Unit -1 National Income and Related

Aggregates

CHAPTER 1: INTRODUCTION OF
MACROECONOMICS AND CIRCULAR
FLOW OF NATIONAL INCOME

 Economics has two main branches:

Microeconomics and Macroeconomics.
 John Maynard Keynes, known as "The Father of
Modern Macroeconomics," played a significant
role in its development.
 His book "General Theory of Employment,
Interest and Money" (1936) is a key work in
Macroeconomics.
 Macroeconomics also called "Theory of Income
and Employment," studies how national income
and employment are determined and how to
manage unemployment.
 It focuses on the entire economy and aims to
achieve full employment of resources (main goal).
SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 1
  Macroeconomics also helps with data collection
and analysis of national income and coordination
with international economic policies.
MEANING OF MACROECONOMICS
It is the Study of aggregates of averages covering the
entire economy.
It focuses on national income, full employment,
aggregate demand, and general price level.
It concerned with the relationship between economic
aggregates.

SCOPE OR SUBJECT MATTER OF

MACROECONOMICS
1. Theory of Employment
Determination of the level of employment in the
economy.
It studies consumption function, saving function, full
employment, and underemployment.
2. Theory of National Income
It studies the related aggregates and generation of
national income using product, income and
expenditure methods.

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 2

3. Theory of General Price Level
It Addresses problems related to inflation, excess
demand, deflation, deficient demand and inflationary
or deflationary gaps using macroeconomic variables.
4. Theory of Money
It explains the functions of money and components of
the money supply.
It explains the banking's role in understanding
macroeconomic problems like inflation and deflation.
5. Theory of International Trade
It studies economic transactions between countries,
balance of payment positions determination of foreign
exchange rates, etc.
6. Theory of Economic Growth
It focuses on fuller utilization of resources and
achieving economic growth objectives.
CAPITALIST ECONOMY
A capitalist economy is an economic system
characterized by private ownership of the means of
production and the operation of markets driven by
supply and demand. In a capitalist economy,
production and distribution are primarily determined
by the decisions of private individuals and businesses

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 3

seeking to maximize their profits. This system relies
on the principles of competition, profit motive, and
limited government intervention in economic affairs.

Features
 Private ownership of means of production.
 Production for selling output in the market.
 Sale and purchase of labor services at a wage rate.
 Free interaction of market forces of demand and
supply.
 Government oversight for growth and social justice.

MICROECONOMICS AND MACROECONOMICS:

MEANING, INTERDEPENDENCE, AND
DISTINCTION:
Meaning of Microeconomics
In Microeconomics, economic problems are studied at
the level of an individual household, a firm, or an
industry. Microeconomics is the study of individual
units and decision-makers within an economy. It is
also known as 'Price theory,' it encompasses the
theory of product pricing and factor pricing. In
microeconomics we study individual economic agents.
For example

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 4

(A) Microeconomic Theory:
Law of demand, law of supply, determination of
producer's equilibrium, determination of consumer's
equilibrium, etc.
(B) Microeconomic Variables:
Demand of a commodity, supply of a commodity,
price of a commodity, profits earned by a producer,
etc.
Meaning of Macroeconomics:
Macroeconomics studies economic problems at the
level of an economy as a whole. It focuses on
aggregate economic units and decision-makers within
the economy. It is also called the Theory of income
and employment, its scope concentrates on
determining the level of income and employment. In
macroeconomics we study macroeconomic agents.
For example
(A) Macroeconomic Theory:
Theory of general price level, theory of national
income, theory of international trade, theory of
economic growth, theory of employment, etc.

(B) Macroeconomic Variables:

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 5

Aggregate demand, aggregate supply, total
consumption, total savings, employment of resources,
etc.

Interdependence of Microeconomics and

Macroeconomics
1. Microeconomics depends on Macroeconomics-
Micro-variables rely on the behavior of macro-
variables. Decisions at the micro level depend on
decisions taken at the macro level.
Example-
1. Increase in overall tax rate influences an
individual's decision to buy a TV set as its price goes
up.
2. Price of a commodity is influenced by the general
price level in the economy.
2. Macroeconomics depends on
Microeconomics:
Macro-variables depend on microeconomic variables.
Decisions at the macro level depend on decisions at
the micro level.
Example-
Aggregate demand depends on the demand of
individual households in the economy.
SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 6
National income of a country is the sum total of
incomes of individual units of the economy.
Economic Agents:
Economic agents or economic units are individuals or
institutions that make economic decisions. They can
be:
Consumers - Decide what and how much to
consume.
Producers - Determine what and how much to
produce.
Entities like
Government - Make decisions regarding budgetary
allocations, subsidies, etc.
Corporations - Make decisions related to production,
investment, and resource allocation.
Banks - Make decisions regarding lending, interest
rates, and investment.

