INCOME DETERMINATION -ratheeshthapasya

CHAPTER 4

INCOME DETERMINATION

v    Ex-ante consumption

v    Ex – ante aggregate demand

v    Determination of equilibrium income

v    Excess demand and excess supply

v    Paradox of thrift

Income Determination

        The classical approach is based on the existence of full employment without inflation.  Full employment is regarded as a normal situation and any deviation from this level is something abnormal which is automatically tends towards full employment. The classical theory believed that whatever is produced will be demanded in the market (Say’s Law of market). Price flexibility, interest rate flexibility and wage rate flexibility will ensure the equilibrium in the economy.

          The classical theory was proved wrong by the Great Depression of 1930’s. Over production, insufficient demand and massive unemployment discredited the classical theory.           Keynes rejected the classical notion of full employment. The effective demand is the basis of Keynesian theory. Effective demand is determined at the point where aggregate demand and aggregate supply are equal. To him, all the problems in the economy are generated due to the deficiency of the effective demand.

One of the most important objectives of Macro economics is the construction of Macro economic models.  Macro economic variables such as savings, investment, consumption etc. can be used under ex-ante and ex-post senses.  The word ex-ante means planned or desired.  In the ex-ante sense the value of these variables means the planned value. Ex-post means realized or actual.  So in the ex-post sense the value of these variables means the realized value of planned economic variables. 

The ex-ante variables are taken to consider for the construction of macro economic models we take in to consideration. In order to predict about the GDP of a country next year, the knowledge about the planned demand and supply of goods and services are essential. So we should study about the ex-ante variables such as consumption, savings, investments etc.

Ex-ante consumption

           People spend a part of their income and save the rest

Y = C + S

Where,        Y - ex-ante income

                   C - ex-ante income

                   S - ex-ante saving

Consumption depends on income. The relationship between income and consumption is known as consumption function.

          C = f(Y)

          The consumption function states that as income increases consumption also increases, but increase in consumption is not proportionate to increase income.  The proportion or percentage of income spent on consumption is called Marginal Propensity to Consume (MPC).

          The ratio between changes in consumption to change in income is known as MPC.

                    MPC =

Where,        Δ C = change in consumption

                    Y = change in income

MPC is denoted by ‘c’. 

People save a portion of their income after consumption. Therefore, if there is an increase in income, saving increases.

          S = Y - C

          When there occurs an increase in income a certain percentage of it is saved.  This proportion is known as Marginal Propensity to Save (MPS).

          The proportion between changes in savings to change in income is known as MPS.

                   MPS =

                   Δ S = change in saving

                    Y = change in income.

The value of MPC and MPS will lie between 0 and 1.

MPC plus MPS is always equal to one

                   MPC + MPC = 1

                   MPC = 1 – MPS

                   MPS = 1 – MPC

          Even when the income is zero, there is a certain amount of subsistence level of consumption. This is known as autonomous consumption. It is denoted by

Therefore the consumption function can be expressed as,

                   C =  + cY

And then saving function will be S=  + (1-c) Y

          Consumption function helps to understand two ratios – Average Propensity to Consume and Average Propensity to Save.

          Average Propensity to Consume (APC) is the ratio between consumption and income. 

APC =  

          Average Propensity to Save (APS) is the ratio between total saving to total income.

                   APS =   

Ex – ante Investment

          Investment is defined as addition to the stock of physical capital and changes in the inventory of firms.

          Investment depends on market rate or interest and marginal efficiency of capital.  Marginal efficiency of capital means the expected rate of return from an additional unit of investment.

          For the simplicity, it is assumed that the firm plans to invest the same amount every year.  Therefore ex-ante investment is taken as 

          I =

Ex-ante aggregate demand

The ex-ante aggregate demand means the expected expenditure of the economy on goods and services in an accounting year. Thus the aggregate demand and total expenditure in the economy are one and the same.

In a four sector economy the components of aggregate demand in the ex-ante sense are

(1) ex-ante private final consumption expenditure

(2) ex-ante private final investment expenditure

(3) ex-ante government expenditure

(4) ex-ante net exports

          In a two sector economy, the ex-ante aggregate for final goods depend on ex ante consumption demand and ex ante investment demand.

                   AD = C + I

                   As C =  + cY ,  and  I =  then

AD = +   + cY

If,    = +  , then Aggregate Demand

          AD =   + cY

Aggregate supply

          Aggregate supply (AS) is gross output in the economy.  This shows total supply of goods and services in an economy.

                   AS = Y

Where, Y is the gross output.

AS curve is a  line with the income.

