Fiscal Policy

Meaning of Fiscal Policy: 

Fiscal Policy may be defined as that part of governmental economic policy which deals with taxation, expenditure, borrowing and the management of public debt in an economy. It is an indispensable instrument of modern public finance. The importance of fiscal policy has greatly increased in modern times, both in the developed as well as the underdeveloped countries of the world. In developed countries, fiscal policy is being increasing used as an instrument to achieve full employment and economic stability. In underdeveloped countries, on the contrary, fiscal policy is more and more being used as a means to step up the rate of economic growth. Fiscal policy primarily concerns itself with the flow of funds in the economy. Taxation diverts the funds from the private sector to the governmental sector. Public expenditure on the contrary, diverts funds from the governmental sector back to the economy. Public borrowing, like taxation also diverts funds from the private sector to the governmental sector, but the two diversions influence the private sector in different ways. Management of public debt includes functions, such as, floating of governmental loans, payment of interest thereon and retirement of matured debts. Fiscal policy, thus, exerts a very powerful influence on the working of the national economy. It directly affects the volume of output, income and employment in the economy. The greater the percentage of national income and expenditure represented by the governmental budget, the greater would be the influence of fiscal policy on aggregate economic activity. 

Objectives of Fiscal Policy in a Developed Capitalist Economy: 

There are two broad objectives of fiscal policy in a developed capitalist economy, namely, 1. To achieve and maintain full employment in the economy, and 2. To achieve economic stability in the economy through avoidance both of inflation as well as deflation. In short, the basic goal of fiscal policy in a developed economy is one of full employment and economic stability. 

Objectives of Fiscal Policy in Underdeveloped Economy: 

The nature of fiscal policy in an underdeveloped economy is bound to be different from that of a developed economy. In a developed economy, the problem is not so much that of development as that of achieving economic stability on account of business fluctuations caused by the operation of the trade cycles. But the problem of an underdeveloped economy is not so much that of economic stability as that of promoting rapid economic growth in the country. 

The major objectives of fiscal policy in an underdeveloped country are: 

• The first objective of fiscal policy in an underdeveloped country should be to maximize the level of aggregate saving by applying a cut to the actual and potential consumption of the public at large. The fiscal policy should especially curb conspicuous consumption of the rich and force them to save more for capital formation. 

• The second objective should be to maximize the rate of capital formation to break economic stagnation and to lead the country on to the path of rapid economic progress and growth. 

• The third objective of fiscal policy in an underdeveloped economy should be to divert capital resources from less productive to more productive and from socially less desirable to socially more desirable uses.
• The fourth objective of fiscal policy should be to protect the economy of an underdeveloped country from inflation. Inflation can ruin an underdeveloped country. As such, the fiscal policy of an underdeveloped country should be designed in such a manner so as to curb inflationary forces arising during the process of growth. 

• The fifth objective of fiscal policy should be to eliminate as far as possible, sectoral imbalances arising in the economy from time to time. 

• The sixth objective of fiscal policy should be to provide incentives for encouraging those industries which have a high employment potential in the economy. 

• The seventh objective of fiscal policy in an underdeveloped country should be eliminate as far as possible, the glaring economic inequalities in the economy and bring about an equitable redistribution of income and wealth in society. 

Fiscal Policy and Economic Growth: 

Fiscal policy is also a potent weapon for the achievement of accelerated economic growth in a backward, underdeveloped economy. Without an appropriate fiscal policy, the process of economic growth in a country is bound to suffer. In achieving a fast economic growth, the government may have to deploy all the instruments of fiscal policy at its disposal, namely, taxation, public expenditure, public debt and deficit financing. The problem in a backward underdeveloped economy is not one of lack of real resources, but that of shortage of financial resources. So the instruments of fiscal policy may have to be used to raise adequate finance for economic growth. 

1. Taxation: 

It is an indispensable instrument for raising finance for economic development. For this purpose, the government may resort to direct as well indirect taxation. Direct taxes, such as, income tax, wealth tax, gift tax, capital gains tax etc may have to be levied to net adequate revenues for development purposes. The incidence of these taxes mostly falls on the richer classes. As such, they are quite justified from the point of equity. The government may impose steep excise duties and import taxes on luxury goods which are consumed exclusively by the rich. To raise enough revenue for developmental purposes, it may also be necessary to levy excise taxes on articles of mass consumption, though the burden of such taxes is mostly borne by the poor and middle-class. 

2. Public Debt: 

Taxation taken alone may not yield adequate revenue for mobilizing the real resources of the country. The government may therefore resort to public borrowings, short-term as well as long-term, to add to its fund of investible resources. There may be opposition to heavy taxation, but no one opposes public borrowings because the government pays interest on public loans. While borrowing from the public, the government should ensure that the burden of interest charges does not turn to be unbearable for it. For this purpose, the government may adopt a cheap money policy to keep interest-rates at a comparatively low level. Since the amount raised through internal borrowings may not be adequate there is no harm if the government if the government resorts to the international money market for raising the necessary funds for developmental purposes. The government may even take loans from foreign countries or international lending agencies on suitable conditions and terms of repayment. While raising external loans, the government has to be alert enough to see that such loans do not compromise its economic and political sovereignty in any way. 

