BBA 4th Semester

Macroeconomics Notes
Unit – 1
Definition of Domestic Income

Domestic Income implies the total money value of the final goods and services
produced within the domestic territory of the country, during a specified period,
say a year. In this way, it covers factor income of both, residents and non-residents,
who are generating income within the country.

Further, domestic product and domestic income are one and the same thing.

For example, Foreign banks and companies that operate and earn income in the
country are taken into account while calculating the domestic income.

Formula of Domestic Income

Domestic Income = Rent + Wages + Interest + Mixed Income + Profit Tax +

Dividend + Undistributed Profit + Surplus of Government Sector (if it is given
separately of private sector)

Or

Domestic Income = Compensation of Employees + Operating Surplus + Mixed

Income

What is meant by Domestic Territory?

In the simplest sense, the term ‘domestic territory’ refers to the political boundaries
of the nation. Further, it also covers:

 Ships and aircraft, which are owned and run by the normal residents amidst
two or more countries.
 Fishing vessels, oil and natural gas rigs, and floating platforms whose
operation is undertaken by the country’s residents in international waters,
with exclusive rights as to its operation.
 Embassies, consulates, and military establishments of a country located in a
foreign country.

However, it does not cover:

 Embassies, consulates, and military establishments belonging to a foreign

nation.
  International organizations such as ILO, WHO, UNO, etc. that are located
within the political frontiers of a country.

Definition of National Income

National Product takes into account the total value of all goods and services arising
as a result of economic activity. National Income implies the total of all the
incomes earned, within or outside the geographical territory of the country, by its
ordinary residents.

Therefore, the two are one and the same thing. This is because, the production of
goods and services due to the use of primary factors, which tends to generate
income.

1. It encompasses only factor incomes and excludes transfer income.

2. Income of only normal residents of the country is included.

What is Factor Income?

Factor Incomes include monetary payment made to the owners of factors of

production by the firm for the factor services used, such as rent for land, interest
for capital, wages for labor, profit for entrepreneurs.

Who are Normal Residents?

A Normal Resident or Ordinary Resident is the person who ordinarily resides in

the country and his/her center of economic interest is present in that country.

Formula of National Income

National Income = Domestic Income + Net Factor Income From Abroad

(NFIA)

Net Factor Income from Abroad = Factor Income from Abroad – Factor
Income paid Abroad

Basic Conversions :

1. From Gross to Net : subtract Depreciation (CFC) and vice versa

2. From Domestic to National : add NFIA (FIFA – FITA) and vice versa
 3. Market Price to Factor Cost : subtract NIT (IT – Subsidies)

GDPMP – Depreciation + NFIA – NIT = NNPFC (National Income)

National Income is the sum total of all the factor incomes earned by the normal
residents of a country within a financial year.

National income means the value of all final goods and services produced by a
country during a financial year. Thus, it is the net result of all economic activities
of any country during a period of one year and is valued in terms of money.

Methods to Calculate National Income (Net National Product at Factor Cost) :

There are 3 methods to calculate National Income :

1. Value Added Method or Product Method

2. Income Method

3. Expenditure Method

1. Value Added or Product Method:

In this method, national income is measured as a flow of goods and services. We

calculate money value of all final goods and services produced in an economy
during a year. Final goods here refer to those goods which are directly consumed
and not used in further production process.

Goods which are further used in production process are called intermediate goods.
In the value of final goods, value of intermediate goods is already included
therefore we do not count value of intermediate goods in national income
otherwise there will be double counting of value of goods.

To avoid the problem of double counting we can use the value-addition method in
which not the whole value of a commodity but value-addition (i.e. value of final
good value of intermediate good) at each stage of production is calculated and
these are summed up to arrive at GDP.

The money value is calculated at market prices so sum-total is the GDP at market
prices. GDP at market price can be converted into by methods discussed earlier.

