INDIAN ECONOMY AND POLICY

UNIT 1: CIRCULAR FLOW OF INCOME

MACRO ECONOMICS:
1) National income methods/Approaches
2 Difficulties in measuring national income
3) 2, 3, 4 sector models
4) Aggregate supply, aggregate demand
5) Influence of monetary and fiscal policy on aggregate demand
6) Recessionary and inflationary gaps

Macroeconomics:
It is the study of the economy as a whole. It analyzes the causes of major problems
such as unemployment, inflation, economic growth etc. It deals with booms and
recession, economy’s total output of goods and services, rates of inflation and
unemployment.

MACRO ECONOMIC EQUILIBRIUM:

It refers to a situation in an economy where the aggregate demand equals the
aggregate supply. It is a point where the economy is in balance. The economy is
operating at a stable point with stable price levels and output. Changes in factors
such as government spending, taxation, monetary policy, and external trade can
all impact the equilibrium and lead to shifts in aggregate demand and supply,
potentially affecting overall economic activity and growth.

CIRCULAR FLOW OF INCOME:

The continuous flow of commodities, services, revenue and expenditure in an
economy is referred to as CFOI.
It helps to understand the overall functioning of the economy. Products and
services are produced with the intention of selling them. The sales then generates a
flow of income by which payments are made to the factors of production.
Household provides services to business firms so that they can produce goods and
services. When prod. Is complete, goods and services are sent to markets to be sold
to households. Thus, there exists a circular flow of income between households
and business firms.
1. There is no govt and international relations. Economy is closed and consists of
only 2 sectors-household and business firms
2. Then the introduction of govt as three sector model.
3. Introducing international trade, i.e, imports and exports, which is a four sector
model

TWO SECTOR MODEL:

There are no savings, consists of only household and business firms. Households
cannot produce g&s. They have to buy commodities from units, i.e, business firms.
So there is a flow of consumer goods from firms to household. This leads to flow
of income to business firms from households. So, total earnings of household is
equal to total expenditure of households.
Factors of production: Labour, Capital, land, entrepreneurial skills
wages, interest, rent, profits
the resources such as land, capital and entrepreneurial ability flow from
households to business firms.

In opposite direction to this, money flows from business firms to the

households as factor payments such as wages, rent, interest and profits.
The total income of all households is spent on the consumption of goods and
services produced by firms, so total receipts of firms are equal to total income of
households. Therefore, all the money that is distributed on various forms is
returned to them. The circular flow of income will continue as long as households
spend all their income and firms keep distributing all their revenues.
WITH SAVINGS:

The part of income that is not spent is called savings. S=Y-C

As savings increase, the CFOI declines because savings reduce expenditure.
Savings are transferred to banks by households and are then forwarded to business
firms in the form of loans/advances. Because of these transactions, money comes
back in circular flow. But sometimes households do not keep their savings in
banks, which is termed as leakage in the circular flow of income

THREE SECTOR MODEL:

Govt plays an important role in facilitating business activities. Taxes are levied
both on firms and households. Tax on HH is personal tax, corporate tax on
firms. The income generated from both these sources forms the total revenue
for the govt. The govt then spends this to meet expenses on administration,
defense, infrastructure, social security, welfare etc.
Government purchases goods and services just as households and firms do.
Government expenditure takes many forms including spending on capital goods
and infrastructure (highways, power, communication), on defense goods, and
on education and public health and so on. Government expenditure may be
financed through taxes, out of assets or by borrowing. The money flow from
households and business firms to the government is labelled as tax payments

FOUR SECTOR MODEL:

If a country exports to another country, income flows in and the residents of the
exporting country do not incur expenditure. The country’s income is increased by
exports and circular flow of income goes up. If imports exceeds exports, there will
be leakage in the circular flow of income.
If exports are equal to the imports, then there exists a balance of trade.
Generally, exports and imports are not equal to each other. If value of exports
exceeds the value of imports, trade surplus occurs. On the other hand if value of
imports exceeds value of exports of a country, trade deficit occurs. Imports are
leakages and exports are injections into the circular flow of income in the
economy.
 Personal taxes Subsidies
Transfer payments and govt GOVERNMENT
expenditure Corporate tax

Expenditure on consumption
FIRMS
HOUSEHOLD
Factor payments Payment for imports
Expenditure for
consumption
Payment for exports
Payment for labour
FOREIGN COUNTRIES

2-Sector Model: In the 2-sector model, the economy is divided into two
sectors: households and businesses.
Households: Households provide labor and other factors of production to
businesses in exchange for income (wages, salaries, etc.). They also consume
goods and services produced by businesses.

