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Study Note - 3

NATIONAL INCOME

This Study Note includes

• Concept of National Income


• Measurement of National Income
• Difficulties in Estimating National Income
• National Income and Economic Welfare
• Consumption, Savings and Investment
• Economic Growth & Fluctuations

3.1 CONCEPT OF NATIONAL INCOME

National Income is nothing but the income of a nation or a country. In real terms a national
income is the flow of goods and services produced in an economy in a particular period - a
year. A National Sample survey has, therefore,defined national income as - money measures of
the net aggregates of all commodities and services accruing to the inhabitants of a community
during a specifed period.

Concepts Associated with National Income

1. Gross National Product (GNP) - The GNP of a country in a year is defined as the market
value of all final goods and services produced by domestic factors in the country in that year.

2. Net National Product (NNP) - NNP at market price is defined as GNP minus depreciation of
capital stock.

Why should we deduct the depreciation from GNP ?


The productive power of physical capital stock of a country diminish gradually because of the
wear and tear that it undergoes in the process of production. When the machine become totally
unproductive, it can be replaced by a new machine. So a sum of money is set aside every year
and put it into depreciation fund and new machine can be purchased by utiliziing this
accumulated sum in the depreciation fund.
So depreciation is deducted from GNP in order to get a more accurate measure of the sustainable
production of goods and services in a country in a given year.

3. NNP at factor cost or National Income- NNP at factor cost = NNP at market price minus
Indirect Business Tax minus Non tax liabilities minus Business Transfer Payments plus Subsidy
from Government = National Income .

ECONOMICS A97
National Income

4. Gross Domestic Product (GDP) - GDP can be defined as the sum total of values of all goods
and services produced within the geographical boundary of the country without adding the
factor income received from abroad.

Distinction between Gross National Product and Gross Domestic Product –

Gross National Product is different from Gross Domestic Product in following respects :

(a) Gross National Product refers to the total market value of all the final goods and
services produced in a country during a given year, plus net factor income from
abroad.
But Gross Domestic Product refers to the total market value of all the goods and
services produced in the given year within the domestic territory of the country.
(b) Gross National Product includes all income earned by the country in abroad. But
Gross Domestic Product does not include the income earned by the country from
abroad.
(c) Gross Domestic Product does not include the income earned by the country from
foreign investments.
(d) G.D.P. includes only those goods and services which can be produced within do-
mestic territory of the country.
(e) G.N.P. is a wider concept than the G.D.P.
But G.N.P. is more useful than G.D.P.

3.2 MEASUREMENT OF NATIONAL INCOME

There are three alternative ways of estimating National Income of a country. Broadly it may be
viewed from income side, output side and expenditure side. Let us discuss these methods:

(a) Product method - In simple terms this method implies that by adding the values of
output produced and services rendered by different sectors one may find out the na-
tional income.

The output method is unscientific. In this method only those goods and services are
counted which are paid for, that is marketed. But there are many goods and services
that do not have market price and are not paid for. Services of a housewife or a teacher-
father; food crop, fruits and vegetable grown in family farm would not be counted as
part of the GNP. Similar services or goods would become a part of GNP if they are paid
for. Thus GNP at market price invariably leads to an underestimate of gross and ser-
vices.

A98 ECONOMICS
Moreover, there lies possibility of double or even triple counting in this method. Counting
wheat, flour and bread’s value separately is methodologically incorrect because bread’s
value contains flour’s value which, in turn., contains wheat’s value. However, this
problem can be overcome if only value of final goods are considered excluding primary
and intermediate goods. The problem can be overcome in another wayknow as the
value added method whereby only the value added by each firm in the production
process is included in the output figure. Thus the value added output of all sectors
makes up GNP at factor cost.

(b) Income method – In this method all income from employment and ownership of assets
before taxation received from productive activities to be counted. It is the factor income
method. The summation of incomes earned by the factors of production for their con-
tribution to production. To these be added the undistributed profits of the private sec-
tor and trading surplus of the public sector corporations. While all those groups of
income generated in production, some other are to be excluded. These are known as
Transfer Earnings. Examples of such earnings are pensioner benefits, un employment
doles, sickness benefits, interest on national debt etc. These are excluded, as they do not
arise from productive activities.

