National Income and related aggregates

+ U N I T - I I N I R ATIONAL NCOME AND ELATED A : B C GGREGATES ASIC ONCEPTS M AND EASUREMENT + + + 2 C HAPTER (cid:1) (cid:7) (cid:7) (cid:7)(cid:11) (cid:7)(cid:6) (cid:7)(cid:15) (cid:2)(cid:3)(cid:4)(cid:5)(cid:2)(cid:4)(cid:3)(cid:6) (cid:8)(cid:9) (cid:2)(cid:10)(cid:6) (cid:12)(cid:5)(cid:3)(cid:8) (cid:5)(cid:8)(cid:13)(cid:8)(cid:11)(cid:14) (cid:5) (cid:7) (cid:7) (cid:7)(cid:13) (cid:7)(cid:16) (cid:16)(cid:3)(cid:5)(cid:4)(cid:17)(cid:12)(cid:3) (cid:9)(cid:17)(cid:8)(cid:18) (cid:8)(cid:9) (cid:12)(cid:2)(cid:16)(cid:8)(cid:13)(cid:12)(cid:17) (cid:13)(cid:5)(cid:8)(cid:11)(cid:6) Macroeconomics, as pointed out earlier, investment and tax payments are all deals with the study of aggregates made by the unit after an analysis of expressed in terms of aggregate income, the accounting information available output, employment, expenditure, to it. exports and imports and so on. In order At the macro level, accounting to determine the actual performance assumes an even greater significance as level of the economy, we need to follow the information is used for a review of a framework of measurement the economy’s performance during the procedures to find these aggregates and year under study. On the basis of this eventually we must interpret the appraisal national governments have to macroeconomic behaviour in terms of formulate their policy programmes to movements in these aggregate maximize the welfare of people. This is measures. National income accounting the basic purpose of national income facilitates the measurement of macro accounting as it renders possible a set aggregates for a given economy. of procedures for measurement of Accounting is believed to be a income and output at the aggregate necessary exercise for any economic level. This means that we are, in fact, unit to know its performance. An measuring the macroeconomic activities individual unit such as a Household or in the economy for a particular year. a Firm maintains its own accounting Accounting for transactions by information since it is interested to individual units is relatively a less know its financial position at the end of complicated and a simple process as an accounting period.1 Important compared to macro economic decisions concerning savings, accounting of aggregate output and 1 An accounting period or a financial year often does not coincide with a calendar year. Ordinarily, a financial year refers to, for example, April 1, 2004 to March 31, 2005. + + 8 INTRODUCTORY MACROECONOMICS income for the economy as a whole. It is 3. National income accounting helps a rather difficult and complex procedure to find out structural changes in the to quantify the macro variables for economy. accounting purpose. It is not adequate 4. National income accounting to merely look at the macroeconomic provides the information for aggregates but it is also equally assessment of the economy’s important to learn the techniques of strengths and failures. measuring these aggregates. Therefore, 5. National income statistics enable national income accounting has evolved comparisons to be made in respect as a branch of study in its own right. of standard of living, distribution of Primarily, there are two basic income and actual composition of functions of national income accounting: national income over time. the first, is to identify specific economic achievements of a country and the 6. National income accounts facilitates second, is to provide an objective basis comparison of output among of evaluation and review of policies nations. under implementation. Hence, national Hence, the national income data may income accounts data not only help us be viewed as a monetary manifestation to measure macroeconomic aggregates of material results of human activity in but also enable us to understand, the economy. They provide standards by analyse and interpret the working of the which economic achievement of policies economy as well. This is precisely the could be partly judged in modern times. reason why the road map to the subject of macroeconomics begin with a study Structure of the Macro Economy of national income accounting. Circular flow2 of macroeconomic Uses of National Income Accounting activity There are some principal uses of National income accounting calls for an national income accounting. They may understanding of the structure of the be stated as follows: macro economy. The conceptual basis 1. National income accounting shows of measurement of national income as to how the national income is begins with a depiction of the inter- shared among the various factors related manner in which economic of production; activities are organised in an economy. 