minus
personal taxes.
It can be either spent on consumption or saved.
 BASIC MACROECONOMICS
Difficulties in measuring the national income in India
There are some conceptual and statistical problems in measuring
national product. Some items are excluded from the national income
accounting, even though they would be properly classified as current
production of goods and services.
Sometimes production leads to harmful side effects which are not taken
into consideration.
A brief discussion of some of these limitations of national products is
given below.
1. Non-market production
The national product fails to account house hold production because
such production does not involve a market transaction.
As a result the house hold services of millions of people are exactly
from the national income accounts.
E.g. house work done by house-wives is not included but the same
work done by paid servant is.
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2. Imputed values
Some self supplied goods and services are given as imputed values for
their inclusion in national income accounts, for examples, owner-
occupied houses and the value for food consumed by the farmers
themselves.
Sometimes this may results in overestimation or underestimation of
national income.
3. The underground economy
There are many transactions that go unreported because they involve
either illegal activities or taxes evasion.
Most of these underground activities produce goods and services that
are valued by the purchasers.
However, these activities are unreported and not included in national
income accounts. They do not figure in our product estimate.
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4. Side-effects and Economic bads
National income accounts make no adjustment for harmful side
effects that sometime arise from several productive activities and the
events of nature.
If they do not involve market transactions, economic bads are not
deducted from national product.
When private rights are not defined properly, air and water pollution
are sometimes side effects of the process of economic activity and
reduce our future production possibilities.
Similarly the growing defense and the greater outputs of military
equipment might increase the national product but the moot point is
whether the country has become better off or not.
Since national accounts ignore these negative aspects of growth and
development, it tends to over state a real national output.
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5. Leisure and human cost
According to Simon Kuznets, the failure to fully include leisure and
human costs is one of the grave oddities of national income
accounting.
National income accounts exclude leisure, a commodity that is
valuable to everybody.
Similarly national product also fails to take into account human cost
of employment in terms of the physical and mental strains associated
with many jobs.
On an average, jobs today are relatively less strenuous and less
exhausting than they were some forty years ago, but they have
become perhaps more monotonous.
These limitations reduce the significance of national product
comparisons in the long run.
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6. Double counting
There is a possibility that some output may be counted twice. Thereby
the measure of national product is exaggerated. We must exclude the
value of inputs if they have already been accounted for. Because, the
distinction between intermediate product and final product is vital in
connection with the welfare significance of the national product
measure.
To calculate real national income or national income at constant prices
for year X:
National income at market prices x 100(base year price index)
Price index of year X

National income must be related to the size of population. When

national income is divided by the total population, this gives per
capita national income.
 BASIC MACROECONOMICS
The uses of national income statistics
National income statistics have four main uses:-
1. As an instrument of economic planning and review.
2. As a means of indicating changes in a countrys standard of living.
3. As a means of comparing the economic performance of different
countries.
4. To indicate changes in the economic growth of a country.
1. As an instrument of economic planning and review
The statistics provide important background information on which the
government can base its decisions.
Private corporate sector can also use the statistics to assess future
prospects.
The figures help in answering numerous questions, such as whether
the economy is growing and at what rate.
Which industries are declining and which expanding?
What is happening to consumer spending, savings and the economy as
a whole?
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2. As a means of indicating changes in a countrys standard of living.
National income statistics are used to assess changes in the standard of living

within a country.
If the national income increases, it is normally assumed that the standard of

living has improved.

However, this may not be the case and certain factors have to be taken into

account to understand why the living standard has not improved:

National income statistics may be expressed in market or current prices and

therefore show an increase due to inflation.

Real national income or national income at constant prices, where statistics

are expressed as an index of prices, is a more reliable indicator.

Another problem, however, is that this says nothing about the distribution

aspects of a national income.

The increase in national income may be accompanied by high social costs

such as pollution, congestion and damage to the environment.

There may be less leisure time, too.
The national income increase may be due to more exports and fewer goods

for home consumption or more defense spending.

Both these situations may not improve citizens standard of living.
National income statistics say nothing about the quality of output.
 BASIC MACROECONOMICS
3. To indicate changes in the economic growth of a country
The best indicator of economic growth is changes in real national
income per capita. However, usually growth is expressed in terms
of percentage changes in GNP.
Economic growth is usually thought to be desirable because it
means a better standard of living for citizens and more wealth to
be allocated.
More money can be spent on social overheads such as education,
health, etc.
It is a fact that our economic growth during the past two decades
has been disappointing compared to that of other developing and
newly industrialized countries such as China, Taiwan, South
Korea, etc.
The reasons for this may include:
Poor management of public and private sector undertakings;
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Damage done by industrial disputes and frequent lockouts;

Education not fitting industrys needs and requirements;
Lack of investment in new technology;
Propping up old and declining industry;
Government taxation policy reducing the amount of money corporate
sector has for investment;
Constant changes in government economic policy- high interest rates,
high exchange rates, inflations followed by changes in administered
prices, budget deficits, etc.
Low quality of labor;
Low level of productivity;
Lack of consistency in managing the economy and policy; and
Fragile Balance of payments (Bop) situation
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4. As a means of comparing the economic performance of
different countries
National income statistic gives a guide to the standard of living
in two different countries. However, there again some
difficulties:
The statistic may be calculated differently.
To avoid the effect of inflation and population size, the statistics
are best presented as real national per capita.
The distribution aspect of national does not fight in the statistics.
There is the problem of the exchange rate between the currencies
of two countries.
The size and composition of unrecor ded transactions may
differ between the tow countries.
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The two countries may have different cultures and climates,
therefore commodities required in one country are not in
demand in other.
National income statistics tell us nothing about the number of
doctors per head of population, the availability of leisure
activities, the climate rate or the number of people physically
or mentally ill.