Session 8: The Macroeconomy : National

Income; Economic Growth; Govt. Role

(Prof A.T.F)

Outline
• Macroeconomics & National Income (NI)
Accounts
• Definition of National Income (GDP & GNP)
• Problems of estimating national income
• Usefulness of NI accounts
• Economic Growth & its determinants
• Concept of Development
• Role of Govt. in the modern economy
 Macroeconomics &
National Income Accounting
Traditionally, Economics has been divided into 2 branches of
study viz. Microeconomics & Macroeconomics

Microeconomics is a study of the behavior of

individual decision making units (e.g. individual consumer’s
buying decision & individual firm’s production decision )

Macroeconomics is a study of the behavior of the total

economy (trends in national output, employment, average
price level, inflation, Balance of Payments etc.)

The point of entry into Macroeconomics is National Income

Accounting
 Definition of National Income
Human wants are limitless & there is continuous production to satisfy these wants. Hence, it
is useful to calculate the value of output (GDP) produced by a country during a given
period.
Gross Domestic Product (GDP) = Market value of all final goods and services
produced in a country during a given time period, usually a year.

GDP at factor cost = a measure of GDP calculated by adding the incomes received
by the 4 factors of production.

GDP at market prices = it is the price at which the GDP sells in the market. The
difference between GDP at factor cost & GDP at market prices is that the latter
includes indirect taxes minus subsidies.

GNP =The income accruing to a country’s residents from the production of all final
goods and services during a given time period, no matter where in the world the
goods and services are produced (e.g. profits, interest, dividends etc.).

NI can be calculated in 1 of 3 ways viz. Output method, Income method, &

Expenditure method. All 3 methods should give the same final figure, because
these are 3 different ways of looking at NI. They are perfect identities.
 Estimation of National Income
Output Method Income Method Expenditure Method
Rs. m Rs. m Rs. m
1. Agriculture, X 1.Compensation of employees X 1.Consumption Expenditure X
Forestry, Fishing 2.Gross operating surplus X 1.1 Pvt. Consumption (C).
2. Industry X 2.1 Net operating surplus 1.2 Govt. Consumption (G)
(Mfg, construction, mining) 2.2 Mixed income 2.GD Capital Formation (I) X
3. Services X 2.3 Consumption of fixed capital 3. GD E at market price (1+2) X
-Banking 3. Other taxes less subsidies X 4. Export of goods & services (X) X
-Health on production 5. Import of goods & services (M) X
-Education
-Transport
-Defence
- IT
4. Gross Value Added (GVA) X 4. Gross value added at Basic price X
at Basic price (1+2+3) (1+2+3)
5.Taxes less product subsidies X 5.Taxes less product subsidies X

6. GDP at market price (4+5) X 6. GDP at market price (4+5) X 6. GDP at market price (3+4-5) X

7.Net primary Income from X 7.Net primary Income from X 7.Net primary Income from X
rest of the world rest of the world rest of the world
8. GNI @ market price (6+7) X 8.GNI @ market price (6+7) X 8.GNI @ market price (6+7) X
 Continued
3 methods of estimating NI are perfect identities
O=Y=E
O = money value of total output
Y = Incomes paid to factors that helped to produce that
output (O=Y)
O consists of consumer goods & capital goods.
It exactly equals the expenditure incurred by firms to
produce that output (O=E) or the spending by consumers
& firms on that output
If part of that output is not sold, it is assumed that the firm
has spent in order to add to its stocks
 Circular Flow of Income

Real flows

Money flows
 Problems of Estimating National Income
1. Achieving 100% coverage of households is difficult
2. Achieving 100% accuracy is difficult e.g. under income method,
individuals tend to understate their income to avoid taxes
3. Need to eliminate effect of inflation on value of output
4. Need to avoid double counting (cars & tyres; cloth & shirt; bread &
flour)
5. Value of unpaid services is omitted (housewife’s services, DIY
services)
6. Existence of the black economy – Illegal economy produces value, but
it is excluded from GDP( illicit liquor, narcotics, smuggling)
7. Valuation of Govt. services is done almost at cost, whereas pvt. sector
adds a profit margin to its cost. Thus, if a country has a large govt.
sector, then that country’s NI will be under- stated
8. Difficult to calculate depreciation accurately
 Usefulness of NI Accounts
A. Output Method of estimating national income - Usefulness
(i) It indicates rate at which the economy grew from year to year
Year 2016 2017 2018
GDP (Rs. M) 1000 1050 1120