2. National income statistics indicate A pictorial illustration of this inter- the specific contributions of dependence between the major sectors individual sectors and their growth of economic activity is called the circular over time; flow of income and product. This 2 Flow refers to change in an economic variable over time. Income and product are flow concepts. This may be distinguished from stock variable which means that there is no change over time. For example, wealth is a stock concept. STRUCTURE OF THE MACRO ECONOMY AND NATIONAL INCOME ACCOUNTING 9 simply means that every economic (b) Goods and services3 flow in one decision of a sector is in response to that direction and money payments to of another. Therefore, macro economy acquire these, flow in the return is in effect a system of interrelationships direction, thereby causing a circular between the decision-makers in every flow. So, the output or product or sector of the economy. real flow from the seller to the buyer The circular flow of income involves necessarily creates the income or two basic principles: payment or money flow from the buyer to the seller. (a) In any exchange process, the seller or producer receives the same We shall now explain this two-way amount that the buyer or consumer process of mutual dependence for spends; and different sectors of the economy. This Clip 2.1 Circular Flow of Income and Product The inspiration for the exposition of macro economy through a Circular Flow of Income and Product appears to have originated from the writings of Physiocrats – a group of French economists who lived in 18th century. Physiocrats strongly believed in the existence of a natural order to guide the working of the economy and hence according to them, there should not be any kind of intervention by the Government in economic activities. They advocated the policy of Laissez faire which means non-interference or minimal interference of the governments in trade and other economic activities and accorded primacy to agriculture as such. Prominent among the Physiocrats was Francois Quesnay who propounded what is called the ‘Tableau Economique’ in 1758. This economic table contains the concept of circulation of wealth and a schematic presentation of the distribution of agricultural output between all classes of society. Though this economic table was recognised as the ‘crowning achievement’ of Physiocrats, this table was not explained by Adam Smith or those belonging to the classical school of economics. It was Karl Marx who rediscovered this table in the mid-19th century. 3 A good is a tangible object (such as a can of fruit juice or a television) that has economic value. A service, on the contrary, is an intangible product (such as advertising) that has economic value. 10 INTRODUCTORY MACROECONOMICS would be a helpful pre-requisite to (i) Household sector has the understand the concepts used in the endowment of factors of production accounting of national income as such. (land, labour, capital and entrepreneurial ability) and sell Circular Flow in a Simple Two-sector them to the Firms that produce Model goods and services, using these To begin with, let us make the following factor inputs. The Firms, in turn, sell assumptions with regard to a simple goods and services thus produced4 economy with only two sectors of to the Household sector for its economic activity. consumption. Therefore, whatever – There are only two sectors in the the Firms produce, is consumed by economy, namely, Households and the Households. Firms. This type of interaction – Households supply factor services between Firms and Households to Firms. can be described as the real flows, – Firms hire factor services from as it involves flow of goods and households. services. – Households spend their entire (ii) Exchange of goods and services income on consumption. between Households and Firms in response to acquiring factor services – Firms sell all that is produced to the from Households corresponds to Households. flows of income and expenditure of – There is no intervention of these two sectors. That is, Firms pay government or foreign trade. the Households in the nature of Such an economy as described above wages for labour services, interest has two types of markets. First, market for capital, rent for land and profits for goods and services – Product to entrepreneurship. These are market; and second, market for factors called factor payments by Firms of production – Factor market. and factor incomes by Households. The economic interdependence This income, in turn, is used by between Households and Firms in this Households to incur expenditure on simple economy can be observed as buying consumer goods and follows: services produced by firms. 