(c) Expenditure Method — By measuring total domestic expenditure we can measure the
income of a nation. Broadly, total domestic expenditure comprises two elements. First,
consumption expenditure of the household sector on goods and services. It also in-
cludes the consumption outlays of business sector and public authorities.

Another part of national expenditure is investment expenditure by private sector and


public authorities. Expenditure is said to be investment when it is used for making a
fixed capital like building, machinery etc. It also means an increase in the stock of in-
puts and finished products.

In measuring total domestic expenditure we have to take some precautions (a) only
new goods be considered. Any spending on old goods is a transfer of asset from one
hand to another. There is no new asset coming through production (b) Only the final
stage of purchase be included because measuring expenditure for intermediate stage
may lead to duplication of spending amounts. (c) Residents of country may spend for
foreign goods (import) any may also earn by selling goods abroad (exports). Hence it is
necessary to exclude spending on imports and to include value of exports.
Usefulness of National Income estimates
National Income estimates are in a sense social accounting showing economic transactions in
terms of which the economy of nation may be studied as a whole made up of parts. National
Income data may serve many purposes.

Firstly, all such data gives an account of the overall growth of an economy. It Shows
how the production is changing, the sectoral contribution and the effects of government
policies and programmes.

ECONOMICS A99
National Income

Secondly, in analyzing the relation between input of one industry and the output of the
other, NI data is necessary. As in input output analysis so also in economic planning
planners must analyse such data to find out deficiencies or excess.

Thirdly, an analysis of NI data reveals the distribution of income among economic


units. They show how much of total income in going to farmers and workers, and how
much among ‘white collar’ workers and land owing classes. On the basis of such data,
government may take corrective actions.

Fourthly, such estimates also show the consumption pattern of different economic classes.
Changes of tastes and fashions are revealed in NI estimates. They are of immense value
to the businessmen in deciding what to produce or for whom to produce.

Lastly, NI estimate helps the government in its economic role than any other organiza-
tion and person. For the perhaps the government of a country spends so much for its
estimation. Indeed the basis of most public policies is NI data. They are useful in guid-
ing decisions taking and controlling the economy in right direction. The national in-
come quantum indicates the ability of a country to pay its share for international pur-
pose e.g. membership of IMF or World Bank.

3.3 DIFFICULTIES IN ESTIMATING NATIONAL INCOME

The difficulties in the estimation of National Income can be broadly divided into conceptual
difficulties and statistical difficulties.

Some of the conceptual problems related to precise estimate of national Income are as
follows : -

(a) There are many services for which no remuneration is paid. Similarly there are goods
that are marketed sold at a price but are used for self-consumption. But no practi-
cable methods exists for their inclusion in National Income accounting.
(b) In estimating National Product we take into account only the so called final goods
which are those goods readily available for consumption. But it is not always pos-
sible to make a clear distinction between primary, intermediate and final goods.
(c) Another problem relates to pricing of products. Prices change overtime and region.
The price that should be chosen to determine the money value of National product
is a difficult question.
(d) There is much debate regarding inclusion of income of foreign companies in Na-
tional Income estimates since, a large part of such income is remitted out of the
country.

A100 ECONOMICS
There are some statistical problems in the computation of national income.

(a) Changes in the price level have to be made in comparing national income of
different years. It involves the use of Index Number. Index Numbers have their
inherent difficulties.
(b) Official statistics are not always accurate Much of it is based on guess work and
sample survey.
(c) Methods of computing NI are not the same in all countries. Statisticians differ in
their opinion regarding statistical computation.
(d) And the statistical data are often not available. Data relating to unaccounted
money, wages of labour in unorganized sector are case in point.

3.4 NATIONAL INCOME AND ECONOMIC WELFARE


Economists like A.C. Pigou, are of the opinion that an increase in wealth means an increase in
welfare and a decrease in it implies a loss of welfare. Such causal relationship is heavily dis-
counted by modern writers like Prof. Paul Samuelson. In their view, there is no direct relation
between wealth and welfare. Samuelson suggests that to calculate economic welfare we have
to correct GNP to allow for disseminates of modern urban living, for enhanced leisure, now
enjoyed by the citizens’, for household work by wives. We must compute the Net Economic
Welfare (NEW) to guage quality of economic life. We must compute the adjusts the conven-
tional measure of GNP to allow for pollution cost, disseminates of modern urban living, leisure
etc. Thus Political economy shows how people if they really wish to, can trade off quantity of
goods for quality of life. Many things that contribute to human welfare are not included in the
GNP. Leisure is an example. Although a shorter work week may make people happier, it will
tend to reduce measured GNP.

