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`INTRODUCTION-MACROECONOMICS

➢ Lord [Link] is known as the father of Macroeconomics. He wrote the book on

Macroeconomics named ‘General Theory of Employment, Interest and Money’ published
in 1936.

➢ Macroeconomics is also called Theory of Income and Employment.

➢ Interdependence of Microeconomic and Macroeconomics
1. Microeconomics depends on Macroeconomics:
Micro-variables depends on behavior of Macro-variables i.e., decisions at micro level
depends on decisions taken on macro level.

Example:
a) Increase in overall tax rate would influence on individual’s decision to buy a T.V.
set as its price goes up.
b) Price of a commodity is influenced by general price level in the economy.

2. Macroeconomics depends on Microeconomic: i.e., decisions at macro level depend on

decisions at micro level.

Example:
a) Aggregate demand depends on the demand of individual households of the
economy.
b) National income of a country is sum total of incomes of individual units of the
country.

Q. What is Micro-Macro paradox? Give example.

Ans. The paradox is

“What is logical at the micro level may not be logical at macro level.”
Example: Saving is a virtue at the micro level but if all the people in the society start saving, it will
lead to:

Fall in demand Fall in investment Fall in production Fall in employment Fall in income
Thereby decrease the growth of the economy. Q. Describe the Great depression of 1929.
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Ans. It affected the developed economics like USA, Europe, etc. During this period, the output
and employment fell by huge amount. The aggregate demand was low, many factories were lying
idle, workers were thrown out of jobs. Income levels were falling, there was widespread
unemployment.

In USA from 1929 to 1933, unemployment rate rose from 3 to 25% and output fell by about 33%.

Q. Give three examples of microeconomic variables.

Ans. Price of a product, demand of a good by household, supply of apples by a fruit vendor.

Q. Give three examples of macroeconomic variables.

Ans. 1. Total employment in the economy.

2. General price level in the economy.
3. Aggregate demand in the economy.

Q. Recession and depression leave the economy shattered in the form of falling income an output
levels. What should be the effort of a rational individual’s to recover economy out of depression?
(VBQ)

Ans. Recession and depression are caused by low level of overall investment. As a rational
consumer, one should take initiative of risking his capital to invest in production activities even if
profit margin are very low initially, but ultimately increase in investment will help the economy
recover from recession or depression.

➢ Basic economic activities-

1. Production – It is generally defined as an activity which produces physical goods and
services or which increases the value of intermediate consumption. Output= (Inputs)
2. Consumption- The process of using up of utility of goods and service for direct
satisfaction of individual or collective human wants is called consumption.
3. Capital formation (Investment) – It is the addition to the capital stock of an economy
during the year. The part of production (Income) which is not used (expenditure) during
a year is investment. In other words, excess of production over consumption is called
capital formation or investment.
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➢ In National Income accounting, houses are treated as capital goods instead of consumer
goods as an exception, since a house continues to produce housing services for a long
period of time.

➢ Four sectors of the economy-

1. Household Sector – It includes consumers of goods and services. Households are the
owners of the factors of production, and provide factor services to the producer sector
(land, labour, capital and enterprise).
2. Producer Sector – This sector includes all producing units or firms (Private sector and
Public / Government sector) in the economy. To produce & services, the firms hire
factors of production: Land, labour, capital & enterprise form the households and sell
goods& services.
3. Government Sector –This sector produces goods and services for collective
consumption. Example: services of roads, dams, street lighting, etc. Here government
promotes the well-being of the citizens.
4. External Sector – This sector is also called rest of the world sector. It is engaged in
export and import of goods and services and the flow of loans and investment between
the domestic economy and other countries of the world.

CIRCULAR FLOW OF INCOME

Q. Define Circular flow.

Ans. It refers to cycle of generation of income in the production process, its distribution among
the factors of production and finally, its circulation from households to firms in the form of
consumption expenditure on goods and services produced by them.

OR

It is flow of the activities of production, income and expenditure inolving different sectors of the
economy.

➢ Phases of Circular flow of Income-

Production Phase
(Generation of Income)

Expenditure Phase Income Phase

(Disposition of Income) (Distribution of Income)
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1. Phase of Production – In this phase, firms produce goods and services with the help of
factor [Link] producer sector hires factor services for the household sector, to
produce goods and services. As there is no end to human wants, there is no end to the
process of production also.
2. Phase of Income Generation/Distribution of Income – This phase involves the flow of
factor income (rent, wages, interest and profit) from firms to the households. There is
generation or distribution of income as an outcome of production of goods and services.
3. Phase of Expenditure/Disposition – In this phase, the income received by factors of
production, is spent on goods and services produced by firms.
In this way, income generated in production units reaches back to production units and
makes the circular flow complete.

➢ Circularity never stops because of–

i) Discovery of new resources. ii) Innovative
technology being used by the producers.

➢ Principles of circular flow of “Income & Product” –

1. Real flows are opposite to money flows i.e. goods and services flow in one direction
and money payment to acquire these, flow in the return direction.
2. In any exchange process, the producer receives the same amount, what consumer
spends.