3. Public Expenditure: 

The government of an underdeveloped country should devote quite a substantial portion of its expenditure to the building up of the necessary infrastructural facilities for economic growth, such as, roads. Railways, communications, irrigation works, power stations, coal-mining, general and technical education. These facilities will induce the rapid growth of the economy. Along with that, a part of the purpose expenditure may also be allocated for the growth and development of basic industries which will provide the foundation of industrial growth in future. Agriculture which is generally the most important segment of an underdeveloped economy should receive special attention of the government. Expenditure incurred by the government on the promotion of labour and social welfare also aids the rapid growth of the economy by improving the productivity of the labour force. 

4. Deficit Financing: 

It is still another important instrument of fiscal policy. It has proved to be a dispensable means of financing the economic growth of underdeveloped economy. Several developing countries have in recent years, employed the technique of deficit financing as a means of financing economic development. 

Limitations of Fiscal Policy: 

Fiscal policy as an instrument of economy stability and economic growth suffers from certain limitations which may be as follows; 

1. Firstly, the difficulty of accurately forecasting the onset of depression robs fiscal policy of much of its utility and effectiveness as an anti-cyclical device. More often than not, a country finds itself already knee-deep in depression before it moves about to take corrective action. 
2. Secondly, the corrective action taken by the government does not produce immediate results, because, there is often a prolonged time interval between the enforcement of fiscal measures and their final impact on the functioning of the economy. 
3. Thirdly, fiscal steps taken by the government to curb unemployment may fail to yield results if the unemployment is due to causes other than the deficiency of aggregate demand. Fiscal measures for example will fail to create any dent on unemployment, if it is due to seasonal, frictional, structural or technological causes. 
4. Fourthly, fiscal measures may prove inadequate or ineffective in dealing even with cyclical unemployment caused by the deficiency of aggregate demand for several reasons. For example: increased public expenditure intended to create more employment opportunities may be accompanied by a decline in private expenditure due to an increase in factoral prices. Increased public expenditure may also have adverse effect on employment-generation in the private sector through a general increase in wage-levels. 
5. Fifthly a strong and powerful fiscal policy adopted to deal with more mass unemployment may unduly inflate the size of the public debt which will impose an unbearable burden on the future generations. 
6. Sixthly, while dealing with hyper-inflation and boom, the government may carry its fiscal measures to the other extreme, namely, far too high taxation and cut-back in public investment, which will pave the way for the forth coming depression. 
7. Lastly, fiscal measures taken to finance economic growth in an underdeveloped economy may not suffice unless and until recourse is taken to monetary devices such as deficit financing etc.

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)

Module 01: Question Bank

Two Marks Questions:

1. Define macroeconomics. 
2. Give any four concepts of macroeconomics. 
3. State any two importance of Macroeconomics. 
4. What is unemployment? 
5. What is an economic policy? 
6. Name any four economic problems in an economy. 
7. Define National Income. 
8. Define economic growth. 
9. Define economic planning. 
10. What is business cycle? 
11. Define stagflation. 
12. Mention the two functions of investment. 
13. Mention any four central issues of Macro economics. 
14. What is Fallacy of composition? 
15. State any four limitations of macro economics. 
16. What is an exchange rate? 
17. What is surplus balance of payments? 
18. What is deficit balance of payments? 
19. State the types of Macro economics. 
20. What is macro statics? 
21. What is Macro dynamics? 
22. What is comparative macro statics? 
23. Mention any two concepts of National Income. 
24. What is NNP? 
25. What is depreciation? 
26. What is Personal Income? 
27. What is disposable personal income? 
28. What is Per capita income? 
29. State the methods of measuring National Income. 
30. State any two difficulties in the estimation of National Income. 
31. State any two importance of National Income analysis. 

Five Marks Questions:

1. Define Macroeconomics and discuss its nature. 
2. Describe the importance of Macro economics. 
3. Discuss any four central issues of macro economics. 
4. Describe the subject matter of macro economics. 
5. Describe any four limitations of macro economics. 
6. Describe macro statics. 
7. Describe macro dynamics. 
8. Describe comparative macro statics. 
9. Discuss Macro statics v/s Macro dynamics. 
10. Describe any four concepts of National Income. 
11. Describe any two methods of calculating the National Income. 
12. Describe the difficulties in measuring the national income. 
13. Describe the importance of national income analysis. 

Ten Marks Questions:

1. Describe the central issues of macro economics. 
2. Describe the limitations of macro economics. 
3. Describe the types of macro economics. 
4. Describe the concepts of National Income. 
5. Describe the methods of measurement of the National Income.

Business Cycles

An important feature of the working of a capitalist economy is the existence of alternating periods of prosperity and depression generally referred to as a ‘business cycle’ or ‘trade cycle’. In a business cycles there are wave like fluctuations in aggregate employment income, output and price-level. The term business cycle has been defined in various ways by different economists. 

• Prof Haberler’s definition is very simple, he says,” The business cycle in the general sense maybe defined as an alternation of periods of prosperity and depression of good and bad trade.” 

• Keynes’s definition in his treatise of money is more explicit: “A trade cycle is composed of periods of good trade characterized by rising prices and low unemployment percentage alternating with periods of bad trade characterized by falling prices and high unemployment percentages.” 