Furthermore, the GNP may not adequately reflect changes in the quality of products. A 1994
TV is a much superior product to a 1984 TV. It is more reliable and has better audio video
quality. But GNP measures do not reflect these changes in quality. Also GNP does not allow
for the capacity of different goods to provide different satisfactions. Crores of rupees spent on
defence products makes the same addition to GNP as crores of rupees spend on a school, a
stadium or shopping expenditures that may produce very different level of consumer satisfac-
tion. GNP does not measure the quality of life. To the extent that material output is purchased
at the expense of such things as overcrowded cities and highways, polluted environments
defaced country sides, mined accident victims and longer waits for Public Services, GNP mea-
sures only part of the total of human well being. This undersirable products are often called
bad to distinguish them from goods which are desirable products. The GNP omits certain
outputs such as the illegal provision of Products people want; non marketed activities and
output in the black economy, some of which clearly add to people’s living standards.

ECONOMICS A101
National Income

Increase in the general price level would bring a fall in the economic welfare. If increase in the
size of national income is the result of prolonged working hours, increased employment of
female workers and children in production, unhealthy and polluted atmosphere inside the
factor premises, such an increase in National Income will not promote economic welfare.

If the net National Product has increased on account of more production of capital goods, it
will not increase welfare. Welfare also depends upon the distribution of National Income. If
the National Income increases and yet if it is not fairly distributed and are concentrated in a
fewer hands, it will not promote economic welfare. The law of Diminishing Marginal Utility
also applies to accumulation of money. As the rich people get richer the additional unit of
money income gives less welfare. The unequal distribution of Nation Income decrease eco-
nomic welfare. When the distribution of National Income changes in favour of the poor they
start getting more commodities and services than before, as a result the economic welfare in-
creases.

The philosophy of the National Income statistician might be expressed in the observation—
Man does not live by bread alone, but it is nevertheless important to know how much bread he
has. The National Income figures do not measure everything that contributes to human wel-
fare, nor are they intended to do so.

3.5 CONCEPT OF CONSUMPTION, SAVING AND INVESTMENT

CONSUMPTION

Keynes held that current consumption depends upon current gross income minus tax liabili-
ties. He says “men are disposed as a rule and on the average, to increase their consumption as
their income increases by not by as much as the increase in their income.” Symbolically 1> C >
0. This is the psychological law of consumption.

Consumption Function

The propensity to consume shows income consumption relationship C = F(Y). here c is con-
sumption a dependent variable and Y is an independent variable. It should be noted that pro-
pensity to consume does not mean desire to consume but effective consumption. C is an in-
creasing function of income as Y and C move in the same direction.

A102 ECONOMICS
Y C=Y

Consumption C = a + by
L
C
A

45O
0 X
Income

Fig. 3.1
OX measures real income and OY consumption. The C curve represents the propensity to
consume. It slopes upward to the right showing consumption rising along with income. At
point A while income is zero consumption is positive, and upto CL on the consumption curve,
we find that consumption exceeds income.

Average Propensity to consume

It implies the ratio of total consumption to total income.

APC = c / y

Marginal propensity to consume

This implies the effect of additional income on consumption. It is the ratio of additional
consumption to additional income : MPC = dc/dy, Or MPC < 1. That is to say MPC is less than
unity. The propensity to consume is a fairly stable function of income.

Determinants of consumption Functions

Consumption function depends on subjective and objective factors. Among objective factors
we may mention a few.

a) Tax Policy – A higher rate of tax will reduce personal income and to that extent
consumption as well.
b) The Rate of Interest – A higher rate of interest may induce more savings and so less
consumption. However a higher interest income may raise consumption by raising
total income.
c) Holding of Assets – If people want to hold more assets, like property, jewellery
etc. they will curtail consumption.

ECONOMICS A103
National Income

d) Windfall Profits or Loss – Consumption level of those classes of people changes


who gain windfall profit or incur heavy loss.

