Economics – II CBCBA4T06

Syllabus topics (RTMNU)

• Nature, Scope, Importance and Limitations of Macro Economics
• Difference between Micro and Macro Economics
• Circular Flow of Income in Two Sector, Three sector and Four sector economy

Nature, Scope, Importance and Limitations of Macro Economics

Meaning: The word "macro" comes from the Greek word makros, meaning large. Macro economics is the study of the economy as a whole – total (aggregate) income, output, employment, general price level, money, savings and investment. It is also called income and employment theory. Modern macro economics grew mainly after J.M. Keynes's book "The General Theory of Employment, Interest and Money" (1936).

Definition: Macro economics studies aggregates – national income, total consumption, total investment, total employment and the general price level – and how they are determined.

Nature:

1. Study of aggregates – it looks at totals and averages, not individual units.
2. Income theory – its central problem is how national income is determined.
3. General equilibrium analysis – it studies the inter-relations of all sectors together.
4. Both positive and normative – it explains what is and also suggests policy.
5. Policy oriented – it guides government and RBI in fiscal and monetary policy.

Scope:

1. Theory of national income – concepts and measurement of GDP, GNP etc.
2. Theory of employment – causes of unemployment and how to remove it.
3. Theory of money – functions of money, value of money, inflation and deflation.
4. Theory of economic growth – how national income rises over time.
5. Theory of business cycles – booms and depressions.
6. Theory of general price level – inflation and price stability.
7. International trade and balance of payments – exports, imports, exchange rate.
8. Macro policies – fiscal policy (Union Budget, taxes) and monetary policy (RBI).

Importance:

1. Helps understand how the whole economy works.
2. Helps the government form economic policies – for growth, employment and price stability.
3. Helps control inflation and deflation (RBI uses monetary policy for this).
4. Helps in economic planning and in comparing living standards of countries.
5. Helps business firms forecast demand – a firm's sales depend on national income and prices.
6. Explains unemployment, poverty and business cycles.

Limitations:

1. Fallacy of composition – what is true for one person may not be true for all; e.g. saving is good for one family, but if everyone saves more, total demand and income may fall (paradox of thrift).
2. Aggregates hide differences – a rise in average income may hide growing inequality.
3. Heterogeneous items are added – adding different goods in money terms can mislead.
4. Measurement problems – data on national income may be inaccurate.
5. Ignores individual units – structural change within the aggregate is not seen.

Difference between Micro and Macro Economics

Both are complementary: macro totals are made of micro units, and micro decisions depend on macro conditions.

Circular Flow of Income in Two Sector, Three Sector and Four Sector Economy

Meaning: Circular flow of income means the continuous flow of money income and of goods and services between different sectors of an economy. Production creates income, income creates spending, and spending creates further production – so the flow is circular. There are two flows: the real flow (factor services and goods) and the money flow (factor payments and spending).

1. Two-sector economy (households and firms):

• Households supply factor services (land, labour, capital, enterprise) to firms.
• Firms pay rent, wages, interest and profit to households (money flow).
• Households spend this income on goods produced by firms; firms supply goods (real flow).
• If households save, saving is a leakage; it returns as investment through banks and financial markets (an injection). Equilibrium: Saving = Investment.

2. Three-sector economy (households, firms, government): The government collects taxes from households and firms (leakage) and spends on purchases, salaries, subsidies and transfer payments like pensions (injection). Equilibrium: S + T = I + G.

3. Four-sector economy (open economy – adds the foreign sector / rest of the world): Imports are a leakage (money goes abroad) and exports are an injection (money comes in). Equilibrium: S + T + M = I + G + X, where M = imports and X = exports.

Importance: shows the interdependence of sectors; is the base of national income measurement (product, income and expenditure methods give the same total); shows how leakages reduce and injections increase income; and guides government policy.

Likely exam questions

1. (Long, 8/16 marks) Explain the nature, scope, importance and limitations of Macro Economics.
2. (Long, 8/16 marks) Explain the circular flow of income in two-sector, three-sector and four-sector economies.
3. (Short, 4 marks) Distinguish between Micro and Macro Economics.
4. (Short, 4 marks) What are leakages and injections in the circular flow of income?
5. (Short, 4 marks) What is the fallacy of composition?