Businesses: Businesses hire labor and other factors of production from

households and produce goods and services. They sell these goods and services
to households in exchange for revenue.

The flow of income is simple: households provide labor and receive income
from businesses, and then use that income to buy goods and services from
businesses. This cycle continues.

3-Sector Model: The 3-sector model adds the government sector to the mix.

Households: Same as in the 2-sector model.

Businesses: Same as in the 2-sector model.

Government: The government collects taxes from households and businesses

and provides public goods and services. It also spends money on various
programs and projects.

In this model, the government collects taxes from households and businesses,
which it uses to fund its expenditures. It can also borrow or repay loans,
impacting the overall economy.

4-Sector Model: The 4-sector model further adds the foreign sector,
representing international trade and transactions.

Households: Same as in the 3-sector model.

Businesses: Same as in the 3-sector model.

Government: Same as in the 3-sector model.

Foreign Sector: This sector includes exports and imports of goods and
services. It involves international trade, where businesses export goods and
services to other countries and import goods and services from abroad.

SIGNIFANCE
 (i) It reflects structure of an economy.

(ii) It shows interdependence among different sectors.

(iii) It gives information about injections and leakages from flow of money.

(iv) It helps in estimation of national income and related aggregates

LEAKAGES IN NATIONAL INCOME:

In the circular flow of income model, leakages represent any withdrawals or
outflows of money from the economy, which can occur through various
channels. The main leakages in the circular flow of income are savings, taxes,
and imports:
Savings: When individuals or households save a portion of their income rather
than spending it on goods and services, it creates a leakage from the circular
flow. Savings are typically placed in banks or other financial institutions and do
not immediately return to the economy.
Taxes: Taxes imposed by the government, such as income taxes, sales taxes,
and corporate taxes, act as another form of leakage. The government collects
tax revenue from households and businesses, and this money does not circulate
directly within the economy but is used for government expenditures.
Imports: When a country purchases goods and services from other countries, it
involves an outflow of money from the domestic economy to foreign
economies. This represents a leakage as the income is not directly reinvested
within the domestic economy.

These leakages can have economic consequences. If leakages exceed injections

(money flowing back into the economy), it can lead to a decrease in economic
activity and income. On the other hand, when injections exceed leakages, it can
result in economic growth and expansion.

NATIONAL INCOME CONCEPTS:

It is the total monetary value of all services and goods that are produced by a nation
during a period of time. It’s the sum of all factor incomes that is generated during the
production year.

Gross and Net concepts:

When any capital equipment are used for production, their value goes down, therefore
an allowance is given, which is called depreciation. Gross is used when no allowance
has been made for capital consumption and Net is used when provision for capital
consumption has been made. The difference between gross and net aggregate is
depreciation.

Domestic and National concepts:

National represents total income accrued to the normal residents of a country because
of their participation in the production process in the current year. It includes all
factors irrespective of whether they are staying in home country or abroad.
Domestic is the total output or income generated within the domestic territory of a
country. It is the output/income within a country either by residents or non-residents.

Market prices and factor cost:

Market prices are always higher than factors of production, when indirect taxes add
to price and subsidies lower the prices. Therefore, GDP or GNP at MP= GDP or GNP
at FC + indirect taxes – subsidies
Factor costs are the earnings obtained by the owners of factors of production in
exchange for providing factor services to the producer.
MP is the price at which a commodity is sold in the open market.
GDP AT MARKET PRICE: GDP AT FACTOR COST:
It is calculated after deducting next It differs from GDPmp by the absence
exports from total final expenditure. of indirect taxes.
Total expenditure = C+I+G+X GDP at FC=GDPmp + subsidies -
If total imports are M, GDP at indirect taxes
MP=C+I+G+(X-M)
GNP at FC: NNP at fc:
It is the total income received by It is calculated by subtracting
residents for their contribution depreciation from GNPfc.
anywhere in the world NNPfc = GNPfc - Depreciation
GNP at FC=GDPfc +/- Net factor
income from abroad

NFIFA= factors of production

received by indian citizens – factors
of production received by foreigners
on assets they own in India.
FACTORS AFFECTING SIZE OF NATIONAL INCOME:
If a nation processes large amount of natural resources and skilled manpower, it
is termed rich.
1. Natural resources: These can include minerals mined from the earth,
agricultural potential, and energy resources.
2. Human resource: If a nation has large literate population and is capable of
wealth creation, then nation will have large national income
3. Capital resources: Includes tools, plants, machines, factories, infrastructure
etc
4. Self-sufficiency: entrepreneurial activities and self-sufficiency

1. Labor Force and Human Capital: The size and skills of the labor force
significantly impact an economy's productive capacity. A larger and more
skilled workforce can contribute to higher levels of output and economic
growth.