Among subjective factors we may mention some motives that lead individuals to refrain from
spending. These are motive of precaution, motive of foresight, motive of improvement, motive
of avarice etc.

SAVING
Definition

Keynes defined savings as an excess of income over expenditure on consumption. Symbolically


S = Y – C. The unconsumed part of national income of all members of the community represents.
National Savings. The total domestic savings are the sum of households’ savings plus business
sector’s savings plus government’s savings. The first two constitute private savings and the
latter public savings.

Determinants

The size and rate of savings in an economy are determined by many a factor. The most impor-
tant determinant of savings is income. Savings is functionally related to income S = f(Y). The
saving income ration tends to rise with increase in income. The savings function is a stable
function of income in the short run. But savings as such is not a stable function of income. So
marginal propensity to save (ds/dy) is always greater than zero but less than unity that is,
people save part of additional income but not the entire income. Symbolically

1 > MPS > 0 or 1 > ds/dy > 0

The saving function is explain by three income concepts in macro economics.

(a) Absolute Income – Keynes was of the opinion that savings are a function of abso-
lute level of income. That is current savings depend on current disposable income
i.e. income minus taxes paid.
(b) Relative Income – According to Duesenberry savings out of a given income by an
individual depends on his relative income i.e., upon his percentile position in the
total income distribution.
(c) Permanent Income – According to Friedman, the basis of determining consumption
and saving is permanent income. Permanent income is current income plus the
expected income received over a period of time. Actual or measure income is the
sum of permanent and transitory income Ym = Yp + Yt . Transitory income implies
unanticipated addition or subtractions in income.

A104 ECONOMICS
A second factor influencing savings is the distribution of income. Generally, inequality of income
distribution helps the process of savings. In this context we may refer to “demonstration effect”,
that is man’s desire to imitate the superior consumption standard of neighbours or relatives.
This induces a man to buy expensive goods and so saving decline.

Thirdly, savings depend on sound financial institutions and the rate of interest. A higher rate
of interest motivates us to save more. So also existence of diverse type of financial instruments
gives people incentive to save more.

Besides the above objective factors, savings also depend on a host of subjective or psychological
factors. A man’s attitude towards savings depends on his farsightedness, his desire to bequeath
a fortune, to enjoy a better living in future or to possess some physical asset. A strong subjective
motive is precautionary in nature. A man saves or insures as a precaution against future
uncertainty and insecurity.

Savings: A Virtue or a vice

According to classical economists savings is a virtue as they believed that what is saved is
being automatically invested. But some classical theorists argued that the act of saving leads to
under consumption and this diminishes effective demand. In effect, over production and
unemployment appear.

While considering savings as a private virtue, Keynes believed it be a social vice. A general
increase in savings means a general reduction in consumption expenditure and a fall in effective
demand. This will lead to a sharp fall in investment, production and employment. As a result
individual income may decline leading to reverse operation of Multiplier.

The Keynesian views are based on the concept of income elasticity of saving. As income falls
due to contraction of expenditure savings will also decline. This stands in sharp contrast to
classical view point where saving was considered as interest elastic. If, however, savings are
hoarded they destroy real capital.

Thus whether savings is virtue or a vice depends upon its use and its effects on income.

INVESTMENT

Definition

Investment has dual aspect. It implies the production of new capital goods like plants and
equipments. Secondly, a change in inventories or stocks of capital of a firm between two peri-
ods.

ECONOMICS A105
National Income

Determinants

The volume of investment undertaken by private entrepreneurs depends primarily upon two
factors (a) the marginal efficiency of capital (MEC) and (b) the rate of interest. The term MEC
implies the prospective yield from the capital asset and the supply price of this asset. MEC, in
the words of Keynes, is “equal to the rate of discount which would make the present value of
the series of annuities given by the return expected from the capital asset during its life just
equal to its supply price”. Symbolically C = Q/P. Where Q is the prospective yield from capital
asset and P is the supply of this asset. In considering a particular investment project the inves-
tor must have some idea of future returns, that is yields from the real asset in its life span.
Suppose for the years 1,2,3,……… n the net return is current values (i.e. value in the year they
are received)

R1, R2, R3,………Rn (1)

