LECTURE NOTES I
THE REAL SECTOR OF THE ECONOMY
Chapters 5, 6, 7,8,9,10 of Waud
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CHAPTER 5
NATIONAL INCOME
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This can be considered from two sides: receipt of
income and its expenditure.
----------------------------------------------------------PART I: RECEIPTS SIDE
----------------------------------------------------------National income is a stock concept. It is taken as the
total income over a period of one year. This is an
accounting procedure for national income.
I.A. CONCEPTS TAKEN AT MARKET PRICE/ MARKET VALUE
GDP/ GNP/ NDP/ NNP are always taken at market price,
i.e., the market value, unless stated otherwise.
1.
Domestic income:
Domestic Income =
+
+
+
+
+
+
Wages and salaries
rents
interest
dividends
undistributed profits
(including depreciation or
CCA)
mixed incomes
direct taxes
Domestic income is known as GDP. Nothing is counted
twice. Therefore, only goods and services bought for final
use
are
considered;
i.e.,
no
unfinished
goods
are
considered.
2.
National Income or GNP/ GNE/ GNI/ Y:
National Income =
Domestic Income
+ net asset income earned from abroad
GNP
=
GNI
GNE
=
=
unduplicated (final) value of the flow of goods
and services produced by a nation annually.
Gross national income
Gross national expenditure
Note: GNP = GNI = GNE = Y
GNP is usually denoted by Y, the national income, and
is used in Keynesian economics
GNP = GDP +
net property income from abroad (X-M)
where E = exports, M = imports
=> GNP
= GDP + (E - M)
= GDP + X
where X is net exports
NOTE: GNP > GDP
We do a detailed breakup of Y later on.
3.
Net increase in capital stock:
Depreciation
goes
towards
replacing
old
stock.
Therefore, by removing depreciation from GDP/NDP, we get
the new buildup of new capital stock. Of course, to this is
added the total output of consumer goods in the year, etc.
Therefore,
NDP is GDP less depreciation.
NNP is GNP less the depreciation.
Further, NNP = NDP + (E - M)
4.
Net Disposable income NDI
If net income paid overseas is subtracted from GNP,
then that gives the net income available to the nation,
including depreciation, i.e.,
NDI = GNP - net disposable income.
5.
National income NI
Out of the NNP, the amount of income received by the
country's residents is the national income. This is
calculated by removing net income paid overseas from NNP.
NI = NNP - net income paid overseas.
6.
Personal income PI, or Household income HI:
If we subtract undistributed profits from NI, then we
are left with the income which normal residents receive.
7.
PDI Personal disposable income: or HDI:
If we subtract the personal taxes from PI, we are left
with PDI.
I. B. CONCEPTS TAKEN AT FACTOR COST
Not all the market value of goods and services is
received by factors of production. Some is paid to
government in indirect taxes. At the same time, some
subsidies are received from government. E.g., out of our
personal income, we pay sales tax, and receive the benefits
of subsidised public transportation system. Hence we have
actually received Wages - indirect taxes + subsidies. This
is what a factor receives, leading to a series of concepts
"at factor cost".
1.
GDP at factor cost
=
+
2.
GNP at factor cost
=
+
3.
GNP at market prices
indirect taxes
subsidies
NDP at factor cost
=
4.
GDP at market prices
indirect taxes
subsidies
GDP at factor cost
NNP at factor cost:
-
depreciation
=
GNP at factor cost
-
depreciation
----------------------------------------------------------PART II: EXPENDITURE SIDE
----------------------------------------------------------Here we consider how the money which is received is
spent. The money spent/ saved must be equal to the money
received. Therefore, from either side, national income must
be the same. Let C= consumption, I= investment.
1.
Two sector economy:
Here, there is no government. Only the producers and
consumers. Therefore, consumers consume C (and save
S),
and
this
goes
towards
new
investment.
Simultaneously, producers (use the savings S to)
invest I.
Y = C + I
- (1)
Further, if S is savings, then,
I = S
This is obvious, since producers can only invest what
all the consumers save. However, there is a simple
proof:
Now, Income = expenditure on goods and services
+ savings (in all three sectors:
government, business and household)
Therefore, Y = C + S
Equating, (1) and (2)
C+I = C+S
or,
2.
