Module 4

Macro economic concepts

 Circular flow of economic activities

 Macroeconomics focuses on understanding the overall

performance of an economy.
 Production, consumption and investment are the basic parameters
that indicate the level of economic activity in an economy.
 Behavior of these parameters are analyzed through circular flow
of money across the various sectors of an economy.
 Basically, it demonstrates how money moves through the
different sectors of an economy.
Circular flow of income in a two-sector economy
In a two-sector model of the circular flow of income, the economy is simplified to consist of only
two sectors: households and firms,

Key points about the two-sector circular flow:

Households: Represent consumers who own factors of production and spend their income on
goods and services.
Firms: Represent producers who use factors of production to create goods and services and pay
income to households in the form of wages, rent, interest, and profit.

How it works:

• Factor services flow: Households provide factors of production (labor, land, capital) to firms.
• Factor payments flow: Firms pay income to households in exchange for these factor services.
• Consumption expenditure flow: Households use their income to purchase goods and services
produced by firms.
• Revenue flow: Firms receive revenue from selling goods and services to households.
Circular flow of income in a three-sector economy
 In a three-sector model of the circular flow of income, the economy consists of households,
firms, and the government

Key elements of the three-sector model:

• Households:Provide factors of production (labor, land, capital) to firms in exchange for

wages and salaries, and use this income to purchase goods and services from firms.
• Firms:Utilize factors of production from households to produce goods and services, paying
wages and salaries to households in return, and also pay taxes to the government.
• Government:Collects taxes from households and firms, uses this revenue to purchase goods
and services from firms, and provides transfer payments (like social security) to households.

Money flows from households to firms for goods and services, then back to households as
income, with the government acting as a key player by injecting funds through spending and
removing them through taxation.
Circular flow of income in a four sector economy
In a four-sector circular flow of income model, the economy's flow of goods, services, and
money involves households, firms, the government, and the foreign sector, with the foreign
sector adding exports and imports to the three-sector model.
Households: Provide labor and receive income in the form of wages, salaries, and other
payments.
Firms: Produce and sell goods and services to households and the government, and also
export goods and services to the foreign sector.
Government: Collects taxes from households and firms, and provides public goods and
services, and also engages in international trade.
Foreign Sector: Represents the rest of the world, including imports and exports of goods and
services.
 In all these models, cash flow from the financial sector is also added. Financial sector
includes banks and other institutes that provides financial services.
 Concept of Stock and Flow
 Stocks are defined at a particular point of time.
 E.g. buildings, machines, vehicles, computers, furniture etc.
 Flows are defined over a period of time.
 National income , income etc.
To further understand the difference between stock variables and flow
variables, take the following example. Suppose a tank is being filled with
water coming from a tap. The amount of water which is flowing into the
tank from the tap per minute is a flow. But how much water there is in the
tank at a particular point of time is a stock concept
 Final goods and intermediate goods
 Goods which are sold to consumers for their own use and not used
as a means for further production are final goods. They do not need
further processing since they are finished products. They are also called
as consumer goods. E.g. cars, mobiles, shoes, refrigerators etc.
 Goods which are used in the production of other goods are
intermediate goods. It is a product used to produce a final good. These
goods need further processing since they are semi-finished products.
They are used as inputs to become part of the finished product. They
are not taken into consideration during the estimation of national
income since their value is included final goods. E.g. raw materials like
steel, copper, rubber, coal .etc
 National income

National income is the total money value of all final goods and
services produced in a country's economy during a specific period,
often a year, and is a key indicator of economic health and well-being.
 National income indicators
There are many concepts of National Income which are used by
different economists, these are explained below:-
 Gross Domestic Product (GDP)
 Net Domestic Product (NDP)
 Gross National Product(GNP)
 Net National Product (NNP)
 National income at Factor cost
 National income at Market price
 Gross Domestic Product (GDP)
Gross Domestic product is the total money value of all final goods
and services produced within the domestic territory of a country
in a year.
GDP= GNP-NFIA