GDP Growth rate = 1050 – 1000 X100 1120 – 1050 X 100

(Economic Growth) 1000 1050

= 5% = 6.7 %

To arrive @ real growth rate, we must eliminate effect of inflation on value of output
Year 2016 2017
Money GDP (Rs.m.) 1000 1050
Price Index 100 105

Real GDP (Rs.m.) = Money GDP @ current prices X 100 = 1000

Current Year Price Index
Usefulness
(ii) Can make cross country comparisons of GDP growth rates
(iii) Can estimate sectoral contributions to GDP & changes over time
 Usefulness of NI accounts (contd.)

B. Income Method- Usefulness

(i) How NI is distributed among owners of resources (wage earners vs

entrepreneurs) & which income groups benefited most from growth

C. Expenditure Method- Usefulness

(i) Shows % expenditure on consumption vs Investment

(ii) Shows a country’s performance in international trade (is value of exports

increasing & are exports becoming more competitive in the world market)?
National income estimations under different methods have implications for
Govt. policy.
 Per Capita Income to judge the Std. of Living
• Per capita income is only an average. The figure gets distorted by the
presence of extreme values
• Provision of (free) Govt. services adds to quality of life but per capita
income ignores this
• Higher per capita income may have been achieved at the expense of
leisure
• Econ. growth may have been achieved but the quality of the
environment could suffer
To compare living standards between countries, value of GDP should
be estimated in terms of a std. international currency (US$).
Thereafter, adjust the per capita GDP figure (GDP/Pop) to allow for
differences in the cost of living between countries (Purchasing power
parity-PPP)
PPP Exchange rate = equivalent cost of the same basket of
goods in different countries
 Economic Growth
- It is a sustained increase in real GNP or preferably, a
sustained increase in per capita real GNP.
Econ. Growth is illustrated by an outward shift of the
production possibility curve.
- If population growth rate exceeds the economic growth
rate, then the std. of living will decline.

Year 2017 2018

Real GNP (Rs.) 100,000 120,000
Population 100 150

Per capita GNP (Rs.) 1,000 800

 Determinants of Economic Growth
1.Labour - increase in size of population
- increase in participation rate of labour
- increase in number of hours worked
- improved labour productivity through education & training

2. Investment in physical capital –Plant & machinery. Labour is more productive when
assisted by better machines.

3. Investment in social capital – Better roads, transportation, irrigation facilities,

communication, electricity

4.Technological advancement – New products & new processes

5. Better management practices

6. Better marketing arrangements & skills

7. Govt. policies – fiscal policy, monetary policy, incentives, subsidies

8. National culture & religion

9. External events – Global recession or boom.

 Economic Growth vs. Development
Economic growth & Development are not synonymous
Growth focuses on per capita GDP growth; But,Dev. examines
whether benefits of growth have accrued to the masses.
Physical Quality of Human Development Human Poverty Index
Life Index (PQLI) Index (HDI) (HPI)
Made up of 3 sub-indices Made up of 3 sub-indices Made up of 3 sub-indices

• Infant mortality • Life expectancy • Adult literacy

• Life expectancy • Education index • % Popn not expected
• Adult literacy (literacy & school to survive beyond 40
enrolment) • Deprivation index
• Per capita income - % pop - no access to safe
adjusted to reflect water
purchasing power - % pop- no access to health
services
parity - % underweight children < 5
years
 Concept of Development
Economic Growth- Per capita income (PCI) is conventionally used to
measure economic progress. It is a pure quantitative measure.
But rising PCI cannot measure an improvement in the quality of
human life. PCI is an average figure & the country’s income might
not be equally distributed .
“No society can surely be flourishing & happy, of which by far the
greater part of the numbers are poor & miserable” (Adam Smith,
1776).
‘Development’ is a multi- dimensional concept. It includes
qualitative indicators such as personal safety, poverty alleviation,
and the entire range of civil & political rights- in addition to
economic growth.
“Human development is concerned with advancing the richness of
human life rather than the richness of the economy in which human
beings live, which is only a part of it” (Amartya Sen, Nobel Laureate, 1998)
.
 Role of Govt. in the Economy:
Govt. Policy & Implications for Business
Outline
• Govt. policy objectives & policy instruments
• Monetary policy & implications for business
• Fiscal policy & implications for business
• Exchange rate policy & implications for business
• Role of Govt. in the modern economy
Purpose of Govt. Policy- Ensure Speedy &
Sustainable Growth with Economic Stability
A Growth-related objectives
i. Achieve rapid economic growth
ii. Full employment
iii. Balance of payments equilibrium
B. Stability-related objectives
i. A stable price level (control inflation)
ii. A stable exchange rate
iii. A more equal distribution of national income
 Government Policy Instruments