I = S
Three sector economy:
-(2)
Here there is government, in addition to producers and
consumers. Let G = government spending. Therefore,
Y = C + I + G
Let T be the taxes. Then,
I + G = S + T
i.e., the total money available in economy for
investment purposes, plus government spending, comes
from savings and taxes. Usually, I = S and G = T.
3.
Four sector economy:
Here, there is interaction with the rest of the world
in addition. Let E= exports, M= imports, then:
Y = C + I + G + (E-M)
or, Y = C + I + G + X
Further, (think a bit)
I + C + E = S + T + M
NOTE: many books use X instead of E to represent exports.
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CHAPTER 7
AGGREGATE DEMAND AND SUPPLY
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Now we look at the economy. THIS IS THE BEGINNING OF
MACROECONOMICS (till now we were just accountants)
AGGREGATE DEMAND
The Aggregate Demand curve (AD) represents what all
the entities in the economy - consumers, businesses,
foreigners, and governments - would buy at different
aggregate price levels. Thus it shows the relationship
between the economy's total demand for output and the price
level of that output.
It measures the total demand in the economy for goods
and services. Who demands?
a)
b)
c)
d)
e)
consumers demand to consume, i.e., C
producers demand to invest, i.e., I
government demands to spend, i.e., G
exporters demand to export, i.e., X
importers demand to import, i.e., M
Therefore,
Aggregate demand D = C + I + G + X-M
Obviously, D will depend on the wealth of a country. If a
country is rich, it will demand more goods and services,
than if it is poor. In other words, consumption C will be
higher. Wealth is a "real balance" and this effect is known
as the real balance effect. Further, it will depend on the
price of money, i.e., the interest rate. If the interest
rate is low, there will be a greater demand for investment
I. Finally there is foreign purchases effect. If the price
level declines, then the domestic goods are cheaper, and
there is a demand for exports X. If the price level is
high, then foreign goods are cheaper and there is a demand
for imports M. It is assumed that the demand for government
spending G, will remain constant, irrespective of the price
level.
The "demanders" keep demanding. But how much can they
demand? Obviously the demanders are limited by the size of
the national income. Indians cannot demand imports beyond
what they can afford; similarly they cannot demand to
consume more than their income, and they cannot demand to
invest more than the money they have. They cannot also
demand to export more than what the foreigners want.
The demanders will keep demanding till the limit is
reached,
i.e.,
there
is
equilibrium.
Therefore,
in
equilibrium,
D
=
Y
In equilibrium, Demand = Income
(I)
AGGREGATE SUPPLY
Now we come to the output or the supply. The demanders
keep on demanding what they want. But obviously, the
economy may not be able to fulfil the demand. Consumers may
not be willing to save the money required by producers to
invest, exporters may not wish to export what foreign
purchasers want to purchase, etc.
The aggregate supply curve (AS) represents the
relationship between the prices businesses will charge and
the volume of output they produce and sell.
The businesses cannot supply less goods than what is
demanded, for that will lead to unused capacity. They will
therefore supply more even at the given price level, since
they have unused capacity. Therefore real output keeps on
increasing at a given price level until the existing
capacity is fully utilised (Keynesian range).
Further, if there is still some unfulfilled demand,
then the suppliers can expand their capacity, but they will
demand a higher price. Therefore, at this point the price
increases, and output also increases. We assume that this
is possible because there is still some unemployed people
who can be used to produce these goods. (Intermediate
range)
However, if there is still unfulfilled demand, then
there is a problem. The producers cannot produce more than
their maximum capacity (which includes fully employing all
possible workers). At this point, it is not possible to
supply further, no matter what the demand. The only effect
of the demand is that the prices start rising (wages rise
first, as there is a competition for workers). At this
point the ratchet effect comes into force: nominal wages
rise but tend not to fall. (Classical range)
A very important Keynesian assumption is that prices
tend to rise, but not fall. Upto the point of full
employment, all increases in nominal income occur because
real income rises, i.e., prices are constant. Beyond the
point of full employment, all increases in nominal income
occur because prices rise, i.e., real income remains
constant. This has been modified by modern Keynesians,
through the Philips curve. The curve measures unemployment
against the rate of change in prices (or, inflation). The
curve shows that at lower levels of unemployment there is
more inflation, and this inflation is reduced at higher
levels of unemployment.
