Module-6

National Income
 Module Contents
National Income: Concept and measurement
Circular flow of economic activities,
Keynesian analysis:
Keynesian theory of employment,
Theory of consumption function
Theory of investment function
Multiplier and Accelerator
Relevance of Keynesian economics in underdeveloped
countries
Business cycle
Money supply and Inflation.
 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)
GDP at Factor Cost
GDP at Market Prices
Gross National Product (GNP)
Net Domestic Product (NDP)
Net National Product (NNP)
Real and Nominal Income
Per Capita Income(PCI)
Personal Income(PI)
Disposable Personal Income(DPI)
 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 = GNP NIA
C ---- Consumption consisting of private (household final consumption
expenditure
I ---- Investment includes, for instance, business investment in equipment
G----- Government Expenditure on final goods and services
X ---Gross exports.
M ---- Gross imports
X- M ------ Net Income from abroad(NIA)
GDP ------ Gross Domestic Product
GNP-------- Gross National Product (GNP)
GDP at Factor Cost and Market Prices

GDP at market price: includes the final value of

goods and services also includes indirect taxes and
excludes the subsidies given by the government.
NI at Factor Cost = NI at Market Prices( GNP)
Taxes - Depreciation + Subsidies
GDP at factor cost is the money value of final goods
and services based on the cost involved in the
process of production.
NI at Market Prices = NI at Factor Cost + Taxes +
Depreciation 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 Income from Abroad (NIA).
GNP = GDP + NIA
GNP = C+I+G+(X-M)+NFIA

Net Income from Abroad: It is the difference between

income received from abroad for rendering factor
services(X) and income paid towards services rendered
by foreign nationals(M) in the domestic territory of a
country.
 Net Domestic Product and
Net National Product
Net Domestic Product(NDP)
NDP = GDP - Depreciation
Net National Product (NNP)
NNP = GNPDepreciation
Thus NNP is the actual addition to a years wealth and is the sum of
consumption expenditure, government expenditure, net foreign
expenditure, and investment, less depreciation, plus net income earned
from abroad.
NNP = C+I+G+(XM)Depreciation + NIA
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.

Nominal GDP
Real GDP =
GDP deflator

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 Capita Income and
Disposable Personal Income
Per capita income is the average income of the people of
a country in a particular year.
National Income
Per Capita Income =
Total Population
Personal income is the total income received by the individuals
of a country from all sources before direct taxes in one year.
Personal Income(PI) = National Income Undistributed Corporate Profits
Corporate Taxes Social Security Contributions + Transfer Payments +
Interest on Public Debt
is the income which can be spent
Disposable Personal Income(DPI):
on consumption by individuals and families.
DPI = Personal Income Personal Taxes
DPI = Consumption + Savings
Circular Flow of Economic Activities
and Income
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
 Circular Flow of Income
(Two Sector Economy)
(Wages, Rent, Interest and Profits)
Factor Payments
(Y)
Factor Inputs

Financial
Households Savings Firms
Market Investment
(S) (I)

Goods and
Services (O)

Consumption
expenditure
(C)
In the equilibrium Y=E=O
 Circular Flow of Economic
Activities and Income
Value of output produced (Y) = value of output sold (O)
Value of output sold = Sum of consumption expenditure (C)
and investment expenditure (I)
Y=O=C+I=E(1)
Income is either consumed or saved (S).
Y=C+S.(2)
C+I=Y=C+S(3)
Therefore: I = S(4)
Savings are withdrawal of money from the circular flow
Investment is injection of money into the circular flow
For equilibrium savings should be equal to investments
Hence Y=O=E( Expenditure)
 Circular Flow of Income
(Four Sector Economy)
The third sector is Government (G)
Government Spending
On provision of public utility goods and services.
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
 Circular Flow of Income
(Four Sector Economy)
Government
(G)
Remittances
Taxes Factor Taxes for purchases
Salaries Payments
Factor Inputs

Savings
Household (S) Financial Market Firms
Investment
s (I)

Exports Goods
Exports
Consumption
Expenditure

Imports Foreign Nations Imports

(X-M)
 Circular Flow of Income
(Four Sector Economy)
National income includes expenditures on consumption
investment, government and net of exports (X-M)
National Income=C+I+G+(X-M)
Since national income can either be consumed, or saved, or
paid as tax to the government:
C+I+G+(X-M)=C+S+T
I+G+(X-M) =S+T
Sum of private investment and expenditure on net exports is
equal to the sum of savings and tax revenue. Thus:
I+G+X =S+T+M
Therefore, W=J
At equilibrium, total injections(J) are equal to total
withdrawals(W).
 Macro-economic Variables

Aggregate Demand and Aggregate Supply

Aggregate 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
 Macro-economic Variables

