UNIT-II NATIONAL INCOME AND RELATED AGGREGATES : BASIC CONCEPTS AND MEASUREMENT

+ UNIT-II NATIONAL INCOME AND RELATED AGGREGATES : BASIC CONCEPTS AND MEASUREMENT +

+ + CHAPTER 2 STRUCTURE OF THE MACRO ECONOMY : CIRCULAR FLOW OF NATIONAL INCOME Macroeconomics, as pointed out earlier, deals with the study of aggregates expressed in terms of aggregate income, output, employment, expenditure, exports and imports and so on. In order to determine the actual performance level of the economy, we need to follow a framework of measurement procedures to find these aggregates and eventually we must interpret the macroeconomic behaviour in terms of movements in these aggregate measures. National income accounting facilitates the measurement of macro aggregates for a given economy. Accounting is believed to be a necessary exercise for any economic unit to know its performance. An individual unit such as a Household or a Firm maintains its own accounting information since it is interested to know its financial position at the end of an accounting period. 1 Important decisions concerning savings, investment and tax payments are all made by the unit after an analysis of the accounting information available to it. At the macro level, accounting assumes an even greater significance as the information is used for a review of the economy s performance during the year under study. On the basis of this appraisal national governments have to formulate their policy programmes to maximize the welfare of people. This is the basic purpose of national income accounting as it renders possible a set of procedures for measurement of income and output at the aggregate level. This means that we are, in fact, measuring the macroeconomic activities in the economy for a particular year. Accounting for transactions by individual units is relatively a less complicated and a simple process as compared to macro economic 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 income for the economy as a whole. It is a rather difficult and complex procedure to quantify the macro variables for accounting purpose. It is not adequate to merely look at the macroeconomic aggregates but it is also equally important to learn the techniques of measuring these aggregates. Therefore, national income accounting has evolved as a branch of study in its own right. Primarily, there are two basic functions of national income accounting: the first, is to identify specific economic achievements of a country and the second, is to provide an objective basis of evaluation and review of policies under implementation. Hence, national income accounts data not only help us to measure macroeconomic aggregates but also enable us to understand, analyse and interpret the working of the economy as well. This is precisely the reason why the road map to the subject of macroeconomics begin with a study of national income accounting. Uses of National Income Accounting There are some principal uses of national income accounting. They may be stated as follows: 1. National income accounting shows as to how the national income is shared among the various factors of production; 2. National income statistics indicate the specific contributions of individual sectors and their growth over time; INTRODUCTORY MACROECONOMICS 3. National income accounting helps to find out structural changes in the economy. 4. National income accounting provides the information for assessment of the economy s strengths and failures. 5. National income statistics enable comparisons to be made in respect of standard of living, distribution of income and actual composition of national income over time. 6. National income accounts facilitates comparison of output among nations. Hence, the national income data may be viewed as a monetary manifestation of material results of human activity in the economy. They provide standards by which economic achievement of policies could be partly judged in modern times. Structure of the Macro Economy Circular flow 2 of macroeconomic activity National income accounting calls for an understanding of the structure of the macro economy. The conceptual basis of measurement of national income begins with a depiction of the interrelated manner in which economic activities are organised in an economy. A pictorial illustration of this interdependence between the major sectors of economic activity is called the circular 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 decision of a sector is in response to that of another. Therefore, macro economy is in effect a system of interrelationships between the decision-makers in every sector of the economy. The circular flow of income involves two basic principles: (a) In any exchange process, the seller or producer receives the same amount that the buyer or consumer spends; and (b) Goods and services 3 flow in one direction and money payments to acquire these, flow in the return direction, thereby causing a circular flow. So, the output or product or real flow from the seller to the buyer necessarily creates the income or payment or money flow from the buyer to the seller. We shall now explain this two-way process of mutual dependence for 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 would be a helpful pre-requisite to understand the concepts used in the accounting of national income as such. Circular Flow in a Simple Two-sector Model To begin with, let us make the following assumptions with regard to a simple economy with only two sectors of economic activity. There are only two sectors in the economy, namely, Households and Firms. Households supply factor services to Firms. Firms hire factor services from households. Households spend their entire income on consumption. Firms sell all that is produced to the Households. There is no intervention of government or foreign trade. Such an economy as described above has two types of markets. First, market for goods and services Product market; and second, market for factors of production Factor market. The economic interdependence between Households and Firms in this simple economy can be observed as follows: INTRODUCTORY MACROECONOMICS (i) Household sector has the endowment of factors of production (land, labour, capital and entrepreneurial ability) and sell them to the Firms that produce goods and services, using these factor inputs. The Firms, in turn, sell goods and services thus produced 4 to the Household sector for its consumption. Therefore, whatever the Firms produce, is consumed by the Households. This type of interaction between Firms and Households can be described as the real flows, as it involves flow of goods and services. (ii) Exchange of goods and services between Households and Firms in response to acquiring factor services from Households corresponds to flows of income and expenditure of these two sectors. That is, Firms pay the Households in the nature of wages for labour services, interest for capital, rent for land and profits to entrepreneurship. These are called factor payments by Firms and factor incomes by Households. This income, in turn, is used by Households to incur expenditure on buying consumer goods and 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 and expenditure can be described as money flows. So, in the circular flow diagram (Fig. 2.1), we can recognise two real flows and two money flows. As a result we can derive the following, in the case of our simple economy: 1. Total production of goods and services by firms = Total consumption of goods and services by Household Sector 2. Factor Payments by Firms = Factor Incomes of Household Sector 3. Consumption expenditure of Household sector = Income of Firm sector 4. Hence, Real flows of production and consumption of Firms and Households = Money flows of income and expenditure of Firms and Households PRODUCT MARKET Money Value of output = Expenditure on Final goods and services final goods and services Firms Households Factor Services : Total i ncome land, = rent labour, capital, +wages+interest+profits entrepreneurship FACTOR MARKET Fig 2.1: The Circular Flow of Income in a Two-sector Economy

