Macro Economics

National Income
Fiscal Policy
Monetary Policy
Trade Cycles

R Srinivasan
BSc FCA, FAFD,RV and RP
National Income

• Concepts
• Components
• Measurement
• Key Terms
National Income – Common Sense View

Distribution as
factor incomes
(Rent , Wages,
Interest &Profit)

Production of Disposition
goods and Consumption
services /Investment
National Income -Definition

National income is the

money value of
all the final goods and services
produced by a country
during a period of one year.
National income - Purpose

For analyzing and evaluating the performance

Knowing the composition and structure of the national

income

Income distribution, economic forecasting and for choosing

economic policies and evaluating them
 National Income - Exclusions
Securities -Stocks and bonds
Transfer of secondhand goods
Government transfer payments
Household production
Social Security
 Illegal underground transactions
Unemployment
compensation
Private transfer payments
Individual gifts
Corporate gifts
National Income - Limitations
 Excludes non-market production (Eg services of housewife).
 Income disparities are not measured, hence is not a measure
of the well-being of a nation. It does not measure per capita
income, hence it is not a measure of a nation’s overall welfare
of citizens.
Thus, National Income (GDP) is essentially a measure of the
value of production in terms of market prices, and an
indicator of economic activity but not a true indicator of
national health.
Components of National Income

Gross National Product

Per Capita Income

Net National Product

Personal Income

Gross Domestic Product

Personal Disposable Income

Net Domestic Product Real and Nominal Income

 Components of National Income
GDP is the money value of all final goods and services produced
in the domestic territory of a country during an accounting year.
Gross Domestic territory is defined to include territory lying within the
Domestic
political frontiers, including the territorial waters (12 nautical
Product
miles, or 22 Km) of the country, ships, aircrafts and oil rigs
operated by the residents of the country.

When depreciation allowance, necessary to replace capital goods

Net like machines, equipment and tools consumed in process of
Domestic production, is subtracted from gross domestic product we get net
Product domestic product.
NDP = GDP – Depreciation
 Components of National Income
Is defined as the sum of the Gross Domestic Product and net factor
incomes from abroad. GNP = GDP + NFIA (where NFIA is the net
Gross factor income from abroad).
National NFIA- Income is earned from abroad by the residents of India by
Product rendering services abroad. Similarly, services are rendered by non-
citizens within the domestic territory of India. These are together
called “Factor incomes from abroad”.

NNP is derived by subtracting depreciation allowance from GNP. It can

Net also be calculated by adding the net factor income from abroad to the net
National domestic product.
Product NNP= GNP- Depreciation or
NNP = NDP + NFIA or
NNP= GDP-Depreciation + NFIA
Measurement of National Income

Income Method

Expenditure Method

Of the three, Income and

Value Added Method Expenditure method are
considered the main methods.
National Income – Expenditure Method
 Expenditure on final goods is equal to the sum of :

 Expenditure on consumer goods and service (also called

consumption expenditure),
 Expenditure on capital goods (also called investment
expenditure),
 Govt expenditure GDP = C + I + G + X
 Net exports (Exports minus Imports).
Expenditure Method- Some points
 Consumption Expenditure (C)
Government Expenditures (G)
Nondurable Consumer Goods
 Life span < three years State, local, and federal
Capital Goods
Valued at cost
Durable Consumer Goods
 Life span of three + years Net Exports (Foreign Expenditures)
. (X)
Net exports = Total exports – Total
imports
Income Approach
Measurement- Income Method
Different factors pool their services for carrying out production
activities. The aggregate of final factor incomes of all the factors
of production are included in calculation of national income by
income method.
The sum of all income paid to the four factors of production
Wages: salaries and labor income
Rent: farms, houses, stores
Interest: savings accounts

Profits: sole proprietorships, partnerships, corporations-

Income Method – Mixed Income of the Self employed

In India as in other developing countries there is fifth category of factor

income which is termed as mixed income of self-employed.

In India a good number of people are engaged in household industries, in

family farms and other unorganized enterprises. Because of self-
employment nature of the business it is difficult to separate wages for the
work done by the self-employed from the surplus or profits made by them.