Stock and Flow

Stock may be defined as any economic variable which has
been accumulated at a specific point of time
like money, assets and wealth.
Flow includes the variables which increase (inflows) and
decrease (outflows) the stock, over a period of time.
like income, consumption, saving and investment
Stock=Inflows-Outflows
Intermediate and Final Goods
Intermediate goods (and services) are items purchased by
firms for using them in production of some other good of utility.
Also known as producer goods because they are used as
inputs in the production of other goods.
 Macro-economic Variables
Capital formation
The process of savings being converted into investment is known as
capital formation
Gross Capital Formation refers to the aggregate of additions to fixed
assets (Fixed Capital Formation) and increase in stocks of inventories
during a period of time.
Employment
An employed person is willing and capable to work in a productive activity
and is engaged for certain number of hours per week, whether working for
self or someone else.
The population of any country is divided into working population (age group
of 16 to 65 ) and dependents.
Government Expenditure and Revenue
Government Expenditure is which is made from public exchequer.
Government Revenue is income received by government in various
forms, e.g. Taxes
 Consumption (C) and investment (I)

In a two sector model, a simple but an imaginary

assumption of no government and no foreign trade
is made.
Here Yd =C+S or Yd =AD (aggregate demand)
This also implies that C+S=C+I
 Consumption
Consumption is the sole end and purpose of all
production. Adam Smith
Consumption is the act of spending income for buying
goods and services to satisfy wants.
Determinants of consumption :
Disposable Income (after tax income) of the consumers(Yd)
Accumulated wealth or assets of consumers(W)
Expected future income, of Consumers(Ce)
The actual price level(P)
The expected general price level, Rate of interest(Pe)
Thriftiness,(T)
Age(A)
Sex(S)
Family size (Fs).
 Consumption function
A relation between consumption and its
various determinants is called the
consumption function.
The consumption function taking all these
determinants into account can be written as:
C=f (Yd, W, Ye, P, Pe, r,A, s, FS..)
Keynesian Consumption function
Keynes, however, asserts that income alone is the most
important determinant of consumption. Here, income
refers to the disposable income. The Keynesian
consumption function, thus, can be written as:
C=f (Yd), 1>f>0
Where,
C=Consumption demand
Yd = Disposable income= (Y-T)
Y=Personal income
T=Taxes (related to income)
Keynesian Consumption function
The assumption of the Keynesian consumption function is
that consumption depends on income, other things being
equal. The higher the income, higher is the consumption,
ceteris paribus.
Keynes psychological law of consumption (The concept
of the marginal propensity to consume).
Keynes argue that when the income increases,
consumption also increases but not to the same extent as
the increase in income.
 Keynesian Psychological Law
The fundamental psychological law states that men are
disposed of, as a rule and on the average, to increase their
consumption as their income increases, but not by as much
as the increase in their income.
The idea is that when the income increases, consumption
also increases but less than proportionately. Alternatively,
Marginal Propensity To Consume (MPC) is positive but
less than unity (0<MPC<1).
Marginal Propensity to Consume
Keynesian Psychological Law is also called the
MPC.
Given the consumption function: C= f (Yd), the
MPC is the ratio between change in consumption
expenditure and the change in income level.
MPC=C = Change in consumption
Yd Change in disposable income
i.e. 0< =C <1
Yd
Marginal Propensity to Consume
Suppose, initial income level is Rs. 1000 and consumption
demand is Rs. 800. When income level increases to Rs.
1500, and consumption demand to Rs. 1200, MPC will be:
=C/ Yd =400/500=0.80
This implies that when income increases by Rs. 100,
consumption demand increases by Rs 80. And the
difference Rs. 20 is the saving.
This means Yd = C+S
i.e. Disposable income=Consumption+Saving
 Consumption function
Short run Keynesian consumption function is
often written as: C=Ca+bYd
Ca is autonomous consumption function. This
implies that Ca is not related to income level
(Yd) since a minimum level of consumption is
required just for survival even if there is no
income.
And b is MPC.
 Average Propensity to Consume
The fraction of total disposable income spent on
consumption demand is called the average propensity to
consume (APC).
APC= Consumption demand = C
Disposable income Yd

APC implies the average spending tendency of the

community or the people of a country.
Given the consumption function, C=C a+bYd
APC=C/Yd=Ca+bYd/Yd
Or, APC = C + b
Yd
 Calculating APC and MPC
Yd C APC MPC S=Yd-C

0 100 - - -100
100 175 1.75 0.75 -75
200 250 1.25 0.75 -50
300 325 1.08 0.75 -25
400 400 1 0.75 0
500 475 0.95 0.75 25
600 550 0.92 0.75 50
 Main observations
When disposable income increases, consumption also
increases but not proportionately.
When disposable income increases, APC declines.
When disposable income increases, MPC remains constant
and APC>MPC.
At low level of income, there is dissaving and at higher
level of income there is saving.
At particular level of income (i.e. at Rs. 400, C=Yd ),
saving is just zero. This point is called the break even
point.
 Graphical presentation
C,S 45 line (Y=C+S)

