National Income LECTURE PLAN Objectives Circular Flow

National Income

LECTURE PLAN Objectives Circular Flow of Economic Activities and Income Two Sector Model Four Sector Model Macroeconomic variables Concepts of National Income Measuring National Income Uses of National Income Data Difficulties in Measurement of National Income

OBJECTIVES To explain the circular flow of economic activity and income. To introduce the concepts of aggregates, stock and flow and final goods. To explain various concepts of national income, like GDP, GNP and NNP. To discuss and analyze the different methods to measure national income. To understand the advantages of national income calculation in global perspective.

CIRCULAR FLOW OF ECONOMIC ACTIVITIES Economic interdependence of Consumers and Sellers. Between Consumers and Sellers the circular Flow of Goods, Services, Income and Expenditure takes place. Other Entities may be Foreign Nations, Government.

CIRCULAR FLOW OF ECONOMIC ACTIVITIES AND INCOME (TWO SECTOR ECONOMY) The simple model of the circular flow assumes two players Firms Produce and supply the goods and services. Require various factors of production to produce these goods and services. Households Include a set of individuals living in the same house Take joint decision about the consumption of goods and services. Provide services in terms of factor inputs to the firms Get paid for these services by firms which households spend on consumption. Money flows from firms to households as factor payments and from households to firms as expenditure on goods and services. It is a circular flow of money or income

Savings are taken out of Circular flow, so these are called “Withdrawals” Savings deposited in Capital Markets goes to the firms as Investment Expenditure, which is known as “Injections”. If Savings are kept with households, it is known as “Leakages”.

CIRCULAR FLOW OF INCOME (TWO SECTOR ECONOMY) (Wages, Rent, Interest and Profits) Factor Payments (Y) Factor Inputs Households Savings (S) Financial Market Investment (I) Goods and Services (O) Consumption expenditure (C) In the equilibrium Y=C+S=C+I Firms

EQUILIBRIUM Aggregate Y Income = Aggregate Expenditure =E Aggregate Income = C+S Aggregate Expenditure = C+I S=I Hence Y = E or Aggregate Demand = Aggregate Expenditure

THREE SECTOR MODEL

Total Expenditure (E)= C+I+G Total Income (Y) = C+S+T In Equilibrium E = Y So C+I+G = C+S+T

CIRCULAR FLOW OF INCOME (FOUR SECTOR ECONOMY) The third sector is Government (G) Government Spending Subsidies, defence, health care, education, infrastructure Provides salaries to the households Pays to firms for purchases of goods and services Government Revenue Households and firms pay various taxes and other payments and provide factor inputs to the government. Government borrows from the financial market to fill revenue gap. The fourth sector is the external sector Imports (M): Outflow of income occurs when the domestic firms buy goods and services from foreign ones. Exports (X): Inflow of income takes place when foreign firms buy goods and services from domestic ones C+I+G=C+S+T

CIRCULAR FLOW OF INCOME (FOUR SECTOR ECONOMY) Government (G) Taxes Factor Payments Remittances for purchases Factor Inputs Salaries Households Savings (S) Imports (M) Financial Market Investment (I) Imports (M) Goods (O) Consumption Expenditure Exports (X) Foreign Nations (X-M) Firms Exports (X) National Income=C+I+G+(X-M)

MACRO-ECONOMIC VARIABLES Aggregate Demand Aggregate Supply Demand is the sum of demand for all goods and services by all the consumers for a given period of time. aggregate demand (AD) for consumer goods i. e. consumption demand (C) aggregate demand for capital goods i. e. (I). Thus AD = C+I Aggregate supply is the total national output produced and supplied by all the factors of production in an economy. It refers to the supply of all goods and services in the economy for a given period of time. Aggregate supply (AS) consists of supply of consumer goods (C) and Supply capital goods (where capital comes from savings (S), Hence AS=C+S

NATIONAL INCOME National income is defined as the money value of all the final goods and services produced in an economy during an accounting period of time, generally one year. Concepts of National Income Gross Domestic Product (GDP) Gross National Product (GNP) Net Domestic Product (NDP) Net National Product (NNP) Per Capita Income

GROSS DOMESTIC PRODUCT Gross Domestic Product (GDP): GDP is the sum of money values of all final goods and services produced within the domestic territories of a country during an accounting year. GDP= C+I+G+(X-M) GDP at market price: includes the final value of goods and services also includes indirect taxes and excludes the subsidies given by the government. GDP at factor cost is the money value of final goods and services based on the cost involved in the process of production. Gross Domestic Product at factor cost = GDP at Market Prices –Indirect Taxes+ Subsidies

GROSS NATIONAL PRODUCT Gross National Product (GNP): GNP is the aggregate final output of citizens and businesses of an economy in a year. GNP may be defined as the sum of Gross Domestic Product and Net Factor Income from Abroad (NFIA). GNP = GDP + NFIA GNP = C+I+G+(X-M)+NFIA Net Factor Income from Abroad: difference between income received from abroad for rendering factor services and income paid towards services rendered by foreign nationals in the domestic territory of a country.