• Prof. Gordon’s definition is precise,” business cycles consist of recurring alternation in aggregate economic activity, the alternating movements in each direction being self-reinforcing and pervading virtually, all parts of the economy”. 

• The most acceptable definition is that given by Prof. Mitchell in these words,” Business cycles are a type of fluctuations found in the aggregate economic activity of nations that organize their work mainly in business enterprise”. 

Thus business cycle, in short, is an alternate expansion and contraction in overall business activity, as evident by fluctuations in measures of aggregate economic activity, such as, the gross product the index of industrial production, employment and income. Generally speaking, the cyclical fluctuations have a tendency towards simultaneous appearance in a;; the branches of the national economy. But sometimes they may be defined only to individual sectors of the economy. Cyclical fluctuations in such cases are referred to as specific cycles.

Characteristics of Business Cycles:

The main characteristics or features of business cycles are as follows: 

1. A business cycle is a wave like movement. 
2. Business cycles operate periodically at fairly regular intervals of 10 to 12 years. 
3. Business cycle is of an all embracing nature, that is, it prevails in all industries, all occupations including agriculture and all areas in a country. 
4. Expansion and contraction in a business cycle are cumulative in effect. 
5. Business cycles are all-pervading in their impact. 
6. A business cycle is characterized by downwards and upward movements. 
7. In business cycles, cyclical fluctuations are recurrent in nature.

Phases of Business Cycles:

A typical or standard business cycle is characterized by; 

1. Recovery
2. Prosperity
3. Recession
4. Depression 

Related Article: Four Phases of Business Cycle

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)

Phases of the Business Cycle

1. Recovery: 

We start from a situation when depression has lasted for some time and revival phase or the lower-turning points starts. The ‘originating force’ or ‘starters’ may be exogenous or endogenous forces. Suppose the semi-durable goods wear out which necessitates their replacement in the economy, it leads to increased demand investment and employment increase. Industry begins to revive. Revival also starts in related capital goods industries. Once begum, the process of revival becomes cumulative. As a result, the levels of employment, income and output rise steadily in the economy. In the early stages of the revival phase, there is considerable excess or idle capacity in the economy so that output increases without a proportionate increase in total costs. But as time goes on, output becomes less elastic, bottlenecks appear with rising costs, deliveries are more difficult and plants may have to be expanded. Under these conditions prices rise. Profit increases, business expectations improve, optimism prevails. Investment is encouraged which tends to raise the demand for bank loans. It leads to credit expansion. Thus the cumulative process of increase investment, employment, output, income and prices will feed upon itself and becomes self-reinforcing. Ultimately revival enters the prosperity phase. 

2. Prosperity: 

In the prosperity phase, demand, output, employment, and income are at a high level. They tend to raise prices. But wages, salaries, interest-rates, rentals and taxes do not rise in the same proportion to the rise in prices. The gap between prices and costs increases the margin of profit. The increase of profit and the prospect of its continuance commonly cause a rapid rise in stock market values.” All securities including bonds rise under the influence of improving expectations. The outstanding change is in stocks that, reflecting the capitalized values of prospective earnings, register in an exaggerated form the rising profits of enterprise”.  The economy is engulfed in waves of optimism. Larger profit expectations further increase investments which is helped by liberal bank credit. Such investments are mostly in fixed capital, plant, equipment and machinery.  They lead to considerable expansion in economic activity by increasing the demand for consumer goods and further raising the price-level. This encourages retailers, wholesalers and manufacturers to add to inventories. In this way, the expansionary process becomes cumulative and self-reinforcing until the economy reaches a very high level of production, known as the peak or boom. 

The peak or prosperity may lead the economy to over-full employment and to inflationary rise in prices. It is a symptom of the end of the prosperity phase and the beginning of the recession. The seeds of recession are contained in the boom in the form of strains in the economic structure which act as brakes to the expansionary path. They are: 

1. Scarcities of labour, raw-materials etc leading to rise in costs relative to prices. 
2. Rise in the rate of interest due to scarcity of capital and 
3. Failures of consumption to rise due to rising prices and stable propensity to consume, when incomes increase.  

The first factor brings a decline in profit margins. The second makes investment costly and along with the first lowers business expectations. The third factor leads to the piling of inventories indicating that sales or consumption lags behind production. These forces become cumulative and self-reinforcing. Entrepreneurs, businessmen and traders become over cautious and over optimism give way to pessimism. 

3. Recession: 

Recession starts when there is a downward descend from the ‘peak’ which is of a short duration.” It marks the turning point during which the forces that make for contraction finally win over the forces of expansion. Its outward signs are liquidation of bank loans, and the beginning of the decline of prices.” As a result, profit-margins decline further because costs start overtaking prices. Some firms close down. Others reduce production and try to sell out the accumulated stocks. Investment, employment, incomes and demand decline. This process becomes cumulative. 