S=50
C
E
S=- C=Y=4
Ca=100 50 00

200 400 600 Disposable income (Yd

 Short run and long run consumption

C,S CLR:
Consumption in
the long run
CSR
C=bYd
Consumption
in the short
Ca run
C=Ca+bYd

Disposable income (Yd

 Short run and long run
consumption
The short run consumption is non-proportional in
the sense that consumption is partly autonomous
and partly induced that is related to the current
disposable income.
The long run consumption fully depends on
income. The long run autonomous consumption is
zero and according to Keynes, in the long run, we
all die if fail to generate our own income.
 Saving Function
The part of the disposable income not spent on consumption
is called saving. In this case, saving is the difference between
disposable income and consumption.
It is based on the premise that Yd=C+S
Then S=Yd-C
S=Yd- (Ca+bYd)
Or, S= -Ca+(1-b)Yd
Where, -Ca=Autonomous saving that is negative or that is
dissaving. A person must borrow in order to survive.
1-b is marginal propensity to save as we know b is marginal
propensity to consume.
 Saving Function
From the macroeconomic perspective, aggregate saving is that part of
real output that is produced but not sold to consumers. Thus,
aggregate saving is the sum total of the private saving, and
government saving.
Gross National Saving=Govt. saving+ private saving
Personal saving is the difference between personal disposable income
and the personal consumption expenditure.
Private saving is the sum of personal saving and gross business
saving. Gross business saving is the profits minus dividends paid to
individuals plus depreciation.
Government saving is the difference between government revenues
and government expenditures.
Again to remind: types of saving
private saving = (Y T ) C
public saving = T G
national saving, S
= private saving + public saving
= (Y T ) C + T G
= Y C G
 Marginal Propensity to save
MPS is the change in saving as a result of an
additional unit of disposable income.
MPS =S = Change in saving
Yd Change in disposable income
Since MPC+MPS=1, when MPC increases, MPS
decreases. This relationship between MPC and
MPS can also be shown graphically by plotting
MPS on the vertical axis and MPC on the horizontal
axis. First think and draw yourself.
 MPC+MPS=1

MPS

S1 B1+s1=1

S2 B2+s2=1

O
b1 b2 MPC
 Average Propensity to save
APS is the ratio between total saving and
total disposable income.
APS =S = Saving
Yd Disposable income
APS increases when disposable income
increases and vice versa.
 Graph for saving function
S
S