NET DOMESTIC PRODUCT AND NET NATIONAL PRODUCT Net Domestic Product = GDP-Depreciation Net National Product (NNP) = GDP–Depreciation +NFIA Or =GNP–Depreciation Thus NNP is the actual addition to a year’s wealth and is the sum of consumption expenditure, government expenditure, net foreign expenditure, and investment, less depreciation, plus net income earned from abroad. = C+I+G+(X–M)–Depreciation + NFIA NNP at Factor Cost is the sum total of income earned by all the people of the nation, within the national boundaries or abroad It is also called National Income. NNP at Factor Cost = NNP at Market Prices –Indirect Taxes+ Subsidies

REAL AND NOMINAL NATIONAL INCOME National income estimated at the prevailing prices, is called national income at current prices or Nominal National Income, or Money National Income or national income at current prices. National income measured on the basis of some fixed price, say price prevailing at a particular point of time, or by taking a base year, is known as national income at constant prices, or Real National Income or national income at constant prices. • GDP deflator is the ratio of nominal GDP in a year to real GDP of that year • GDP deflator measures the change in prices between the base year and the current year.

PER CAPITAL INCOME AND PERSONAL INCOME • Per capita income is the average income of the people of a country in a particular year. Personal income is the total income received by the individuals of a country from all sources before direct taxes in one year. Personal Income = National Income –Undistributed Corporate Profits – Corporate Taxes – Social Security Contributions + Transfer Payments + Interest on Public Debt Personal Disposable Income is the income which can be spent on consumption by individuals and families. Personal Disposable Income = Personal Income – Personal Taxes

METHODS OF MEASURING NATIONAL INCOME Hence there are three approaches to the measurement of GDP: Product (or Output) Method: National Income by Industry of Origin Final Product Method Value Added Method Income Method or National Income by Distributive Shares Expenditure Method

PRODUCT (OR OUTPUT) METHOD The market value of all the goods and services produced in the country by all the firms across all industries are added up together. Process The economy is divided on basis of industries, such as agriculture, fishing, mining and quarrying, large scale manufacturing, small scale manufacturing, electricity, gas, etc. The physical units of output are interpreted in money terms The total values added up. (GDP or GNP at market price) The indirect taxes are subtracted and the subsidies are added. (GDP at factor cost) Net value is calculated by subtracting depreciation from the total value (NDP at factor cost).

LIMITATIONS OF PRODUCT METHOD Problem of Double Counting: Not Applicable to Tertiary Sector: This method is useful only when output can be measured in physical terms Exclusion of Non Marketed Products unclear distinction between a final and an intermediate product. E. g. outcome of hobby Self Consumption of Output Producer may consume a part of his production.

INCOME METHOD The net income received by all citizens of a country in a particular year, i. e. total of net rents, net wages, net interest and net profits. (GDP at factor cost). It is the income earned by the factors of production of a country. Add the money sent by the citizens of the nation from abroad and deduct the payments made to foreign nationals (individuals and firms) (GNP at factor cost) or Gross National Income (GNI). Process: • Economy is divided on basis of income groups, such as wage/salary earners, rent earners, profit earners etc. • Income of all the gruops is added, including income from abroad and undistributed profits. • The income earned by foreigners and transfer payments made in the year are subtracted. GNP at factor cost = Rent + Wage + Interest +Profit + Net Income from Abroad- Transfer payments

LIMITATIONS OF INCOME METHOD Exclusion of non monetary income: Ignores the nonmonetized section of economic activities. Economic activities that contribute to national income, but due to their non monetary nature, they go unrecorded. For e. g. a farmer and family working in their own field. Exclusion of Non Marketed Services: People undertake a particular activity that are difficult to ascertain in money value. E. g. mother’s services to the family.