4. Depression: 

Recession merges into depression when there is a general decline in economic activity. There is considerable reduction in the production of goods and services, employment, income, demand and prices. The general decline in economic activity leads to a fall in bank deposits. Credit expansion stops because the business community is not willing to borrow. Bank rate falls considerably. According to prof. Esley; “This fall in active purchasing power is the fundamental background of the fall in prices. That, despite the general reduction of output, characterizes the depression”. Thus depression is characterized by mass unemployment, general fall in prices, profits, wages, interest rate, consumption expenditure, investment, bank deposits and loans. Factories close down and construction of all types of capital goods, buildings etc. comes to a standstill. These forces are cumulative and self reinforcing. 

Depression may be short lived or it may continue at the lowest point for considerable time. But sooner or later limiting forces are set in motion which ultimately tends to bring the contraction phase to end and pave the way for the revival. A cycle is thus complete.

Related Article: Four Phases of Business Cycle

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)

Methods of Measuring National Income

In preparing the national income estimate it is necessary to add the values of all final goods and services produced and exchanged during a year. Thus what ever is produced is either used for consumption or saving. There are three methods of estimating national income. They are: 

• The census of products method 

• The census of income method 

• The expenditure method 

1. The Census of Products Method: 

This is also called inventory or output method. Under this method, the value of aggregate production of final goods and services in an economy in a year is considered. The economy is divided into different sectors such as agriculture, mining, manufacturing, small enterprises, commerce, transport, communication and services etc. Then the gross product is found out by adding the net values of all production that has taken place in these sectors during a year. The aggregate of all these is called the gross national product at market price. While calculating the gross national product under this method, care must be taken to avoid double counting.

The computation of national income of a country through output method has been illustrated in the following table.

2. The Census of Income Method: 

This method approaches the national income from the distribution side. The incomes accruing to all the factors of production during the process of production are aggregated together. This is called national income at factor cost. National income is calculated by adding the following: 

• 1. Wages and salaries 

• 2. Social security 

• 3. Earning of self-employed or professional income 

• 4. Dividends 

• 5. Undistributed profits 

• 6. Interest 

• 7. Rent 

• 8. Profits of public sector enterprises and 

• 9. Subsidies and transfer payments have to be deducted. All unpaid services are to be excluded. Financial investments in the form of equity shares, sales of old property etc. are to be excluded. Direct tax revenue to the government should be subtracted from the total income. Government subsidies should be deducted. In India the national income committee is using this method in calculating national income. 

3. The Expenditure Method: 

Expenditure method arrives at national income by adding up, all expenditure made on goods and services during a year. Income can be spent on consumer goods or capital goods. Again, expenditure can be made by private individuals and households or by government and business enterprises. Further, people of foreign countries spend on the goods and services which a country exports to them. Similarly people of a country spend on imports of goods and services from other countries. We add up the following types of expenditure by households, government and by productive enterprises to obtain national income. 

• Expenditure on consumer goods and services by individuals and households. This is called final private consumption expenditure and is denoted by ’C’. 

• Government expenditure on goods and services to satisfy collective wants. This is called government’s final consumption expenditure and is denoted ‘G’. 

• The expenditure by productive enterprises on capital goods and inventories or stocks. This is called gross domestic capital formation, which, is denoted by ‘I'. Gross domestic capital formation is divided into two parts. 

                    a) Gross fixed capital formation 

                    b) Addition to the stocks or inventories of goods 

• The expenditure made by foreigners on goods and services of a country exported to other countries, which are called exports and are denoted by ‘x’. We deduct from exports ‘x’ the expenditure by people, enterprises and government of a country on imports (M) of goods and services from other countries. That is, we have to estimate net exports (that is exports- imports) or (x-m).

Thus we add up the above four types C+G+I+(x-m) to get final expenditure on gross domestic product. On deducting consumption of fixed capital, we get net domestic product.

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)

Concepts of National Income

There are a number of concepts pertaining to national income. They are: 

• 1. Gross National Income (GNP) 

• 2. Net National Income (NNP) 

• 3. Gross Domestic Product (GDP) 

• 4. Personal Income 

• 5. Disposable Personal Income 

• 6. Per Capita Income 

1. Gross National Income: 

GNP is the total measure of the flow of goods and services at market value resulting from current production during a year in a country, including net income from abroad, GNP includes four types of final goods and services: (1) Consumer’s goods and services to satisfy the immediate wants of the people. (2) Gross Private Domestic Investment in capital goods consisting of fixed capital formation, residential construction and inventories of finished and unfinished goods.(3) goods and services produced by the government and (4) net exports of goods and services that is, the difference between value of exports and imports of goods and services, known as net income from abroad.

In this concept of GNP there are certain factors that have to be taken into consideration. 

• First, GNP is the measure of money, in which all kinds of goods and services produced in a country during one year are measured in terms of money at current prices and then added together. 

• Second, in estimating GNP of the economy, the market price of only the final products should be taken into account. 

• Third, goods and services rendered free of charge are not included in GNP, because, it is not possible to have a correct estimate of their market prices. 

• Fourth, the transactions which do not arise from the produce of current year or which do not contribute in any way to production are not included in GNP 

• Fifth, the profits earned or losses incurred on account of changes in capital assets as a result of fluctuations in market prices are not included in the GNP if they are not responsible for current production or economic activity. 

• Lastly, the income earned through illegal activities is not included in GNP. 