Determination of Equilibrium income

          An economy will be in equilibrium when aggregate demand and aggregate supply are equal.

          In a two sector model, equilibrium income is

                     =

                =

At equilibrium, Y = AD. E is the equilibrium point and   is the equilibrium income.

Excess demand and excess supply

                  

When income is less the  (suppose Y₁) then aggregate demand for goods and service is greater than the Aggregate supply. This is the case of excess demand. Excess demand leads to fall in inventory.

          When income is greater than   (suppose Y₂), then aggregate supply is greater than aggregate demand. This is the case of supply and leads to increase in inventory.

          The change in equilibrium due to change in autonomous components (autonomous investment)

          Increase in autonomous investment results in the upward shift of aggregate demand curve parallally and attains the new equilibrium point E2. The new equilibrium income is greater than first one.

         

The change in income is greater than change in investment. This is due to the working of multiplier.

           Y = K ×  I

                   K =  

Where, K is the multiplier.

Multiplier Mechanism

          Multiplier has a dominant role in income determination.  An initial increase in investment leads to multiple increases in income is known as multiplier mechanism.

          MPC plays a vital role in increase in the income.  If MPC is high, increase in income is also high.

 =

The change in equilibrium when there is change in MPC

          When MPC increases the aggregate demand curve will shift upwards without changing the vertical intercept.

         

AD₁ is the initial aggregate demand. Y* is the initial equilibrium income.  If MPC increases the AD curve will shift to AD₂. Yi is the new equilibrium income. The equilibrium income will increase.

If MPC decreases the curve will shift downwards without changing the vertical intercept. So equilibrium income will decline.

If MPC increases, equilibrium income will increase. If the MPC decreases equilibrium income will decrease

Paradox of thrift

          If the MPS in an economy has increased, it may not lead to increase in total savings. Instead the total savings may remain constant or may decrease. This tendency is known as paradox of thrift

NATIONAL INCOME ACCOUNTING - ratheeshthapasya

CHAPTER 2

NATIONAL INCOME ACCOUNTING

v    Basic concepts

v    Circular flow of income

v    Methods of calculating National

          Income

v    Some Macro Economic Identities

v    GDP &Welfare

NATIONAL INCOME ACCOUNTING

National income is the total money value of all final goods and services produced in an economy during an accounting year.  National income estimates helps to understand the economic performance of a country.

Basic Concepts

Closed and Open Economies:

A closed economy is one which has no economic relation with the rest of the world.

Open economy is one which has economic relation with the rest of the world. All modern economies are open economies.

In a closed economy GDP and GNP would be the same.

Final goods and intermediate goods

Final good is an item that is meant for final use and do not pass through any more stages of production or transformation.

Intermediate goods are those goods which are used for producing other commodities. They are used as raw materials or inputs.

Consumption goods and capital goods

Final goods can be classified into consumption goods and capital goods.

Consumption goods are directly used for the consumption. They do not undergo any other production process again. They are also called consumer goods.

Consumer goods can be durable or non durables.  Durable goods are those that last long. Examples car, television, computer etc., Consumer non durable goods extinguish with the consumption

Capital goods

Capital goods are those goods which once produced and do not undergo any transformation, but are used again and again for the production of the other goods. Examples - factories, buildings, roads, machineries etc.

On the basis of their use, a good can be either a consumer good or capital good.

                                      Classification of goods

Depreciation

Depreciation is the loss of value of fixed capital assets due to normal wear tear and expected obsolescence.

All firms keep a separate portion of their revenue to meet depreciation, called depreciation Provision. Depreciation is also termed as consumption of fixed capital

Stocks and Flows

Stock is a variable which can be measured at a particular point of time.

Flow is a variable which can be measured at a given period of time.

Difference between stock and flow

stock	flow
Measured at a particular point of time	Measured at a given period of time
Static concept	Dynamic concept
Has no time limit	Has time limit
E.g. Water in a reservoir, wealth, Inventory, money supply,	The amount water flowing into the tank from the tap per minute, Income, Changes in the inventory

         

Double Counting

It is the act of counting the value of a commodity more than once in estimating national income.  The value of intermediate goods shall not be included in the calculation of NI, which may lead to double counting.

Gross investment

It is the value of capital goods in the total value of final goods produced in a country in an year.

Net investment

It is the addition to the existing capital stock in a country.

Net investment = Gross investment – Depreciation

Inventory

It is the stock of semi-finished goods, unsold finished goods and unused raw materials which a firm carries from one year to the next year.

Inventory is a stock variable.  Inventory during an year is a flow variable.

If the value of the inventory at the end of the year is higher than the value at the beginning of the year, it means inventory has increased.

