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In tro d u ctio n to

M a cro e co n o m ics
Introduction to
Macroeconomics
• Microeconomics examines the
behavior of individual decision-
making units—business firms and
households.
• Macroeconomics deals with the
economy as a whole; it examines
the behavior of economic
aggregates such as aggregate
income, consumption, investment,
and the overall level of prices.
– Aggregate behavior refers to the
behavior of all households and
firms together.
2
Introduction to
Macroeconomics
• Microeconomists generally
conclude that markets
work well.
Macroeconomists,
however, observe that
some important prices
often seem “sticky.”
• Sticky prices are prices
that do not always adjust
rapidly to maintain the 3
Introduction to
Macroeconomics
• Macroeconomists often
reflect on the
microeconomic principles
underlying
macroeconomic analysis,
or the microeconomic
foundations of
macroeconomics.

4
The Roots of
Macroeconomics

• The Great
Depression was
a period of severe
economic
contraction and
high
unemployment
that began in
1929 and
continued
throughout the 5
The Roots of
Macroeconomics
• Classical economists applied
microeconomic models, or “market
clearing” models, to economy-wide
problems.
• However, simple classical models
failed to explain the prolonged
existence of high unemployment
during the Great Depression. This
provided the impetus for the
development of macroeconomics.

6
The Roots of
Macroeconomics
• In 1936, John Maynard Keynes published The
General Theory of Employment, Interest, and
Money.
• Keynes believed governments could intervene in
the economy and affect the level of output and
employment.
• During periods of low private demand, the
government can stimulate aggregate demand
to lift the economy out of recession.

7
Recent Macroeconomic
History
• Fine-tuning was the phrase used by
Walter Heller to refer to the
government’s role in regulating
inflation and unemployment.
• The use of Keynesian policy to fine-
tune the economy in the 1960s, led
to disillusionment in the 1970s and
early 1980s.

8
Recent Macroeconomic
History
• Stagflation occurs when the overall
price level rises rapidly (inflation)
during periods of recession or high
and persistent unemployment
(stagnation).

9
So what is ‘the economy’?
• The economy is made up of four sectors sometimes
called economic agents:
• Households who receive payments (income) for their
V ita lkn o w le d g e

services (eg labour and land) and use this money to


buy the output of firms (ie consumption or
household spending).
• Firms who use land labour and capital to produce
goods and services for which they pay wages rent
etc (income) and receive payment (expenditure)
• Government (also known as the public or state
sector) and
• International eg consumers buying overseas
products (M) and Foreigners buying UK products (X)

Key Concepts
Yo u w illle a rn a lla b o u t th is !

• Gross Domestic Product (GDP)


– The monetary value of all goods and services
produced within the UK in a given time period
• Real GDP
– The volume of goods and services produced within
the UK (i.e. GDP adjusted for changes in the price
level)
• Economic Growth
– The percentage rate of increase of real GDP
• Inflation
– The annual percentage rate of change of the general
price level
Difference between micro &
macro
• Microeconomics
• Recession in the tourist industry due to
the global downturn
• A government subsidy to steel
producers
• A recession in the textiles industry
• Increased spending on the National
Health Service
Microeconomics
Difference between micro &
macro
• Macroeconomics
• Strong economic growth arising from
high levels of consumer spending
• A fall in exports because of a recession
in leading European markets
• Higher interest rates to curb inflationary
pressure
Macroeconomic Concerns
• Three of the major concerns of
macroeconomics are:
– Inflation
– Output growth
– Unemployment
– BOP & Exchange rate

15
Inflation and Deflation

• Inflation is an increase in the overall


price level.
• Hyperinflationis a period of very
rapid increases in the overall price
level. Hyperinflations are rare, but
have been used to study the costs
and consequences of even
moderate inflation.
• Deflation is a decrease in the overall
price level. Prolonged periods of
deflation can be just as damaging
for the economy as sustained
inflation. 16
Output Growth:
Short Run and Long Run

• The business cycle is the


cycle of short-term ups
and downs in the
economy.
• The main measure of how
an economy is doing is
aggregate output:
– Aggregate output is the
total quantity of goods
and services produced in
an economy in a given 17
Output Growth:
Short Run and Long Run
• A recessionis a period during which
aggregate output declines. Two
consecutive quarters of decrease in
output signal a recession.
• A prolonged and deep recession
becomes a depression.
• Policy makers attempt not only to
smooth fluctuations in output
during a business cycle but also to
increase the growth rate of output
in the long-run.