 Gross National Product (GNP)

Gross national Product is the total market value of all final goods
and service produced by nationals of a country in a year plus net
factor income from abroad.(NFIA)
GNP=GDP+ NFIA
 GDP GNP
Gross Domestic product is the total Gross national Product is the total money
money value of all final goods and value of all final goods and service
services produced within the domestic produced by nationals of a country in a
territory of a country in a year. year plus net factor income from
abroad.(NFIA)

Domestic territory of a country Nationality of citizens

Only includes goods and services Include goods and services produced
produced within the domestic territory within the domestic territory also include
and does not include income generated by income generated by home nationals
home nationals abroad abroad

GDP=GNP-NFIA GNP=GDP+NFIA
 Net Domestic Product (NDP)
The net domestic product (NDP) equals the gross domestic product (GDP) minus
depreciation on a country's capital goods.
NDP = GDP – Depreciation
 Net National Product (NNP)
It is the money value of final goods and services produced in an economy during an
year after deducting depreciation.
NNP = GNP – Depreciation

* Depreciation - It refers to the loss of value of the fixed capital due to tear and wear, passage
of time and expected obsolescence
 National Income at Factor Cost
Computes National income only on the basis of cost incurred to
produce goods and services.
NI FC = NI MP – Indirect tax + Subsidies

 National Income at Market Price

It computes National Income on the basis of Market Price
NI MP = NI FC + Indirect tax – Subsidies
 Personal Income(PI)
Personal income is the part of national income which is received by
households.
PI = NI- Social security contribution - corporate income
taxes - undistributed corporate profits + transfer payments

Personal Disposable Income (PDI)

It is the part of personal income which is actually available to
individuals and households for consumption and savings.
PDI = PI – Personal Income Taxes
.
 Measurement of National Income

National Income can be measured by three methods:

 Output or Product Method

 Income Method
 Expenditure Method
 Output Method or Product Method
 This method is also called the value-added method.
 Under this method, the economy is divided into different sectors
such as agriculture, fishing, mining, construction, manufacturing
,trade and commerce, transport, communication and other
services.
 NI = value of output from primary sector + value of output from
industrial sector + value of output from services sector
 Income Method

 According to this methods, national income is obtained by

summing up incomes of all individuals in the country.
 Thus national income is calculated by adding up the rent of land,
wages and salaries of employees, interest on capital and profits of
entrepreneurs.
 NI = W+ R + I +P
 Expenditure Method
 This method arrives at national income by adding up all the expenditure
made on goods and services during a year.
 Thus the national income is found by adding up the following types of
expenditure by households, private business enterprises and the government.
 NI = C+I+G+(X-M)
 Expenditure on consumer goods and services by individuals and households
denoted by (C)
 Investment Expenditure made by business enterprises denoted by (I)
 Government expenditure on goods and services i.e. government purchases
denoted by (G)
 Expenditure made by foreigners on goods and services of the national economy
denoted by (X –M).or it is the net exports.
 NI FC = NI MP – Indirect tax + Subsidies
 NI MP = NI FC + Indirect tax – Subsidies
 NNP at market price = GNPMP – Depreciation
 GDPMP = GDPFC + Net indirect taxes
 GDPFC= GDPMP-Net indirect taxes
 NNP at factor cost (National Income) =NNPMP -net indirect tax
 GDP = GNP-NFIA where, NFIA is the Net Factor Income from Abroad
 NDP = GDP - Depreciation
 GNP =GDP+ NFIA
 NNP at market price = GNP – Depreciation
 NNP at Factor cost (National Income) =NNPMP – Indirect tax + subsidies
 GDP using Income Method= W+ R + I +P
 GDP using Expenditure Method = C+I+G+(X-M)
 * ( Net indirect tax is the difference between indirect taxes and subsidies)
 National Income- Numerical Examples
1) Suppose the national income of a country is Rs.1000 and depreciation equals Rs.300.
If NFIA equals Rs (-400) and Net Indirect Taxes equals Rs.300,
Estimate NNP, NDP, GDP and GNP (all figures in Rs. Crores).