Value Added = Value of Output – Intermediate Consumption

Value of Output = Sales + Change in Stock (Closing Stock – Opening Stock)

Gross Value Added at Market Price = Value Added of (Primary Sector +

Secondary Sector + Tertiary Sector) = GDPMP

2. Income Method:

Under this method, national income is measured as a flow of factor incomes. There
are generally four factors of production labour, capital, land and entrepreneurship.
Labour gets wages and salaries, capital gets interest, land gets rent and
entrepreneurship gets profit as their remuneration.

Besides, there are some self-employed persons who employ their own labour and
capital such as doctors, advocates, CAs, etc. Their income is called mixed income.
The sum-total of all these factor incomes is called NDP at factor costs.

Components :

1. Compensation of Employees :

a. Salary and Wages

b. Payments in kind
c. Employer’s contribution to social security
d. Pension on Retirement by the employer

2. Operating Surplus :

a. Rent and Royalty

b. Interest
c. Profit :

i. Dividends
ii. Corporation Tax
iii. Undistributed Profits (Retained Earnings)

3. MISE (Mixed Income of Self Employed)

By Adding 1 + 2 + 3 = NDPFC

3. Expenditure Method:
In this method, national income is measured as a flow of expenditure. GDP is sum-
total of private consumption expenditure. Government consumption expenditure,
gross capital formation (Government and private) and net exports (Export-Import).

Components :

1. Private Final Consumption Expenditure

2. Government Final Consumption Expenditure
3. Gross Domestic Capital Formation (GDCF)
4. Net Exports (Exports – Imports)

By Adding 1+2+3+4 = GDPMP

When GDCF is not given direct , then it can be calculated by either of the
following steps :

1. GDCF = Gross Fixed Capital Formation + Change in Stock

2. GDCF = Net Domestic Capital Formation + Depreciation
3. GDCF = Net Fixed Capital Formation + Change in Stock + Depreciation

Types of Income :

There are three types of Income :

1. Private Income : Income earned by Private Enterprises and household

individuals.
2. Personal Income : Income earned only by household individuals.
3. Personal Disposable Income : It is the balance of personal income after
deducting the taxes.

What does Personal Income mean?

This is the total earnings generated by an individual from investments, salaries,

dividends, bonuses, pensions, social benefits and other ventures over a given
period. Other sources of personal income include profit-sharing from business
ventures, rent received from property ownership and distributions received from
investments. Often referred to as gross income, it is calculated before the deduction
of taxes charged.

Personal income largely affects consumer consumption which in turn drives the
economy. It tends to fall in times of economic recessions and rise during economic
expansions. Also, economic growth in a country or specific region leads to an
increase in personal income for the peoples in those regions.

What does Personal Disposable Income mean?

This is the amount of revenue or funds a person has after taxes have been paid.
This also amounts to money that people can spend on their needs and save. As
such, it is used to closely gauge the economic performance of an economy.

Economists use economic indicators and statistical measures derived from personal
disposable Including:

Personal savings rates- This is the percentage of disposable income that is

channeled to retirement or savings

 Discretionary income- This is disposable income less all payments for

necessities such as rent, food, transport and health insurance.
 Marginal propensity to save- This is the percentage of each additional
revenue that is saved
 Marginal propensity to consume- This is the percentage of each additional
revenue that is used immediately

Similarities between Personal Income and Personal Disposable Income

 Both are used by economists to gauge consumer spending, saving and

borrowing

Differences between Personal Income and Personal Disposable Income

Key Difference – Personal Income vs Personal Disposable Income

Personal income and personal disposable income are two terms that should be
distinguished accurately since they are used interchangeably despite their
differences. The key difference between personal income and personal disposable
income is that personal income refers to an individual’s total earnings in the form
of wages, salaries and other investments whereas personal disposable
income refers to the amount of net income available to an individual to spend,
invest and save after income taxes are paid. Thus, the tax payment can be
identified as the main distinguishing factor between personal income and personal
disposable income.

What is Personal Income?

Personal income refers to an individual’s total earnings in the form of

wages, salaries, and other investments. It is the sum of all the incomes received by
an individual over a period of time. Personal income can be classified as active or
passive income.

