CHAPTER-3

NATIONAL INCOME AND THEIR MEASUREMENTS

Structure

3.0 Objectives
3.1. Introduction
3.2. Concept of National Income
3.3 Methods of Measuring National Income
3.4. Problems in the Measurement of National Income
3.5. Determinants of National Income or Factors Affecting the National Income
3.6 Summary
3.7 Check your Progress
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3.0. Objectives

The objective of the lesson is to make you understand the measurement and compute the
National income of an economy, the three different methods of calculating the national income.
And also discussing the precautions that are necessary while using the different methods of
national income; and Problems that occur while measuring the national income especially in an
underdeveloped economy.

3.1. Introduction

National Income is an uncertain term which is used interchangeably with national

dividend, national output and national expenditure. On this basis, national income has been
defined in a number of ways. In common parlance, national income means the total value of
goods and services produced annually in a country.

In other words, National Income is the value of the aggregate output of the different
sectors during a certain time period. In other words, it is the flow of goods and services produced
in an economy in a particular year. Thus, the measurement of National Income becomes
important.

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 The definitions of national income can be grouped into two classes: One, the traditional
definitions given by Marshall, Pigou and Fisher; and two, modern definitions.

According to Marshall, the labour and capital of a country acting on its natural resources
produce annually a certain net aggregate of commodities, material and immaterial including
services of all kinds. This is the true net annual income or revenue of the country or national

in respect of depreciation and wearing out of machines. And to this, must be added income from
abroad.

A.C. Pigou has in his definition of national income included that income which can be

income of the community, including of course income derived from abroad which can be

This definition is better than the Marshallian definition. It has proved to be more practical
also. While calculating the national income now-a- days, estimates are prepared in accordance
with the two criteria laid down in this definition.

consists solely of services as received by ultimate consumers, whether from their material or
from the human environments. Thus, a piano, or an overcoat made for me this year is not a part

Modern

3.2. Concept of National Income

Gross Domestic Product (GDP):
GDP is the total value of goods and services produced within the country during a year. This is
calculated at market prices and is known as GDP at market prices. Dernberg defines GDP at

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 l goods and services produced in the

3.3. Methods of Measuring National Income

There are three ways of measuring the National Income of a country. They are from the
income side, the output side and the expenditure side. Thus, we can classify these
perspectives into the following methods of measurement of National Income.
1. Product Method
2. Income Method
3. Expenditure Method
The product approach measuring national income involves adding up the value of all the final
goods and services produced in the country during the year. The expenditure approach measures
national income as total spending on final goods and services produced within nation during a
year. Income approach is another alternative way of computing national income; this method
seeks to measure national income at the phase of distribution. Economists have tried to measure
national income in terms of its all the three aspects with a view to have a deeper understanding of
the structure of the company along with the knowledge of various determinants of growth such
as the level of production, consumption, savings or investments.
We now look at each of the three methods in turn.
(1) Product Method or Value Added Method:
Goods and services are counted in gross domestic product (GDP) at their market values. The
product approach defines a nation's gross product as that market value of goods and services
currently produced within a nation during a one-year period of time. The product approach
measuring national income involves adding up the value of all the final goods and services
produced in the country during the year. Here we focus on various sectors of the economy and
add up all their production during the year. The main sectors whose production value is added up
are:
Agriculture
Manufacturing
Construction
Transport and Communication
Banking
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 Administration and Defense and
Distribution of Income.
The following example will help us to understand.
Let us suppose that there are only two kinds of producers in the economy. They are the
wheat producers (or the farmers) and the bread makers (the bakers). The wheat producers grow
wheat and they do not need any input other than human labour. They sell a part of the wheat to
the bakers. The bakers do not need any other raw materials besides wheat to produce bread. Let
us suppose that in a year the total value of wheat that the farmers have produced is Rs 100. Out
of this they have sold Rs 50 worth of wheat to the bakers. The bakers have used this amount of
wheat completely during the year and have produced Rs. 200 worth of bread. What is the value
of total production in the economy? If we follow the simple way of aggregating the values of
production of the sectors, we would add Rs 200 (value of production of the bakers) to Rs. 100
(value of production of farmers). The result will be Rs 300. A little reflection will tell us that the
value of aggregate production is not Rs 300. The farmers had produced Rs. 100 worth of wheat
for which it did not need assistance of any inputs. Therefore, the entire Rs. 100 is rightfully the
contribution of the farmers. But the same is not true for the bakers. The bakers had to buy Rs. 50
worth of wheat to produce their bread. The Rs 200 worth of bread that they have produced is not
entirely their own contribution. To calculate the net contribution of the bakers, we need to
subtract the value of the wheat that they have bought from the farmers. If we do not do this, we
50 worth of wheat will be
counted twice. First it will be counted as part of the output produced by the farmers. Second
time, it will be counted as the imputed value of wheat in the bread produced by the bakers.
Therefore, the net contribution made by the bakers is, Rs 200 Rs 50 = Rs 150. Hence,
aggregate value of goods produced by this simple economy is Rs 100 (net contribution by the
farmers) + Rs 150 (net contribution by the bakers) = Rs 250. The term that is used to denote the
net contribution made by a firm is called its value added. We have seen that the raw materials
that a firm buy from another firm which are completely used up in the process of production are
n of the
firm value of intermediate goods used by the firm. The value added of a firm is distributed
among its four factors of production, namely, labour, capital, entrepreneurship and land.