Syllabus topics (RTMNU)

• Concept of National Income
• Gross National Product (GNP)
• Net National Product (NNP)
• Gross Domestic Product (GDP)
• Net Domestic Product (NDP)
• Personal and Disposable Income
• Per Capita Income
• Methods of National Income Measurement
• Difficulties in Measurement of National Income
• Importance of National Income

Concept of National Income

Definition: National income is the total money value of all final goods and services produced by the normal residents of a country during one year, after deducting depreciation, plus net factor income from abroad. In strict terms, national income = NNP at factor cost.

Marshall described it as the net aggregate of commodities and services produced by the labour and capital of a country acting on its natural resources in a year. In India national income is estimated by the National Statistical Office (NSO) under the Ministry of Statistics and Programme Implementation; the financial year runs from 1 April to 31 March.

Key terms:

• Final goods – goods bought for final use, not for resale or further processing. Only final goods are counted, to avoid double counting.
• Depreciation – wear and tear of fixed capital during production.
• Net Factor Income from Abroad (NFIA) – factor income earned by residents abroad minus factor income earned by foreigners in India.
• Net indirect taxes (NIT) – indirect taxes (like GST) minus subsidies.
• Market price (MP) vs factor cost (FC) – FC = MP – NIT.

GNP, NNP, GDP, NDP, Personal and Disposable Income, Per Capita Income

1. Gross Domestic Product (GDP): the market value of all final goods and services produced within the domestic territory of a country in one year, by residents and non-residents.
2. Gross National Product (GNP): the market value of all final goods and services produced by the normal residents of a country in one year, at home or abroad. GNP = GDP + NFIA.
3. Net Domestic Product (NDP): NDP = GDP – Depreciation.
4. Net National Product (NNP): NNP = GNP – Depreciation. NNP at factor cost = NNP at MP – NIT = National Income.
5. Personal Income (PI): income actually received by individuals from all sources. PI = National Income – undistributed corporate profits – corporate tax – social security contributions + transfer payments (pensions, scholarships, unemployment allowance).
6. Disposable Income (DI): income left with individuals to spend or save after paying personal direct taxes. DI = PI – personal direct taxes (income tax). DI = Consumption + Saving.
7. Per Capita Income (PCI): average income per person. PCI = National Income ÷ Total population. It is used to compare living standards.

Worked illustration (₹ crore): GDP at MP = 10,000; NFIA = (–) 200; Depreciation = 800; Net indirect taxes = 900; undistributed profits = 400; corporate tax = 300; social security contributions = 200; transfer payments = 500; personal direct taxes = 700; population = 5 crore.

Methods of National Income Measurement

1. Product (Value Added) Method: add the value added by every producing unit in primary (agriculture, mining), secondary (manufacturing, construction) and tertiary (services) sectors. Value added = Value of output – Intermediate consumption. Sum of value added = GDP at MP; then adjust for depreciation, NFIA and NIT. Care: count only final goods, or use value added, to avoid double counting.

2. Income Method: add all factor incomes earned in production – compensation of employees (wages, salaries), rent, interest, profit and mixed income of the self-employed. Sum = NDP at FC; add NFIA to get NNP at FC. Transfer payments, gifts and lottery winnings are not included.

3. Expenditure Method: add all final spending in the economy: GDP at MP = C + I + G + (X – M), where C = private consumption, I = investment, G = government final consumption, X – M = net exports.

Illustration (₹ crore): C = 6,000; I = 2,000; G = 1,500; X = 800; M = 1,100; depreciation = 700; NFIA = (–) 100; NIT = 600. GDP at MP = 6,000 + 2,000 + 1,500 + (800 – 1,100) = 9,200. NDP at MP = 9,200 – 700 = 8,500. NNP at MP = 8,500 – 100 = 8,400. National income (NNP at FC) = 8,400 – 600 = 7,800.

In India, a combination of the product and income methods is used, with the expenditure method as a cross-check. In theory all three methods give the same total, because one person's spending is another's income.