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 7

 Differences between Microeconomics and
Macroeconomics
S.
Microeconomic Macroeconomic
N Basis
s s
.
Study of Macroeconomics:
individual Study of
1 Meaning
economic units economy as a
of an economy. whole.
Limited degree of Vast degree of
aggregation (e.g., aggregation (e.g.,
2 Aggregation industry as an all industries,
aggregation of national income).
firms).
Allocation of Determination of
resources and level of income
related and employment,
Central and related
3 principles and
Problems principles and
policies. policies (central
problems of
fuller utilization
of resources and

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 8

 growth of
resources).
Instruments Demand and Aggregate
4 of Study or supply. demand and
Tools aggregate supply.
Determinan Price Income.
5
t
Partial General
equilibrium equilibrium
analysis (shows analysis (studies
effect of one interdependence
factor while among
assuming other macroeconomic
Method of
6 factors remain variables like
Study
constant). total income,
total output,
total
consumption,
total savings,
etc.).
Alternative Price theory. Theory of income
7
Name and employment.

8 Terms Derived from the Derived from the

Greek word Greek word

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 9

 'Micros’ meaning 'Makros'
small. meaning 'large.'

TWO SCHOOLS OF THOUGHT CLASSICAL AND

KEYNESIAN:
1. The Classical School
 Economists like Adam Smith, James Mill,
Marshall, Malthus, Pigou, and Ricardo advocated
for a free economy.
 In a free economy, the government does not
interfere in production, consumption, and
investment.
 Decisions on what to produce, how to produce,
and for whom to produce are determined by
market forces of demand and supply.
 Profit maximization is the main motive of
producers.
 Classical economists believed that in a free
economy, resources are always fully and optimally
utilized.
 Full employment equilibrium (AD=AS) is
considered a normal feature of this economy.

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 10

  Any disequilibrium is expected to be short-lived
and corrected by market forces through the
automatic mechanism.
 This belief persisted until the Great Depression of
1929-30.
 After the Great Depression, the automatic system
of the free economy failed to bring equilibrium.

2. The Keynesian School

 This school of thought is advocated by Lord
Keynes.
 Following the Great Depression of 1929, there was
a worldwide economic downturn.
 The Great Depression witnessed a significant
decline in output and employment levels in
Europe, North America, and other parts of the
world.
 Aggregate demand was low, leading to idle
factories and unemployment.
 In the USA, the unemployment rate rose from 3%
to 25% between 1929 and 1933, with aggregate
output falling by about 33% over the same period.

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 11

  The period saw persistent decreases in prices,
profits, investment levels, and employment.
 Keynes observed that the classical economic
beliefs were not effective in addressing the
situation, as unemployment persisted.
 He suggested government intervention to correct
disequilibrium situations where aggregate demand
exceeds or falls short of aggregate supply.
 Macroeconomics emerged as a separate branch of
economics after the publication of John Maynard
Keynes' "The General Theory of Employment,
Interest and Money" in 1936.
 In his book Keynes emphasized the need for
government intervention in production and
investment to address underemployment
equilibrium by creating new job opportunities.
JOHN MAYNARD KEYNES
 British economist John Maynard Keynes was
born in 1883.
 He studied at King's College, Cambridge, and
later became its dean.
 Keynes was involved in international diplomacy
after World War 1.

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 12

  He predicted the failure of the war's peace treaty
in his 1919 book "The Economic Consequences of
the Peace".
 Keynes's 1936 book "General Theory of
Employment, Interest and Money" is a very
important economics book.
 He was also skilled at speculating on foreign
currency exchange rates.

ADAM SMITH:
 Adam Smith: Founding father of modern
economics, also known as political economy
during his time.
 He was Scottish philosopher and professor at the
University of Glasgow.
 His book "An Inquiry into the Nature and Causes
of the Wealth of Nations" (1776): Considered the
first major comprehensive book on economics.
 Famous passage from Smith's work emphasizes
self-interest in economic transactions, advocating
for a free market economy.
 Philosophical approach focuses on individuals
pursuing their own self-interest, leading to
SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 13
 societal benefit through the operation of the
invisible hand(Market forces).