GNP is the most frequently used national income concept. It is a better index than any other concept because it expresses the actual condition of production and employment in a country during a specific period. It provides a general idea of the performance of the economy. 

2. Net National Income (NNP): 

GNP includes the value of total output of consumption and investment goods. But the process of production uses up a certain amount of fixed capital. Some fixed equipment wears out, its other components are damaged or destroyed and still others are rendered obsolete through technological changes. All this process is termed as depreciation or capital consumption allowance. In order to arrive at NNP, we deduct depreciation from GNP. The word ‘net’ refers to the exclusion of that part of total output which represents depreciation. So , NNP = GNP- Depreciation. 

3, Gross Domestic Product (GDP): 

Income generated by the factors of production within the county from its own resources is called domestic income or domestic product. Gross domestic product includes: 

1. Wages and salaries 
2. Rents, including imputed house rents 
3. Interest 
4. Dividends 
5. Undistributed corporate profits including surpluses of public sector undertakings 
6. Mixed incomes consisting of profits of unincorporated firms, self-employed persons, partnerships etc. 
7. Direct taxes 

Since gross domestic product or income does not include income earned from abroad, it can also be shown as: 

Domestic Income = National Income – Net Income from Abroad 

Thus the difference between domestic income and national income is the net income earned from abroad may be positive or negative. If exports exceed imports, net income from abroad is positive. In this case national income is greater than domestic income. On the other hand, when inputs exceed exports, net income earned from abroad is negative and domestic income is greater than national income. 

4. Personal Income: 

Personal income is the total income received by the individuals of a country from all sources before direct taxes in one year. The entire national income will not be available for consumption. National income is different from personal income. In order to arrive at personal income several deductions are to be made. For example, corporations have to pay income-tax from the corporate profits before declaring dividends. Likewise a part of the corporate profits available for distribution is reduced. Similarly salaried persons and wage earners pay a certain percentage of their income towards social security contribution. To that extent income available to the employees and workers is reduced. Against this, the government may give social security benefits such as unemployment allowances, old age pensions etc. These payments are called transfer payments are called transfer payments. These are to be added to arrive at personal income. Therefore. 

Personal Income = National Income – Corporate income taxes – undistributed corporate profits-social security contributions + transfer payments. 

The concept of personal income is a useful concept. It helps in estimating the potential purchasing power of the households in an economy. The weakness of this concept is that it does not clearly tell us the actual amount of money available for disposable personal income. 

5. Disposable Personal Income: 

Disposable income or personal disposable income means the actual income which can be spent on consumption by individuals and families. The whole of the personal income cannot be spent on consumption, because it is the income that accrues before direct taxes have actually been paid. Therefore, in order to obtain the disposable income, direct taxes are deducted from personal income. Thus: 

Disposable income = personal income – direct taxes 

But the whole of the disposable income is not spent on consumption and a spent on consumption and a part of it is saved. Thus, 

Disposable income = consumption expenditure + savings expenditure. 

6. Per Capita Income: 

The average income of the people of a country in a particular year is called per capita income for that year. This concept also refers to the measurement of income at current prices and at constant prices. For instance, in order to find out the per capita income at current prices, the national income of a country is divided by the population of the country in that year. 

Per capita Income = National income÷ population 

This concept enables us to know the average income and the standard of living of the people. But it is not very reliable, because in every country due to unequal distribution of national income a mojor portion of it goes to the richer sections of the society and thus income received by the common man is lower than the per capita income.

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)

Difficulties in the Measurement of National Income

There are a number of difficulties in the measurement of national income of a country. The following are the important difficulties of national income analysis: 

• 1. National income is always measured in terms of money, but, there are certain goods and services whose money measurement is not possible. For example: the services performed by housewife for her family, voluntary services performed with a charitable object, etc. such items are excluded from the national income figures. This leads to an underestimate of the national income. 

• 2. Income obtained from illegal activities is not included in the national income and their exclusion results in an under-valuation of the national income. 

• 3. It is difficult, to obtain accurate statistics. This is the reason, why there is big differences between the national income statistics collected by the different institutions. 

• 4. The collection of depreciation on capital consumption, presents another formidable difficulty. There are no accepted standard rates of depreciation applicable the various categories of capital goods. Thus, the national income estimate will not be correct. 

• 5. The difficulty of avoiding double counting in the national income. To avoid this difficulty, final goods and services are to be included in the national income, but it is not an easy task. 

• 6. The difficulty of price changes arises in the national income estimate. When the general price index increases, the national income will also increase, even if the national output is reduced. Similarly, if general price index decreases, the national income will also decrease, although, there may be an increase in national output. Therefore, due to price changes, we may not find an accurate estimate of national income. 

• 7. The prevalence of non-monetized transactions in underdeveloped countries creates an important problem in the measurement of national income. A considerable part of the output does not come into the market at all. In agriculture, a major part of output is consumed by the farmer themselves which reduces the national income figure to a great extent. 

• 8. Due to illiteracy, most of the producers in less developed countries have no idea of the quantity and value of their output and do not keep regular accounts, which, creates difficulties in national income measurement.