o E
Yd

-Ca
 Determinants of consumption
and Saving
Since consumption is the counterpart of
saving, both are related to each other.
Factors affecting the consumption demand
also affect saving.
Thus, determinants of consumption and
saving are interrelated and presented in
the next slide.
 Determinants of consumption
and Saving
1. Change in disposable income affects
consumption and saving.
Once the Yd changes, both consumption and
saving change. A higher Yd increases both C and S.
However, it also depends on the preference of an
individual.
Increase in Yd shifts the budget line rightward
indicating that more consumption and more saving
are possible.
 Determinants of consumption
and Saving
2. Change in interest rate affects consumption and
saving.
Real interest rate is the difference between nominal
interest rate (i) and inflation rate (), i.e. r=i- .
There is a positive relationship between real interest
rate, r and saving, S. When r increases S also increases
since r is the reward for saving. However, increase in r
reduces consumption. Even people who borrow and
consume are discouraged to consume more.
When there is more saving and less consumption due to
increase in r, it is called the substitution effect of
increased real interest rate.
 Determinants of consumption
and Saving
2. Change in interest rate affects consumption and
saving.
But the increased interest rate will also raise the future
income relative to the current income. In this case,
consumption may increase with the expectation of
higher future income. This effect of higher interest rate
on consumption is called income effect. This leads
towards less saving at higher interest rates.
However, the effect of higher interest rate on S and C
depends on the relative strength of substitution effect
and income effect.
 Determinants of consumption
and Saving
2. Change in interest rate affects
consumption and saving.
For low income group, substitution effect will
outweigh the income effect- saving increases with
higher rate of interest.
For high income group who tend to save relatively
large parts of their income, the income effect may
outweigh the substitution effect. At high interest
rates saving declines.
 Determinants of consumption
and Saving
3. Change in price level and price expectations affect
consumption and saving:
The effect of price level change on C and S depends on
what happens to the real disposable income when price
level changes.
If current disposable income rises or falls
proportionately with the price level, real income remains
unchanged. In this case, the shares of consumption and
saving remain unchanged.
 Determinants of consumption
and Saving
3. Change in price level and price expectations
affect consumption and saving:
Real income= nominal income/price level
For example, real income at present is current
income/price level i.e. 2000/5=400
After price level and Yd change say by 20 % i.e.
2400/6=400
In both cases S and C remain unchanged since
there is no change in real income.
 Determinants of consumption
and Saving
3. Change in price level and price expectations affect
consumption and saving:
However, this may not be valid in the case of money
illusion, a situation in which a person cares more about
the nominal income than the real income. If a person
increases his saving because of the money illusion than
the real consumption will decline.
In the absence of money illusion, when real disposable
income decreases because of the increase in price level,
there will be an absolute decrease in real consumption
expenditure.
 Determinants of consumption
and Saving
3. Change in price level and price expectations affect
consumption and saving:
Given the disposable income, expectation of a higher
price level in the future may cause increase in
consumption expenditure thereby reducing the
saving. Because higher price in the future period will
reduce the value of saving in real term (value of money
declines due to price rise).
If the expected price level declines, people postpone
consumption expenditure and increase saving with the
hope that they can take advantage of higher purchasing
power of money they deposited.
 Determinants of consumption
and Saving
4. Pattern of income distribution:
According to N. Kaldor, people with low income level
have higher MPC and hence lower MPS. On the
contrary, people with higher income level have lower
MPC and higher MPS.
This implies that MPS is higher for high income group
and lower for low income group. In other words, low
income group consumes whatever they earned while
high income group saves more when income increases.
 Determinants of consumption
and Saving
4. Pattern of income distribution:
However, still there are debates. A number of hypothesis
in discussion are :
Absolute income hypothesis (J. M. Keynes)
Relative income hypothesis (James Duesenberry)
Permanent Income hypothesis (M. Friedman)
Life-cycle hypothesis (F. Modigliani)
These are discussed in advanced level.
 Determinants of consumption and
Saving
5. Real assets, financial assets and outstanding debt affects
consumption and saving:
Ceteris paribus, accumulation of wealth in terms of real
(houses, other consumer durables) and financial (stocks,
bonds, and other forms of deposit) assets leads to increase
consumption expenditure. Given the size of real and
financial assets, consumption expenditure depends on the
rate of interest (as a return fro such assets) and the price
level.
Any outstanding debt compels an individual to reduce
consumption expenditure thereby saving more. In the
case of no outstanding debt, this may be opposite.
 Determinants of consumption and
Saving
6. Thriftiness, old age security and social safety net also
affect consumption and saving:
Attitudes toward thrift (desire to save more) also influences
the allocation of disposable income between consumption
and saving. If people are thriftier, they keep aside increasing
fraction of their disposable income for future
consumption by reducing current consumption.
In a society with sufficient provision of old-age security
and social safety net, people will save less and consume
more. Converse will hold in the absence of such program in
the society.
 Determinants of consumption and
Saving
7. Growth rate of population and its age distribution affects the
consumption-saving pattern:
Population growth rate and its age distribution affects the
consumption-saving pattern accordingly. If population growth
rate is quite high and exceeds that of economic growth rate,
disposable income per capita declines. This reduction in
income reduces per capita consumption expenditure and so
does saving.
Another factor is the age structure. Big families spend
proportionately more from income than small families. Young
families busily acquire durables, while established families tend
to replace only worn out durables. Thus, societies full of young
or large families consume more.
 Determinants of consumption and
Saving
8. Availability of credit and the state of financial
institutions also affects consumption-saving
pattern.
Consumption expenditure for durable goods may increase
if credits are easily available. If getting credit is relatively
difficult, expenditures on consumer durables decline.
Saving habit of people also depends on the institutional
arrangement. For working people, the provision of
provident fund, life insurance and arrangements of
financial institutions also help to save more for future use.
 Aggregate expenditure
The desired expenditures, made up of desired
consumption, desired investment, desired
government purchases, and desired net exports
account for total desired expenditure.
The result is total desired expenditure on
domestically produced goods, and services called
desired aggregate expenditure, or more simply
aggregate expenditure (AE):
AE=C+I+G+NX
 Aggregate expenditure
Desired expenditure need not equal actual
expenditure, either in total or in any individual
category.
National income accounts measure actual
expenditures in each of the four expenditure
categories. National income theory deals with
desired expenditures in each of these four
categories.
 Equilibrium National Income
is that level of national income where desired aggregate expenditure
equals actual national income.