Therefore, the incomes earned by them are mix of wages, rent, interest and
profit and are, therefore, called mixed income of the self-employed.
Income Method- Precautions
Exclusions

1. Transfer payments .
2. Illegal money such as hawala money, smuggling etc.
3. Windfall gains such as prizes won, lotteries etc.
4. Corporate profit tax (that is, tax on income of the companies) should not be
separately included as it has already been included as a part of profits.
5. Receipts from the sale of second-hand goods.

Inclusions
7. Imputed rent of self-occupied houses.
8. Value of food production used for self-consumption.
 Measurement – Value Added Method
 In this method (also “Production” method)
 Various industrial sectors are identified and classified
 Net value added by each enterprise/ industrial sector are added up.
 Value added by an enterprise is obtained by deducting from the
value of output.
 (a) Expenditure incurred on intermediate goods such as raw materials,
unfinished goods (purchased from other firms)
 (b) Depreciation
 (c) Indirect Taxes, (i. e. indirect taxes less subsidies provided by the Government).
National Income – Key Terms
 Nominal and Real Incomes
 Nominal income is the actual receipt in cash. It is income in actual currency terms unadjusted for inflation.
 Real income is simply inflation-adjusted income. To exemplify, the nominal income increased today by 10 percent
from last year, the real income remains the same as that from before if the prevailing inflation rate today is 10 percent.
 Real wage = Nominal wage – inflation
 Calculating the GDP Deflator - GDP Deflator= Nominal GDP * 100/ Real GDP. Eg if nominal GDP is $100,000,
and real GDP is $45,000, then the GDP deflator will be 222 (GDP deflator = $100,000/$45,000 * 100 = 222.22).
Relationship between GDP Deflator and CPI
 Like the Consumer Price Index (CPI), the GDP deflator is a measure of price inflation/deflation with respect to a
specific base year taken as 100.
National Income – Key terms

 Revenue and Capital expenditure –

 Revenue is expenditure for
 the normal running of government departments and various
services,
 interest charges on debt incurred by government,
 subsidies etc
 Any spend which do not result in the creation of assets.
 Capital expenditure is which results in increasing of
government asset or reduce some liability (paying back
old loans).
National Income – Key Terms
 Revenue, Fiscal and Primary Deficit –
 A Revenue deficit occurs when the net income generated, revenues less expenditures, falls short of the
projected net income. This happens when the actual amount of revenue/ expenditures do not
correspond with budgetary estimates.
 Fiscal deficit occurs when a government's expenditures (including capital expenditure) exceed the revenue
(including capital sources, but excluding borrowings) that it generates.
 Primary deficit= Fiscal Deficit- Interest.
 Fiscal deficit is met by printing new currency and / or borrowings. This decision vests with Ministry of
Finance.
 National Income – Key Terms
 FRBM- The Fiscal Responsibility and Budget Management Act, 2003 is an Act to institutionalize financial
discipline and reduce India's fiscal deficit to max of 3%.
 Personal Income and Personal Disposal Income –
Personal income is the sum of all incomes actually received by individuals during a given year.
From personal income of the individuals, deduct personal income taxes to arrive at personal disposable income which is
equal to consumption plus saving.
 Transfer Payments- Includes amount paid by Govt to individuals towards pension, social security, scholarships,
compensation for disasters etc.
 Base Year for reckoning National Income – Currently is 2011-12 (earlier 2004-05).
 Coincident indicator -  Is a metric which shows the current state of economic activity. These indicators change at
approximately the same time as the whole economy, Example- Retail sales, orders for capital goods etc.
Definition and Objectives
Tools
Purpose
Limitations
Fiscal Policy – Definition & Objectives

 Definition - Fiscal policy is the tool by which government

spending, taxation and borrowing are used to influence both the
pattern of economic activity and level of growth of aggregate
demand, output and employment.