Answer:
NNP FC (National Income) = 1000 (National Income)
NNP Mp = NNP Fc + Net Indirect Tax
=1000+300
NNP Mp = 1300
NNP Mp = 𝐺𝑁𝑃 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
1300= 𝐺𝑁𝑃 − 300
1300+300= GNP
GNP = 1600
GDP = 𝐺𝑁𝑃 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
= 1600 − (−400)
GDP = 2000
NDP= 𝐺𝐷𝑃 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
= 2000 − 300
NDP = 1700

2) Estimate GDPMP, GNPMP and National Income (All figures in Rs.000 Crores).
Private Consumption Expenditure = 3000
Government consumption = 600
NFIA = - 400
Investment = 1000
Net Exports = 700
Depreciation = 500
Net Indirect Tax = 300

Answer:

GDP using Expenditure Method = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀)

= 3000 + 1000 + 600 + 700
= 5300
GNP MP = 𝐺𝐷𝑃 + 𝑁𝐹𝐼𝐴
= 5300 + −400 =4900
 NNP MP = 𝐺𝑁𝑃 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
= 4900 − 500 =4400
National Income That is; NNP at Factor Cost = 𝑁𝑁𝑃𝑚𝑝 − 𝑁𝑒𝑡 𝐼𝑛𝑑𝑖𝑟𝑒𝑐𝑡 𝑇𝑎𝑥
= 4400 − 300
= 4100

3) From the data given below, Estimate Gross National Product, Net National Product and
National income.
GDP= 5000 (in 100 billion)
NFIA = -50
Indirect tax =70
Subsidies= 20
Depreciation =30

Answer:

GNP= 𝐺𝐷𝑃 + 𝑁𝐹𝐼𝐴

= 5000 + −50 = 4950

NNP= 𝐺𝑁𝑃 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛

= 4950 − 30 = 4920

National Income = 𝑁𝑁𝑃𝑚𝑝 − 𝐼𝑛𝑑𝑖𝑟𝑒𝑐𝑡 𝑡𝑎𝑥 + 𝑆𝑢𝑏𝑠𝑖𝑑𝑖𝑒𝑠

= 4920 − 70 + 20 = 4870
 Difficulties of measurement of NI
Non monetized sector:
A considerable part of the agricultural output is consumed in the farm
itself and does not come into the market for sale. Hence they are not
valued in terms of money and as such excluded from national income
estimates.

Lack of data on occupational specialization

A large number of workers are engaged in many activities simultaneously.
So it creates lack of data regarding their actual income

Double counting
In national income estimates, the same product may be counted more than
once. This over inflates the national income. For example, tyres may be
initially counted in the tyre factory and later at the automobile factory
since the value of the automobile includes the value of its tyres also.
Non availability of data about certain incomes:
Most small manufactures do not keep accounts. It is thus difficult to get
reliable information from a large number of small producers. And also the
lack of adequate statistical data in the hands of the various government
agencies make the estimation of national income difficult.