4 Firms may produce either producer goods (capital goods used for making other goods) or consumer goods that is, goods meant for only consumption as such. Consumer goods can further be classified into ‘durable’ and ‘non-durable’ variety depending upon whether they have short or long span of life in their use to the consumers. A washing machine or an air-conditioner may be called durable good while food items will fall under the category of non-durable or perishable good, as they do not last long. STRUCTURE OF THE MACRO ECONOMY AND NATIONAL INCOME ACCOUNTING 11 This flow of money payments 2. Factor Payments by Firms = and expenditure can be described as Factor Incomes of Household money flows. Sector So, in the circular flow diagram 3. Consumption expenditure of (Fig. 2.1), we can recognise two real Household sector = Income of Firm flows and two money flows. sector As a result we can derive the following, in the case of our simple economy: 4. Hence, Real flows of production and 1. Total production of goods and consumption of Firms and services by firms = Total Households = Money flows of consumption of goods and services income and expenditure of Firms by Household Sector and Households PRODUCT MARKET u e of o utpu F t in = a E lg x o p o e d n s di a t n u d re s o e n rv f i i c n e a s lgood s a n d V al s e r e y v ic n e o s M Firms Households F p a hi c to r T S ot e a rv l i i c n e c s o : m la e n = d, re la n b t o + u w r, a c g a e p s+ it i a n l, te e r n e t s r t e + p p re r n o e fi u ts r s FACTOR MARKET Fig 2.1: The Circular Flow of Income in a Two-sector Economy 12 INTRODUCTORY MACROECONOMICS This simple circular flow highlights Households and Firms can lend and the following interrelationships between: from which they can borrow would – Factor Market and Product Market become relevant. – Output flow and Income flow Households are the net lenders. – Business production and This is possible due to generation of Consumer spending personal savings, which is the difference Each sector is seen in its dual role: between household income and that of the buyer and seller. This consumption. Firms are net borrowers perpetuates the circular flow between since they have to finance new the two sectors. investment in plant and equipment. All Circular Flow of Income with lendings and borrowings are Financial System channelled through the financial system. So long as lending is equal to A wide variety of financial institutions the borrowing, that is, leakage is equal and markets constitute the financial system5 in our economy. Financial to the injection, the circular flow will institutions are primarily intermediaries continue indefinitely (Fig.2.2). between savers and investors, or lenders Financial institutions pay interest to and borrowers. They are specialise in the savers as their funds are placed with their respective areas of financial them for a period of time under a function. Development economists point contract. Firms pay dividend and out the significance of financial interest for the sums they have borrowed development of an economy as a from the financial markets in the form of concomitant outcome of economic shares, bonds and public deposits. development. Therefore, understanding Financial institutions, through their role the macroeconomic activity will be of intermediation, enable funds transfer incomplete without the inclusion from ultimate lenders to ultimate of financial system in our circular borrowers. Saving and investment flow model. process create better prospects for capital So far, in our presentation of circular formation, thanks to the operations of flow of income, we have not considered financial institutions and markets. the role of saving and investment. This Financial system is therefore very is mainly due to the reason that we important to the working of the modern have assumed that the two sectors – economy. But it is sometimes believed Households and Firms are balanced that money and finances are only a spenders (that is, they neither have a surplus nor deficit). Once we relax this cover over the production of goods and assumption a financial system to which services. But we cannot dismiss the 5 Here we assume that Households and Firms save part of their income, which constitutes a leakage from the circular flow of income. The saved amount is made available in the financial system. Firms borrow for purposes of investment, which becomes injection into the circular flow. STRUCTURE OF THE MACRO ECONOMY AND NATIONAL INCOME ACCOUNTING 13 PRODUCT MARKET Mo n n a e l y co v n al s u u e m o e f r fi g n o a o l d g s oo a d n s d a s n er d vi s c e e r s vices Fi Savings Savings Financial Firms Households System Borrowings Borrowings FactorServices FactorPayments FACTOR MARKET Fig 2.2: Circular Flow of Income in a Two-sector economy with Financial System funds flow between sectors as inclusion of the Government sector. unimportant. Finance as some Economic interrelationships between economists have held, is only a Households and the Government on the ‘lubricant’ that makes the economy to one hand and Firms and