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Therefore, wages, interest, profits and rents paid out by the firm must add up to the value added
of the firm. Value added is a flow variable.
Here, all the variables are expressed in terms of money. We can think of the market
prices of the goods being used to evaluate the different variables listed here. And we can
introduce more players in the chain of production in the example and make it more realistic and
complicated. For example, the farmer may be using fertilizers or pesticides to produce wheat.
The value of these inputs will have to be deducted from the value of output of wheat. Or the
bakers may be selling the bread to a restaurant whose value added will have to be calculated by
subtracting the value of intermediate goods (bread in this case). We have already introduced the
concept of depreciation, which is also known as consumption of fixed capital. Since the capital
which is used to carry out production undergoes wear and tear, the producer has to undertake
replacement investments to keep the value of capital constant. The replacement investment is
same as depreciation of capital. If we include depreciation in value added, then the measure of
value added that we obtain is called Gross Value Added. If we deduct the value of depreciation
from gross value added, we obtain Net Value Added. Unlike gross value added, net value added
does not include wear and tear that capital has undergone.
For Example,
Let us say a firm produces Rs 100 worth of goods per year, Rs 20 is the value of
intermediate goods used by it during the year and Rs 10 is the value of capital consumption.
The gross value added of the firm will be, Rs 100 Rs 20 = Rs 80 per year.
The net value added will be, Rs 100 Rs 20 Rs 10 = Rs 70 per year.
It is to be noted that while calculating the value added we are taking the value of
production of firm. But a firm may be unable to sell all of its produce. In such a case it will have
some unsold stock at the end of the year. Conversely, it may so happen that a firm had some
initial unsold stock to begin with. During the year that follows it has produced very little. But it
has met the demand in the market by selling from the stock it had at the beginning of the year.
How shall we treat these stocks which a firm may intentionally or unintentionally carry with
itself? Also, let us remember that a firm buys raw materials from other firms. The part of raw
material which gets used up is categorized as an intermediate good. What happens to the part
which does not get used up? In economics, the stock of unsold finished goods, or semi-finished
goods, or raw materials which a firm carry from one year to the next is called inventory.
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Inventory is a stock variable. It may have a value at the beginning of the year; it may have a
higher value at the end of the year. In such a case inventories have increased (or accumulated). If
the value of inventories is less at the end of the year compared to the beginning of the year,
inventories have decreased. We can therefore infer that:

The change of inventories of a firm during a year = Production of the firm during the year
Sale of the firm during the year

irrespective of what variables we have on the left hand and right hand sides of it.