➢ Difference between Real Flow and Money Flow –

Real Flow
Money Flow
1. It refers to the flow of goods &
services across different sector of 1. It refers to the flow of money across
the economy. different sectors of the economy.
2. It is flow of physical output among 2. It is flow of monetary transactions
sectors. among sectors.
3. It is also known as physical flow as 3. It is also known as nominal flow as only
either goods or services are money is exchanged among sectors.
exchange among sectors. 4. There is no such difficulty in case of
4. There may be difficulties of barter money flow.
system in exchange of goods and
factor services.
➢ Circular flow of Income in a Two-Sector Economy -
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Two sector Model in Simple Economy:

4. Final consumption expenditure on goods & services (Money Flow)

3. Final goods and services (Real Flow)

Producer Sector/Firms Household Sector

(Real Flow)
1. Factor services (land, labour, capital, entrepreneur)

2. Factor Payments (rent, wages, interest, profit)

(Money Flow)

A simple economy assumes that there are only two sectors: Household sector and Firm
sector. There is no Government sector and Foreign sector.

*Households are the owners of factors of production and consumers of goods and services.
*Firms produce goods and services and sell them to the households.

1. Household sector supplies factor services only to firms and the firms hire factor services
only from households.

2. Firm produce goods and services and sell their entire output to the households.
3. Households receive factor income for their services and spend the entire amount on
consumption of goods and services.

4. There are no savings in the economy, i.e. neither the households save from their incomes,
nor the firms save from their profits.

*In the circular flow of income, production generates factor income, which is converted into
expenditure. This flow of income continues as production is a continuous activity due to never
ending human wants. It makes the flow of income circular.
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Thus is a simple economy-

1. Total production of goods & services by firms = Total consumption expenditure of goods
& services by household sector.

2. Factor payment by firms = Factor income of households.

3. Consumption expenditure of households = Income of producer sector.
4. Real flow of production and consumption of firms and households = Money flow of income
and expenditure of firms and households.

➢ Difference between-
Stock Flow
1. It means that quantity of 1. It is that quantity of an economic
an economic variable variable which is measured during a
which is measured at a
period of time.
particular point of time.
2. It has no time dimension 3. 2. It has time dimension.
It is a static concept. 3. It is a dynamic concept. Example:
Example: Wealth, capital, A Rs.100 note, Income/Investment, capital
bank deposits, money supply. formation, prod., Domestic
Income

Q. What is the significance of circular flow models?

Ans. 1. They provide knowledge of interdependence among different sectors.

2. They give knowledge of structure of the economy.

3. They enable estimate of National Income and

4. They provide knowledge of injections and leakages.

Q. What are the four factors of production and what are the remunerations to each of the these
called?

Ans. Factors of Production Remunerations paid

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Land Rent
Labour Wages/Salaries
Capital Interest
Entrepreneur Profit
Q. Why is the flow of income and product called a circular flow?

Ans. It is because-

i) Real flows and money flows flow in opposite direction.

ii) In an exchange process, the producers receive the same amount what consumers
spend.

iii) Activities of production, income and expenditure keep moving always in a circular
manner.

NATIONAL INCOME AND RELATED AGGREGATES:

Some Basic Concepts

➢ End Use Classification of Goods –

➢ Difference between Intermediate & Final goods –

Intermediate goods Final goods

1.(i) These are used for production of other goods 1. Final goods are of two types: (i)
and services (raw materials). Consumer goods: When purchased by
consumer for final consumption. (ii) Capital
(ii) These are meant for resale (purchase by a dealer goods: When purchased by producers for
for resale). investment.
2. They remain within the production boundary 2. They are outside of production
and are not ready for use by final users. boundary and are ready for use by final users.
3. Value is to be added to these goods. 3. Value is not to be added to these
goods.
4. These goods are not included in the 4. These goods are included in the
estimation of National Income (to avoid the estimation of National Income.

problem of double counting).

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➢ All purchases by one production unit from other production units are not intermediate
purchases. For example: Purchase of machines, equipment’s, buildings, etc. are not
intermediate purchases (if they are not meant for resale) as their value is not included in
the value of final good. In fact, such purchases are termed as final products as they are
purchased for investment.

➢ There are some durable capital goods purchased by government for defence (military)
services like missiles, bombs, tanks, military vehicles, etc. which are treated as
intermediate goods. These are taken as raw materials used for generating defence services
and not for market sale.
➢ Value of intermediate goods is merged with the value of final goods.
➢ Final goods can be classified into two groups:

➢ Consumption goods and Capital goods:

Difference between:

Consumption goods Capital Goods

1. These goods satisfy human wants 1. These goods satisfy human wants
directly. indirectly.
2. These are used by consumers (direct 2. These are used by producers (derived
demand). demand).
3. Most of the consumption goods have 3. These generally have an expected life
limited expected life time. of more than one year Ex: Machinery,
plants, etc.
Ex: Bread, Scooter, T.V, etc.

➢ Consumer goods can be divided iii) Non-durable goods–These are

into four categories – used up in a single act of
i) Durable goods – These are those consumption. Their existence is
goods which can be used in over, the moment they are
consumption over a long period of consumed. Ex: Milk, bread, veg.,
time. Ex: refrigerators, cars, T.V, etc. etc.
iv) Services – These are invisible/
ii) Semi-durable goods–These are
intangible activities i.e. they can
the goods which can be used for a
neither be seen nor touched. They
limited period of time. Ex: furniture,
are purchased by consumers for
shoes, clothes, crockery, etc.
direct satisfaction of their wants.
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Ex: services of doctors, lawyers,

teachers, banks, etc.
ii) Capital goods: It includes
fixed assets like plant and
➢ All Producer goods are not Capital machinery, which can be
goods used again and again to
➢ Classification of Producer Goods – produce goods & services.
i) Intermediate goods/ Single – Use Ex: A sewing machine used
Producer goods: It includes by a tailor to stitch a shirt.
raw material like coal, wood,
etc. They are not capital
So, it can be said that all Capital
goods as they cannot be
goods are producer goods, but all producer
repeatedly used in the
goods are not capital goods.
production process. Ex:
Cloth used by a tailor to stitch
a shirt.