Black Money
Black money is hidden from government authorities and is not reflected
in the GDP of India, national income, etc
 Inflation
 In economics, inflation is a rise in the general level of prices of
goods and services in an economy over a period of time.
 Inflation is a process of rising price.
 Money buys less when the price level rises. That is inflation
reflects a reduction in the purchasing power or unit of money.
 The value of money varies inversely with the price level.
 Causes of Inflation
Demand-pull factors Demand-pull inflation occurs when demand for
goods and services exceeds supply in the economy. While demand
increases, the supply of goods and services available for purchase may
remain the same or drop. Demand-pull inflation causes upward pressure on
prices due to shortages in supply , a condition that economists describe as
too many dollars chasing too few goods.
Cost-push Factors Cost-push inflation occurs when increased production
costs increase prices for goods and services. Factors such as rising wages,
raw material costs, taxes, and exchange rate fluctuations contribute to this
type of inflation.
Excessive printing of Currency notes: Excessive printing of notes will
increase the circulation of money and it leads to inflation.
Black money: Anti social elements are engaged in black marketing,
smuggling. They will not pay tax, as a result government looses its
incomes. This type of underground economy leads to inflation.
Increase of wages and salaries:When the price are high, people
demand more salary to maintain the standard of living. When the
cost of living is more, increase of wages and salaries are
indispensable. Government has to announce more DA. This leads to
inflation.
Excessive Taxation:If government levy more taxes on the
commodities, the prices of commodities will increase. The increase
in price leads to inflation.
War:During war time, essential commodities will be supplied to
military people. And as a result industries, agricultural work and
overall society will be badly affected. Because of this greater
scarcity of essential commodities, inflation spread over.
 Types of Inflation
The various types of inflation are discussed below:
 Demand pull inflation- caused by demand pull factors. Inflation that
occurs due to increase in aggregate demand is referred to as demand
pull inflation
 Cost push inflation- Cost-push inflation means prices have been
"pushed up" by increases in the costs.
 Creeping Inflation-When prices are gently rising ,it is referred as
creeping inflation. It is the mildest form of inflation and also known
as Low inflation. When prices rise by not more than (up to) 3% per
annum (year) it is called creeping inflation.
 Walking inflation- When prices rise by more than 3% but less
than 10% per annum( i.e between 3% and 10% per annum) it is
called as walking inflation
 Running Inflation-When prices rise by more than 10% per
annum, running inflation occurs .We may consider price rise
between 10% to 20% per annum( double digit inflation rate) as a
running inflation
 Galloping Inflation-If prices rise by 30% or 400% or 999% per
annum, then the situation can be termed as galloping inflation.
 Hyper Inflation -It refers to a situation, where the prices rise at
an alarming high rate. The prices rise so fast that it becomes very
difficult to measure its magnitude.
 Inflation effects
Inflation has resulted in serious imbalances in the Indian economy.
 Inflation results in business uncertainty in the country. Companies would
find that the cost of a project keeps on increasing during its lifetime and
their initial profit calculations may go wrong.
 Inflation leads to depreciation in the value of money. When the prices of
essential commodities increase, less money is available for purchasing
other products.
 It discourages savings as the value of savings also declines as money
value declines.
 Inflation badly affects the fixed income earners. People having a fixed
salary find that they can buy fewer commodities today than they could in
earlier years.
 During inflation, debtors gain while creditors lose.
 Methods to control inflation
 Inflation has been the most pressing problem in India in the recent
years. Controlling inflation largely depends upon checking monetary
expansion and controlling food prices. With oil prices expected to
go up further, controlling prices will be difficult.
 The following are the policies to control inflation:
(A) Monetary Policy
(B) Fiscal Policy
Monetary Policy
 Monetary measures are classified into Quantitative and Qualitative.
1. Quantitative techniques
 These techniques aim to regulate the volume of credit in the economy.
 (a) Bank Rate Policy The Bank rate is the minimum lending rate of a central
bank . If the Reserve Bank of India increases the bank rate, the interest rates
charged by other banks go up. When the rate of interest goes up, businessmen
will be discouraged to borrow more money. Thus, to control inflation, the
central bank will increase the bank rate. Moreover, loans will become more
costly and people will postpone their purchases.
 (b) Open market operations It is the purchase and sale of securities by the
central bank. If the RBI sells securities, money will flow from the banks to the
Central Bank and the amount of money left with the banks to be given out as
loans will be reduced. The central bank will sell securities to the banks and the
amount of cash with the banks will come down forcing them to reduce their
loans
 (c) Variation in reserve ratio
CRR is the percentage of total deposits which commercial banks are required
to maintain in the form of cash reserves with the RBI. If CRR is raised, the banks now
have to keep more reserves forcing them to reduce the supply of loans.
Statutory liquidity ratio SLR is the proportion of total deposits which
commercial banks are required to maintain in the form of liquid assets like cash, gold,
government securities etc.