18
Unemployment
• The unemployment rate is the
percentage of the labor force that is
unemployed.
• The unemployment rate is a key
indicator of the economy’s health.
• The existence of unemployment
seems to imply that the aggregate
labor market is not in equilibrium.
Why do labor markets not clear
when other markets do?
19
Government in the
Macroeconomy
• There are three kinds of
policy that the
government has used to
influence the
macroeconomy:
1.Fiscal policy
2.Monetary policy
3.Growth or supply-side
policies
20
Government in the
Macroeconomy
• Fiscal policy refers to government
policies concerning taxes and
spending.
• Monetary policy consists of tools
used by the Federal Reserve to
control the quantity of money in the
economy.
• Growth policies are government
policies that focus on stimulating
aggregate supply instead of
aggregate demand.

21
Why Macro Economics
• B coz there are forces
attracting the economy
as whole

• A problem can be tackled


at the level of whole
economy
ROLE OF GOVERNMEN IN
THE MACRO ECONOMY
Three type of policy to influence the
working

1)
The Components of
the Macroeconomy

• The circular flow


diagram shows
the income
received and
payments made
by each sector of
the economy.

26
The Three Market Arenas

• Households, firms, the


government, and the rest
of the world all interact in
three different market
arenas:
1.Goods-and-services market
2.Labor market
3.Money (financial) market

27
The Three Market Arenas
• Households and the government purchase goods
and services (demand) from firms in the
goods-and services market, and firms
supply to the goods and services market.
• In the labor market, firms and government
purchase (demand) labor from households
(supply).
– The total supply of labor in the economy depends on
the sum of decisions made by households.

28
The Three Market Arenas
• In the money market—sometimes called the
financial market—households purchase stocks
and bonds from firms.
– Households supply funds to this market in the
expectation of earning income, and also demand
(borrow) funds from this market.
– Firms, government, and the rest of the world also
engage in borrowing and lending, coordinated by
financial institutions.

29
Financial Instruments

• Treasury bonds, notes,


and bills are promissory
notes issued by the
federal government when
it borrows money.
• Corporate bonds are
promissory notes issued
by corporations when they
borrow money.
30
Financial Instruments

• Shares of stock are


financial instruments that
give to the holder a share
in the firm’s ownership
and therefore the right to
share in the firm’s profits.
– Dividends are the portion
of a corporation’s profits
that the firm pays out
each period to its
31
shareholders.
The Circular Flow of Income in
Symbols
• Domestic Output (GDP) is either
– Consumed (C)
– Invested (I)
– Bought by the Government (G)
– Bought by the foreigners, net
exports (X-Z)

• Factor Incomes are spent on
– Consumption (C)
– Saving (S)
– Paying taxes net of benefits (T-B) 32
The Economic Problem
• The circular flow of income
– firms and households
The circular flow of goods and incomes
The Economic Problem
• The circular flow of income
– firms and households
– goods markets
• real flows: goods and services
The circular flow of goods and incomes
The circular flow of goods and incomes
Goods and services
The Economic Problem
• The circular flow of income
– firms and households
– goods markets
• real flows: goods and services
• money flows: consumer expenditure
The circular flow of goods and incomes
Goods and services
The circular flow of goods and incomes
Goods and services

£
Consumer
expenditure
The circular flow of goods and incomes
Goods and services

£
Consumer
expenditure
The Economic Problem
• The circular flow of income
– firms and households
– goods markets
• real flows: goods and services
• money flows: consumer expenditure
– factor markets
The circular flow of goods and incomes
Goods and services