THE GREAT DEPRESSION OF 1929:

 Worldwide Depression: After the Great Depression
of 1929, there was a global economic downturn that
affected countries across Europe, North America,
and beyond.
 Fall in Output and Employment: The Great
Depression witnessed a significant decline in both
output and employment levels in affected countries.
Factories operated below capacity, leading to
widespread unemployment.
 Impact on Aggregate Demand: Aggregate demand
was low during this period, contributing to the
economic downturn. With reduced demand for goods
and services, factories remained idle and workers
were laid off.
 Rise in Unemployment: In the United States, the
unemployment rate surged from 3% to 25% between
1929 and 1933, indicating the severity of the crisis.
 Decline in Aggregate Output: The decline in
output was substantial, with aggregate output in the

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 14

 USA falling by approximately 33% over the same
period.
 Persistent Economic Decline: The Great
Depression was characterized by persistent falls in
prices, profits, levels of investment, and
employment, exacerbating the economic challenges
faced by countries.

IMPORTANT DEFINITIONS:
Entrepreneurs: Individuals who exercise control over
major decisions and bear a large part of the risk
associated with a firm or enterprise.
Capital: The financial assets or resources used to run
an enterprise, which can be provided by the
entrepreneurs themselves or borrowed. It includes
machinery, equipment, and funds used for
production.
Natural Resources: Resources obtained from nature
and used in production, such as raw materials and
land.
Labour: The human effort exerted in the production
process.

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 15

Revenue: The total income earned from selling
products or services in the market.
Profit: The remaining earnings of the entrepreneur
after paying rent for land, interest for capital, and
wages for labour. It is often reinvested in the
business.
Investment Expenditure: Expenses incurred by
producers to increase productive capacity, such as
buying new machinery or building new factories.
Wage Rate: The price at which labour services are
bought and sold in the market, typically referred to as
wages.
Wage Labour: Labour that is sold and purchased
against wages, implying a contractual agreement
between employers and employees.
Firms: Economic units organized according to
capitalist principles, where entrepreneurs hire wage
labor, employ capital and land, and undertake
production with the motive of selling goods and
services in the market to earn profits.
State: A political entity responsible for framing laws,
enforcing them, delivering justice, and often
undertaking production, imposing taxes, and

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 16

providing public infrastructure, education, health
services, etc.
Government: The administrative body of the state
responsible for implementing laws, delivering public
services, and managing economic functions such as
taxation, spending, and regulation.
Household Sector: Consists of individuals or groups
of individuals who make decisions related to
consumption, savings, and taxes. They earn income
through wages, salaries, profits, rent, and interest.
External Sector: Refers to the sector involved in
external trade, including exports, imports, and the
flow of capital between domestic and foreign
countries.
Exports: Goods or services sold by the domestic
country to the rest of the world.
Imports: Goods or services purchased by the
domestic country from the rest of the world.

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 17

BASIC ECONOMIC ACTIVITIES:
1. Production:
 Defined as the process of converting inputs
(resources) into outputs (goods and services).
 It involves adding value to raw materials through
production processes.
 Example: A baker transforming wheat flour into
bread with added value.

2. Consumption:
 The process of using goods and services to satisfy
individual or collective needs.
 Individuals consume goods like food and services
like doctor visits.
 Public consumption refers to using services like
roads and parks.

3. Capital Formation (Investment):

 The portion of income saved and not consumed,
used to create new capital goods.
 Capital goods are used for further production, like
machines and factories.
 Investment leads to economic growth by increasing
production capacity.

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 18

These three activities are interrelated. Changes in
production will affect consumption or capital
formation, and vice versa. This creates a circular flow
of income within an economy.

FOUR SECTORS OF THE ECONOMY:

From the macro point of view, economy is often
divided into four sectors:
1. Household sector: It includes consumers of goods
and services. Households are the owners of the
factors of production and provide factor services to
the producer sector (of land, labour, capital and
enterprise).
2. Producer sector: This sector includes all
producing units or firms (Private sector and
Public/Government sector) in the economy. To
produce goods and services, the firms hire factors of
production- land, labour, capital and entrepreneur
from the households and sell goods and services.
3. Government sector: This sector produces goods
and services for collective consumption. For example,
services of roads, dams, defense, law and order, street

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 19

lighting etc. Here government promotes the well being
of the citizens.
4. The External sector: This sector is also called rest
of the world sector. It is engaged in export and import
of goods and services and the flow of loans and
investment between the domestic economy and other
countries of the world.
STOCK AND FLOW
Stock: Stock variable refers to that variable, which is
measured at a particular point of time. The ‘period of
time’ could be a day, a weak, a year, etc. For
example, stock of goods in the godown as on 31
January, 2024. Other examples national wealth,
national capital, money supply etc.
Flow: Flow variable refers to that variable, which is
measured over a period of time. For example,
production of goods during the month of January
2024, birth rate in the year 2022, national Income in
the year 2022 are flow variables.
The amount of water in the tank at any given moment
represents a stock. It quantifies the quantity of water
present in the tank at a specific point of time.
Conversely, the water flowing into the tank from a tap
represents a flow. This flow of water is continuously

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 20

being added to the tank over time, measured as the
rate of water being added per unit of time.
Difference between stock and flow

Basis Stock Flow

Meaning Stock variable Flow variable

refers to that refers to that
variable, which variable, which is
is measured for measured over a
a particular period of time.
point of time.