 Objectives
 Achievement and maintenance of full employment,
 Maintenance of price stability,
 Acceleration of the rate of economic development, and
 Equitable distribution of income and wealth.
Fiscal Policy - Tools
 Government expenditure – Increased Government expenditure (both capital and current) means more money
pumped in the economy, leading to consumption, investment, and transfer payments.
 Taxes - The tax rates are varied in the context of the overall economic conditions prevailing in an economy.
During recession and depression, the tax rate is lowered to encourage private consumption and investment.
Taxes determine the size of disposable income, which in turn determines aggregate demand.
 Public Debt- Borrowing from the public through the sale of bonds, small savings etc. curtail the aggregate
demand by reducing money supply in the economy. Conversely, repayments of debt by governments increase
the availability of money in the economy and increase aggregate demand.
 Budget - The budget is a statement of revenues earned from taxes and other sources, from which expenditures
are made by the government in a year. A surplus budget actually has a negative effect because government is
sucking up the disposable surplus from the hands of its people. A deficit budget (within acceptable limits) has a
positive effect because it stimulates demand.
Fiscal Policy - Purpose
 Promoting long term Growth - When government spends on building a modern infrastructure such as
roads, education, research and development etc., it promotes long-run economic growth. Similarly, a good
tax policy that rewards innovation and entrepreneurship, will promote private businesses.
 Minimising inequality in Society –
 Direct Taxes: A good direct tax system ensures that the well-off pay
more than the poor, the tax burden being distributed equitably among
the population. This is achieved by having progressively higher slabs of
taxation for higher income.
 Indirect Taxes: This is achieved by taxing at a higher rate commodities
primarily consumed by the richer income group.
Fiscal Policy - Limitations

 Recognition lag : Delay in policy change recognition.

 Decision lag : Delay in decision making.
 Implementation lag : Delays in legislative
implementation.
 Impact lag : Delay visibility of policy outcomes.
Monetary Policy
Definition and Objectives
Mechanisms
Direct Instruments
Administration
 Monetary Policy – Definition and Objectives
 Definition - Monetary policy is the use of monetary instruments by RBI to regulate the availability and cost of money
and credit.
 Objectives

Control flow of credit Thereby control the Finally, the combined

Control of money effect of money
or Direct flow of quantum of money
credit to specific available in that
supply influences availability and cost
(interest rate) leads to
sectors sector the interest rates correction in prices.
Monetary Policy - Mechanisms
 The mechanisms at the disposal of RBI are:

 The interest rates

 The exchange rate
 The quantum of money supply and credit
 The regulation of equity and real estate prices.
 RBI uses its influence on money market as the issuer of reserve money (currency in circulation and deposit
balances with the central bank) and determines the direction and pace of the nation’s monetary policy.
Monetary Policy – Direct Instruments
 Cash Reserve Ratio (CRR)
 The term refers to the sum mandatorily deposited with RBI in CASH by scheduled commercial
banks(SCBs).
 The quantum to be deposited is a prescribed percentage of the total net demand and time liabilities (NDTL)
of the SCB.
 The cash reserve ratio is generally around 4.0 per cent.
 During slowdown, the RBI reduces the CRR in order to enable the banks to expand credit and increase the
supply of money available in the economy.
 During high inflation, in order to contain credit expansion, the RBI increases the CRR.
Monetary Policy – Direct Instruments
 Statutory Liquidity Ratio (SLR)
 All SCBs are required to maintain a stipulated percentage of their NDTL in one of the following forms:
(i) Cash, (ii) Gold, (iii) Investments in Govt debt.
 Currently SLR is around 20%.
 While CRR has to be maintained by SCBs as cash with the RBI, the SLR can be held by the bank itself in
one of the above three categories.
 The banks which fail to meet its SLR obligations are levied penal interest by RBI.
 Like CRR, changes in the SLR affect the availability of resources in the banking system for lending.
 Monetary Policy – Direct Instruments
 Liquidity Adjustment Facility (LAF) –
 A central bank is a ‘bankers’ bank. Through LAF facility the SCBs can borrow from RBI against the collateral of non
SLR securities like commercial bills, government securities, treasury bills, etc.
 By varying the terms and conditions of refinance, the RBI could deploy the sector-specific refinance facilities to
encourage /discourage lending to particular sectors.
 Repo (Repurchase Options), is a money market instrument for borrowing funds by SCBs selling securities with an
agreement to repurchase the securities on a mutually agreed future date at an agreed price which includes interest on
the funds borrowed.
 ‘Reverse Repo’ is defined as an instrument for lending funds by SCBs by purchasing securities from RBI with an
agreement to resell the securities on a mutually agreed future date at an agreed price which includes interest for the
funds lent.
 (Reverse Repo =1% less than Repo rate).
Monetary Policy – Direct Instruments
 The repo and reverse repo have only a 1 day tenor.
 The ‘repo rate’ and the reverse repo rate’ are changed only through the announcements made during the Monetary
Policy (Bi-Monthly) Statements of the RBI.
 There used to be a bill discounting facility under which banks could borrow from RBI for longer tenors. The
discounting rate was called the “Bank Rate” and was the floor rate for banks’ lending to its customers.
 But this facility is now largely dormant. The Bank Rate is typically 100 bps above the Repo rate.
 Monetary Policy – Direct Instruments
 Marginal Standing Facility (MSF) - MSF refers to the facility under which SCBs can borrow overnight money from
the central bank, over and above what is available to them through the LAF window.
 This provides a safety valve against unexpected liquidity shocks to the banking system.
 The minimum amount which can be accessed through MSF is Rs 1 crore and in multiples of Rs 1 crore thereafter.