£
Consumer
expenditure

Services of factors of production (labour, etc)


The Economic Problem
• The circular flow of income
– firms and households
– goods markets
• real flows: goods and services
• money flows: consumer expenditure
– factor markets
• real flows: services of labour and other
factors
The circular flow of goods and incomes
Goods and services

£
Consumer
expenditure

Wages, rent
dividends, etc.
£

Services of factors of production (labour, etc)


The Economic Problem
• The circular flow of income
– firms and households
– goods markets
• real flows: goods and services
• money flows: consumer expenditure
– factor markets
• real flows: services of labour and other
factors
• money flows: wages and other incomes
The Economic Problem
• The circular flow of income (cont.)
– macroeconomic issues
• the size of total flows
– microeconomic issues
• individual markets
• choices within goods and factor
markets
Circular Flow Between Firms and
Households
(real resources)

Goods and services

Households Firms

Factor Input

Household includes workers, managers,


entrepreneurs etc
48
Circular Flow Between Firms and
Households
(corresponding flow of payments)
Spending on
goods and services

Households Firms

Factor incomes
49
Circular Flow Between Firms and
Households
Spending on
goods and services

Goods and services

Households Firms

Services of
productive factors

Factor incomes
50
Circular Flow Between Firms and
Households
ng
Spending on
r i he
Expenditure
goods and services
s u t
e a in
m y
of vit
Goods and services
Output

a y ti
w ac
Households
n t c Firms
r e mi
f e no
i f coServices of
d e productive
y factors
3 he o m
t con Income
e Factor incomes
51
Three measures of national output

• Expenditure
– the sum of expenditures in the
economy
• Income
– the sum of incomes all factor
incomes
• Output
– the sum of output (value added)
produced in the economy

• All three approaches are should give 52


Leakages from the Circular Flow

• Leakages (in terms of flow of payment)


– money paid to the households but not
returned to firm
– Or flow of payments that started from
firms but did not return back to
firms
– e.g. household savings, net taxes and
imports

53
Circular Flow Between Firms and
Households
(corresponding flow of payments)
Spending on
goods and services

Leakages

Households Firms

Factor incomes

54
Injections into the Circular Flow

• Injections (in terms of flow of payment)


– are revenue for firms not from sales
to household

– e.g. investment by firms, government
purchases and exports

55
Circular Flow Between Firms and
Households
(corresponding flow of payments)
Spending on
goods and services

Injectio
ns

Households Firms

Factor incomes

56
Figure 2-2 Introduction of Saving and Investment to the Circular Flow
Diagram
Saving investments identity in
National Income Accounts

S im p le e co n o m y n ie th e r g o vt N o r fo re ig n tra d e

va lu e o f o u tp u t so ld in e co n o m y Y = C + I ( i)

W h a t h a p p e n s to u n so ld o u tp u t

T h is le a d s to in cre a se in ve n to rie s o f g o o d s

w h ich is tre a te d a s a ctu a l in ve stm e n t.

G N P Fro m vie w p o in t o f its a llo ca tio n b e tw e e n C + S

S in ce N a tio n a l in co m e Y = C + S ( ii)
Fro m id e n titie s ( i) a n d ( ii) w e g e t

C + I= Y = C + S

Le ft h a n d sid e C + I= Y C o m p o n e n ts o f A g g . d e m a n d )

R ig h t h a n d sid e Y = C + S ( A llo ca tio n a t N . I to e ith e r C o r S )

so va lu e o f o u tp u t p ro d u ce d o r so ld e q u a l to to ta l Y re ce ive d

In co m e re ce ive d is S p e n t o n g o o d s & S e rvice s p ro d u ce d in ,


N o w S u b stra ctin g th e C fro m b o th sid e s

I= S

S im p le e co n o m y I = S
R e la tio n o f in ve stm e n t a n d sa vin g
T h e p o rtio n o f h o u se h o ld in co m e th a t is n o t
co n su m e d is ca lle d p e rso n a lsa vin g . T h e se
fu n d s a re ch a n n e le d to b u sin e ss firm s in tw o
w a ys:

1 . T h e y b u y b u sin e ss b o n d s o r sto cks


2 . T h e y d e p o sit sa vin g s in fin a n cia l
in te rm e d ia rie s to b e le n t to b u sin e ss firm s

S a vin g is a le a ka g e from the income used for


co n su m p tio n exp e n d itu re s. T h is le a ka g e m u st
b e b a la n ce d b y a n in je ctio n o n n o n -
co n su m p tio n sp e n d in g in th e fo rm o f p riva te
in ve stm e n t.
With government and foreign
agents
• Need to account for :
a.Government purchases of goods and
services.
b.Government payments for factor services
(wages, rent, interest).
c.Transfer payments between different
agents.
d.Firms and households pay taxes to
government.
e.Taxes paid on income, property, goods and
services.
f. Transactions with the foreign sector.
The circular flow of income

Consumption of
Factor domestically
payments produced goods
and services (Cd)
The circular flow of income

Consumption of
Factor domestically
produced goods BANKS, etc
payments
and services (Cd)

Net
saving (S)
The circular flow of income

Investment (I)

Consumption of
Factor domestically
produced goods BANKS, etc
payments
and services (Cd)

Net
saving (S)
The circular flow of income

Investment (I)

Consumption of
Factor domestically
produced goods BANKS, etc GOV.
payments
and services (Cd)

Net
Net taxes (T)
saving (S)
The circular flow of income

Investment (I)
Government
expenditure (G)
Consumption of
Factor domestically
produced goods BANKS, etc GOV.
payments
and services (Cd)

Net
Net taxes (T)
saving (S)
The circular flow of income

Investment (I)
Government
expenditure (G)
Consumption of
Factor domestically
produced goods BANKS, etc GOV. ABROAD
payments
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)
The circular flow of income

Export
expenditure (X)
Investment (I)
Government
expenditure (G)
Consumption of
Factor domestically
produced goods BANKS, etc GOV. ABROAD
payments
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)
The circular flow of income

Export
expenditure (X)
Investment (I)
Government
expenditure (G)
Consumption of
Factor domestically
produced goods BANKS, etc GOV. ABROAD
payments
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)

WITHDRAWALS
The circular flow of income

INJECTIONS

Export
expenditure (X)
Investment (I)
Government
expenditure (G)
Consumption of
Factor domestically
produced goods BANKS, etc GOV. ABROAD
payments
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)

WITHDRAWALS
Economic Base Model Collapses All Spending
into Regional and Non-Regional

INJECTION

Export
expenditure (X)
Regional Purchases of
Factor regionally produced goods
OUTSIDE OF REGION
payments and services
Import
expenditure (M)

WITHDRAWAL
Transactions with foreign
sector
• Includes sales of goods and services,
assets, and transfers
• Exports - sales of domestically
produced goods to other countries
• Imports - goods bought from other
countries
With Government sector

Total Exp = C + I +G - (i)

Total income received allocated

Y = C + S+T ----- (ii)

Since expenditure must be equal Income received


From equ (i) and (ii)

C + I+G = C+S+T ---- (iii)


Since C cancels out

I + G = S+T - (iv)

By rearranging we obtain

G- T = S -I ----- (v)
If Govt budget is not balanced
G > T ( Budget deficit )
Govt borrow from financial market
For this purpose , pvt invt < Savings
Govt borrowing reduces pvt investment
Govt borrowing crowds out pvt invt
• Leakages and Injections
• Note that
• C + S + T = C + I +G +NX
• -C -C

• S + T ≡ I + G + NX (4)
• Leakages (S+T) must be exactly balanced
by injections of non consumption
spending (I+G+NX)
• Equation 4 is the magic equation. Its
technical name “the leakages-injection)
identity”.
• If there is a budget deficit (T-G) < 0 then,
• I + NX – S < 0 (T-
• If T<G, the government is running a deficit,
there are 3 implications
1.Budget deficit could make (I) smaller.
2.Budget deficit requires that (S) must rise to
avoid any downward pressure on total
investment (I+NX).
3.If S does not increase, to avoid a decline in
(I+NX), there must be more borrowing
from foreigners and a decline in lending
to foreigners.
•e.g.,