Difficulties in Measurement of National Income

1. Non-monetised sector – much farm output in villages is consumed at home or bartered, so it is hard to value.
2. Unpaid services – housework by family members is not counted.
3. Double counting – the risk of counting intermediate goods twice.
4. Lack of reliable data – the large unorganised sector keeps no accounts.
5. Black money / parallel economy – hidden income is not recorded.
6. Depreciation estimate – difficult to measure correctly.
7. Changing prices – nominal figures must be converted into real (constant price) figures using a base year (2011-12 in India's current series).
8. Illiteracy of small producers who cannot give correct figures.

Importance of National Income

1. Shows the economic performance and growth rate of the country.
2. Helps in economic planning and budget making.
3. Shows the contribution of each sector (agriculture, industry, services).
4. Per capita income helps compare living standards across countries and states.
5. Shows distribution of income among wages, rent, interest and profit.
6. Guides business decisions – firms forecast demand from income trends.
7. Useful for international comparison and for research.

Likely exam questions

1. (Long, 8/16 marks) Define National Income. Explain the methods of measuring national income and the difficulties in its measurement.
2. (Long, 8/16 marks) Explain the concepts GNP, NNP, GDP, NDP, Personal Income, Disposable Income and Per Capita Income. From the following data calculate GNP at MP, NNP at MP and National Income: GDP at MP ₹10,000 crore, NFIA (–) ₹200 crore, Depreciation ₹800 crore, Net indirect taxes ₹900 crore.
3. (Short, 4 marks) Distinguish between GDP and GNP.
4. (Short, 4 marks) What is Per Capita Income?
5. (Short, 4 marks) State the importance of National Income.

Syllabus topics (RTMNU)

• Meaning, Definition and Types of Money
• Functions of Money
• Value of Money
• Quantity Theory of Money-Fisher’s Version
• Cambridge Quantity Theory of Money
• Inflation, Deflation, Reflation, Disinflation- Meaning, Causes and Effects

Meaning, Definition and Types of Money

Meaning: Money is anything that is generally accepted as a medium of exchange and as a measure of value. Before money there was the barter system (direct exchange of goods), which had problems like lack of double coincidence of wants, no common measure of value, and difficulty in storing wealth.

Definitions: Crowther: money is anything that is generally acceptable as a means of exchange and at the same time acts as a measure and a store of value. Walker: "Money is what money does" – a functional definition.

Types of money:

1. Commodity money – goods used as money in early times, e.g. cattle, grain, shells.
2. Metallic money – coins of gold, silver, copper. Full-bodied coins have metal value equal to face value; token coins have metal value less than face value (today's ₹1, ₹2, ₹5 coins).
3. Paper money – currency notes issued by the central bank (in India, RBI issues notes; the ₹1 note is issued by the Government of India).
4. Legal tender money – money that must be accepted by law for payment of debts; coins and notes are legal tender. Optional (non-legal tender) money like cheques can be refused.
5. Fiat money – money by order of the government, not backed by gold.
6. Bank (credit) money – demand deposits that can be withdrawn by cheque.
7. Digital / plastic money – debit and credit cards, UPI payments, mobile wallets; and the RBI's Central Bank Digital Currency (e₹, pilot launched 2022).

Functions of Money

Kinley's classification:

• Primary functions: (1) Medium of exchange – removes barter's problem of double coincidence. (2) Measure of value – values of all goods are expressed in ₹.
• Secondary functions: (3) Store of value – wealth can be saved in money. (4) Standard of deferred payments – loans are taken and repaid in money. (5) Transfer of value – money can be sent from one place or person to another.
• Contingent functions: distribution of national income among factors, basis of credit, helps consumers and producers reach equilibrium (equalising marginal utility and marginal productivity), and gives liquidity.

Value of Money

Meaning: Value of money is its purchasing power – the quantity of goods and services one unit of money can buy. It moves inversely to the general price level: Value of money = 1 ÷ Price level. When prices rise, the value of money falls; when prices fall, it rises. Changes in the value of money are measured by price index numbers (in India, the Consumer Price Index and the Wholesale Price Index).

Quantity Theory of Money – Fisher's Version

Statement: Other things remaining the same, the price level changes in direct proportion to the quantity of money, and the value of money changes in inverse proportion. Irving Fisher gave it in "The Purchasing Power of Money" (1911).

Equation of exchange: MV = PT, so P = MV ÷ T. Extended form: MV + M′V′ = PT.