Parameter LAF MSF

Minimum Bidding amount Rs 5 Cr Rs 1 Cr
Eligibility Govt and SCBs SCBs only
Security Non SLR Securities Any, including SLR
Borrowing Limits No Limit 2% of NDTL
Rates Repo Rate Repo Rate +1%
Monetary Policy – Direct Instruments
 Open Market Operations (OMO)
OMO is a term used for market operations conducted by the RBI by way of sale/ purchase of Government
securities to/ from the market with an objective to adjust the rupee liquidity conditions in the market.
When the RBI feels there is excess liquidity in the market, it resorts to sale of securities thereby sucking out the
rupee liquidity and vice versa.
Monetary Policy – Administration

 Monetary Policy Framework Agreement (MPFA) - MPFA refers to the maximum tolerable inflation rate
that the RBI should target to achieve price stability.
 Accordingly, the Central Government has notified 4 per cent Consumer Price Index (CPI) inflation as the
target for the period from August 5, 2016 to March 31, 2021 with the upper tolerance limit of 6 per cent and
the lower tolerance limit of 2 per cent.
 Monetary Policy Committee (MPC) - MPC consists of the RBI Governor (Chairperson), and members
drawn from RBI and Central Government.
 The MPC shall determine the policy (repo) rate required to achieve the inflation target. Accordingly, fixing
of the benchmark policy rate is made through debate and majority vote by this panel.
Trade Cycles
 Trade/ Business Cycle - Definition

 The rhythmic fluctuations in aggregate economic activity over a period

of time are called business cycles or trade cycles.
 A trade cycle has 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.
 In India, business cycles are monitored by Nation Bureau of Economic
Research (NBER).
Trade/ Business Cycle - Phases

A typical business cycle has 5 distinct phases. These are:

 Expansion: This phase sees full employment and maximum production.

There is increasing prosperity and people enjoy high standard of living.
The growth rate eventually reaches its peak and starts to slow down.
 Peak: In peak phase output prices rise rapidly leading to increased cost
of living. Consumers begin to review their consumption expenditure on
housing, durable goods etc. Actual demand stagnates. This is the end of
growth phase, after which economy starts to move in reverse direction.
 Contraction: During contraction, there is fall in the levels of investment
and employment. Since producers do not immediately recognize the
drop in demand, they continue with high levels of investment and
production. The result is that supply far exceeds demand.
Trade/ Business Cycle - Phases

 Depression: Growth rate becomes negative. Demand for products and services decreases, prices are at their
lowest. Activity declines rapidly forcing firms to shut down production facilities. A typical feature of
depression is the fall in interest rate. Despite lower interest rates, the demand for credit declines because
investors' confidence has fallen. Large number of bankruptcies and liquidation occur.
 Recovery: The process of reversal of the economy begins. Business confidence improves, investments
happen, the banking system starts expanding credit, employment increases, aggregate demand picks up and
prices gradually rise.
It is very difficult to predict the exact turning points of business cycles.
Trade/ Business Cycle - Causes