2. Physical Capital and Technology: The availability and quality of physical

capital (machinery, infrastructure, and technology) play a crucial role in
determining a country's productive capacity. Advanced technology and well-
maintained infrastructure can lead to increased efficiency and higher output.

3. Natural Resources: Abundance and efficient utilization of natural resources,

such as minerals, energy, and agricultural products, can contribute to economic
growth. However, reliance on finite resources without sustainable management
can also pose challenges.

4. Investment and Capital Formation: Higher levels of investment in productive

activities, such as factories, equipment, and research and development, can lead
to increased production and economic growth.

5. Government Policies: Fiscal and monetary policies can influence economic

activity. Government spending, taxation, interest rates, and regulatory policies
can impact consumption, investment, and overall economic performance.

6. Trade and Globalization: International trade can stimulate economic growth

by providing access to larger markets and promoting specialization. Openness
to trade can lead to increased production and export of goods and services.
7.Political Stability and Rule of Law: A stable political environment and
effective legal institutions can attract investment and promote economic
activity.

8. Infrastructure and Connectivity: Efficient transportation, communication,

and energy infrastructure can lower production costs and promote economic
growth.

9. Income Distribution: The distribution of income among various segments of

the population can affect consumption patterns and overall demand for goods
and services. A more equitable distribution may lead to higher consumer
spending.

Demographics: Population size, age structure, and demographic trends

influence the size and composition of the labor force, consumption patterns,
and overall economic dynamics.

Educational Attainment: A well-educated population is better equipped to

contribute to economic productivity and innovation.

Technological Innovation: Advances in technology can lead to higher

productivity, new industries, and increased economic output.

Macroeconomic Stability: Stable inflation, low unemployment, and sound

monetary policy can create an environment conducive to economic growth.

External Factors: Global economic conditions, international events, and

changes in commodity prices can impact a nation's economic performance
through trade, investment, and financial channels.

APPROACHES TO MEASURE NATIONAL INCOME:

1. Product Approach:
National income is measured by calculating total value of the final output of a
country. The products of quantities produced and their respective prices are added
to arrive NI. In this method, all goods and services produced during the year in
various industries are added up. This is also known as value-added to GDP or GDP
at the sector of origin's cost factor. India includes the following items: agriculture
and allied services; mining; development, construction, the supply of electricity,
gas, and water, transport, communication, and trade; banking and industrial real
estate and property ownership of residential and commercial services and public
administration and defence and other services (or government services). It is, in
other words, the amount of the added gross value.
This would give GDPmp, to convert it to NNPfc=
To reach National Income (that is, NNP at FC)

 Add Net Factor Income from Abroad: GNP at MP = GDP at MP + NFIA

 Subtract Depreciation: NNP at MP = GNP at MP – Dep
 Subtract Net Indirect Taxes: NNP at FC = NNP at MP – NIT

2. Income Approach:
The annual flow of factor earning in the form of wages, rents, interest and profits
are taken into account in the income approach. It is Estimated by adding all the
factors of production (rent, wages, interest, profit) and the mixed-income of self-
employed.
3. Expenditure approach:
NI is calculated by aggregating the flow of total expenditure on final goods and
services in an economy . NI will be equal to sum of expenditures of all three
sectors.
The expenditure method to measure national income can be understood by the
equation given below:
Y = C + I + G + (X-M),
where Y = GDP at MP, C = Private Sector’s Expenditure on final consumer goods,
G = Govt’s expenditure on final consumer goods, I = Investment or Capital
Formation, X = Exports, M = Imports, X-M = Net Exports
Any of these methods can be used in any of the sectors – the choice of the method
depends on the convenience of using that method in a particular sector

DIFFICULTIES IN MEASURING NATIONAL INCOME:

1. Non market production:

It fails to account for HH production because some don’t involve market
transactions. The household services of millions of people are excluded. Ex:
housework done by housewives is not included, but same work done by a servant
is accounted for.
2. Imputed values:
It arises mostly in agricultural sector, where G&S produced are consumed by
individuals for themselves are not indicated in the NI.