12 This simple circular flow highlights the following interrelationships between: Factor Market and Product Market Output flow and Income flow Business production and Consumer spending Each sector is seen in its dual role: that of the buyer and seller. This perpetuates the circular flow between the two sectors. Circular Flow of Income with Financial System A wide variety of financial institutions and markets constitute the financial system 5 in our economy. Financial institutions are primarily intermediaries between savers and investors, or lenders and borrowers. They are specialise in their respective areas of financial function. Development economists point out the significance of financial development of an economy as a concomitant outcome of economic development. Therefore, understanding the macroeconomic activity will be incomplete without the inclusion of financial system in our circular flow model. So far, in our presentation of circular flow of income, we have not considered the role of saving and investment. This is mainly due to the reason that we have assumed that the two sectors Households and Firms are balanced spenders (that is, they neither have a surplus nor deficit). Once we relax this assumption a financial system to which INTRODUCTORY MACROECONOMICS Households and Firms can lend and from which they can borrow would become relevant. Households are the net lenders. This is possible due to generation of personal savings, which is the difference between household income and consumption. Firms are net borrowers since they have to finance new investment in plant and equipment. All lendings and borrowings are channelled through the financial system. So long as lending is equal to the borrowing, that is, leakage is equal to the injection, the circular flow will continue indefinitely (Fig.2.2). Financial institutions pay interest to the savers as their funds are placed with them for a period of time under a contract. Firms pay dividend and interest for the sums they have borrowed from the financial markets in the form of shares, bonds and public deposits. Financial institutions, through their role of intermediation, enable funds transfer from ultimate lenders to ultimate borrowers. Saving and investment process create better prospects for capital formation, thanks to the operations of financial institutions and markets. Financial system is therefore very important to the working of the modern economy. But it is sometimes believed that money and finances are only a cover over the production of goods and 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 Firms Money value of final Final consumer goods and goods and services Financial System services Households Factor Services Factor Payments FACTOR MARKET Fig 2.2: Circular Flow of Income in a Two-sector economy with Financial System funds flow between sectors as unimportant. Finance as some economists have held, is only a lubricant that makes the economy to work smoothly. Circular Flow of Income with Government 6 Whatever has been presented in the foregoing section leads us to the conclusion that under the two-sector model, the value of total output flow in our simple economy is equal to the total value of factor incomes and the value of personal consumption flow. Let us now expand the two-sector model and obtain a three-sector model with the inclusion of the Government sector. Economic interrelationships between Households and the Government on the one hand and Firms and Government on the other are very important from the point of view of the role of Government as regulator and as an agent of promoting general welfare of the people of the country. All the changes which are necessitated by inclusion of Government sector are shown in Fig. 2.3. In order to make the analysis simple, now onwards we will see only monetary flows. Government purchases goods and services from Firms and labour services 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 Government Firms Purchases Taxes Subsidies Factor Government Sector Financial System Consumption Expend Payments iture Payments for services Transfer Payments Taxes Households Fig 2.3: The Circular Flow of Income in a Three-sector Economy taxes from Households and Firms in order to finance its expenditure. The government makes transfer payments to the Households in the form of social security, scholarships, etc. It also gives subsidies to the Firms for various purposes. In India, subsidies are given to small industries, export units, and other priority sectors of our economy. 7 Circular Flow of Income with External Sector We now need to study the international dimension of macroeconomic activity because international economic environment affects output and employment in the domestic economy. The external sector is also called the Rest of the World (ROW) sector and this is connected with circular flow of domestic economy (Fig. 2.4). The domestic economy and the rest of the world are connected through international trade and capital flows. One country s exports are another country s imports. This import and export of goods and services ultimately decide what the domestic economy gains or loses in the international trade. Home economy enjoys a trade surplus when there is excess of exports over imports; it suffers a trade deficit when the opposite happens. 8 The four-sector model of the economy demonstrates the overall macro economic condition of income 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 Government Taxes Firms Purchases Subsidies Factor Receipts for Expert s Payments for Import s Government Sector Financial System Consumption Expend External Sector Payments iture Payments for Services Transfer Payments International Taxes Inte rnational Factor Households Incom e Transfer Income (Net) Fig 2.4 : The Circular Flow of Income in a Four-sector Economy Y C + I + G + (X M) Wherein Y = Income or output C = Private Consumption Expenditure on Consumer goods I= Investment expenditure by Producing sectors G = Government Purchases X M = Net exports (Where, X = Exports, M = Imports) The science of national income accounting is based on this identity. SUMMARY l l l l l Structure of the macro economy is given by the circular flow of income and output. National income accounting has its foundation in the circular flow model. National income accounting has several uses for economic policy and research. Circular flow of income can be depicted in two-sector, three-sector and four-sector models. 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.