 Fluctuations in Effective Demand: Effective demand refers to the willingness and ability of consumers to
purchase goods at different prices.
 Fluctuation in Investment: Investments fluctuate because of changes in profit expectations. Investment
may also rise when the rate of interest is low in the economy.
 Variations in government spending: Government spending impacts aggregate economic activity.
Government spending, especially during and after wars, has destabilizing effects on the economy.
Fiscal Deficit
 Explained: What is fiscal deficit?
“Fiscal Deficit is the difference between the Revenue Receipts plus Non-debt Capital Receipts
(NDCR) and the total expenditure”.
In other words, fiscal deficit is “reflective of the total borrowing requirements of Government”.
 What is the significance of fiscal deficit?
 In the economy, there is a limited pool of investible savings. These savings are used by
financial institutions like banks to lend to private businesses (both big and small) and the
governments (Centre and state).
 If this ratio is too high, it implies that there is a lesser amount of money left in the market for
private entrepreneurs and businesses to borrow. Lesser amount of this money, in turn, leads to
higher rates of interest charged on such lending.
 So, simply put, a higher fiscal deficit means higher borrowing by the government, which, in
turn, mean higher interest rates in the economy.
 A high fiscal deficit and higher interest rates at a time like this would also mean that the efforts
of the Reserve Bank of India to reduce interest rates are undone.
Fiscal Deficit
 What is the acceptable level of fiscal deficit?
 There is no set universal level of fiscal deficit that is considered good.
 Typically, for a developing economy, where private enterprises may be weak and
governments may be in a better state to invest, fiscal deficit could be higher than in
a developed economy.
 In developing economies, governments also have to invest in both social and
physical infrastructure upfront without having adequate avenues for raising
revenues.
 In India, the Fiscal Responsibility and Budget Management Act requires the central
government to reduced its fiscal deficit to 3 per cent of GDP. India has been
struggling to achieve this mark.
 Fiscal Deficit
 Why true fiscal deficit is higher than stated? What is “off-budget” spending?

 All government expenditure, revenues and debts are required to be carried out through the Consolidated Fund of India
(CFI).
 If it is done so, the fiscal deficit of the Government should equal to the additional debt incurred during the year, all
recorded in the CFI.
 Unfortunately, all these transactions are not recorded through the CFI all the time. Some debt/liabilities are not assumed
outside the CFI — either in the Public Account or totally outside the formal accounting system of the Government i.e.
outside CFI and Public Account,” Such transactions are described popularly as Below the Line, Off Budget etc”.
 For instance:
 Equity infusion in the Public Sector Banks (PSBs), during last few years, has been done by deducting debt received by the
Government of India in from the PSBs from the equity investments made. As a result, there is no impact of such
expenditure/investment on fiscal deficit but the debt and liabilities stock of the Government goes up”.
 Government of India has been issuing what is described in the budget papers as Fully Serviced Bonds (FSBs). These bonds are
raised outside the CFI and Public Account and used from special purpose vehicles outside budget/ accounts to pay off the
government expenditure/ subsidy. Interest and principals of these liabilities are serviced by the Government at the time of payment.
These bonds don’t enter into calculations of either fiscal deficit or the debt and liabilities of the Government”.
 The government has also been “paying off food subsidy liability by providing cash from the National Small Savings Fund (NSSF).
Such transactions have the effect of reducing fiscal deficit and not showing up in the Debt and Liabilities of the Government,” he
states.
Fiscal Deficit
 Is this the first time India’s fiscal deficit is being questioned?
 No.
 According to a July report of the Economic Times: “In a presentation to the
15th Finance Commission (FFC) on July 8, three days after the July 5 budget,
CAG has asked whether the extra-budgetary resources accounted for in the
budget reflect the correct picture. To make its point, the auditor re-calculated
the fiscal deficit of 2017-18 to show that it actually works out to 5.85%. The
government had reported a fiscal deficit of 3.46% that year.”
 During 2004-09, Bonds were issued to Oil Companies and Fertiliser
Companies and accounted for in the Public Account (instead of CFI) to pay
off oil/fertiliser cost under-recoveries. These transactions also had similar
impact…”