M = quantity of money (currency), V = velocity of circulation of money, M′ = bank (credit) money, V′ = velocity of bank money, P = price level, T = total volume of transactions.

Example: M = ₹1,000, V = 5, T = 500 units. P = (1,000 × 5) ÷ 500 = ₹10. If M doubles to ₹2,000, P = (2,000 × 5) ÷ 500 = ₹20 – price level doubles and the value of money halves.

Assumptions: V, V′ and T are constant; M′ bears a fixed ratio to M; full employment; long period; P is passive (an effect, not a cause).

Criticisms: V and T are not constant in reality; full employment is unrealistic; it ignores the rate of interest and the store-of-value function; it explains only the supply side of money; it is a truism (an identity); it does not explain business cycles.

Cambridge Quantity Theory of Money

Economists of Cambridge University – Marshall, Pigou, Robertson and Keynes (early work) – gave the cash-balance approach. It stresses the demand for money – people want to hold a part (k) of their income as cash.

• Marshall: M = kPY, where Y = real income, k = proportion of income held as cash.
• Pigou: P = kR ÷ M, where R = real resources (income) and k = proportion held as cash.
• Keynes (Tract on Monetary Reform, 1923): n = pk, or n = p(k + rk′), with bank deposits included.

The value of money depends on the demand for cash balances: if k rises (people hold more cash), price level falls.

Inflation, Deflation, Reflation, Disinflation – Meaning, Causes and Effects

Inflation: a continuous and significant rise in the general price level, i.e. a fall in the value of money. Crowther: a state in which the value of money is falling, i.e. prices are rising. Types by speed: creeping, walking, running and hyper-inflation. RBI follows flexible inflation targeting (CPI inflation target of 4% with a band of ±2%, set by the Government; check the latest notification).

Causes: (a) Demand-pull – rise in money supply, government spending, credit, exports, population; (b) Cost-push – rise in wages, raw material and fuel prices, indirect taxes, profit margins; (c) supply shortages – crop failure, hoarding, black-marketing.

Effects: fixed-income earners, creditors and pensioners lose; debtors, businessmen and producers gain in the short run; savings fall; inequality rises; exports become costly; but mild inflation encourages investment and growth.

Deflation: a continuous fall in the general price level, with falling output and employment. Causes: fall in money supply, tight credit, low demand, excess production. Effects: profits fall, firms close, unemployment rises, debtors lose and creditors gain – it is often worse than inflation.

Reflation: a deliberate rise in prices brought about by the government/central bank to lift the economy out of deflation or depression, back to a normal level – through lower interest rates, more credit and more public spending. Effect: output, employment and income recover.

Disinflation: a fall in the rate of inflation – prices still rise, but more slowly (e.g. inflation falling from 7% to 5%). It is achieved by anti-inflation measures like higher interest rates and lower government deficit. Effect: price stability, but if done too hard, growth may slow.

Likely exam questions

1. (Long, 8/16 marks) Define money. Explain its types and functions.
2. (Long, 8/16 marks) Explain Fisher's Quantity Theory of Money and compare it with the Cambridge version. OR What is inflation? Explain its causes and effects.
3. (Short, 4 marks) What is meant by value of money?
4. (Short, 4 marks) Distinguish between deflation and disinflation.
5. (Short, 4 marks) What is reflation?

Syllabus topics (RTMNU)

• Consumption Function: Meaning, Types, Importance and Factors Determining Consumption Function
• Investment Multiplier: Concept, Importance, Limitations
• Investment Function: Concept, Types

Consumption Function: Meaning and Types

Meaning: The consumption function (propensity to consume) shows the relationship between total consumption expenditure and total income. It was introduced by J.M. Keynes in "The General Theory" (1936). It is written as C = f (Y), where C = consumption and Y = income.

Keynes's Psychological Law of Consumption: when income increases, consumption also increases, but by less than the increase in income; the rest is saved.

Linear form: C = a + bY, where a = autonomous consumption (consumption even at zero income, financed from past savings or borrowing) and b = MPC.

Each ₹100 rise in income raises consumption by ₹80, so MPC = 80/100 = 0.8. Break-even point (C = Y, S = 0) is at Y = 250.