In order to find the present value of all expected future returns we have to discount all future
returns. Consequently the stream of returns, as shown in equation (1), has a present value of
n
R1 R2 R3
å
Rj Rn
= + + +........... +
3
(1 + r)j (1 + r) 1
(1 + r) 2 (1 + r) (1 + r)n
j=1
An investor will compare this present value of return with cost of the real assets (Pc). The
condition for the maximization of net returns over costs is that increments has a present value
of expected returns which just covers the initial cost.
n
Rj
Pc = å (1 + r)j
j=1

Generally there exists a negative relation between interest rate and investment expenditure. A
fall in the rate of interest may induce an increase in investment expenditure whereas a higher
rates, investment is likely to be less. At a higher interest rate, a firm instead of using funds for
capital equipments may invest in financial assets. Thus the level of investment is a negative
function of the rate of return.

Investment expenditure also depends on over all economic climate. An optimistic outlook is
highly encouraging for investment in capital goods. Risk, uncertainty and instability tend to
discourage business to undertake investment projects.

Moreover, a firm may expand investment outlay for innovation viz. introducing a new good or
a new technique. Such innovations either by increasing sale or by reducing cost may help the
innovating firm a larger return on its investment.

Finally, investment decisions of a firm are influenced, to no small extent, by the cost of capital
goods. A firm normally calculates the initial cost of acquisition, and the subsequent cost of

A106 ECONOMICS
maintenance and operation of capital goods. The present stock of capital goods on hand and
their working condition, moreover, determine whether to incur investment for buying the capital
or its purchase be postponed.

Marginal Efficiency of Capital (MEC) and Marginal Productivity of Capital (MPC).

The term MPC, as used by Marshall, implies the additional physical product obtained due to
the employment of one extra unit of capital (do/dc) per unit of time. In other word, it relates to
the increment of value received by using one more physical unit of capital. In contrast, MEC
denotes the series of increments in output anticipated over the life of the capital equipment.
Thus while MPC i.e. dQ, MEC is dQ1, dQ2, dQ3, ….. dQn. The former (MPC) indicates just the
current output, the latter the stream of output over a period of time.

The MPC is net current product of the capital good minus the cost of capital good. In other
words, the current rate of return over cost MEC, on the other hand, implies the return over cost
throughout the life of the capital goods. Thus the basic difference between the two concepts is
that, the one (MPC) denotes current yield and the latter implies prospective yields from a
capital asset.

Investment Multiplier

The Keynesian multiplier shows how many times the total income increases by a given amount
of initial investment. If dI represents increase in investment, dY represents increase in income
and M the multiplier, the M = dY/dI. Thus the Multiplier is the number by which the initial
investment is to be multiplied to get the resulting change in income. With the help of the mar-
ginal propensity to consume the relation between a given dose of investment and the resulting
change in income can be shown.

Suppose a firm makes an additional investment of Rs. 1000/- for enlarging its business. The
money thus spent by the firm will lead to an equal amount of increase in income of some other
men. These income earners will spend a part of the additional income for consumption and
save the rest (dY = dC + dS). If we assume marginal propensity to consume to be 0.8, they will
spend Rs. 800 out of Rs. 1000 for consumption goods. In effect the producers of these goods will
have an extra income of Rs. 800 and they will in turn spend 4/5. That is Rs. 640, which will be
the extra income of some other people. Thus there is a chain a income and expenditure gener-
ated from the original and autonomous investment. The total increase is the sum of the in-
crease in income at each stage. The sum can be calculated as follows

1000 + 800 + 640 + 512 ……….n


or 1000 [1 + (4/5) + (4/5)2 + ………..]

Using geometric progression, we find

Rs. 1000 (1/1-4/5) = 1000 x 1/5 = 5000

ECONOMICS A107
National Income

The investment Multiplier thus denotes the ratio of change in income to the change in primary
Investment. The value of the multiplier can be calculated by the formula

K = 1/ (1- MPC)
This can be derived in the following way :-

Y = C + I (National Income = Total consumption + Total Investment)


dY = dC + dI
or 1 = dC/dY + dl/dY (dividing both sides by dy).
or, dI/dY = 1- dC/dY
or, dY/dI = 1/(1-dC/dY)
= 1/(1-MPC) = 1/MPS
We know that

K = dY/dl
So, 1 – dC/dY = 1/K
So, K = 1/ (1 – dC/dY) = 1/ (1-MPC )= 1/MPS

The value of the Multiplier is the inverse of the MPS (marginal propensity to save).