• T – G = (I + NX) - S
• -1.8 = (17.8 – 1) – 18.4 (deficit financed by
foreign borrowing (-NX), and S to be greater
than I)
• 4.4 = (20.8 – 4) – 12.4 (surplus with greater
borrowing (-NX) allowed I to increase to 20.8
• The government budget and the twin
deficits
• Rearrange eq. 4 to show the uses of a
government budget surplus
• T – G = (I + NX) – S (5)
• If T>G, there are 3 ways that a
government budget surplus can be
used
1.A budget surplus allows private
savings to decline without a need
for a decline of total investment
(I+NX).
2.A budget surplus can stimulate
domestic investment (I)
3.a budget surplus can boost foreign
T h u s in o p e n e co n o m y

N a tio n a l In co m e = C + I + G + X n

X n re p re se n ts n e t e x p o rts ( X - M )

N . I ca n e ith e r b e co n su m e d , sa v e d o r p a id a s Ta x e s

T h e re fo re C + I + G + X n = C + S + T
Is ,
C is C o m m o n o n b o th sid e s
I+ G + X n = S+T

S h o w s su m o f p v t In v t , G o v t E x p a n d X - M is e q u a l

to th e su m o f sa v in g s a n d ta x re v e n u e .
(b) Certain transactions are excluded from national
income accounting

1. Transfer payment (Excluded)

This represent the redistribution of income From


one group to another, From govt. to people viz

-> prize money, pensions, reliefs benefits,


unemployment benefits, interest on govt debt, gift s,
Charity payments and awards etc.

-> It do not form the payments made For


rendering productive Services in the Current year to
Transfer payments
• Transfer payments – are transactions
wherein one party is not obliged to
deliver a good or service in return
for the payment.
• Examples: retirement benefits,
unemployment benefits,
scholarships, and donations.
• personal Y = N .I - social security contributions -
corporate Income Taxes -undistributed profits
+ Transfer payments.

• Disposable Income (DI)



DI = P.I-personal Taxes

• It can be either consumed or saved,


Hence, DI = C+S


-> circular flow of income in Three 'and four Sector
economy

-> Introducing the government and Foreign Trade to


National income accounting

-> Govt also affects economic activities denoted by G

-> Govt receives its income by direct and in direct taxes


denoted by T

-> Govt purchase good and Services and creates agg demand

-> There is also a transfer of income from govt to


household in form of
employement Benefit
Pensions and other forms denoted by R

-> For this beneficiaries do not contribute any thing


towards productive activities of economy

-> But it will increase disposable income to put sector


to expand C + S or both
-> Foreign sector forms the external sector in the economy

-> Its inclusion in the national income accounts through


exports and imports is demoted by Nx = [ X - M ]

-> This significantly affects economy's income and output

-> The national income identity with the govt sector ( G ),


transfers ( R ), Taxes ( T ) and Foreign Trade Nx becomes

Y = C + I + G + Nx

The income received in the Pvt sector is used for spending


denoted by DY

DY = Y + R - T ( Taxes are deducted and Transfers are


added )
Y = Income
R = Transfers from govt to people
T = Tax from people to govt
These are incorporated into national income accounts to exhibit
the
agg . output and disposable incomes ( DY ) are related

Accordingly DY = Y + R - T

So that Y = DY + ( T - R )

-> This disposable income can be either spend or saved or both

so the identity holds good are

DY = C + S
From DY = Y + R - T and DY = C + S
we Obtain

C + S = T + R - T and
C = { Y + R - T } - S - DY - S ( As DY = C + S )