45 line or actual expenditure

Desired expenditure

Desired expenditure line

E

Actual National income

 Determination of equilibrium income and output

Y=AD, AD=C+I+G+NX
AD=Y
AD E1 AE2
AE1
E

Planned spending precisely matches production in the

points E, and E1.
 Determination of equilibrium
income and output
In the previous graph:
Increase in AE has shifted the equilibrium income
upward.
Given the intercept, a steeper aggregate demand
function-as would be implied by a higher marginal
propensity to consume-implies a higher level of
equilibrium income.
Similarly, for a given MPC, a higher level of
autonomous spending-a larger intercept- implies a
higher level of equilibrium income.
 The Multiplier Model
Multiplier Model is used to know the magnitude of change in equilibrium GDP as
a result of the change in aggregate expenditure.
Multiplier analysis is an important tool of income expansion, and business cycle
analysis
The multiplier is the ratio of the change in GDP to the change in expenditure.
It is also defined as the ratio of the final change in income to the initial change in
autonomous expenditure.. stands for any increase in autonomous
expenditure, this could be an increase in investment or in the autonomous
component of the consumption.
Thus a multiplier can be written as K= Y/ , where K is multiplier, Y is
change in GDP, and is change in autonomous expenditure.
The dynamic multiplier process is shown in the following table.
 The Dynamic Multiplier process
Roun Increase Increase Total increase
d in in in income (all
demand productio rounds)
this round n in this
round
1
2 b b (1+b)
3 b2 b2 (1+b+b2)
4 b3 b3 (1+b+b2+b3)
. .. ..
1
 The Multiplier

The equation AD= (1+b+b2+b3 ) , following the

rule of geometric series, simplifies to:
1 *, (1-
b) .
The idea is that cumulative change in aggregate spending is
equal to a multiple of the increase in autonomous spending. The
multiple 1/(1-b) is called the multiplier.
The multiplier is the amount by which equilibrium output
changes when autonomous aggregate demand increases by 1
unit.
 The Multiplier
You should note that, 1-b is Marginal Propensity to Save (MPS),
thus multiplier in other words is the reciprocal of MPS. That is,
K=1/(1-b).
It should also be understood that the multiplier effect occurs when
one persons spending becomes someone elses income, and some
of the second persons income is subsequently spent, becoming
the income of a third person, and so on.
Discuss an example, where MPC is o.5 and autonomous
expenditure is Rs. 10,000, what is the final income?
 The Effect of Multiplier

E2 C+I+I'
C+I
E1 C

0.5
C
45
O Y1 Y2
Y

Y1 increased to Y2 because of the multiplier effect and

a new equilibrium is attained.
 The Multiplier
The basic assumption of the above mentioned multiplier principle
for a two sector economy are:
there is no change in the marginal propensity of consume during the
adjustment process which remains more or less constant,
there is no induced investment (i.e. accelerator is not operating),
the new higher level of investment is maintained long enough for the
completion of the adjustment process,
the output of consumer goods is responsive to effective demand for
these goods,
there is complete absence of government activity like taxation or
expenditure,
there is no time lag between the receipt of income and its
expenditure, and
there is a closed economy.
 Leakages and Injections in Multiplier
Leakages:
Households receive income in terms of factor payments. The HHs
income is divided into four components: consumption demand (C),
Taxes to the government (T), import expenditure (M), and saving.
The total households income that is not used for consumption
demand is called the leakages or withdrawals.
Here leakages = net saving+ net taxes +import expenditure
Saving is the difference between Yd and consumption. Generally,
this is deposited at banks. Net saving is the difference between
savings deposited at banks and any borrowing made there from.
Net taxes is the difference between government tax revenue and any
transfer payments made by the government.
Expenditure on imported goods is another form of leakages from the
circular flow of income.
 Leakages and Injections in
Multiplier
Types of Leakages (Withdrawals)
economic model
Two sector S, (Net savings)
Three sector S+T (Net savings, Net
Four Sector taxes)
S+T+M (Net savings, Net
taxes, Imports)
In addition, leakages can also result in from debt
conciliation, price inflation, hoarding, and purchase of
stocks and securities.
 Leakages and Injections in Multiplier

Injections:
Injections are the sources of demand for goods and
services other than consumer demand.
In two sector model, the sources of AD are C and I.
In three sector model, the sources of AD are
C+I+G. And in open economy, the components of
AD are C+I+G+X.
 Leakages and Injections in
Multiplier
Types of Injections
Economic models
Two sector Investment (I)
Three sector Investment, government
spending (I+G)
Four sector Investment, government
spending, Exports (I+G+X)
 Investment
Investment is the spending devoted to increasing or
maintaining the stock of capital. Investment demand can
be disaggregated into: business fixed investment,
residential investment, and inventory investment.
Investment is a flow variable and its counterpart stock
variable is capital.
Capital
Produced, durable, used for further production
Examples: tangibles (structures, equipment), intangibles
(software, patents)
Capital stock will increase if there is positive net
investment and vice versa.
 Investment
Capital stock increases if gross investment>depreciation
Capital stock deceases if gross investment<
depreciation.
Basic role of investment in macro
Important for short run because it is a volatile part of
aggregate demand
Recall decline of I in Great Depression
Important for long run because key determinant of growth
of potential output and major way that governments affect
economic growth.
 Investment

Why does investment occur?