✓ Investment means additions made to the existing stock of fixed capital and change in
inventories during the year. It increases productive capacity of the producers. I = ∆K (K =
Capital Stock).

✓ Gross Investment or Capital Formation: The total addition of capital goods to the existing
stock of capital during a given time period is called gross investment.
Gross Investment = Gross Fixed Investment + Change in stocks
OR
Capital Formation = Gross fixed capital formation + Inventory Investment

✓ Gross Fixed Investment is the increase in the stocks of fixed asset, which is estimated by
adding:
▪ Gross Business fixed investment: It is defined as expenditure on fixed assets.
Example, machinery, equipments, factory buildings, etc.
▪ Gross Residential Construction investment: It is the amount spent on construction
of flats and residential houses (By producers, households and government sector)
▪ Gross Public investment: It is the expenditure by government on hospitals, schools,
roads, dams, etc.
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It is also called fixed capital formation. Increase in fixed investment increases the level of
output and hence is a sign of economic growth.
Gross fixed investment = stock of fixed assets – stock of fixed assets in at
the of the year the beginning of year
(closing stock) (opening stock)

✓ Inventory is the stock of unsold finished goods, semi-finished goods and raw materials
which a firm carries from one year to the next.
Inventory is measured at a given point of time, e.g. value of inventory in the beginning of
the year or value of inventory at the end of the year. So, it is a stock variable.

Net change (or increase) in inventories = Closing Stock - Opening Stock

Change in inventories (or stock) takes place over a period of time. Therefore, it is a flow
variable.

• Unplanned Accumulation and Decumulation of inventories: In case of unexpected

fall in sales, the firms will have unsold stock of goods which it had not
anticipated. Hence, there will be unplanned accumulation of inventories. In the
opposite case, where there is unexpected rise in the sales there will be unplanned
decumulation of inventories.

Example: Suppose a firm produces shirts. It starts the year with an inventory of
100 shirts. During the coming year it expects to sell 1000 shirts. Hence, it
produces 1000 shirts, expecting to keep an inventory of 100 at the end of the year.
However, during the year, the sales of shirts turn out to be unexpectedly low. The
firm is able to sell only 600 shirts. This means that the firm is left with 400 unsold
shirts. The firm ends the year with 400 + 100 = 500 shirts. The unexpected rise of
inventories by 400 is an example of unplanned accumulation of inventories.

If , on the other hand, the sales had been more than 1000 we would have
unplanned decumulation of inventories. For example, if the sales had been 1050,
then not only the production of 1000 shirts will be sold, the firm will have to sell
50 shirts out of the inventories.
• Planned Accumulation and Decumulation of Inventories: Suppose the firm wants
to raise the inventories from 100 shirts to 200 shirts during the year. Expecting
sales of 1000 shirts during the year (as before) the firm produces 1000 + 100
1100shirts. If the sales are actually 1000 shirts, then the firm indeed ends up with
a rise of inventories. The new stock of inventories is 200 shirts, which was indeed
planned by the firm. This rise is an example of planned accumulation of
inventories.
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On the other hand, if the firm had wanted to reduce the inventories from 100 to 25
(say), then it would produce 1000 – 75 = 925 shirts. This is because it plans to sell
75 shirts out of the inventory of 100 shirts it started with (so that the inventory at
the end of the year becomes 100 – 75 = 25 shirts, which the firm wants). If the
sales indeed turn out to be 1000 as expected by the firm, the firm will be left with
the planned decumulation of inventory of 25 shirts.

➢ Difference between Capital and Investment:

The accumulated stock of capital goods in the beginning of the year (opening stock) is
called capital and additions made to the capital during the year is called investment.

▪ Net Investment = Gross investment – Depreciation.

▪ Net investment is actual addition to the capital stock of the economy. It enhances
the production capacity, helps in generation of employment and accelerates
economic growth and National income.

➢ Difference between:
Depreciation Capital Loss
1. It is loss in the value of fixed assets 1. It is loss in the value of fixed assets
due to normal wear and tear, passage due to natural fixed assets due to
of time and expected obsolescence. national calamities and unforeseen
2. It is expected loss in the value of asset (unexpected) obsolescence.
3. Provision for depreciation is by 2. It is unexpected loss.
maintaining Depreciation Reserve 3. Provision for capital loss is by
Fund. getting insurance done.

➢ Depreciation = Gross investment – Net investment

Depreciation on capital = Cost of the capital asset - Scrap value

____________________________________
Estimated life of the capital asset (in years)

➢ Depreciation is also known as:

▪ Consumption of fixed capital
▪ Replacement cost of fixed capital
▪ Current replacement cost
▪ Capital Consumption Allowance
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➢ Domestic or Economic Territory – It is the geographical territory administered by a

government within which persons, goods and capital circulate freely. Domestic territory
includes:
1. Political frontiers including territorial waters and air space. Ex: Telecommunication
services produced by Reliance Communications in India.
2. Embassies, consulate, military bases etc. located within political frontiers. Ex: Indian
embassy in America is a part of the domestic territory of India.
3. Ships, aircrafts, etc. operated by the residents between two or more countries. Ex:
Services provided by Air India between Singapore and Japan are a part of domestic
territory of India.
4. Fishing Vessels, oil and natural gas rings etc. operated by residents in the international
water or other areas over which country enjoys exclusive rights.