Agg . C is equal to DY - savings

-> since we have already Stated that

C + I + G + NX , substituting we get .
C = ( Y + R - T )- S

OR

C = C + I + G + Nx + R - T - S

As Y = C + I + G + Nx

Rearranging S - I = ( G + R - T ) + NX

When X = M , Nx = 0

so that ( G + R ) = T ( Govt expt = Govt revenue )


and
S=I
-> Budget deficit ( G + R > T )

-> The saving exceed investment ( S > I )

even it Nx = 0

-> B coz to Finance budget deficit the govt borrow


from financial market there is rise in
interest rates Which decrease I and increase S

-> Govt borrowing Reduces Pvt Invt ( Crowding out


OF Pvt I )

so I<S
Even if budget deficit is zero

i . e ( G + R )= T there is Still possibility

of S > I due to Net exports remain


positive ( X > M )

-> During 1980's most of countries have


witnessed huge budgetary deficit with
mounting trade imbalance ( deficits )
Becoz

-> Govt resort to external borrowings to


tide over the deficit Following inadequate
domestic savings to cut down pvt invt
-> i . e govt resort to external borrowings
to Save

Crowding out of pvt Invt

Relationship amongst the variables Y ,


G , DY , C , S , I , Nx , R and T

Y = C + I + G + Nx ( X - M ), DY = Y + R - T = C + S

Accordingly we obtain
y = DY + T - R = C + S + T - R ( As DY = C + S )
= C + I + G + Nx
with foreign Trade included Y = C + I + G + Nx

technically called GDP

-> Disposable income DY = Y + R - T = C + S it is


allocated into consumption and savings

-> Accordingly we obtain

C + S + T - R = C + I + G + Nx
OR
S - I = G + R + Nx - T

-> There is saving invt equality when govt


budget is balanced so that G + R = T and there
is a trade balance with Nx turns into Zero ,
Net Factor Income from Abroad

(Components)

1) Net compensation of employees


•2) Net income from property i.e a rent,


interest, and income from
entrepreneurship
• (i.e profits and dividends)

3) Net retained earnings of the resident


companies working in foreign countries.


3 Approaches for measuring
GDP
1.Expenditure Approach (upper loop) –
measures GDP as the sum of
expenditures on final goods and
services.
2.Income Approach (lower loop) – measures
GDP as the sum of incomes of factors
of production (wages, rent, interest and
profit.
3.Value-added Approach – measures GDP as
the sum of value added at each stage
of production (from initial to final
stage)
Expenditure Approach
• Uses the upper loop of the circular flow
diagram.
• Example: Suppose the economy has
only one product, namely, rice.

Good Price per Q sold Expenditure


unit
Rice 20 1000 20,000
GDP 20,000
Income Approach
• Uses the lower loop of the circular flow diagram: sum of
payments to the various factors of production.
• Suppose that in the production of rice the sales and
expenses are as follows:

Sales P 20,000
Expenses:
Wages 8000
Rent 4000
Interest 2000
Total 14,000
Profit 6,000
GDP=Sum of Payments to 20,000 P 20,000
factors
Value Added Approach

Suppose that rice is the only final product of an


economy: It goes through several (3) stages of


production.
Value of
Stage of Prod’n intermediate Value of Value-added
good Sales
Farmer - Palay 12,000 12,000
Rice Miller -Milled Rice 12,000 15,000 3,000

Retailers - Rice 15,000 20,000 5,000


GDP= Total Value 20,000
Added
Notes of the 3 approaches
• The expenditure approach, income approach, and the
value-added approach all come up with the same
estimate of the GDP. They are equivalent approaches.
• In the income approach, profitis also considered a payment
to the entrepreneur. So the incomes are (1) wages, (2)
rent, (3) interest, and (4) profit. Profit adjusts to make
the sum equal to the final value of the good.
• In the value added approach, only the value added in each
stage of production are included. If we add the value of
intermediate product with the value of the final product,
we commit the sin of “double-counting.”
• At each stage of production, the value-added is equal to
wages, interest, rent, and profit. Therefore the value of
the final product is likewise the same of all payments to
the factors of production.
The distinction between GDP
and GNP