3. Illegal activities:
Some transactions go unreported because they involve illegal transactions.
4. Double counting:
There is a possibility of some outputs being counted twice. Hence, national income
is exaggerated.
5. Quality changes and new products:
techno advancements and intro of new products can make it challenging to account
for changes in quality of goods and services.
6. Inflation and deflation:
changes in price levels may distort the measurement of GDP.
7 Importance of services:
accurate valuation and measuring services is challenging, because it’s intangible
and difficult to quantify.
8. Depreciation:
There are no accepted standard rates of depreciation applicable to the various
categories of machine. Unless from the gross national income correct deductions
are made for depreciation the estimate of net national income is bound to go
wrong.

UNIT 2:
AGGREGATE DEMAND AND SUPPLY:
Aggregate demand refers to total value of all final goods and services that are
planned to be purchased by all sectors of the economy at a given level of income
over a given time.
Aggregate supply is the monetary value of all final goods and services purchasable
by an economy over a period of time.
Aggregate supply is the quantity of goods and services that are supplied at a given
price level. It describes, for each given price level, the quantity of output firms are
willing to supply.
The classical AS curve is vertical, indicating same amount of goods will be
supplied at whatever the price level. It is based on the assumption that labour
market is in equilibrium with full employment of the labour force.
SHORT RUN AGGREGATE SUPPLY:
It is influenced by factors such as resource availability, technology, and production
capacities
LONG RUN AGGREAGTE SUPPLY:
Factors like labour force growth, capital accumulation. Its indicated as a vertical
line, indicating changes in price levels does not affect the economy’s total output
potential.

Aggregate demand is the total aggregate or aggregate quantity of output bought

willingly at a given price level:
It represents the total quantity of goods and services that households, businesses,
government and foreign buyers are willing and able to purchase at different price
levels over a specified period. It is the sum of consumption, Investment,
Government spending and net exports (X-M)

Components of Aggregate Demand (AD):

Aggregate demand (AD) is the total demand for goods and services in an economy
at various price levels. It is the sum of spending by different economic agents. The
components of aggregate demand are:

Consumption (C): This is the total spending by households on goods and services.
It includes spending on necessities, discretionary goods, and services.

Investment (I): Investment refers to spending by businesses on capital goods such

as machinery, equipment, and structures. It also includes spending on residential
construction and changes in business inventories.

Government Spending (G): Government spending includes expenditures by the

government on goods and services, such as public infrastructure, defense,
education, and healthcare.

Net Exports (X - M): Net exports represent the difference between a country's
exports (X) and imports (M). Positive net exports indicate that a country is
exporting more than it is importing, contributing to aggregate demand.

Components of Aggregate Supply (AS):

Aggregate supply (AS) represents the total output of goods and services that
producers are willing and able to supply at different price levels. It is divided into
short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS), each
with its own components:

Short-Run Aggregate Supply (SRAS):

Labor Costs: The availability of labor and the costs associated with it, including
wages and salaries, influence the level of production.

Input Costs: Prices of raw materials, energy, and other inputs affect production
costs and supply.

Technology and Productivity: Technological advancements and changes in

productivity can impact the efficiency of production.

Expectations of Producers: Producers' expectations about future prices and

business conditions can influence their willingness to supply in the short run.

Government Regulations: Regulations and policies affecting production, such as

taxes and subsidies, can impact short-run supply.

Long-Run Aggregate Supply (LRAS):

Labor Force: The size and skills of the labor force, influenced by factors like
population growth and education, determine the economy's long-run productive
capacity.

Technological Progress: Advances in technology and innovation contribute to

increased production and potential output.

Capital Formation: Investment in capital goods and infrastructure enhances the

economy's long-term production capacity.