Active Income

Active income is the income resulting from any business activity in which the
individual materially participates.

 Wages, salaries, bonuses, commissions or other payments for services

rendered
 Profit from a trade or business in which you are a material participant
 Gain on the sale of assets used in an active trade or business
 Income generated from intangible property

Passive Income

This is the income resulting from any business activity in which the individual
does not materially participate.

 Earnings from a business that does not require direct involvement from the
owner
 Interest income from deposits and pension
 Dividend and capital gains from securities or commodities
 Royalties earned on intellectual property

Personal income is taxed at a varying level according to the income. The method of
calculating tax is different in each country. However, in general terms, taxes are
levied on net income (gross income less allowable tax savings) and capital gains of
individuals. Below are some examples of minimum and maximum personal tax
rates in countries.
What is Personal Disposable Income?

Personal disposable income is referred to as the amount of net income available to

an individual to spend, invest and save after income taxes are paid. It can be
calculated by subtracting income taxes from income.

Personal Disposable Income = Personal Income- Income Tax Payment

What is the difference between Personal Income and Personal Disposable Income?
Personal Income vs Personal Disposable Income
Personal income refers to an Personal disposable income is referred
individual’s total earnings in the to as the amount of net income available
form of wages, salaries, and other to an individual to spend, invest and
investments. save after income taxes are paid.

Income Tax Adjustment

Personal income is the gross Personal disposable income is arrived at

income before adjusting for after deducting the income tax.
income tax.

Nature

Personal income is the Personal disposable income is

aggregation of all active and dependent on the personal income.
passive incomes.

Summary – Personal Income vs Personal Disposable Income

The difference between personal income and personal disposable income is that
personal income refers to the total earnings obtained as active or passive income
while personal disposable income is arrived at after considering tax payments.
Thus, personal disposable income is smaller and depends on the personal income.
Tax evasion on personal income is illegal and the payment is unavoidable. Tax
rates applied on personal income is subjected to change over time and are also
based on the country of residence.
Quantity Theory of Money

Cambridge Cash Balance Approach

Cambridge Cash Balance equation is a modified version of Fisher's equation
because this theory is linked with that quantity of money which people hold back
with them in the form of cash balances.

Marshall’s Equation:-

He said, “in every society, there is some fraction of income which people keep in
the form of currency, it may be a 5th or a 10th.......

M = KY + K'A

Where,

M = money with people

Y = total real income

K = part of annual income which people want to keep with them as purchasing
power

A = value of assets

K' = part of total property which people want to keep back as cash balance.

The supporters of Marshall removed the property part, then

M = KY

Or M = K.P.O ....... since Y = PO

Thus,P = M / KO

Where,

P = price level

O = total production
M = total supply of money

K = part of income which people want to keep with them.

Result :-

According to Marshall it is the value of K and not M which influences the price.

Pigou'sEquation :-

Marshall’s cash balance approach was further developed by his student, A.C.
Pigou

P = KR / M

Where,

P = purchasing power of one unit of money

K = ratio of money which is kept in the form of cash money

R = real income

M = total quantity of active money

He improved his equation :-

P = KR / M [ C + h(1-C) ]

Where,

C = part of total money which is held back in the form of cash balance

(1-C) = part of total money which is deposited in banks

h = part of bank deposits which banks keep with them in the form of cash balance

Result:-

If K and R are considered as static then any increase in the quantity of money will
bring down the value of money proportionately.

Robertson’s Equation :-
M = KPT

Thus, P = M / KT

Where,

M = quantity of money

K = part of T which people want to keep with them in the form of cash balance

P = price level

T = total transactions in one year

According to Robertson, the demand for money is for store of value or hoarding
value.

Keynes's Equation :-

Keynes has laid more stress on consumer goods. In his opinion, people want to
keep cash balance to purchase consumer goods. This equation is called Real
Balance Approach.

n = P ( K + rK' )

Or P = n / ( K + rK' )

Where,

n = total quantity of money

P = price level

K = part of money kept for purchasing consumer goods

r = ratio of cash balances out of bank deposits with banks

K' = quantity of money in banks to purchase consumer goods and which people
want to keep in bank.