Gross Domestic Product GDP 4,022,700

Net Factor Income from the NFIRW 267,500


Rest of the World

Gross National Product GNP 4,290,200


Difficulties in the
computation of National
Income
( a ) The goods and services having monetary
tra n sa ctio n s e n te rin g th e m a rk e t a re in clu d e d in
n a tio n a l in co m e a cco u n ts

-> household works are omitted

H o u se w iv e s
h o u se re p a irs
w a sh in g a n d C le a n in g

-> This is becoz difficulties o f measuring the money


v a lu e o f o u tp u t flo w in g fro m th e m .
• some incomes such as social security
contribution

• Corporate income taxes & undistributed


profits are not actually received

• Some incomes which are Received like


Transfer payments are not currently
earned

• Transfer payment (old-age pension s,


unempt compes- ation , relief payments,
int-payment on public debts.

2 . Capital gains or losses ( Excluded )

There is a possibilities of the rise in the value at fixed


assets with the rise in their
mkt prices such as Flats
Iand
other assets
This refers to capital gains . This gain do not Form a part of
national income

3 . Illegal Activities ( Excluded )

Smuggling , black - marketing , gambling and bribe

4 . second - hand buying and selling Activities ( Excluded )

-> Of houses , property , shares , debentures

-> there is mere transfers of ownership despite gains ,

-> These goods already exist and their values are included in
previous year's N . I

-> However service rendered by broker constitute this years GNP


since this refers to current year's output .
( c ) Income generated by Foreign firms
- > The Foreign Firms are located in a country

-> they generate a segment of output and income in Our


country .

Q ) should this income Form a part OF national income


OF India or a parent country to which the firm belongs?

-> IMF has viewed that the production of output and income
generated will be a part of GDP Of the country where they
are located

profits generated by the foreign company will be the GNP of


the parent county .

( d ) Problems arising out of imputing values to goods and


services that do not enter the market .

-> In farm sector Where many farmers produce crops like


wheat , mice , Vegetables not for market but for self
consumption

-> In the companies the managers and executives enjoy


'fringe benefits' When their company offers them free
-> These good amounts of income and output generated From
current economic activity
do not appear in the market

-> other monthly income of these executives is equal to


their monthly salary plus the imputed values of these fringe
benefits and these are to be included in national income
accounts
-> It is hardly reported in any country for the purpose of
measurement in national income accounts

( e ) Treatment of government services in national income


accounting

-> services rent rendered by the govt - like defense , military ,


administration and law and order do not enter the mkt for
purchase and sale .

-> These are difficulties in measuring values

f Difficulty arising out of inventory adjustments and


depreciation

-> When the business firm is adding to its inventories the


Stock of unsold goods
-> The diffiiculty arises since the business Firms hardly
maintained the record of the Changes in the physical volume of
inventories

-> and many a times they maintain the record in value terms rather
than physical terms

-> valuation poses a real problem

-> correctly estimating depreciation is a difficult task

-> It is either understated or overstated

Diffculties of computing national income in developing countries


including India

1 . Problem arising out of non - monetized segment Of the economy

-> The output is retained for self consumption or exchanged For


other goods

-> only a rough estimate of the value of these outputs can be made

2 . Failure to keep accounts / Records

3 . Income and output generated by industry of origin


-> Estimation of NI cannot be precise in country .
-> occupational Classifcation is incomplete and un scientific

-> B coz in rural areas people get income from various sources
like working on farm land doing part time jobs etc

-> This makes estimation difficult task

4 . Reliable data is inadequate

-> The national income committee arise has noticed that the
Statistical data available in agri . and small Scale sector is
inadequate and unreliable

5 . other problems

-> Diffculties in adopting particular method

-> Economy either use product or income method

-> Many facts and Figures for income method are lacking

-> Difficulty arises on account of illeteracy and superstitions


among people

-> people hardly disclose their income or they provide is


mislending .
Nominal and Real GDP and GDP
Deflator

* Nominal GDP
Measures the value of output Of goods and services
produced in a given period at the current prices