➢ A normal resident is said to be a person or an institution – (i) who ordinarily resides or is

located in a country and (ii) whose centre of economic interest lies in that country.

- The residents live or is located within the Domestic territory, and

- The resident carries out basic economic activities of earnings, spending and
accumulation from that location.
- Citizenship is a Legal concept, based on the place of birth of the person or some legal
provisions allowing a person to become a citizen.
▪ A person is citizen or national of a country in which he is born or citizenship is
allowed on some legal criterion.
• Residentship is an Economic concept, based on the economic activities performed by a
person.
• A person is treated resident of a country if he ordinarily resides in the country for a
period of more than one year and his centre of economic interest also lies in that
country.
▪ A person can be citizen of one country and normal resident of some other country.
▪ These are called non-residents. Examples –
a) International organisations like World Bank, WHO, I.M.F are not treated
residents of any country but of international area. These are non-resident
organisations for the country in which these are situated.
b) Employees of international organisations are considered residents of the
countries to which they belong and not of the international area. However, if
the employees are working for more than one year in such international
institutions, then they become the normal resident of a country in which such
institutions are located. Example, If an Russian is working in the UNO office
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in India for more than one year, then he will be treated as normal resident of
India.
c) Workers from across the border who cross borders regularly to work in the
given country. They are treated as residents of the country where they live and
not the residents where they work.
d) Foreign visitors or travellers visiting the given country for studies, medical
treatment, etc. are non–residents for the country they are visiting.
e) Foreign staff of embassies and member of foreign armed forces located in a
given country.
f) The crew of foreign ships, aircrafts, etc.

➢ The concept of Domestic territory helps to estimate ‘Domestic Product’. It includes goods
produced by production units located in the economic territory irrespective of the fact
whether carried out by the residents or non-residents. The monetary value of domestic
product is termed as Domestic income.

➢ The concept of Normal Resident helps to estimate ‘National Product’. It includes goods
produced by normal residents irrespective of the fact whether performed within the
economic territory or outside it. The monetary value of national product is termed as
National Income.

➢ Factor Cost and Market Price–

▪ Factor cost refers to all factor payments made by the producing unit (firm) to the
factors of production (land, labour, capital, entrepreneur) for rendering productive
services in the production of goods and services. It is called factor cost because it
is the cost of the producer firm towards factor of production in the form of rent,
wages, interest, profits, etc.

▪ Market price is the price at which a commodity is sold in the market. It is the price
what the buyers pay for the commodity.

MP = FC + NIT

➢ Net Indirect Taxes:

NIT = IT – Subsidies.
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1. Indirect Taxes: All taxes on goods and services during their production are called
indirect taxes. Ex: Excise duty, custom duty, sale tax, octroi, licensing fees, services
tax, entertainment tax etc. these taxes raise the prices of goods and services produced.
These are called indirect because burden of these taxes is shifted to buyers although the
responsibility of paying these taxes is on production units.

2. Subsidies: These are Financial / Economic assistance by government to an enterprise

on production of a certain commodity or a compensation for selling a good at a certain
price fixed by the government which is below the market price.
- Some kind of subsidies are:
a) To encourage exports
b) To encourage employment
c) As compensation for selling goods below open market price.

Subsidies reduce the prices of goods and services.

➢ Domestic Income and National Income:

➢ Domestic Income is the money value of all final goods and services produced within the
domestic territory of a country during the period one year. If NFIA (by normal residents of
the country) is added to it, it becomes National Income.

N.I = D.I + NFIA

Domestic Income is the sum of NDPFC by all producing units in the domestic economy.

➢ Difference Between:
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NFIA

Net Exports
1. It is the difference between factor
income earned by normal 1. It is the difference between value
residents of a country from abroad and of exports & imports of goods &
factor income earned by non residents in services related to domestic
a country. territory of a country.

2. It is a part of National Income. 2. It is a part of Domestic Income.

3. Its components are:
- Net Compensation of 3. Its components are:
Employees - Export and imports of goods
- Net Operating Surplus - Exports & imports of services.
- Net retained earnings of residents
companies abroad.

Factor Income (Payment) Transfer Income (Payment)

1. It is the income received in return for 1. It is the income received without any
rendering factor services by the good & service in return.
factors of production. 2. It is a receipt concept.
3. These are from household, corporate
2. It is an earning concept.
3. Types are: rent, wages, interest & or govt. sectors and vice-versa, ex:
profits. gifts, donation, etc.
4. These are included in National 4. These are not included in National
Income because there is Income as there is no corresponding
corresponding flow of goods and flow of goods and services
services.
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➢ National Income Accounting is a method of preparing and presenting National income

accounts based on the principle of double entry system of business accounting.

➢ Uses of National Income Accounting –

1. It indicates specific contribution of individual sectors.
2. It helps to find out structural changes in the economy i.e. shift from primary to
secondary and tertiary sector.
3. If reflects how National Income is shared among various factors of production.
4. It enables comparison of National Income and per capita income among nations.
5. It identifies economic strengths and failures
6. It enables us to understand and interpret the working of an economy.

➢ National income is the sum of money value of final goods and services produced by
normal residents of a country within and outside the country during and accounting year.
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Difference between:

National Income at Current Prices National Income at constant Prices

(Nominal N.I) (Real N.I)

1. It is the money value of final goods 1. It is money value of final goods and services
and services produced in a year, produced in a year, measured at prices of
measured at prices of the current base year .
year.
2. It can increase without the increase 2. It can rise only if there is rise in physical
in physical output. output.
3. It does not eliminate the effect of 3. It eliminates the effect of change in prices.
change in price. 4. It is a true indicator of economic growth as it
4. It is not a true indicator of economic can rise only if there is rise in physical
development, as it can increase with output.
increase in price. 5. A sustained rise in Real National Income
5. This cannot be used to compare the reflects the economic growth of the country.
real changes in physical output of It can be used for comparison (within the
goods and services (within the country/at international level).
country/at international level).