The significance of the concept of Investment Multiplier is that it shows how a given autonomus
investment enlarges income. We can explain the multiplier effect graphically.

Y Y = C+ I
C+ I
F
H C+ I
C

45O
0 X
Y1 Y2

Fig. 3.2

A108 ECONOMICS
In this graph OX measures income (Y) and OY axis represents C and I. The curve C shows
marginal propensity to consume which is assumed to be ½ . Hence the slope of the curve is 5.
Since the aggregate demand curve C + I cuts the 45o angle at E, OY1 is the equlibrium income.
If investment is increased to EH(dl), the aggregate demand curve shifts upward to C + I and
cuts the 45o angle line at F. The new equilibrium level of income is OY2. Thus income increases
by Y1 and Y2 as result of an increase in investment by EH which (Y1Y2) is double of EH. This is
because when MPC is ½ the multiplier is 2.

1/1-MPC = 1/ (1- ½) = 1/1/2 = 2

Leakages

The multiplying process of income propagation is much weakened by the operation of certain
exogenous factors. Indeed it may operate at the reverse direction also causing a cumulative
decrease in income and spending. The swelling of income may peter out because of such leakages
:-

(a) A decrease in MPC and an increase in MPS may reduce the value of multiplier
because multiplier is the reverse of MPS. If, for example, MPS rises from 1/5 to
½, value of the multiplier will fall from 5 to 2, increase in National Income would
be less.
(b) A part of the extra income may leak out of the income stream if invested in
financial assets, naturally consumption expenditure will be less.
(c) Similarly if a large part of additional income is invested in financial assets, natu-
rally consumption expenditure will be less.
(d) A strong liquidity preference may lead to holding of cash balance in hand in-
stead of spending for consumption goods.
(e) An excess of imports over exports causes a net outflow of funds from domestic
economy, thus weakening income propagation through earning and spending.
(f) A small part of the extra income can be used for consumption expenditure if the
rate of taxation is very high.

The Acceleration Principle

The concept of Multiplier highlights the effects of initial investment upon national income
through changes in consumption expenditure. Such change in output of consumption goods
cause investment for production of capital goods used in producing those consumption goods.
Thus a given autonomous investment begets a chain of induced investments. The ratio be-
tween the net change in consumption outlay and the induced investment is known as accelera-
tion coefficient : a = dI/dC, where dI is net change in investment and dC for net change in
consumption expenditure and for accelerator. Suppose a net increase of consumption outlay of
Rs. 10 lakh induces an additional investment of Rs. 20 lakh then the value of accelerator is 20/
10 = 2.

ECONOMICS A109
National Income

The value of accelerator depends on capital output ratio i.e. the amount of capital required to
produce a given volume of output. It also depends upon the durability of capital goods. The
acceleration effect will be high if capital equipments have more durability and capital output
ratio is high. A small change in consumption expenditure, generally speaking, is likely to cre-
ate a larger induced investment.

3.6 ECONOMIC GROWTH AND FLUCTUATION


Economic Fluctuation

One of the characteristics of capitalistic economy is economic instability. The business world in
such an economy is said to experience ups and downs in its economic activities. These fluctua-
tions take the form of Wave like rise and fall in a regular time sequence. In economics, such
movements are known as Trade Cycle or Business Cycle. As the fluctuations in income em-
ployment, output move in a cyclic order, they are known as trade cycle.

It has been aptly remarked that all such cycles are members of the same family but not twins. It
means that general pattern of the cycles is same. Some cycles are of long-run while others have
a shorter duration. Secondly, the impact of fluctuation is often confined to few countries or
may take a world wide shape. The Great Depression of the 30s aptly illustrates the point. Thirdly,
cyclical fluctuations may be of different degrees—they may be mild or serve, causing little or
violent disturbances to business.

Whatever may be its form or durability, every trade cycle pass through four phases (i) Prosper-
ity (ii) Recession (iii) Depression and (iv) Recovery.