 (d) Repo Rate and Reverse Repo Rate

The repo rate and reverse repo rate are interest rates that the Reserve Bank of India
(RBI) uses to control inflation and manage liquidity in the economy:
Repo rate - The interest rate at which the RBI lends money to commercial banks in
exchange for securities. The RBI uses the repo rate to control inflation and cash flow.
Reverse Repo Rate The interest rate at which commercial banks can park their extra
funds with the RBI by selling securities. The RBI uses the reverse repo rate to manage
liquidity in the banking system.
 2. Qualitative techniques (Selective Credit Control)
 These are directives issued by the RBI to banks regarding their loans
 The common qualitative credit control techniques are:
(a) Defining the purposes for which loans may be given
(b) Moral Suasion: It is the issuing of warnings threatening strict action if the
banks do not comply with the directives issued by RBI.
B. Fiscal Policy
 1. Increasing taxes-If direct taxes are raised, the disposable income in the
hands of the people is reduced and public spending will come down. If taxes
on commodities are raised, the cost of purchases will increase and people
will postpone consumption
 2. Reduction in government expenditure.-However, this is not easy since
most of the government spending is on infrastructure, health, education and
defense.
 Business Financing
 Finance is essential for a business operation, development and expansion.
Funds can be procured from different sources and therefore procurement is
always considered as a complex problem by business concerns.
There are two main sources of funds ; Internal sources External sources
 Internal sources refers to sources from within the company such as funds
raised from retained earnings or the savings of the company and personal
capital.
 External sources refer to outside sources consisting of equity finance
( share capital ) and dept finance (debenture capital, loans and advances etc)
 Bonds and Shares

BOND
 A bond is a loan which pays investors a fixed rate of return.
 Bonds risk depends on the credit worthiness of the issuer.
 The interest rate on the bond determines its value to the
investor.
 It is a type of fixed income security and pays back a regular
amount to the investor.
 Bonds are used by governments and companies.
Advantages
 1. Bonds are relatively safe.
 2. They provide a fixed rate of return.
Disadvantages
 1. They carry low interest rates.
 2. The bond issuer may not be able to pay the investor on time,
hence bonds have a default risk.
SHARES
 Shares are units representing ownership in a company. Companies
issue equity shares to investors in return for capital. Shares of privately
held companies are owned by the founders or partners.
 As small companies grow, shares are sold to outside investors like
friends and venture capitalists. If the company continues to grow it will
seek to raise additional equity capital by selling shares to the public
through an initial public offering.
 Being owners of the firm, they elect the board of directors and have a
right to vote on every resolution placed before the company.
Advantages
 1. It represents permanent capital
 2. There is no liability for repayment.
Disadvantages
 1. The cost of equity capital is very high.
 2. They have a low priority if there is a claim to the income or assets
of the firm.
 Financial market
 Financial market is the market that facilitates transfer of funds
between investors/lenders and borrowers/users.
 It consists of individual investors, financial institution and other
intermediaries for trading the various financial assets and credit
institutions.
Financial market can be classified into two money market and
capital market.
 Money market-The money market is that part of a financial
market which deals in the borrowing and lending of short-term
loans generally for a period of less than or equal to one year.
 Capital Market-Capital market may be defined as a market for
borrowing and lending long term capital funds required by
business enterprises.
BASIS MONEY MARKET CAPITAL MARKET
Meaning It is a market dealing in It is a market dealing in
securities of short-term securities for long term
funds whose maturity funds whose maturity
period is up to one year. period is more than one
year
Participants RBI, Commercial banks, Financial institutions,
financial institutions and banks, corporate entities,
finance companies foreign investors and
ordinary investors
Instruments T-bills, Certificate of Shares , Bonds,
deposit etc. Debentures, etc.
Investment outlay Huge sum of money It does not require huge
required for instruments , investment outlay
because these are quite
expensive