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)

Importance of National Income Analysis

Today, national income statistics are collected by all the countries of the world for a number of years. Raising national income is the important goal of all economic activity. Economic welfare of a country depends upon what goods and services are available for the consumption of its individuals. The changes in national income statistics show how the economy is developing and enables the government to lay down the appropriate economic policy necessary under the circumstances. With the help of national income statistics it is possible to chart cyclical movements, find out the inflationary gap, measure economic growth and development, and evaluate the country’s material standard of living in comparison with other countries. The following are the main uses of national income.

• 1. Since income is a flow of wealth changes in the national income give some indication of economic welfare. 

• 2. National income is used to compare standards of living in different countries. 

• 3. National income figures are used to measure the rate of growth of a country. 

• 4. The national income accounts make it possible for an analysis of the behaviour of the different sectors of the economy. 

• 5. Inflationary and deflationary pressures can be estimated with the help of national income statistics. 

• 6 National income statistics can be used to forecast the level of business activity at later date, and to find out trends in other annual data. 

• 7. The national income figures are useful in providing a correct sense of proportion about the structure of the economy. 

• 8. In war time, the study of components of national income is of great importance because they show the maximum possible production possibilities of the country. 

• 9. National income statistics can be used to determine how an international financial burden should be an apportioned between different countries. The quantum of national income measures the ability of a country to pay contributions for international purposes, just as the income of a person measures his ability to pay for the upkeep of his country. 

• 10. Above all the national income statistics are used for planned economic development of a country. In the absence of such data, planning will not be possible. 

In the words of Prof. Samuelson, "By means of statistics of national income, we can chart the movements of a country from depression to prosperity, its steady long-term rate of growth and development, and finally, its material standard of living in comparison with other nations".

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)

Subject Matter of Macro Economics (Central Issues)

The subject matter of macro economics are as follows: 

1. Determination of National Income: 

The first major issue in macro economics is to explain what determines the level of employment and national income in an economy and therefore what causes involuntary unemployment. The level of national income and employment are very low in times of depression as in 1930s in various capitalist countries of the world. This will explain the cause of huge unemployment that emerged in these countries. Classical economists denied that there could be involuntary unemployment of labour and other resources for a long time. Classical economist thought that with changes in wages and prices, unemployment would be automatically removed and full employment established. But this did not appear to be so at the time of great depression in the thirties (1930) and after. Keynes explained the level of employment and national income is determined by aggregate demand and aggregate supply. With aggregate supply curve remaining unchanged in the short run, it is the deficiency of aggregate demand that causes under employment equilibrium with the appearance of involuntary unemployment. According to Keynes it is the changes in private investment that causes fluctuations in aggregate demand and is, therefore, responsible for the problems of cyclical unemployment.

2. General Price-level and Inflation: 

Another macro economic issue is to explain the problem of inflation. Inflation had been a major problem faced by both the developed and developing countries in the last 50 years. Classical economists thought that it was quantity of money in the economy that determined the general price level in the economy and according to them, rate of inflation depended on the growth of money supply in the economy. Keynes criticized the ‘quantity theory of money’ and showed that the expansion in money supply did not always lead to inflation or rise in price-level. Keynes who before the second world war explained that involuntary unemployment and depression were due to the deficiency of aggregate demand, during the war period when prices rose very high, he explained in his booklet’ how to pay for war’ that just as unemployment and depression were caused by the deficiency of aggregate demand, inflation was due to the excessive aggregate demand. Thus, Keynes put forward what is now called ‘demand-pull theory of inflation’. After Keynes, theory of inflation has further developed and many theories of inflation depending upon various causes have been put forward, to analyze the problem of inflation is an important issue in macroeconomics. 

3. Business Cycles: 

Throughout history market economics have experiences business cycles. Business cycles refer to fluctuations in output and employment with alternating periods of boom and recession. During boom or prosperity both output and employment are at high levels, whereas in recession both output and employment fall as a consequence large unemployment came into existence in the economy. When recession is extremely severe, they are called depression. What are the causes of these business cycles is an important macro economic issue which has been highly controversial. The objective of macro economic policy is to achieve economic stability with equilibrium at full- employment, level of output and income. 

4. Stagflation: 

During the decade of 1970s and in the subsequent decades market economies have experienced a still more intricate problem which has been described as stagflation. While in business cycles, recession or depression is accompanied by not only high degree of unemployment but also rapid inflation. This is a period which has high unemployment and recession (stagflation) which co-exists with high inflation. This problem is called stagflation. Stagflation could not be explained with Keynesian theory, which focuses on the demand side. Therefore, a new economic thought which is called supply-side economies emerged which explained stagflation by laying stress on the supply side of economic activity. Stagflation is an important issue of modern macro economics. 

5. Economic Growth: 

Another important issue in macro economics is to explain what determines economic growth in a country. Theory of economic growth has been recently developed as an important branch of macro economics. The problem of growth is a long-run problem and Keynes did not deal with it. It was Harrod and Domar who extended the Keynesian analysis to the long-run problem of growth with stability. They laid stress on the dual role of investment- one of income generating, which Keynes ignored because of his preoccupation with the short-run. Harrod and Domar in their models showed that investment adds to productive capacity (capital stock), and then if growth with stability (without stagnation or inflation) is to be achieved, income or demand must be increasing at a rate large enough to ensure the full utilization of the increasing capacity. Thus, macro economic models of Harrod and Domar have explained the rate if growth of income that must take place if the steady growth of the economy is to be achieved. These days growth economics has been further developed and extended a good deal and new theories of growth have been put forward by Solow, Meade, Kaldor and Joan Robinson. 