Government work smoothly. on the other are very important from the point of view of the role of Circular Flow of Income with Government as regulator and as an Government6 agent of promoting general welfare of Whatever has been presented in the the people of the country. foregoing section leads us to the All the changes which are conclusion that under the two-sector necessitated by inclusion of Government model, the value of total output flow in sector are shown in Fig. 2.3. In order to our simple economy is equal to the total make the analysis simple, now onwards value of factor incomes and the value we will see only monetary flows. of personal consumption flow. Let us Government purchases goods and now expand the two-sector model and services from Firms and labour services obtain a three-sector model with the from Households. Government collects 6 Government purchases of goods and services are included in the circular flow. Other flows include tax payments by households to government and transfer payments by governments to households. 14 INTRODUCTORY MACROECONOMICS urc hases Gov S e e r c n t m or ent Paym e n G o v e r n m e nt P T a S x u e b s si di e s F a ctor S a v in g s r r o w i n g s Paym T e r n a t n s sfer P a T y m a x e n e t s ts fo r s e r v ic e s o s B Savings Financial Savings Firms Households System Borrowings Borrowings C onsumptionExpenditure Fig 2.3: The Circular Flow of Income in a Three-sector Economy taxes from Households and Firms in is connected with circular flow of order to finance its expenditure. The domestic economy (Fig. 2.4). The government makes transfer payments domestic economy and the rest of the to the Households in the form of social world are connected through security, scholarships, etc. It also gives international trade and capital flows. subsidies to the Firms for various One country’s exports are another purposes. In India, subsidies are given country’s imports. This import and to small industries, export units, and export of goods and services ultimately other priority sectors of our economy.7 decide what the domestic economy Circular Flow of Income with gains or loses in the international trade. External Sector Home economy enjoys a trade surplus We now need to study the international when there is excess of exports over dimension of macroeconomic activity imports; it suffers a trade deficit when because international economic the opposite happens.8 environment affects output and The four-sector model of the employment in the domestic economy. economy demonstrates the overall The external sector is also called the macro economic condition of income Rest of the World (ROW) sector and this and output in the following identity: 7 All taxes are leakages and all government expenditures are injections into the circular flow. 8 Note that imports are leakages and exports are injections into the circular flow of income in the economy. STRUCTURE OF THE MACRO ECONOMY AND NATIONAL INCOME ACCOUNTING 15 G o v e r n m e n T t a S u x P e b u s s r i d ch i e a s F s a e c s tor G S a v i o n g s v S e e r c n t m o B o r r r o w e i n g s nt Paym T e r n a P t n a s s y fe m r e P n a T y a t m s x e e n f s t o s r S e r v ic e s Savings Financial Savings Firms Households Borrowings System Borrowings o r e P a y m e n R t e s c e f ip o t r s I fo m r p E o x r p t e s C rt o s nsum E p S t x i e o t n e c r t E o n xp r a e l nd I I n i n t t u t e r e e r r n n a a t t i I o i n o n c n a o a l m F l a e T c r t ( N a n e s t f ) er I n c o m Fig 2.4 : The Circular Flow of Income in a Four-sector Economy Y ≡≡≡≡≡ C + I + G + (X – M) Producing sectors Wherein G = Government Purchases Y = Income or output X – M = Net exports (Where, X = Exports, C = Private Consumption Expenditure M = Imports) on Consumer goods The science of national income I= Investment expenditure by accounting is based on this identity. SUMMARY (cid:1) Structure of the macro economy is given by the circular flow of income and output. (cid:1) National income accounting has its foundation in the circular flow model. (cid:1) National income accounting has several uses for economic policy and research. (cid:1) Circular flow of income can be depicted in two-sector, three-sector and four-sector models. (cid:1) National income accounting provides the standards by which economic activity of a country could be assessed. 16 INTRODUCTORY MACROECONOMICS EXERCISES 1. What are the uses of national income accounting? 2. What is the principle of circular flow of income and product? 3. Explain the circular flow in two-sector economy. 4. Explain the circular flow in three-sector economy. 5. Explain the circular flow in four-sector economy. 6. With the help of a circular flow model, show that income and product flows are equal. 7. Explain the concepts of ‘leakages’ and ‘injections’ in the circular flow of income.