# BETTER INDICATOR – REAL OR NOMINAL

Real National Income is a better indicator because –

1. N.I measured at constant prices truly represents the real change in physical output of a
country whereas N.I at current prices does not. It is useful in estimating the real growth of
the economy.
2. Real N.I eliminates the effect of change in prices whereas Nominal N.I does not.
3. Real N.I enables us to make a year to year comparison of changes in the quantity of output
of goods and services.
4. Real N.I is also helpful in making international comparisons of economic performance of
different countries on the basis of real growth.

# CONVERSION OF NATIONAL INCOME AT CURRENT

PRICES INTO CONSTANT PRICES –

➢ Price Index is an index number which shows the change in price level between two different
time periods.

Current Price Index =

𝑃1 = Price of Current year

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𝑃0 = Price of base year

It shows whether rise in N.I is real or not.

N.I at constant price =

Real GDP =

GDP Deflator – It is used to eliminate the effect on price changes and to determine the real change
in physical output of current year. It measures the average level of prices of all goods and services
taken to find GDP.

GDP deflator =

# LIMITATIONS OF GDP OR GNP (REAL) AS INDICATOR OF

ECONOMIC GROWTH –
Rise in GDP/GNP is taken as an index of economic welfare of the people. When per capita real
GDP rises, it means greater availability of goods and services and hence greater economic welfare,
but rise in GDP may not be a true indicator of economic welfare due to the following limitations
–

1. Distribution of GDP – If there is inequality in the distribution of income such that

concentration of income is in few hands only resulting in making the rich more richer and
poor more poorer. It will reduce economic welfare of the poor more because for him utility
of a rupee of income is more than the rich. Therefore, if the distribution of GDP is not
uniform, inequalities may not lead to increase in welfare of a country.

2. Non-monetary exchanges – These are those activities in an economy which cannot be

evaluated in terms of money due to non-availability of data. Example, services of
housewives, kitchen gardening, etc. are not paid for. Since GDP does not account for such
activities, therefore, welfare of the people is underestimated. Thus, GDP may not give us a
clear indication of the production activity and welfare of the people of the country.
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3. Composition of GDP – If rise in GDP is the result of more production of war material like
weapons, military services, etc. which provide less welfare as compared to consumer goods
like food items, houses, clothes, etc. GDP will not contribute equally to economic welfare.
If the production of tobacco products, liquor, etc. increases in the country, GDP will
increase since it is counted in GDP. However, these harmful goods adversely affect the
health of people. And if the government imposes a ban on consumption of tobacco
products, liquor etc., it will bring down the production and therefore, GDP will fall.
However, the ban will improve the health in general, and thus increases welfare.

4. Population Growth –GDP does not consider the changes in the population of a country. If
the rate of population growth is higher than the growth rate of GDP, it will cause fall in per
capita availability of goods and services implying lesser economic welfare.

5. Externalities – These refer to benefits (positive externalities) or harms (negative

externalities) which are caused by a firm or an individual, for which they are not paid or
penalized. The activities which result in benefits to others are termed as Positive
externalities and activities which result in harm to others are termed as Negative
externalities.

Example of Positive externalities: (1) Introduction of metro rail has saved the time and
money of general public and has provided safe means of transport.
(2) Use of public parks by the people for pleasure for which no payments are made by the
public. It increases welfare through positive effect on health.
Positive externalities increases welfare of people or general public. However, GDP does
not account for such positive externalities. Thus, GDP as an index underestimates welfare.

Example of Negative externalities: (1) Pollution caused by vehicles and smoke out of
chimneys of factories.
(2) Traffic jams
Such externalities may cause harm to the people. Hence, their welfare will fall. However,
GDP does not account for such negative externalities. Thus, GDP overestimates the actual
welfare.

➢ Green GNP is considered a better measure of economic welfare. It measures National

Income or output adjusted for the depletion of natural resources and degradation of the
environment. It will help to attain a sustainable use of natural environment and equitable
distribution of benefits of development.
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VALUE ADDED METHOD

• Value added refers to the addition of value to the raw material (intermediate goods) by a
firm, by virtue of its productive activities.

VA = VO – IC
• Intermediate consumption refers to the expenditure incurred by a production unit on
purchasing those goods and services from other production units, which are meant for
resale or for using up completely during the same year.
• Intermediate goods include all those inputs, whose value is merged with the value of final
goods.
**However, any machinery purchased is not an intermediate good as its value will not be
included in the value of intermediate consumption.

• Value of Output refers to market value of all goods and services produced during a period
of one year.

(1) When the entire output is sold in an accounting year, VO = Sales.

(2) When the entire is not sold in an accounting year, VO = Sales + Change in stock

Change in stock = closing stock – opening stock

• VO = ( quantity x price ) + change in stock

• VO = Sales + Production for self-consumption + change in stock
• Sales = Domestic sales + Exports
• Intermediate Consumption = Domestic purchase + Imports

# STEPS FOR CALCULATING NATIONAL INCOME BY

VALUE ADDED/OUTPUT/PRODUCT METHOD -

2. Identification and classification of Producing Units –

These are –
a) Primary Sector: which exploits natural resources, example agriculture, fishing, etc.
b) Secondary Sector: which transform one type of commodity into another example: cloth
produced from cotton, etc.
c) Tertiary Sector: It includes production units engaged in producing services example
banking, insurance, etc.