(i) The main spring of business prosperity is profit. In a capitalist economy as prof-
its inflate industrialists and businessmen get necessary incentive to produce more
and invest more. An air of optimism blows from one corner to another. More in-
vestment leads to more employment and so more income more effective demand.
Indeed, a virtuous circle engulfs the entire business environment. The economy
drives up and reaches the peak of prosperity (P).

(ii) No business, trade or industry can remain in the peak of prosperity forever.
Excessive expansion leads to diseconomies of large scale production, rising cost,
higher wages and much shortages. Similarly, demand for bank credit being high
and rising, interest rates tend to move up. These diminish profit to a lower level.
The economy moves towards contraction either slowly or abruptly. It is the stage
of recession .

(iii) The recessionary trends ultimately pull the economy to the rock bottom level,
Income, employment and output decline sharply. Investments fall and enterprise
is discouraged. Pessimism leads to depression and deflation.

A110 ECONOMICS
(iv) Depression does not continue for indefinite period. It is an improving stage of
trade. Weaker units are liquidated, old debts are repaid, and enterprises are reor-
ganized. Unemployment rate gradually decreases and income is generated. A good
harvest or the manufacture of a new industrial good may pave the way for recov-
ery.

Causes

Different explanations have been offered for periodicity of business cycles. According to clas-
sical writers fluctuations in farm products cause business cycles. Some economists believe that
expansion and contraction of bank credit cause cyclical fluctuation. But bank credit is more
often the effect than the cause of trade cycle. Another explanation is to be found in the Innova-
tion Theory which seeks to explain prosperity by the introduction of new goods and depres-
sion by the fall in the demand for old products. Often due to over saving or under consumption
of the people, supply remains unsold as a vast majority of the population do not buy them.

Lord Keynes explained trade cycle by the changes in the expected profitability of investment
or what he called Marginal Efficiency of capital. In Keynesian theory, employment depends on
three variables :

Propensity to consume, rate of interest and marginal efficiency of capital (MEC). While the
former two are more or less stable in the short run, it is the MEC that is the primary determinant
of employment. When MEC is high, optimism prevails in the business world, Investment goes
on rising and so also income and employment. The economy thus reaches the peak of prosperity.
The process is reversed by two retarding factors –

(a) high cost arising from shortage of resources


(b) a falling tendency of the rate of profit due excessive increase in supply.

This shows the seed of pessimism and a decline in MEC leading finally to a depression.
The economy revives when MEC revives. A ray of optimism appears when the prospect
of profit revives. The excess stock of consumer goods is exhausted and growing scarcity
of consumer goods lead to higher profit expectation.

Anti Cyclical Policy

Government of a country may take some measures to control cyclical fluctuations. Through an
expansionary or contractionary credit policy the central bank can control business cycle. Rais-
ing the rate of interest in boom and lowering it in depression by reducing the volume of invest-
ment or encouraging it may reduce the swings of a trade cycle. This may not happen in real life.
Even with a low interest rate, investment may not be promoted if expectation of profit is weak.
If, on the other hand, expectation of profit is quite high, businessmen will borrow for invest-
ment despite higher interest rate.

ECONOMICS A111
National Income

A contra cyclical fiscal policy can be used to eliminate trade cycle. In a period of depression
government should spend more and tax less with the object of increasing effective demand
that is buying power of people. In prosperity phase government should spend less and tax
more so as to leave less in the hands of people. Keynes advocated deficit spending for a depres-
sionary economy.
The socialists think that cyclical fluctuations are the outcome of a capitalistic economy where
profit motive is the main driving force. The problem can be uprooted if the system move from
capitalism to socialism with state ownership of the means of production.

Economic Growth

Definition

By the term economic growth is meant the expansion in the capacity of an economy to produce
goods and services over a period of time. It implies an outward shift of production possibilities
frontier of an economy showing the different maximum possible combinations of quantities of
two goods if it employs all its available resources full and given the existing state of technol-
ogy.

Measurement

Different methods have been suggested for measuring economic growth. One measure is a
country’s over all capacity to produce goods and services. The money value of GNP can change
because of change in price. Hence it is necessary to measure economic growth rate by using
constant Rupees, or real income.