Since the growth theories of Harrod, Domar, Kaldor, Meade and others apply particularly to the present day developed countries, special theories which explain the causes of underdevelopment and poverty in less developed countries and they also suggest strategies for initiating and accelerating growth in them have also been propounded. These special growth theories relating to less-developed countries are generally known as economies of development. 

6. Balance of Payments and Exchange Rate: 

Balance of payments is the record of economic transactions of the residents of a country with the rest of the world during a period. The objective of preparing such a record is to present an account of all the receipts of goods imported, services rendered, and capital received by the residents of a country and the payments made for goods imported, services received and capital transferred to other countries by residents of a country. There may be deficit or surplus in balance of payments. Both create problems for an economy. An important effect is that the transactions in balance of payments are influenced by the exchange rate. The exchange rate is the rate at which a country’s currency is exchanged for foreign currencies. The instability in exchange rate has been a major problem in recent years which has given rise to serious balance of payments problems.

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)

Limitations of Macro Economics

There are, however certain limitations of macro economic analysis. Mostly these stem from attempts to yield macro economic generalizations from individual experiences. 

1. Fallacy of Composition: 

In macro economic analysis the,’ fallacy of composition’ is involved, that is, aggregate economic behaviour is the sum total of individual activities. But what is true of individuals is not necessarily true of the economy as whole. For instance, savings are a private virtue but a public vice. If total savings in the economy increase, they may initiate a depression unless they are invested. Again, if an individual depositor withdraws his money from the bank there is no danger but if all the depositors do this simultaneously the banking system will be adversely affected. 

2. To Regard the Aggregates as Homogeneous: 

The main defect in macro analysis is that it regards as homogeneous without taking into consideration their internal composition and structure. The average wage in a country is the sum total of wages in all occupations, that is, wage of clerks, typists, teachers, nurses etc. But the volume of aggregate employment depends on the relative structure of wages rather than on the average wage. If, for instance, wages of nurses increase but of typists fall, the average may remain unchanged. But if the employment of nurses fall and typists rises much, aggregate employment would increase. 

3. Aggregate Variables may not be Important Necessarily: 

Aggregate variables which form the economic system may not be of much significance. For instance, the national income of a country is the total of all individual incomes. A rise in national income does not mean that individual incomes have risen. The increase in national income might be the result of the increase in the incomes of a few rich in the country. Thus a rise in the national income of this type has little significance from the point of view of the community. Prof. Boulding calls these difficulties as, “macro economics paradoxes”, which are true when applied to a single individual but which are untrue when applied to the economic system as a whole”. 

4. Indiscriminate Use of Macro Economic is Misleading: 

An indiscriminate and uncritical use of macro economics in analyzing the problems of the real world can often be misleading. For instance, if the policy measures needed to achieve and maintain full employment in the economy are applied to structural unemployment in individual firms and industries, they become irrelevant. Similarly, measures aimed at controlling general prices cannot be applied with much advantage for controlling prices of individual products. 

5. Statistical and Conceptual Difficulties: 

The measurement of macro economic concepts involves a number of statistical difficulties. These problems relate to the aggregation of micro-economic variables. If individual units are almost similar aggregation does not present much difficulty. But if microeconomic variables relate to dissimilar individual units, their aggregation into macro economic variable may be wrong and dangerous.

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)

Scope and Importance of Macro Economics

Macro economics is of theoretical and practical importance. They are:

1. To Understand the Working of the Economy:

The study of macro economics variables is indispensable for understanding of the working of the economy. Our main economic problems are related to the behaviour of total income, output, employment and the general price level in the economy. These variables are statistically measurable, thereby facilitating the possibilities of analyzing the effects on the functioning of the economy. As Timbergen observes, macro economic concepts help in,” making the elimination process understandable and transparent”. For instance, one may not agree on the best method of measuring different prices, but the general price level is helpful in understanding the nature of the economy.

2. In economic Policies:

Macro economics is extremely useful from the point of view of economic policy. Modern governments, especially of the underdeveloped countries, are confronted with innumerable national problems. They are the problems of overpopulation, inflation, balance of payments, general under-production etc. The main responsibility of these governments rests in the regulation and control of overpopulation general prices, general volume of trade, general output etc. Timbergen says, "Working with macro economics concepts is a bare necessity in order to contribute to the solutions of the great problems of our times". No government can solve these problems in terms of individual behaviour. 