3. Calculation of GDPMP or GVAMP –

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First GVA is calculated for each sector separately and then added to find GDPMP. (GDPMP
= ƩGVAMP)

a) GVOMP = Sales + stocks

b) GVAMP / GDPMP = GVOMP – IC

4. Calculation of Domestic Income (NDPFC) –

a) NDPFC = GDPMP – Dep. – NIT

5. Calculation of National Income (NNPFC)

a) NNPFC = NDPFC + NFIA

# PRECAUTIONS –

Following items not to be included:

1. Sale and purchase of second hand goods is not included: Their value had already been
included in the National Income in the year in which they were produced. If they are
included again, it will lead to double counting. However, any commission or brokerage of
a dealer should be included because he has rendered productive service.
2. Change in stock of goods (inventory) will be included. Net increase in the stock of
inventories will be included as it is a part of capital formation.
3. Imputed value of owner-occupied houses should be included as people who live in their
own houses, do not pay rent. But, they enjoy housing services similar to those people who
stay in rented house. Therefore, value of such housing services is estimated according to
market rent, known as imputed rent.
4. Value of intermediate goods and services are not included as their value has already been
included in final goods. If included again, it will lead to double counting.
5. Production of services for self-consumption like services of housewife, kitchen gardening,
etc, are not included as it is difficult to measure their market value. These services are
produced and consumed at home and do not enter the market place and are termed as
Nonmarket transactions.( It must be noted that paid services, like services of maids, drivers,
private tutors, etc. should be included in the national income .)
6. Production of goods for self-consumption will be included in national income as they
contribute to the current output. Their value is to be estimated or imputed as they are not
sold in the market.

Following items should be included:

1. Value of final goods and services as these are ready for use by their final users.
2. Imputed rent of owners occupied houses as house provides service to the owners.
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3. Imputed value of goods produced for self-consumption by producers as these contribute to

the current year’s output.
4. Imputed value of fixed assets produced for self-consumption by enterprise, government
and households as these contribute to current year’s output.

INCOME METHOD

• According to this method, all the incomes that accrue to the factors of production by way of rent,
wages, interest, profit, etc. are summed up to obtain national income.
• Components of Income method-
(1) Compensation of Employees (COE): It refers to amount paid to employees by
employer for rendering productive services. It consists of 3 elements:
1) Wages and salaries in cash: I t includes all monetary benefits, like wages, salaries,
bonus, dearness allowances, commission, etc.
**Any reimbursement of business expenses incurred by the employees will be
excluded from COE as such expenses are part of intermediate consumption of
business enterprises.
2) Wages and salaries in kind: It includes all non-monetary benefits, like rent free
Home, free car, free medical and educational facilities, etc. An imputed value of
These benefits should be included in national income.
*However it does not include any facility which is necessary for work and in which
employees do not have any discretion. For example, uniforms to be worn during
work only or vehicles to be used for work only. Such payments are intermediate
consumption of business enterprises.
3) Employer’s contribution to social security schemes: It includes contributions made
by employer for the social security of employees. Example, contribution to
provident fund, gratuity, retirement pension or any other scheme for the benefit of
employees, etc.
*However, any contribution by the third party (like, insurance company) to an
employee is not the part of COE as the insurance company is not the employer of
injured worker.
*Any contribution by employees is also not included as such payments are made
by the employees from COE only.
*Gifts received from employer, example: festival gift, gifts on independence day,
[Link] not included in national income as it is a transfer payment.
*Old age pension is not included in national income as it is a transfer income and
do not add to flow of goods and services.
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(2) Rent and Royalty: Rent is that part of national income which arises from ownership of
land and building. Rental income includes both actual rent and imputed rent. Imputed
rent of owner occupied houses is calculated on the basis of market rental value of the
house.
Royalty refers to income received for granting leasing rights of sub-soil assets.
Example, owners of mineral deposits like coal, iron-ore, natural gas, etc. can earn
income by giving rights of mining to the contractors.

(3) Interest: It refers to amount received for lending funds to a production unit. It includes
both actual interest as well as imputed interest of funds provided by the entrepreneur.
Interest Income includes interest on loans taken for productive services only.
* It includes:
- Payment of interest by banks to its depositors or Payment of interest by a firm
(government firm or a private firm) to households or Payment of interest by a firm to
a bank is included in national income because it is factor payment. The borrowed
money is used for carrying out production of goods and services.

*It does not include:

- Interest paid by government on public debt and interest paid by consumers as such
interest is paid on loans taken for consumption purposes. There is no contribution to
production of goods and services. Therefore, it is not a factor payment.
- Interest paid by one firm to another firm.

(4) Profit: It is the reward to the entrepreneur for his contribution to the production of
goods and services. It is the residual income, which an entrepreneur earns after paying
all the other factors of production. It is used for 3 purposes:
1) Corporate tax / Profit tax / Business tax : It is the direct paid tax by an enterprise to
the government on the total profit earned by it.
2) Dividend / Distributed profits : It refers to that part of profit, which is paid to the
shareholders in the ratio of their shareholding.
3) Retained earnings / Undistributed profits / Savings of private corporate sector /
Reserves and surplus: It refers to that part of profit, which is kept as reserve to meet
unexpected contingencies or for business expansion.