EXPENDITURE METHOD OF MEASURING NATIONAL INCOME The total expenditure incurred by the society in a particular year is added together to get that year’s national income. Components of Expenditure: personal consumption expenditure net domestic investment : capital, residential and inventory investment government expenditure on goods and services, and net foreign investment Limitations Ignores Barter System Ignores Own Consumption Affected by Inflation

USES OF NATIONAL INCOME DATA National income is the most dependable indicator of a country’s economic health. Difference between GDP and GNP indicates the contribution of net income earned abroad Necessary for Economic planning: useful aid in judging which sectors should be given more emphasis A measure of economic welfare. higher aggregate production implies more and more goods and services being available to people Helps in determining the regional disparities, income inequality and level of poverty in a country. Helps in comparing the situations of economic growth in two different countries.

DIFFICULTIES IN MEASUREMENT OF NATIONAL INCOME Non monetized transactions: Exchange of goods and services which have no monetary payments, like services rendered out of love, courtesy or kindness are difficult to include in the computation of national income. Unorganized sector: Contribution of unorganized sector are unrecorded. It is very difficult to identify income of those who do not pay income tax. Multiple sources of earnings: Part time activity goes unrecognized and such income is not included in national income. Categorization of goods and services: In many cases categorization of goods and services as intermediate and final product is not very clear. Inadequate data: Lack of adequate and reliable data is a major hurdle to the measurement of national income of underdeveloped countries.

INFLATION Coulborn: it is a state of “too much money chasing too few goods”. Two broad categories: price inflation (generally called as inflation) money inflation. Both have cause and effect relationship, i. e. money inflation leads to price inflation. Money inflation is increase in the amount of currency in circulation. Which may be due to: Deficit financing : direct cause is printing of additional currency on demand of the government to meet its needs. Additional money supply through foreign exchange inflows in the form of capital, such as foreign direct investment and foreign institutional investment, tourism and other incomes from abroad. Price inflation is a persistent increase in the general price level or a persistent decline in the real income of people, i. e. decline in value of money.

CONCEPTS OF INFLATION Headline Inflation: Headline inflation is a measure of the total inflation within an economy, including commodities such as food and energy prices (e. g. , oil and gas), which tend to be much more volatile and prone to inflationary spikes. Hyperinflation: prices increase at such a speed that the value of money erodes drastically This is also known as galloping inflation or runaway inflation. Stagflation: a typical situation when stagnation and inflation coexist. (Slow economic growth + Inflation). Suppressed Inflation: Petrol and diesel prices Disinflation: a well planned process to bring down the prices moderately. Deflation: a state when prices fall persistently; just opposite to inflation

INFLATION AND DECISION MAKING Impact on Consumers increase in any price upsets the home budget. Impact on Producers (or Suppliers) Producers as sellers are benefited by inflation; higher the prices, higher are their profits. when as buyers of raw material, they are adversely affected by inflation. Impact on Government: Government has to take the economy to higher levels of growth by encouraging production and investment, At the other end, has to see that taxpayers’ money is not eroded by hyperinflation. Thus government has to act as the balancing force between consumers and sellers.

MEASUREMENT OF INFLATION Price Index = (Current Year’s Price/Base Year’s Price)*100 Consumer Price Index Wholesale Price Index GDP Deflator

CONTROL OF INFLATION Inflation erodes the value of money and discourages savings But zero inflation is undesirable Need to control inflation monetary policy measures (proposed by those who believed money supply is the major culprit) fiscal policy measures (proposed by Keynes and his followers). Other measures The government has to adopt an appropriate combination of these measures after thorough examination of the causes of inflation

MONETARY POLICY MEASURES Increasing the bank rate (increasing repo rate) Higher reserve ratios: Cash Reserve Ratio (CRR) Statutory Liquid Ratio (SLR) Open market operations: directly sell government securities to public and restrain their disposable income Selective credit control: selective credit control (SCC) on advances by banks against the mortgage of sensitive commodities such as rice, wheat, oilseeds, etc. It is out of fashion now.

FISCAL POLICY MEASURES The government may reduce public expenditure or increase public revenue to keep a check on inflation Reducing public expenditure When government spends on activities like health, transport, communication, etc. , income of individuals increases; this in turn increases the aggregate demand. Therefore the reverse will also be true. Increasing public revenue Major source of government revenue is various types of taxes Increase in income tax leaves less of disposable income in the hands of consumers

INDEXATION Indexation is a technique to adjust income payments by means of a price index, in order to maintain the purchasing power of the public after inflation Indexation is the Automatic Linkage between Monetary Obligations and Price Levels.