If K, K' and r assumed to be static then P will change according to changes in n.

Features of Keynes Equation :-

  It considers the demand for money from practical point of view.
 It analyses the value of money in short period.
 The demand for money in short period is static.
 This equation combines both legal tender money and credit money.

Criticism :-

 It is difficult to measure K, K' and r.

 The equation ignores the velocity of real money and credit money
 Present consumption has been given preference whereas demand for money
in the fields of speculation and investment is more important.
 Effect of the changes in the rate of interest and bank rate on the ratio of
different types of deposits has not been explained.

2) Milton Friedman's Quantity Theory of

Money :-

It is a mixture of Keynesian and post Keynesian theories. It is also known as

“Restatement of Quantity Theory of money”.

He asserted that :-

 Demand for money can be determined just like demand for commodity.
 Two types of people holding money – business firm and wealth holders.He
deals with those who hold money in the form of money, bonds, shares etc.
 Ratio of human to non- human wealth should also be considered as
subsidiary variable in the money demand function. Expectation :- higher the
human component, greater will be the demand for money.

M / P = f ( Rb,Re,Rm,Pe,w,Yp,u )

Where,

M/P = demand for real cash balances

Rb = rate of return from bonds

Re = rate of return from equity shares

 Rm = rate of return from money

Pe = rate of return from physical goods

W = ratio of non-human to human wealth

Yp = permanent income

u = individual tastes and preferences

The equation was reduced to :-

M/P = f ( r, Yp, u )

Where, r = rate of return

Features of Friedman’s Theory :-

 Money is considered as a luxury good.

 He attempts to show that there is a predictable relationship between change
in the money stock and changes in Gross National Product.

Criticism :-

The theory failed to find any role for rate of interest in determination of demand
for money.

Monetary Policy :

Repo Rate : Repo rate is the rate at which the central bank of a country (Reserve
Bank of India in case of India) lends money to commercial banks in the event of
any shortfall of funds. Repo rate is used by monetary authorities to control
inflation.

Description: In the event of inflation, central banks increase repo rate as this acts
as a disincentive for banks to borrow from the central bank. This ultimately
reduces the money supply in the economy and thus helps in arresting inflation.

The central bank takes the contrary position in the event of a fall in inflationary
pressures. Repo and reverse repo rates form a part of the liquidity adjustment
facility.
Reverse Repo Rate : Reverse repo rate is the rate at which the central bank of a
country (Reserve Bank of India in case of India) borrows money from commercial
banks within the country. It is a monetary policy instrument which can be used to
control the money supply in the country.

Description: An increase in the reverse repo rate will decrease the money supply
and vice-versa, other things remaining constant. An increase in reverse repo rate
means that commercial banks will get more incentives to park their funds with the
RBI, thereby decreasing the supply of money in the market.

Cash Reserve Ratio (CRR) : CRR refers to the minimum percentage of a bank's
total deposits required to be kept with the RBI. It is fixed by the RBI and is varied
from time to time to regulate the supply of money in an economy . When the
supply of money is to be increased CRR is lowered and when the supply of money
is to be reduced CRR is raised.

Fiscal Policy : Fiscal policy is the use of government spending and taxation to
influence the economy. Governments use fiscal policy to influence the level of
aggregate demand in the economy in an effort to achieve the economic objectives
of price stability, full employment, and economic growth.

The government has two levers when setting fiscal policy:

1. Change the level and composition of taxation, and/or

2. Change the level of spending in various sectors of the economy.

There are three main types of fiscal policy:

1. Neutral: This type of policy is usually undertaken when an economy is in

equilibrium. In this instance, government spending is fully funded by tax
revenue, which has a neutral effect on the level of economic activity.
2. Expansionary: This type of policy is usually undertaken during recessions
to increase the level of economic activity. In this instance, the government
spends more money than it collects in taxes.
3. Contractionary: This type of policy is undertaken to pay down government
debt and to cap inflation. In this case, government spending is lower than tax
revenue.