Change in the inventory = production of the firm during the year – sale during the year.

Inventories are treated as investment because inventories are unsold stock.

Change inventory can be planned or unplanned. Anticipating changes in the demand, firms make planned accumulation or decumulation of inventory.   The unexpected fall in demand results in accumulation of unplanned inventories.

Circular flow of income

It is the pictorial representation of interrelationships and interdependence between different sectors of the economy.

It shows exchange of factors of production or goods and services or income between different sectors of the economy.

Circular flow of income in a two sector model

Circular flow of income in a two sector model is based on the following assumptions,

1.   There are only two sectors – households and firms

2.   Households supply factor services to the firms.

3.   Firms hire factor services from household sector.

4.   Households spend their entire income on consumption – there is no saving

5.   Firms sell their entire products to the households.

6.   There is no government sector.

7.   Economy is a closed one – there is no foreign trade

The two sector economy consist of

1.   Factor market – for factors of production

2.   Product market – for goods and services

There are two types of flows

1.   Real flow – flow of goods and services and factors of production.

2.   Money flow – monetary payment for the factor services and goods and services

The following figure explains the circular flow of income and expenditure in a two sector model -

 

The lower part of the diagram shows the factor market in which households sell their factor services and receive incomes.

          The upper part of the diagram represents product market in which households buy goods and services produced by the firms.

From the diagram it can be seen that,

Total income = total production = total expenditure.

The value of the flow of the product in an economy at point A, B and C in an year can be calculated.  At point A we measure the value of the product through Expenditure method, at point B we measure the value of flow by Product method.  At C we can calculate total factor payments, it is income method.  Each of these methods will give the same value of GDP.  Therefore there are three methods to calculate national income.

1.   Product method or value added method

2.   Expenditure method

3.   Income method

Methods of measuring National Income

National Income estimates are necessary to assess the performance of the economy and for the formulation of appropriate economic policies.

There are three main methods for measuring the national income.

1.   Product method

2.   Expenditure method

3.   Income method

1.   Product method

Under this method GDP (Gross Domestic Product) is measured by adding the money value of all final goods and services produced within the domestic territory of a country during a year.

According to the product method, GDP is the sum of the Gross Value Added by the entire production units in the economy.

Suppose there are N production units in the economy. GDP is the sum total of the gross value added of all firms in the economy.

GDP = GVA₁+GVA₂+ …………. + GVA_N

                Where GVA means Gross Value Added

Therefore GDP is    GVA_i

Here GDP is calculated on the basis of market price.

Gross value of output of firm i = quantity of output produced by the firm i× market price.

If the Depreciation cost of the firm is D_i

NVA_i = GVAi – D_i

GVA_{i =} NVAi + D_i

Therefore GDP = _i  + _i 

2.   Expenditure method

Under the expenditure method GDP is calculated from the demand side of the products.  Here GDP is calculated by adding the final expenditures incurred in the economy.  Final expenditure includes.

1.   Consumption expenditure.

2.   Final investment expenditure

3.   Final government expenditure

4.   Export expenditure

All the final expenditures are identical to revenues denoted by RV (Revenue Value)

          RV_i  = C_i+ I_i+ G_i+ X_i

If there are N firms in the economy then,

_i  = _i +_i  +  _i   + _i

In an open economy we have to consider both domestics and foreign expenditures.  So expenditure on final goods and services in an economy consists of

1.   Private final consumption expenditure (C)

2.   Final investment expenditure (G)

3.   Government expenditure on final goods (G)

4.   Net exports (X – M)

Therefore the GDP = C+I+G+X-M

GDP is the sum total of all final expenditure received y all the firms in the domestic economy that is the total value of the four components of final expenditure gives us the value of GDP.

3.   Income method

Under this method, GDP is calculated by adding up all the incomes received by all the factors of production.  This means that the national income is the sum total of all factor incomes – rent, wage, interest and profit.

Let there be N numbers of households in the economy,

W_i be the wages and salaries received by i^th  households

P_i be the gross profit received by i^th  households

In_i be the interest received by i^th  households

R_i  be the rent received by i^th  households,

     Then,

GDP_MP = _i   +  _i  +   _i + _i

It means GDP = W + P + In + R

Reconciliation of the three methods

GDP can be calculated by using three methods – Product method, expenditure method and income method. Each of these methods will give same value of GDP.

Expenditure Method                Income Method     Product Method

C	=	P	=
I		In
G		R
X-M		W

Budget Deficit and Trade Deficit

          Households spend their income for consumption or for saving or to pay taxes.