When there is a discrepancy between desired stock
of capital (K*) and actual stock of capital (K).
Desired stock of capital refers to the expected
capital stock by the business community in order to
conduct their business. Actual capital stock implies
the existing stock of capital at any point in time.
Investment occurs in order to bridge the gap
between the desired stock of capital and the actual
stock of capital.
 Investment

Determinants of investment demand

Expectations: desired investment is primarily driven by expectations
of future profit and sales. Investment takes place when expected return
exceeds the expected cost of capital. Expectations depend on several
factors:
1. Degree of confidence in the future course of economic events: Business
cycle expectations are important in this regard.
2. Government spending and tax policies: Favorable expenditure and tax
policy having lower rates and wider base helps to increase the incentive to
invest.
3. Behavior of input and output prices: Increase in input prices without any
rise on output prices may lower the expectations. Increasing prices of
output relative to the input prices increase expectations. For example, if
wage rate is increasing without increase in the labor productivity.
4. Political situation
 Investment

Determinants of investment demand

Interest rates:
An increase in the real interest rate raises the cost of capital and
discourages investment demand. However, a decline in the real interest
rate reduces the cost of capital and stimulates the investment demand.
This implies that there exists an inverse relationship between interest
rate and the investment demand. This is what suggested by the
classical view of the investment demand curve (function).
The Keynesian view, however, is different. According to Keynes, role
of expectations is important. Even if there is no change in interest rate,
investment demand can stimulate if there are high expectations about
the business. And even at a lower level of interest rate if expectations
worsen, investment demand curve may shift to the left.
 Investment

Determinants of investment demand

Change in the output level:
During recovery, investment rises very rapidly.
When economic growth rate slows down,
investment demand falls dramatically. The idea is
that there is a positive relationship between
investment demand and the change in output
level (national income).
This relationship is also explained by the
accelerator theory.
 Investment

Determinants of investment demand

Level of income (output):
Profit is the pivot around which investment
revolves. And profit depends upon the level of
income. Therefore, it is argued that, investment
could be the function of income:
I=I (Y)
1>I(Y)>0, when income level increases,
investment also increases but less than the
increase in income level.
 Investment

Determinants of investment demand

Marginal Efficiency of Capital (MEC):
According to Keynes, MEC is the major determinant of
investment. Keynes says, MEC as being equal to that
rate of discount which would make the present value of
the series of annuities given by the returns expected from
the capital asset during its life just equal to its supply
price.
The idea is MEC is that rate of discount which would
make the present value of the expected net returns from
the capital goods just equal to its supply price
(considering the supply price as constant over the years).
 Investment

Determinants of investment demand

Marginal Efficiency of Capital (MEC):
MEC of capital is also called the Internal Rate of Return.
Cost=R1/(1+r)+R2/ (1+r)2+Rn/(1+r)n
Where, Cost is the supply price of investment, R1 is the expected
return from investment in year 1 and so on, r is the MEC, and n is the
number of periods.
If we sum the right side of the equation, we will get the present value
(PV) of all future returns.
If cost<PV of future returns, investment is made.
If cost>PV of future returns, investment is not made.
If MEC is higher than market rate of interest, investment is profitable.
If MEC is lower than market rate of interest, investment is unprofitable.
 Investment
MEC schedule:

Investme MEC Supply Cumulativ

nt project price e supply
(Cost) price
A 15% 1000 1000
B 12% 1200 2200
C 10% 900 3100
D 9% 400 3500
 Investment
MEC schedule:

If the market rate of interest is 10%, projects A,B,

and C could be undertaken depending upon the
availability of the fund. Project D can not be
undertaken since its MEC is less than the market rate
of interest.
This is also shown in the graph in the next slide.
 Investment
Investment Demand Curve:
MEC
15%
MEC=r