Types / technical attributes:

1. Average Propensity to Consume (APC) = C ÷ Y – the share of total income consumed. APC falls as income rises.
2. Marginal Propensity to Consume (MPC) = ΔC ÷ ΔY – the share of extra income consumed. 0 < MPC < 1.
3. Average and Marginal Propensity to Save: APS = S ÷ Y; MPS = ΔS ÷ ΔY. APC + APS = 1 and MPC + MPS = 1.
4. Short-run and long-run consumption function: in the short run APC falls as income rises (the curve has a positive intercept); in the long run, studies (Kuznets) show APC stays nearly constant (the curve passes through the origin).

Importance of Consumption Function

1. Explains why income and employment fall – consumption does not rise as fast as income, creating a gap that must be filled by investment.
2. Base of the investment multiplier: K = 1 ÷ (1 – MPC).
3. Explains the turning points of the business cycle.
4. Shows the importance of investment and public spending to keep demand high.
5. Rejects Say's Law ("supply creates its own demand").
6. Helps government policy – e.g. transferring income to poor people (high MPC) raises total demand.

Factors Determining Consumption Function

(a) Subjective factors (psychological, stable in the short run): precaution for emergencies, foresight for old age and children's education, desire to improve standard of living, pride and miserliness; for businesses – desire to expand, liquidity and financial prudence.

(b) Objective factors (can change):

1. Changes in income distribution – more equal distribution raises consumption.
2. Windfall gains or losses – e.g. a share market boom.
3. Fiscal policy – taxes reduce disposable income; subsidies raise it.
4. Rate of interest – a high rate may encourage saving.
5. Expectations of future price changes.
6. Consumer credit – easy EMIs and credit cards raise consumption.
7. Stock of wealth and liquid assets.
8. Demonstration effect – copying the consumption of richer people.

Investment Multiplier: Concept, Importance, Limitations

Concept: The investment multiplier is the ratio of the change in national income to the change in investment that caused it. The idea was first given by R.F. Kahn (1931, employment multiplier) and developed by Keynes.

Formula: K = ΔY ÷ ΔI = 1 ÷ (1 – MPC) = 1 ÷ MPS.

Example: If MPC = 0.8, K = 1 ÷ 0.2 = 5. An extra investment of ₹100 crore raises national income by ₹500 crore. It works in rounds: ₹100 crore spent becomes income; 80% of it (₹80 crore) is spent, then ₹64 crore, then ₹51.2 crore … and the total reaches ₹500 crore. If MPC = 0.5, K = 2; if MPC = 0.9, K = 10. Higher MPC means a bigger multiplier.

Importance:

1. Shows the importance of investment in raising income and employment.
2. Supports public investment (roads, railways) during depression.
3. Explains the cumulative upswing and downswing of business cycles (it works in reverse too).
4. Helps in deciding the size of government spending needed to fill a deflationary gap.
5. Explains how saving and investment become equal through changes in income.

Limitations / leakages: (1) saving, (2) paying off old debts, (3) buying old shares and securities, (4) hoarding idle cash, (5) imports – money flows abroad, (6) taxes, (7) price inflation absorbing the extra money, (8) shortage of consumer goods. The multiplier also assumes constant MPC, a time lag, no change in other investment, excess capacity and a closed economy.

Investment Function: Concept, Types

Concept: In economics, investment means adding to the stock of real capital – new machines, buildings, roads, inventories – not buying existing shares. The investment function shows the relation between investment and its determinants: I = f (MEC, r), where MEC = marginal efficiency of capital (expected rate of profit on a new capital asset) and r = rate of interest. Investment takes place as long as MEC is more than the rate of interest.

Types:

Other types: gross investment (total spending on capital goods) and net investment (gross investment – depreciation); private and public investment; real and financial investment; planned (ex-ante) and actual (ex-post) investment.

Likely exam questions

1. (Long, 8/16 marks) What is the consumption function? Explain its types, importance and the factors determining it.
2. (Long, 8/16 marks) Explain the concept of the investment multiplier with an example. State its importance and limitations. If MPC is 0.8 and investment increases by ₹200 crore, find the increase in national income.
3. (Short, 4 marks) Distinguish between APC and MPC.
4. (Short, 4 marks) Distinguish between induced and autonomous investment.
5. (Short, 4 marks) State the leakages of the multiplier.