Institutional Factors: Factors such as property rights, rule of law, and market
competition affect the long-run supply potential

AGGREGATE DEMAND IN 2 SECTOR MODEL: (Consumption and

investment):
when AD equals National Product(NP), equilibrium is reached. AD included
consumption + Investment. Any point to the right of this equilibrium indicates that
economy is over producing. This would result in unsold products, excess inventory
which would ultimately lead fall in expenditure. Any point to the left indicates
market is not able to meet the demand .
AD AND AS APPROACH:
It indicates that whatever the producers intended to manufacture during the year
is exactly equal to what the buyers intended to purchase during the year.
SITUATIONS:
If AD>AS, a situation of unfulfilled demand persists. To curb this, producers
will enhance level of output and production such that AS could increase and
become equal to AD, and equilibrium is restored.
If AS>AD, situation of unwanted stocks persists. To curb this, producers will
decrease the level of output such that AS=AD and eqlbrm is restored.
g AS
E AD
r

AGGREGATE DEMAND MODEL IN 3 SECTOR MODEL:

When economy had high levels of unemployment, the govt can take fiscal
measures to reduce unemployment. Ex: govt can increase AD during recession by
changing its spending or tax rates. AD=C+I+G

MULTIPLIER MECHANISM:
It shows what the eventual change in income will be as a result of change in
investment. As a result, output and income will rise in the next round, causing
consumption and AD to rise.
MONETARY POLICY:
It refers to central bank activities that are directed towards influencing the quantity
of money and credit in an economy. It is a set of tools used by a nation’s central
bank to control the overall money supply and promote economic growth and
employ strategies. It includes revising interest rates and changing bank reserve
requirements. It is the control of quantity of money available in an economy and
the channels by which new money is supplied.
Impact on national income:
1. Interest rates: Central banks can raise/lower interest rates to influence
borrowing and spending behavior. Lower interest rates encourages borrowing,
stimulating economic activity and potentially increasing NI.
2. Money supply: CB impact liquidity and spending. Increasing money supply can
lead to higher spending, contributing to econ growth and higher NI.
3. Exchange rates: A weaker currency can make exports more competitive and
boost foreign demand, which positively impacts NI.
4. Investment/consumption: Lower interest rates can stimulate investment by
making borrowing cheaper. Increased investments leads to economic growth.
5. Control Inflation: Stable and controlled inflation is important for maintaining
purchasing power and overall economic stability.

FISCAL POLICY:
The use of government spending and tax policies to influence economic
conditions, especially macroeconomic conditions. It involves governments actions
related to taxation and government spending. It can be expansionary (increased
govt spending, decreased taxes) or contractionary (decreasing govt spending,
increased taxes).
Impact:
1. Government spending: Increase in this would stimulate economic activity
directly by creating demand for goods and service, leading to higher production
and income.
2. Taxation: Decreasing taxes leads to increased consumption and investment
which leads to higher contribution to NI
3. Multiplier effect: Initial increase in govt spending can lead to chain reaction of
increased spending by households and business, which can impact NI.
4. Public goods and services: spending on public goods like infrastructure,
education, healthcare can enhance productivity, positively influencing NI.
5. Counter cyclical policy: It can be used to counter economic downturns.
Expansionary policy during recession can boost demand, promote economic
recovery and support NI.
These 2 are used by governments and banks to manage economy and influence
economic growth, inflation and employment.

RECESSION AND INFLATIONARY GAP:

A recessionary gap, also known as a negative output gap, refers to a situation in an
economy where the actual level of output (Gross Domestic Product or GDP) is
lower than its potential level of output. In other words, the economy is operating
below its full capacity, and there is a shortfall in aggregate demand compared to
the economy's productive potential. This gap signifies an underutilization of
resources and can lead to economic inefficiency and unemployment.

The recessionary gap occurs when the aggregate demand in the economy is
insufficient to support the production of goods and services at the economy's full
capacity. This can result from a decrease in consumer spending, business
investment, government spending, or net exports, causing a decline in overall
economic activity.

Characteristics:
1. Unemployment: businesses produce less due to lower demand, leading to layoffs
and reduced hiring
2. Underutilized resources: when the economy operates below the potential output,
there is excess capacity in industries. This means that factors, machines and labour
are not being utilized properly.
3. Deflationary pressure: lack of demand may lead to downward pressure on
prices, leading to deflation.

To reach full employment or the potential output level, the government will have
to increase spending by the amount of recession gap. Expanded fiscal policy
(increase in government spending) and expanded monetary policy (lower interest
rates) can be implemented in case of recession gap. These policies are aimed at
boosting AD, reducing unemployment.

INFLATIONARY GAP:
The difference between actual AD and the level of AD required to achieve full
employment is known as inflation gap.
It occurs when AD is above the NP. In this, all factors of production are fully
employed, it is difficult to fulfill additional requirement in the economy. This leads
to a situation where prices start to increase and goods are not available. As output
can’t be increased beyond full employment level, prices will rise, causing a
situation of inflation.

The government can impose higher taxes and reduce government expenditure.
Taxes reduce purchasing power.