-> 2007 nominal GDP will be value of G & S produced in 2007


valued at 2007 market price

-> 2000 nominal GDP is value of output produced in 2000 measured


at market prices prevailed in the year 2000
-> If P increases by 50% -> and nominal GDP will increase by 50%
although economy produces exactly same qty last & current year
* Real GDP
Measures the Changes in the physical output of goods
and services produced during two different-time periods by valuing
goods and services at these periods at the same prices called
constant prices
* GDP deflator
It is th e ra tio o f n o m in a lG D P to re a lG D P O f th e
g ive n ye a r

-> Itis a measure of the Changes taking place in the price


o f th e g o o d s b e tw e e n b a se ye a r a n d C u rre n t ye a r.

su p p o se if N o m in a l G D P a t 2 0 0 7 is 7 8 8 5 5
R e a l G D P o f 2 0 0 7 is 6 3 1 7 0

G D P D e fla to r = N o m in a lG D P / R e a lG D P

7 8 8 5 3 = I. 25
63170

-> This has significantimplication since 25 percent


in cre a se in G D P is d u e to p rice in cre a se o r in fla tio n o ve r
th e p e rio d 2 0 0 0 to 2 0 0 7
Nominal and Real GDP
• GDP at current prices or nominal GDP - GDP
measured using the prices of the year for which
it is calculated
• Nominal GDP can be a misleading indicator of
changes in output or income because it also
embodies changes in the prices of goods and
services.
• Real GDP or GDP at constant prices  measures
the total value of output using the prices of a
selected year (the base year).
• Real GDP better for analysis overtime because it
eliminates the effects of price changes
Table 8.5
YEAR 1 YEAR 2
QUANTITY
Ice Cream 100 100
Buko Pie 100 100
PRICE
Ice Cream 50 100
Buko Pie 100 200
VALUE
Ice Cream 5,000 10,000
Buko Pie 10,000 20,000
NOMINAL GDP 15,000 30,000
• GDPyear 1 = (100) (50) + (100) (100) = 15,000
• GDPyear 2 = (100) (50) + (100) (100) = 15,000
• In practice, calculating real GDP using the
previous approach is a tedious process because
there are so many goods and services are
produced in an economy. Can simplify the
calculation process by using the GDP deflator.
• GDP deflator - a price index that allows us to
convert nominal GDP into real GDP. (note: price
index to be defined later)
Real GDP
GDP, GNP, Depreciation

Nominal GNP for year t


GNP Deflator for year
t = Real GNP for
year t

Changes in GNP Deflator allows us to


isolate the effect of increasing prices
on Nominal GNP

122
Calculation of Real GDP

Item 1990 1998 2002


GDP at current 1,072,000 2,665,100 4,022,700
prices (million PhP)
GDP deflator (base 149.5 300.1 384.6
year 1985)
GDP at constant 720,700 888,000 1,046,100
prices (million PhP)
Real GDP : goods are evaluated at
constant (base year) prices
Nominal GDP : goods are evaluated at
current year prices
GDP deflator = (nominal GDP/real GDP)
× 100, measures price movement over time.
long run trend in GDP vs. short run
fluctuations
recessions or slumps
expansions or booms

124
Real and Nominal GDP

125
Real and Nominal GDP

126
Real and Nominal GDP

127
Real and Nominal GDP

128
GDP, GNP, Depreciation

• Nominal Gross National Product


– Measures national output at current prices
• = value of all goods at current prices

• Real Gross National Product


– Measures output at base year prices
• e.g. value of todays national output at
1995 prices
– Allows us eliminate the effect of price
changes and see how real output evolves
over time
• 129
Price indices in India and their
Measurement

Five Index series in India


•GDP Deflator
•WPI
•CPI
ØCPI for industrial workers
ØCPI For urban non - manual employees
ØCPI For agricultural labourers
1 ) GDP deflator
It refers to the index of average price of
the goods and services produced in the
economy . It excludes those of
in termediate goods and raw - materials .