10%

MEC
1000 3100 Investment
 Investment
Investment function:
The aggregate investment function can be expressed as: I= I
(Y, r). This implies that I changes either due to the change in
Y or due to the change in r.
The classical case: Investment is the function of the interest
rate. I=I (r). When r increases, I declines and vice versa.
The Keynesian case: Investment demand is better explained
by the expected reruns from the investment projects under
consideration. As already discussed in the MEC section,
investment decision is based on: the expected flow of income
from the investment projects, the purchase price of the capital
good, and the market rate of interest.
 Investment
- Accelerator Theory
Accelerator theory: Oldest and simplest theory, states that
investment is a function of change in output. Investment
demand is proportional to the change in output. The term
accelerator refers that a relatively modest rise in national
income can cause much larger increase in investment
demand.
- Here, the idea is there is a target capital-output ratio, K* =
v Y. Where, K* is desired capital stock, v is capital output
ratio and Y is output.
 Investment
-
Accelerator Theory
- I* = K* + K = v Y + K.
- Where, I* is desired investment, K is capital stock, Y is
the acceleration of production, and = depreciation rate.
- The actual investment might differ from the desired, but
this is a simple and useful model. It shows why there is a
close relationship between investment and output change.
- This model is little used now because it assumes a fixed v.
Modern I theory assumes v depends upon financial
conditions.
 Investment
-
Accelerator Theory
Denoting current change in output by Yt, and change in
output in the past year by Yt-1 the accelerator theory
asserts that:
Investment will increase when the growth of national
income/output is rising. If Yt> Yt-1 , investment
increases.
Investment will be constant even if national income is
growing, when the increase in income this year is the same
as last year, i.e. Yt= Yt-1, investment remains the same.
If the growth rate of income/output is slowing down,
investment will fall even if national income is still
growing, i.e. if Yt< Yt-1 , investment declines.
 Investment
- Summary of investment theory
1. The major components of investment are residential,
business plant and equipment, software, and inventories.
2. These are among the most volatile components of output
in the short run.
3. In equilibrium, demand for capital determined where the
rental cost of capital equals the marginal productivity of
capital.
 Investment
- Summary of investment theory
4. The major theories are the accelerator theory, the
neoclassical theory, and the Q theory. We have not discussed
the latter two. These apply differently in different sectors.
5. Economic policy affects investment through both monetary
and fiscal policy:
monetary policy through r
fiscal policy through things like depreciation policy and
investment tax credits.
 Methods of measuring national income
Calculating National Income
There are various methods for calculating the national income such as production
method, income method, expenditure method etc.
Income Method: Different factors of production are paid for their productive services
rendered to an organization. The various incomes that are included in these methods
are wages, income of self-employed, interest, profit, dividend, rents, and surplus of
public sector and net flow of income from abroad.
Expenditure Method:The various sectors the household sector, the government sector,
the business sector, either spend their income on consumer goods and services or they
save a part of their income. These can be categorized as private consumption
expenditure, private investment, public consumption, public investment etc. as shown
in the above table.
Product Method:The production method gives us national income or national product
based on the final value of the produce and the origin of the produce in terms of the
industry.
 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 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:

unclear distinction between a final and an
intermediate product.
Not Applicable to Tertiary Sector:
This method is useful only when output can be
measured in physical terms
Exclusion of Non Marketed Products
E.g. outcome of hobby or self consumption
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.
GNI = Rent + Wage + Interest +Profit + Net Income from Abroad-
Transfer payments
 Limitations of Income Method

Exclusion of non monetary income: Ignores the non-

monetized 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. mothers 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 years
national income.
Components of Expenditure:
personal consumption expenditure
net domestic 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 countrys
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
National Income estimates are 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.
Percapita income indicates the standard of living of people
 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.
Lack of Conceptual Clarity
Unpaid Services are excluded from National Income Computation
Existence of Parallel economy due to red-tapism and corruption
leads to lack of accuracy in NI estimates.
Money Supply and Inflation
 Money
Money does not have any inherent value
It is valuable because it is:
Medium of Exchange:
the most convenient medium of exchange.
all the things which have utility are available in exchange for money.
Under barter system where goods (or services) are exchanged for
goods (or services) dual coincidence of wants is the basis for exchange.
Measure of Value:
Provides a common denominator to all types of goods and services.
Store of Value:
Can be saved for future with convenience, whereas other goods can be
saved for a limited time period only.
 Demand for Money

Keynes has identified three motives to hold money

Transaction Motive:
Consumers need money to meet their day to day needs,
producers need money to make investments.
Precautionary Motive:
To cover for unforeseen events such as sickness, accidents and losses, money
is kept as precaution for contingency.
Speculative Motive:
For making gains from speculation on future value of bonds and securities.
Money may be demanded as a flow (transaction motive) as well
as a stock (precautionary motive).
Money as a flow is that which is in circulation.
Total money supply at any point of time consists of money in
circulation as well as in stock (in various forms of savings and
deposits).
 Supply of Money
Earlier money was in the form of coins, composed of gold,
silver and copper ,etc. Value of the coins was based on the value
of the metals they contained.
The gold standard broke down in 1930 in UK, in USA it lasted
till 1971
A currency issued by the government is called a fiduciary issue
(based on trust and confidence).
Modern form of money is simply pieces of paper or numbers in
a ledger.
System of paper money was introduced based on the gold
standard or silver standard or some combination of the two, to
ensure peoples faith in the system.
 Quantity Theory of Money
Fisher : Value of money varies inversely with its quantity
Any given percentage increase (or decrease) in the quantity of money will lead
to the same percentage decrease (or increase) in the general price level.
MV=P
P= MV/T
where P is general price level,
T is transaction volume of goods and services,
M is supply of currency and
V is velocity with which money circulates
All money in circulation includes currency and credit.