An increase in real GNP if followed by a higher rate of growth of population may lead to a
deterioration or no change in the standard of living of the population. The problem can be
overcome by raising per capital national income. Secondly, if GNP increases owing to an in-
crease in arms and ammunitions, ships, engines etc. the quality of life of people would remain
the same. Thirdly, an increase in GNP may not help growth if its not distributed fairly and
equally. Fourthly, if increase in GNP is achieved by more efforts and exertions on the part of
the labour force then welfare is likely to diminish.

Real GNP per capital = Real GNP/ Population

If the numerator (GNP) grows faster then the denominator (Population), real GNP per capita
will grow and quality of life will improve. On the contrary, if GNP grows at a rate lower than
population, real GNP per capita goes down. But changes in real GNP per capita does not tell us
any thing about distribution of income or the quality of goods and service that compose GNP.

A112 ECONOMICS
Components of Economic Growth

The growth of economy’s total output depend generally on four components

(i) the size of the population (P)


(ii) fraction of population that constitute labour force L/P (L = PX)
(iii) the total number of labour hours actually worked by the labour force

L x H = P x L/P x H

(iv) Output per labour i.e. labour productivity.


This is equal to total output Q divided by the total number of Labour hour i.e.
Q/(L x H).
Thus the economy’s full employment total output Q may be expressed as

Q = (L x H x Q)/(L x H)

(a) Population : Population helps economic growth by enlarging demand on the


one hand and paves the way for producing large quantity of output on the other.
(b) The fraction of total population engaged in productive activities constitutes
Labour force. Obviously if this proportion (L/P) is high more will be produc-
tive capacity of an economy and vice versa.
(c) The length of the average work hour of the labour force generally seems to have
a direct impact on the rate of economic growth. It may also be argued that a
decline in the average work-week may indicate a good life provided by eco-
nomic growth.
(d) Growth in productivity is said to be the primary element of economic growth.
Productivity that is, output per labour hour has a direct bearing on the level of
GNP. The more productive labour, the more will be the total output of an indus-
try. Economic history of different developed economies support this conten-
tion. Labour force acquires skill through proper training and education, and
also on the quality and quantity of capital as also the technology.

Relation between Stability and Growth

In the 30s, the committee on Finance and Industry in England spoke of “avoidance of the trade
cycle” and the “stability of the price level” as the goals to be pursued by the Bank of England.
These works are as true today as they were when uttered in 30s.

Indeed financial stability is essential for economic growth. First, if a country’s currency
is not stable, people will be much reluctant to save for fear of further fall in the value of
currency. Such slowing down of savings would tend to retard progress.

Secondly, a stable economy can help the formation of capital by stimulating the inflow
of foreign capital.

ECONOMICS A113
National Income

Stability of currency, thirdly, is necessary to stimulate a rapid increase in productivity.


If prices are not stable, firms can make ‘easy’ profit and repay their old debts in
depreciated currency. This is likely to depress businessman’s incentive to innovate, the
desire to take risks and such other finer qualities of business enterprises. But in a situation
of financial stability firms can no longer make that ‘easy’ profit. They are compelled to
improve their methods of production and over all organizations.

Finally, the existence of well-organised financial institutions is likely to quicken economic


growth by mobilizing savings for investment purposes. These institutions thrive in a
climate of financial stability.

A114 ECONOMICS
Exercise
1. Distinguish between –
(a) GDP & GNP
(b) GDP & NDP
(c) NNP & GNP
(d) GDPMP & NDPFC
2. Explain the ‘production method’ of measuring national income. State the
difficulties in this method.
3. Explain the income and expenditure method of calculating national income,
along with the difficulties associated.
4. Point out the difficulties in the measurement of national income.
5. What is the meaning of ‘double counting’ in national income accounting and
what does it lead to?
6. Why are the services of house wives not included in national income?
7. Why are the following not included in national income :
(a) Sale of an old car;
(b) Winning of a lottery;
(c) Income of a smuggler.
8. Give an example of transfer payment.
9. What is meant by Consumption functions? What is the distinction between
Average propensity to consume and Marginal Propensity to consume? Dis-
cuss the factors determining Marginal Propensity to consume.
10. Discuss with the help of a graph the concept of Investment Multiplier. Explain
the relation between multiplier and Marginal propensity to consume.
11. What is meant by Economic Growth? What are the components of economic
growth?
12. Discuss whether savings is a virtue or a vice for –
a) an individual
b) the society

ECONOMICS A115