i. Monetary policy- manipulate interest rate & money

supply (r, MS)
ii. Fiscal policy- manipulate tax rate & Govt.expenditure
(t, G)
iii. Exchange rate policy (er)
 Changing Role of Govt.
- Traditional role: Law & order and internal security, external security; poor
relief; currency, foreign policy .
- Classical & Neoclassical view 1776- 1930: “Let markets work”. Price mechanism
will automatically solve basic econ. questions

- Keynes’ view: Great Depression of the 1930s. Advocated direct Govt.

intervention in the economy through deficit financing

- Monetarist view 1970s (Milton Friedman) : Deficit budgeting & monetary

expansion would lead to inflation. Govt. must maintain strict control over the
money supply in line with the increase in GDP

- Modern view: Pvt. Sector as the engine of growth & Govt. has to facilitate the pvt.
sector to perform that role.
- Govt’s Role: A service provider, a facilitator, a regulator, & a moderator
1) Govt. as a Service Provider
- Govt. has to correct ‘market failures’ by providing ‘public goods’
(national defence, reservoirs, lighthouses, street lights, public parks, highways)

- Govt. must also provide ‘merit goods’ (health, education) It is another e.g. of Mkt.
failure. These will not be provided in adequate quantities by pvt. sector, but are
considered as socially desirable.

- Some services are best provided by the State (e.g. water, electricity).These are in the
nature of natural monopolies
Pvt. competition & duplication of facilities lead to a waste of society’s resources
2) Govt. as a Facilitator

Provide Institutions
- To protect property rights
- To enforce contracts
- To settle disputes (judiciary)
- To maintain law & order (police)

An efficient & effective public service

Good governance & security are vital for investment, both local & foreign investment
4 pillars of good governance are: accountability, transparency, predictability, & participation
Consistent macroeconomic policies
- a tax system that does not discourage effort, risk taking & investment
- a monetary policy which will control inflation
 3) Government as a Regulator
• Externalities
- Pvt. sector econ. activity imposes costs on third parties (e.g. environmental
pollution)
Hence, Govt. regulations. ‘Polluter must pay’

• Maintain Competition
Natural tendency in a free mkt. for monopolies to arise
Govt. must control abuses of monopoly power
• Markets (e.g. in agriculture) do not respond to price signals quickly
Agri. crops- long gestation periods & supply cannot respond quickly
• Stabilization of the economy (business cycle)
(4) Govt. as a Moderator
• Regional imbalances in employment, income & infrastructure are not conducive to
sustained growth. There must be balanced regional Dev.; inclusive growth and not
exclusive growth.
• Unequal distribution of income under free market system (‘Haves’ vs. ‘Have nots’).
Poverty, malnutrition, unemployment justify Govt. intervention
• Equity without growth – not sustainable;
• Growth without equity – not sustainable
“A society that is not socially just & does not intend to be, puts its own future in danger”
(Pope John Paul ii, Brazil,1980)
 Problems of State Intervention
• Govt. planning may be less flexible
than decision making by private sector
• Maximum price fixing – leads to market
distortions (black market)
• Guaranteed minimum prices –
leads to market distortions
Excess supply & waste of society’s resources
• Controls lead to corruption & rent- seeking behavior.
Powerful groups with a vested interest
in planning e.g. bureaucrats & businessmen
can manipulate the system to their benefit

• Individuals need incentives to work & innovate

The discipline & rewards of the market
cannot be easily replicated in Govt. Depts.
and public enterprises.

Govt.’s role is to promote development

Need for an efficient pvt. sector & an efficient public sector