P= MV+ MV/T
where M is credit money (like cheques) and V is the velocity of credit money.

If T and V remain constant in the short run; P changes by the same proportion
as change in money supply.
 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: measure of the total inflation within an economy
affected by the areas of the market which may experience sudden
inflationary spikes such as food or energy.
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.
Disinflation: a process of keeping a check on price rise by deliberate
attempts.
Deflation: a state when prices fall persistently; just opposite to inflation
Inflationary Gap (Keynes): Excess of anticipated expenditure over available
output at base price
When money income exceeds the supply of goods and services, a gap is
created between demand and supply resulting in inflation.
 Wage Price Spiral

Wages chase prices and prices chase wages, thus create a

wage price spiral.
When prices rise, workers
demand higher money (or
nominal) wages to protect their Prices Rise
real wages. This raises the
costs faced by their employers.
Cost of
To protect the real value of production rises
profits producers pass the Cost of
higher costs onto consumers in living rises
the form of higher prices.
Wages rise
Workers (who are also
consumers demand for higher
money wages.
 Causes of Inflation
Demand Pull Inflation: when aggregate demand increases due to any
reason, and supply of output is unable to match this increased demand; i.e
demand pulls prices up.
Increase in money supply/ Increase in disposable income
Increase in aggregate spending
Increase in population of the country
Cost Push Inflation: An increase in price of any of the inputs will
increase the cost of production; i.e. prices pushed up by cost.
Low Increase in Supply: if supply falls short of demand, prices will
increase.
Obsolete technology/Deficient machinery
Scarcity of resources
Natural calamities/ Industrial disputes/ external aggressions
Built in Inflation: Built in inflation is a type of inflation that has resulted
from past events and persists in the present.
It is also known as hangover 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.
 Measuring Inflation
A price index is a numerical measure designed to compare how the prices of
some class of goods and/or services, taken as a whole, differ between time
periods or geographical locations. (prices of the base year are assumed to be
equal to 100.)

Current Year' s Price

Price Index = 100
Base Year' s Price
The most common term used to denote inflation is inflation rate, which is annual
rate of increase of prices.

Last year's Index - Current Year' s Index

Inflation Rate 100
Current Year' s Index
 Measuring Inflation
Producer Price Index (PPI): measures average changes in prices
received by domestic producers for their output.
Wholesale Price Index (WPI): measures wholesale prices of a wide
variety of goods (including consumer and capital goods.
USA has replaced WPI with PPI
Consumer Price Index (CPI): measures the price of a selection of goods
purchased by a typical consumer.
CPI differs from PPI in that price subsidy, profits, and taxes may cause the
amount received by the producer to differ from what the consumer paid.
Cost of Living Indices (COLI): used to adjust fixed incomes and
contractual incomes to maintain the real value of such incomes.
wage indexation is based on such indices.
Service Price Index (SPI): With the growing importance of service
sector across the world, many countries have started developing services
price indices (SPI).
 Inflation and Employment
A. W. H. Philips studied the relationship between
unemployment and rate of changes in money wages in UK,
taking statistics for a period from 1862 to 1957.
Philips postulated that the lower the rate of unemployment,
the higher is the rate of change of wages.
labours accept jobs at lower pay if they are unemployed and firms
are more willing to hire due to low wages.
But this effect dissipates as inflation becomes more expected with
workers demanding higher wages and firms being less willing to hire.
the objectives of low unemployment and low rate of inflation may be
inconsistent.
Hence the government must choose between the feasible
combinations of unemployment and inflation.
 Philips Curve
P/P W/W

8 10
8
Annual 6
Price Philips Annual
Rise % 4 6 Wage
curve
2 4 Rise %
O
2 4 6 8 2
1

Unemploy
ment %
Demand pull inflation refers to the effects of falling unemployment rates
(rising real national income) in the curve.
Cost push inflation and built in inflation will lead to shifts in the Phillips
curve.
 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 discount rate: The central bank
rediscounts the eligible papers offered by commercial
banks. This is also called bank 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: discourages consumption but
not investment
 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
 Money supply aggregates in India
RBI calculates various concepts of money supply which are known as money
supply aggregates or measures of monetary aggregates.
M1: Currency with public, i.e. coins and notes + demand deposits of public with
banks. (very liquid assets)
It is also known as Narrow Money
M2: M1 + Post office savings deposits
M3: M2 + Time deposits of the public with banks+ Other deposits with RBI
It is also known as Broad Money.
M4: M3 + All other deposits with Post office
M0: Currency in circulation+ Bankers deposits with RBI+ Other deposits with
RBI.
It is also called Reserve Money.

Now RBI calculates only three of the above measures, i.e. M0, M1, and M3.