Profit = Corporate tax + Dividend + Retained earnings

Profit = Profit tax + Profit After- tax

Profit After-tax = Dividend + Retained earnings

*Payment of corporate tax by a firm is not included in National income, as it is a

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Transfer payment. Corporate tax is already included in profits. It accrues to

[Link] is not received by the owners of factors of production. Hence, it
is not a factor income.

(5) Mixed income of self- employed: It is the income generated by own-account workers
(like farmers, barbers, doctors, chartered accountants, etc. ) and unincorporated
enterprises (like retail traders, small shopkeepers, etc. ). It is the term used for any
income that has elements of more than one type of factor income. Mixed income arise
from productive services of self-employed persons, whose income includes wages,
rent, interest and profit and these elements cannot be separated from each other.
Example, Income of a doctor running a clinic at his residence.

# STEPS FOR ESTIMATING NATIONAL INCOME BY INCOME METHOD –

1. Identification of producing enterprises:

The industrial categories of producers are –
Primary, Secondary and Tertiary Sectors.

2. Classifying Factors Payments:

Factor Payments are classified as:

a) Compensation of Employee (C.O.E)

It is the total amount of remuneration in cash, in kind and in the form of social security
contribution, an employee receives from his employer in exchange for his factor
services. It includes:
i) Wages in cash: These are monetary benefits like basic pay, bonus, commission,
etc.
ii) Wages in kind: these are non-monetary benefits like rent free accommodation,
free conveyance, medical facilities, etc.
iii) Employer’s contribution to social security schemes: Example Contribution
made to provident fund gratuity, retirement pension, etc.

b) Operating Surplus (OS)

It is income from property (rent, royalty and interest) and income from
entrepreneurship (profit).
1) Rent: it is a factor income generated from ownership of land and building. It
includes rent of lent out properties (actual rent) and rent of owner occupied
properties (imputed rent).
2) Royalty: It refers to income generated for granting leasing rights, copyrights, etc.
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3) Interest: It is a factor payment made by a production unit for capital borrowed for
productive purposes.
4) Profit: It is a factor income generated from entrepreneurship. The profit generated
is divided in three categories:
a) Dividends: It is distributed among shareholders.
b) Corporate/Business/Profit Tax: It is tax on profits which is paid to government.
c) Undistributed profit/savings of Private Corporate Sector/Retained Earnings:
These are kept as resources to expand business or to meet any unexpected
expense.

3. Mixed Income of Self-Employed (M.I)

Income of own account workers (like farmers, doctors, barbers, etc.) and unincorporated
enterprise (like small keepers, repair shops, etc.) is known as mixed income. They do not
maintain proper account. They use their own resources like land, labour, etc. As a result, it
becomes difficult to classify their income.

# PRECAUTIONS –

1. Transfer income like unemployment allowance, charity, old age pensions, etc. are not included
in National Income because such receipts do not correspond to flow of goods and services.

2. Income from sale of second-hand goods will not be included as it has already been counted.
However any commission or brokerage received by a broker for transactions involving
sale/purchase will be included in National Income, since it is an income for the productive
service rendered.

3. Income from the sale of shares and bonds, debentures, etc. (financial assets) are not included
in National Income since such financial assets are mere paper claims and do not contribute to
the production of goods and services. However, brokerage paid to the broker will be included
as it is his income from the productive service rendered by him.

4. Windfall gains like lotteries, horse race, etc. are not included as there is no flow of goods &
services.
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5. Income earned through illegal activities like smuggling, black marketing, hoarding, etc. will
not be included in N.I as these are illegal activities and not recorded anywhere.

6. Payments like gifts tax, wealth tax, etc. are paid out of wealth or accumulated savings of
taxpayers. Hence not included in N.I since they do not add to the current flow of goods and
services.

7. Indirect taxes like VAT, Octroi, excise duty, custom duty, etc. raise the market price of goods
and services. So such taxes are to be included in N.I at market price but not in N.I at factor
cost.

8. Interest paid by production units on capital borrowed is included in N.I as the capital is used
for investment purpose (factor payment). But interest paid by consumers on capital borrowed
is not included in N.I as the capital is used for consumption purposes (non-factor payment).

9. Imputed value of owner-occupied houses is included as house renders services.

10. Production of goods and fixed assets for self-consumption by the producing units will be
included in N.I as these are productive activities and add to the flow of goods and services.

EXPENDITURE METHOD

• This method measures national income as sum total of final expenditures on the final goods
and services (both consumption goods and capital goods ) incurred by households, business
firms, government and foreigners, produced within the domestic territory of the country.
• This total final expenditure is equal to GDP at market price.
• This method is also known as Income Disposal Method.

1. Private Final Consumption Expenditure (PFCE): It refers to expenditure incurred by

households and private non-profit institutions serving households on all types of consumer
goods, i.e. durable (*except houses), semi-durable, non-durable goods and services.
Example, purchase of car by a household, expenditure on education of children by a family
(school fee or purchase of books), etc.

PFCE = Household Final Consumption Expenditure + Private Non-Profit Institutions

Serving Households
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** PFCE includes expenditures incurred by normal residents, whether in the domestic

territory or abroad. So any expenditure incurred by residents during their foreign travel
will be added in PFCE.
**However, any expenditure incurred by non-residents and foreign visitors in the domestic
market will be deducted from PFCE.

2. Government Final Consumption Expenditure (GFCE ): It refers to the expenditure incurred

by general government on various administrative services like government expenditure on
free services provided such as defence, law and order, education, health, police service,
etc. Government produces goods and services with the aim of social welfare without any
intention of earning profits.