Aggregate supply depends on:
*
potential output
*
wage-price behaviour
EQUILIBRIUM
At the equilibrium, of course a nation can produce
only that output which is demanded.
Therefore, Demand = Output
(II)
FUNDAMENTAL IDENTITY OF MACROECONOMICS
From (I) and (II), we see that
Demand = Income = Output
This is the fundamental identity of MACROECONOMICS:
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CHAPTER 8
CLASSICAL AND KEYNISIAN THEORIES
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TOPIC I: AGGREGATE DEMAND AND SUPPLY
See Waud: 194, Fig. 8.2
I.SUPPLY SIDE ANALYSIS BY CLASSICALS:
Assumption:
Prices and wages are flexible. Classicals think that
prices react instantaneously and Say's law holds (i.e., all
markets clear and there is no excess of supply of goods and
services).
Key factor in eqbm: Interest rate:
Further, the interest rate is flexible and ensures
that savings equal investment. If the savings are less than
the demand for investment, then the interest rate rises and
people have an incentive to save more. Obviously, interest
rate will rise only till the point at which it becomes
uneconomical for business to pay more for money. If they
can get 16% return from business, they will not borrow at
17%.
Full employment:
According to the classicals, the wages also adjust
instantaneously, and this leads to full employment at all
levels of price. In fact, they assume full employment.
Equilibrium:
The classical supply curve is vertical. If the
aggregate demand falls, then the prices fall, but the total
output and employment remains the same.
Effect of macroeconomic policy:
Nil. Macroeconomic policy cannot affect the level of
unemployment and output.
II. DEMAND SIDE ANALYSIS BY KEYNESIANS:
Assumption:
Prices and wages are sticky. According to Keynes, Says
law is true of a barter economy, but not for an economy in
which individuals can hold financial assets such as bonds
and money.
Key factor in eqbm: Disposable income (Income-expenditure
approach):
According to Keynes, it is disposable income and not
interest that determines savings. It is therefore the
aggregate demand that determines employment. Hence this is
called the demand side analysis of the economy.
Effect of macroeconomic policy:
Government can stimulate the economy toward high
employment, by increasing aggregate demand.
TOPIC II: DETERMINING THE EQUILIBRIUM INCOME
A. INCOME EXPENDITURE APPROACH TO EQULIBRIUM
Fundamental identity:
Savings + consumption = disposable income
Consumption function:
According to Keynes, consumption is a function of
income (sounds obvious). Therefore,
C = a + bY,
where b = the marginal propensity to consume MPC,
i.e., the fraction of any change in GNP that
is consumed. This is given by the slope of
the consumption schedule
i.e.,
C = C (Y)
Savings function:
The savings function relates savings to disposable
income. The savings and consumption functions are mirror
images since MPS = 1- MPC
Determinants of consumption (and therefore, savings)
*
disposable income (current year's income)
*
permanent income (long-term income)
*
wealth
*
other influences
*
credit conditions
*
expectations about employment prices and income.
Determinants of investment:
*
overall level of output (GNP)
*
costs
*
expectations
*
the interest rate
*
technological change and new products
Keynesian Cross diagram:
A diagram showing the aggregate desired expenditure
schedule and a 45 degree line showing equilibrium between
desired expenditures and income at each level of income.
Determination of equilibrium:
This is when E = C + I where E = expenditure
At this point, the expenditure line crosses 45
degrees, and equilibrium income is obtainted.
At equilibrium, S = I
see Waud, diag. on p.206
Multiplier model:
v. good diagram: Waud/246
The multiplier M in the economy is equal to:
1
--MPS
i.e.,
=
1
----1-MPC
Change in output = 1/MPS x change in investment
This arises due to the chain of spending. When savings are
low, i.e., MPS is low, then the multiplier is high. Income
which goes into the economy rebounds from one person to the
other, as it were, and each time generates more income.
This is the paradox of thrift.
Paradox of thrift:
What is true of the part may not be true of the
whole (fallacy of composition). An example is the
paradox of thrift, where the more you save,
beyond a point, the lower the income falls.
Keynes therefore showed that savings is not
necessarily a good thing for an economy. On the other hand,
we must understand that S = I, and therefore, new
investment is closely linked to savings. Therefore, low
savings are required to achieve current increase in output
and therefore, full employment, but high savings are
required to achieve long term increase in output.