Macroeconomic study helps in the solution of certain complex economic problem like:

a) General Unemployment:

The Keynesian theory of employment is an exercise in macro economics. The general level of employment in an economy depends upon effective demand which in turn depends on aggregate demand and aggregate supply functions. Unemployment is thus caused by decrease in effective demand. In order to eliminate it, effective demand should be raised by increasing total investment, total output, total income and total consumption. Thus, macro economics has special significance in studying the causes, effects and remedies of general unemployment.

b) National Income:

The study of macro economics is very important for evaluating the overall performance of the economy in terms of national income. With the advent of the great depression of the 1930s it became necessary to analyse the causes of general unemployment. This led to the construction of the data on national income. National income data help in forecasting the level of economic activity and to understand the distribution of income among different groups of people in the economy.

c) Economic Growth:

The economics of growth is also a study in macro economics. It is on the basis of macro economics that the resources and capabilities of an economy are evaluated. Plans for the overall increase in national income, output, and employment, are framed and implemented so as to increase the level of economic development of the economy as a whole.

d) Monetary Problems:

It is in terms of macroeconomics that monetary problems can be analyzed and understood properly.  Frequent changes in the value of money-inflation or deflation- affect the economy adversely. They can be counteracted by adopting monetary, fiscal and direct control measures for the economy as a whole.

e) Business Cycles:

Further macro economics as an approach to economic problems started after the great depression. Thus its importance lies in analyzing the causes of economic fluctuations and in providing remedies.

f) For Understanding the Behaviour of Individual Units:

Macro economics helps in the understanding the behaviour of individual units. Demand for individual products depends upon aggregate demand in the economy. Unless the causes of deficiency in aggregate demand are analyzed, it is not possible to understand fully the reasons for a fall in the demand of individual products. The reasons for increase in costs of a particular firm or industry cannot be analyzed without knowing the average cost conditions of the whole economy. Thus, the study of individual units is not possible without macro economics. Thus macro economics enriches our knowledge of the functioning of an economy by studying the behaviour of national income, output, investment, saving and consumption. Moreover, it throws much light in slowing the problems of unemployment, inflation, economic instability and economic growth.

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)

Nature of Macro Economics

Macro economics is the study of aggregates or averages covering the entire economy, such as, total employment, national income, national output, total investment, total consumption, total savings, aggregate supply, aggregate demand, and general price-level, wage level and cost structure. 

In other words, it is aggregate economics which examines the interrelations among the various aggregates, their determination and causes of fluctuations in them. Thus in the words of Prof. Ackley, "Macroeconomics deals with economic affairs. 'In the large', it concerns the overall dimensions of economic life. It looks at the total size and shape and functioning of the entire economy. It studies the character of the forest independently of the trees which compose it". 

Macro economics is also known as the theory of incomes and employment, or simply income analysis. It is concerned with the problems of unemployment, economic fluctuations, inflation or deflation. International trade and economic growth. It is the study of the causes of unemployment, and the various determinants of employment.

In the field of business cycles it concerns itself with the effect of investment on total output, total income, and aggregate employment. In the monetary sphere it studies the effect of the total quantity of money on the general price-level. In international trade, the problems of balance of payments and foreign aid fall within the purview of macroeconomics analysis. 

Above all, macroeconomics theory discusses the problems of determination of the total income of a country and causes of its fluctuations. Finally it studies the factors that retard growth and those which bring the economy on the path of economic development.


Notes provided by Prof. Sujatha Devi B (St. Philomina's College)

Meaning and Definitions of Macro Economics

Introduction 

The term ‘macro’ was first used in economics by Ragner Frisch in 1933. But as a methodological approach to economic problems, it originated with the mercantilists in the 16th and 17th centuries. They were concerned with the economic system as a whole. From the 18th century physiocrats to modern economists have contributed to the development of macro economic analysis. But credit goes to Keynes who finally developed a general theory of income, output and employment in the wake of the great depression. 

Definitions of Macro Economics

Macro economic is concerned with aggregates and averages of the entire economy. Such as national income, output, total employment, total consumption etc. In other words, macro economics studies how the aggregates and averages of the economy as a whole are determined and what causes fluctuations in them. From the theoretical reasoning and on the basis of empirical reasoning and knowledge the old assumption of full employment is not valid and therefore, it is very vital that we should investigate how these aggregates are determined and how to ensure maximum level of income and employment.

Macro economics has been defined in various ways, they are: 

• "Macro economic theory is the theory of income, employment, prices and money". 

• "Macro economics is that part of economics which studies the overall averages and aggregates of the system". 

• "Macro economics is the study of the forces of factors that determine the levels of aggregate production, employment and prices in an economy and their rates of change over time". 

• Prof. Gardner Ackley defines, macro economics thus: "Macro economics itself with such variables as the aggregates volume of output of an economy, with the extent to which its resources are employed, with the size of national income, with the general price level". 

It is evident from the above definitions that the subject-matter of macro economics is to explain what determines the level of total economic activity, that is, the size of the national income and employment and fluctuations in it in the short-run. It also explains what causes the general price level to rise and determines the rate of inflation in the economy. 

Macro economics deals with how an economy grows, it analyses the chief determinates of economic development and the various stages and process of economic growth. The problem of increasing productive capacity and national income in the long run. The problem of increasing productive capacity and national income over time is called the problem of economic growth. Thus, what determines rate of growth of an economy is also the concern of macro economics. 

The justification of a separate macro approach to the study of several economic problems lies in the fact that micro approach is not only inadequate but may lead to misleading conclusions. In economics, what is true of the parts is not necessary true of the whole. After all, the problem of the aggregates is not merely a matter of adding or multiplying what happens in respect of the various individual parts of the economy. It may be quite different and far more complicated than a mere summation or multiplication.

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)