          GDP = C+S+T

According to the expenditure method

                    GDP = C+I+G+X-M

Therefore C+S+T = C+I+G+X-M

          Solving this equation, we will get

                    M-X = (I-S) + (G-T)

          M-X shows difference between imports and exports.  The excess of imports over the exports is referred to as trade deficit.

          G-T shows the difference between government expenditure and tax revenue.  The excess of government expenditure over its revenue is referred to as budget deficit.

          When there is not government and foreign trade X=0, M=0 and T=0, then

                    I - S = 0

                    I = S

This means that aggregate saving is equal to aggregate expenditure.

           

Some Macro Economic Identities

Gross Domestic Product (GDP)

          The total money value of all final goods and services produced within the domestic territory of a country during an year.

It can be expressed on the basis of market price or at factor cost.

          GDP_{MP =} GDP_FC + Net Indirect Tax

          GDP_{FC =}   GDP_MP - Net Indirect Tax

                             Net Indirect Tax = Indirect Tax – Subsidies

                             GDP_MP = Depreciation + Domestic Factor Income + NIT

Gross National Product (GNP)

          It is the total money value of all final goods and services produced in a country during an year.

GNP includes and GDP and Net Factor Income from Abroad.

          GNP = GDP + Net Factor Income from Abroad.

          Net factor income is the difference between factor income received by the residents of the country from abroad and the factor income paid to the non-residents in the domestic territory.

          GNP_MP  = GNP_FC  + NIT

GNP_FC = GNP_MP  - NIT

Net National Product (NNP)

          It is the total money value of goods and services produced by a country during an year less depreciation.

          NNP_MP = GNP_MP - Depreciation

          NNP_FC = GNP_FC - Depreciation

          NNP_MP = NNP_FC + NIT

          NNP_FC = NNP_MP – NIT

          NNP_FC = GDP_MP – Depreciation + Net Factor Income from abroad – NIT

Personal Income (PI)

          It is the income received actually by the households of a country from national income.

PI = NNPFC – Undistributed Profits – Net Interest Payments – Corporate Tax + Transfer payments to the households.

Net interest payments = interest paid by the households – interest received by the households.

         

Transfer payments include pension, scholarship, pension etc. received by the households.

Personal Disposable Income (PDI)

          PDI is the part of personal income which is actually available to the individuals and households for consumption.

          PDI = PI – Personal tax and non tax payments.

         

Personal tax payments include direct taxes. Non tax payments include fines, penalties etc.

Per Capita Income

          It is the income per head of the population.

          Per Capita Income =

GDP at current price

          If GDP is measured on the basis of current market prices, it is known as GDP at current price or nominal GDP.   GDP at current price doesn’t show real growth as it may increase due to the increase in prices.

GDP at constant prices

          If GDP is calculated on the basis of a base year price, it is known as GDP at constant price or real GDP.  Base year is a selected past year.  Base year price is known as constant price.

GDP Deflator

          GDP Deflator is the ratio between Nominal GDP to Real GDP, expressed as percentages.

GDP Deflator =  

          It gives an idea of how prices have moved from the base year to the current year.

Consumer Price Index

          It shows the changes in retail price of goods consumed by a consumer between two years.

          CPI = × 100

Wholesale Price Index

          It shows the change in wholesale price between two different time periods.

          It is referred to as producer’s price index.

GDP Deflator and CPI

          GDP deflator involves the value of all goods and services.  CPI includes only goods consumed by a normal consumer.  GDP deflator doesn’t include the value of imported goods. CPI includes the value of imported goods consumed by a normal consumer.

GDP and Welfare

          GDP can be considered as a measure of welfare.  Higher GDP growth rate indicates higher welfare.  But this argument is criticized on the following grounds.

1.   Unequal distribution of income

As GDP increase welfare may not increase.  Suppose, the income of a few increases on a large scale and the income of the most of the people decreases, and then also GDP may increase.  But welfare of the people doesn’t increase due to the increase in GDP.

2.    Non – monetary transaction

Many non-monetary transactions like services of housewives, barter transactions are not included in GDP.  Here GDP is underestimated.

3.   GDP and externalities

Externalities are unintended consequences of an action. Externalities can be beneficial or harmful.  Construction of a road in village- comforts in the journey is an example of positive externality.

Functioning of a factory creates pollution and health problems.  It is an example of negative externality.  These externalities are not included in GDP.

4.   Production of harmful goods

In the calculation of GDP, value of harmful products like cigarettes, alcohols etc. are too included. Their production increases, GDP also increases, but it may not increase the welfare.

Note : Equations are not visible in their actual form as they are not compatible with this format