Time It does not have It has a time

Dimension a time dimension as its
dimension. magnitude can be
measured over a
period of time.

Nature of It is a static It is a dynamic

Concept concept. concept.

Examples 1. Population of 1. Number of

India as on deaths during
31.3.2016. 2016.

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 21

 Basis Stock Flow

2. Total number 2. Cars

of cars in Delhi. manufactured
3. Money supply during January,
(money in 2016.
circulation). 3. Expenditure or
4. National transactions in
Wealth. money.
5. Quantity of 4. National
rice stored. Income.
5. Quantity of rice
produced.

CIRCULAR FLOW OF INCOME:

Introduction
 Production process involves the combination of
factors of production (Land, Labour, Capital, and
Enterprise) by firms to create goods and services.
 Firms pay factor incomes (rent, wages, interest, and
profit) to households for their contribution to
production.

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 22

 Households, in turn, spend their income on
purchasing goods and services produced by the
firms, completing the circular flow of income.

Meaning of Circular Flow of Income:

It is the flow of money income or the flow of goods
and services across different sectors of an economy in
a circular form. Or It is a flow of the activities of
production, income and expenditure involving
different sectors of the economy namely household
sector, producer sector, government sector and rest of
the world sector.

Phases of Circular
Flow of Income

1. Production Phase
(Generation of
income): In this
phase, firms produce
goods and services
with the help of factor services.

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 23

2. Income Phase (Distribution of Income) : This
phase involves the flow of factor income (rent, wages,
interest and profit) from firms to the households.
3. Expenditure Phase (Disposition of Income): In
this phase, the income received by factors of
production, is spent on the goods and services
produced by firms.
In this way, income generated in production units
reaches back to production units and makes the
circular flow complete.

Types of circular flow:

There are two types of circular flows: (i) Real flow; (ii)
Money Flow.
Real Flow: Real flow
refers to the flow of
factor services from
households to firms
and the
corresponding flow of
goods and services from firms to households.
 It Involves exchange of goods and services between
households and firms without money.
 It is also known as 'Physical flow".
SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 24
 It Determines the growth process of an economy.
 Example: Households provide factor services to
firms, leading to increased production and economic
growth.

Money Flow: Money

Flow refers to flow of
factor payments from
firms to households for
their factor services and
corresponding flow of
consumption expenditure from households to firms
for purchase of goods and services produced by the
firms.
 It Involves exchange of money between households
and firms.
 Also known as 'Nominal flow'.
 Example: Firms pay households for factor services,
and households spend this income on goods and
services produced by firms.

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 25

CIRCULAR FLOW IN A SIMPLE ECONOMY
(TWO-SECTOR ECONOMY):
A simple economy assumes the existence of only two
sectors, i.e. household sector & firm sector.
 Households are the owners of factors of
production and consumers of goods and services.
 Firms produce goods and services and sell them to
the households.
It is the simplest form of closed economy", in which
there is no government sector and foreign trade.

Assumptions of circular flow of model:

1. There are only 2 sectors in the economy:
Households and Firms. It means, there is no
government and foreign sector.
2. Household sector supplies factor services only to
firms and the firms hire factor services only from
households.
3. Firms produce goods and services and sell their
entire output to the households.

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 26

4. Households receive factor income for their services
and spend the entire amount on consumption of
goods and services.
5. There are no savings in the economy, i.e. neither
the households save from their incomes, nor the firms
save from their profits

The outer loop of diagram

shows the real flow, i.e.
flow of factor services from
households to firms and
corresponding flow of
goods and services from
firms to households.

• The inner loop shows

the money flow, i.e. flow of factor payments from
firms to households and the corresponding flow of
consumption expenditure from households to firms.
In the circular flow of income, production generates
factor income, which is converted into expenditure.
This flow of income continues as production is a
continuous activity due to never- ending human
wants. It makes the flow of income circular.

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 27

Conclusions of Circular Flow in a Simple Economy
(i) Total Production of goods and services by Firms =
Total Consumption of goods and services by
Households.
(ii) Factor Payments by firms = Factor Incomes of
households.
(iii) Consumption Expenditure by households =
Factor Income of households.
(it) Real Flow in the form of factor services and final
goods and services = Money Flow between firms and
households.

SUBHASH CHANDRA JOSHI (Chapter-1) MACROECONOMICS 28