In times of recession, Keynesian economics suggests that increasing government

spending and decreasing tax rates is the best way to stimulate aggregate demand.
Keynesians argue that this approach should be used in times of recession or low
economic activity as an essential tool for building the foundation for strong
economic growth and working towards full employment. In theory, the resulting
deficit would be paid for by an expanded economy during the boom that would
follow.

The classical theory of interest is based upon the following assumptions:

(i) Perfect competition exists in the factor market.

This assumption has the following implications:

(a) The equilibrium rate of interest is determined by the competitive forces of

demand and supply in the capital market.

(b) Interest rate is flexible, i.e., it freely moves to whatever level the demand and
supply forces dictate.

(ii) The theory assumes full employment of resources.

This assumption has the following implications:

(a) Saving involves sacrifice of abstaining from or postponing of consumption and

interest is the reward for abstinence or waiting: it is only when all resources are
fully employed, higher rate of interest is paid to induce people to save or abstain
from consumption or postpone consumption

(b) Income level is assumed to be constant; it is at the full employment level that
income and output do not change and become constant.

(c) The assumptions of full employment and given level of income lead to the
further assumption that the demand and supply schedules of capital are
independent and do not influence each other; it is only when income changes as a
result of a change in investment, that saving changes in consequence.

(iii) Economic agents act rationally, i.e., they are motivated by self-interest and
want to maximise economic benefit.

(iv) The price level is assumed to be constant. If it changes then the economic
agents do not suffer money illusion, i.e., savers and investors react to changes in
the real interest rates and not the changes in the money interest rates.
(v) Money is neutral and serves only as a medium of exchange and not as a store of
value.

Supply and Demand for Capital:

Supply of Capital:

The supply of capital depends upon savings which, in turn, depend upon a number
of psychological, economic and institutional factors broadly classified as – (a) the
will to save, (b) the power to save, and (c) the facilities to save. Saving means
curtailment of consumption or postponement of the present consumption. Thus,
saving involves a sacrifice, abstinence or waiting. The rate of interest is considered
to be the reward for abstinence or waiting.

It is an inducement for the act of saving or foregoing the present consumption. In

deciding between the present consumption (which involves no saving) and the
future consumption (which requires saving), the individual has to take into
consideration the opportunity cost of each alternative and the opportunity cost is
measured by the rate of interest.

For example, if the current rate of interest is 5% then by consuming Re. 1 of

income now, the individual is foregoing the consumption of Rs. 1.05 one year
later. Thus, the higher the current rate of interest, the greater the opportunity cost
of present consumption as compared to the future consumption, and, as a result,
greater the inducement to save out of the present income.

Hence, saving is interest elastic and there is a positive relationship between the rate
of interest and saving. The supply curve of capital or the saving schedule (SS curve
in Figure 1) slopes upward to the right which indicates that higher the rate of
interest, larger will be the savings and greater will be the supply of capital and vice
versa.
Demand for Capital:

Capital is demanded by the investors because it is productive and brings profits to

them. The demand for capital or investment demand depends, on the one hand, on
the productivity of capital, i.e., returns on investment, and on the other hand, on the
rate of interest, i. e., the cost of investment. Productivity of capital is subject to the
law of diminishing returns.

Additional units of capital are less productive than the earlier units; with the
investment of more and more capital, the marginal productivity of capital declines.
The producer will continue his investment of capital as long as the productivity of
capital is more than the rate of interest and will stop further investment when the
productivity of capital equals the rate of interest. This shows that at higher rates of
interest, the producers demand less capital and at lower rates of interest, they
demand more capital.

Thus, the demand for capital is inversely related to the rate of interest. The demand
curve for capital or the investment schedule (II curve in Figure I) slopes downward
to the right which indicates that higher the rate of interest, smaller the demand for
capital.