3. Gross Domestic Capital Formation ( GDCF ) / Gross Investment: It is the final investment
expenditure by firms and the government, on acquiring goods for investment by the
production units located within the domestic territory. Example: purchase of tractor by a
farmer, purchase of taxi by a taxi driver, purchase of a machine or refrigerator installed in
a production unit by a firm, etc.

-It refers to the addition to capital stock of the economy.

GDCF = Gross Domestic Fixed Capital Formation + Net Change in Stocks

GDCF = (Net Fixed Capital Formation + Depreciation ) + ( Closing stock – Opening stock)

-Gross Fixed Capital Formation ( GFCF ): It refers to the expenditure incurred on purchase
of fixed assets. This expenditure id divide into 3 sub-categories:
1. Gross Business Fixed Investment: It includes expenditure in the purchase of new plants,
machinery, equipments,etc.
2. Gross Residential Construction Investment: It includes expenditure on purchase or
construction of new houses by the households.
3. Gross Public Investment: It includes expenditure on construction of flyovers, roads,
bridges, etc. by the government.

-Inventory Investment / Change in stock: It refers to the physical change in the stock of raw
material, semi-finished goods and finished goods lying with the producers. It is included
as an investment because it represents the goods produced but not used for current
consumption.

GFCF = Gross Business Fixed Investment + Gross Residential Construction Investment +

Gross Public Investment
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4. Net Exports (X – M): It refers to the difference between exports and imports of a
country during a period of one year.
*Exports refer to expenditure by foreigners on purchase of domestic products. The exported
goods have been produced within the country’s domestic territory, so they are included in
output of an economy.
*Imports is the expenditure by residents on foreign products. Imports are deducted to obtain
domestic product as they are not produced within the domestic territory.
** Net Imports is negative of net exports. For example, If net imports = Rs 30 crores, it
means net exports = (-) 30 crores.
GDP at MP = PFCE + GFCE + GDCF – Net Imports

# STEPS FOR ESTIMATING NATIONAL INCOME BY EXPENDITURE

METHOD-

1. Identification of economic units incurring final expenditure:

a) Household sector
b) Producer sector
c) Government sector
d) Rest of the world sector

2. Classification of final expenditure:

a) Private Final consumption expenditure (PFCE)
b) Government Final consumption expenditure (GFCE)
c) Gross Domestic capital Formation (GDCF)
d) Net Exports (X – M)
The sum of four components of final expenditure gives GDPMP i.e. GDPMP = PFCE +
GFCE + GDCF + (X – M)

3. Calculate Domestic Income/NDPFC

NDPFC = GDPMP – Depreciation – NIT

4. Estimate NFIA to arrive at N.I/NNPFC NNPFC = NDPFC + NFIA

# PRECAUTIONS:

1. Expenditure on intermediate goods will not be included in N.I, as it is already included in

the value of final expenditure. If it is included again, it will lead to double counting.
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2. Transfer payments such as scholarships, old age pension, donations, gifts, charities,
scholarships, etc. are not included as such payments are connected with any productive
activity and there is no value addition.
3. Expenditure on purchase of second hand goods because there is no corresponding flow of
goods. (No value addition).
4. Purchase of financial assets will not be included as such transactions do not contribute to
current flow of goods and services. These financial assets are mere paper claims and
involve a change of title only.
5. Expenditure on own account production like production for self-consumption, imputed
value of owner occupied houses, free services from general government and private non-
profit making institutions serving households, will be included in N.I, since these are
productive services.

*NCERT Question-
Q. Why should the aggregate final expenditure of an economy be equal to the aggregate factor
payments?
Ans. In a simplified economy, it is assumed that there are no savings, taxes, exports and imports.
During the production process, four factors of production (land, labour, capital and enterprise)
receive income in the form of rent, wages, interest and profit for their factor services. The sum
total of these incomes is the factor income received during a year. The entire factor income is spent
by the factors on purchase of final goods and services. The sum of these purchases is the aggregate
final expenditure during the year. So, it is rightly said that aggregate final expenditure in a year is
equal to aggregate factor payment.

Q12. Explain the problem of Double counting in the estimation of National Income. How can the
problem be avoided?
Ans. Double counting means counting of the value of same product (or expenditure) for more than
once. If certain items are counted for more than once resulting in over estimation of National
Income to the extent of the value of intermediate goods included, this will cause the problem of
double counting.
Example – There are three producers – farmer, miller, and baker.

Producers-Product VO(Rs) IC(Rs) VA(Rs)

1. Farmer-Wheat (sells to 500 0 500
miller)
2. Miller - Flour (sells to 700 500 200
baker)
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3. Baker – Bread (sells to 1000 700 300

consumers)
2200 1200 GVA=1000

If for the purpose of calculation we take Value of Output as (500+700+1000) = 2200, this will lead
to double counting. In this, value of wheat has been included three times, flour two times and bread
one times, whereas value of final product is Rs.1000 only i.e. the value of bread (2200 – 1200 =
1000).
To avoid double counting, we should use the following –
1. Value Added Method: According to this method, sum total of the value added by each
producing unit should be taken in the N.I, i.e.,
VA = VO – IC = 2200 – 1200 = Rs.1000
2. Final Output Method: According to this method, value of only final goods should be added
to determine the National Income, i.e. value of bread i.e., Rs.1000 (VO).

Q13. When does NFIA becomes positive or negative?

Ans. NFIA is positive when the income earned by the normal residents of the country from abroad
is more than the income earned by foreigners in India and vice versa.
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