For example, let us suppose that a firm had an unsold stock worth of Rs 100 at the
beginning of a year. During the year it had produced Rs 1,000 worth of goods and managed to
sell Rs 800 worth of goods. Therefore, the Rs 200 is the difference between production and sales.
This Rs 200 worth of goods is the change in inventories. This will add to the Rs 100 worth of
inventories the firm started with. Hence the inventories at the end of the year is, Rs 100 + Rs 200
= Rs 300. Notice that change in inventories takes place over a period of time. Therefore, it is a
flow variable. Inventories are treated as capital. Addition to the stock of capital of a firm is
known as investment.
Components of National Income in terms of Value Added
As the sum total of net value added at factor cost across all producing units of
the economy, National Income involves the estimation of its following components:
*Gross value added across primary, secondary and tertiary sectors within
the domestic territory of the country:
Gross Domestic Products at Market Price (GDP MP ) Depreciation
= Net Domestic Products at Market Price (NDP MP ) Net Indirect Taxes
= Net Domestic Products at Factor Cost (NDP FC ) -Net Factor Income from
Abroad
= Net National Products at Factor Cost (NNP FC ) = National Income

For Example:

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Calculate

Gross Value Added at Market Price and (ii) National Income from the
following data:

(i) Value of output: (Rs.)

(a) Primary Sector 800

(b) Secondary Sector 200

(c)Tertiary Sector 300

(ii) Value of intermediate inputs purchased by:

(a) Primary sector 400

(b) Secondary sector 100
(c) Tertiary sector 50

(iii)Indirect Taxes paid by all sectors: 50

(iv) consumption of fixed capital of all secto 80

(v) Factor income received by the residents from rest of the world 10

(vi) Factor income paid to non-residents 20

(vii) Subsidies received by all sectors 20

Solution

Gross Value Added at Market Price = value of ou tput of different sectors- value
of intermediate inputs purchased by different sectors

= Rs. 800+ Rs. 200+ Rs. 300- Rs. 400- Rs. 100- Rs. 50 = Rs. 750

National income = gross domestics product at market price - consumption of

fixed capital- indirect taxes+ subsidies+ factor income received by the residents
from the rest of the world- factor income paid to non-residents

Rs. 750-Rs 80- Rs.50+Rs. 20+Rs. 10-Rs.20 = Rs. 630

(2) Expenditure Method
The expenditure approach measures national income as total spending on final
goods and services produced within nation during a year. The expenditure approach to

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measuring national income is to add up all ex penditures made for final goods and
services at current market prices by households, firms and government during a year.
Total aggregate final expenditure on final output thus is the sum of four broad
categories of expenditures:
(i) Consumption expenditure (C): Consumption expenditure is the largest
component of national income. It includes expenditure on all goods and services
produced and sold to the final consumer during the year.
(ii) Investment expenditure (I): Investment is the use of today's resources to
expand tomorrow's production or consumption. Investment expenditure is expenditure
incurred on by business firms on (a) new plants, (b) adding to the stock of inventories
and (c) on newly constructed houses.
(iii) Government expenditure (G): It is the second largest component of
national income. It includes all government expenditure on currently produced goods
and services but excludes transfer payments while computing national income.
(iv) Net exports (X - M): Net exports are defined as total exports minus total
imports.
National income calculated from the expenditure side is the sum of final
consumption expenditure, expenditure by business on plants, government spending and
net exports.
NI = C + I +G + (X - M) Precautions
Components of National Income in Terms of Value Added
As the sum total of expenditure on the final goods and services national income
involves the estimation of following expenditure:
Gross Domestic Products at Market Price (GDP MP ) Depreciation
= Net Domestic Products at Market Price (NDP MP ) Net Indirect Taxes
= Net Domestic Products at Factor Cost (NDP FC ) -Net Factor Income from
Abroad
= Net National Products at Factor Cost (NNP FC ) = National Income
In the farmer baker example that we have described before, the aggregate value
of the output in the economy by expenditure method will be calculated in the following
way. In this method we add the final expenditures that each firm makes. Final
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expenditure is that part of expenditure which is undertaken not for intermediate
purposes. The Rs 50 worth of wheat which the bakers buy from the farmers counts as
intermediate goods, hence it does not fall under the category of final expenditure.
Therefore, the aggregate value of output of the e conomy is Rs 200 (final expenditure
received by the baker) + Rs 50 (final expenditure received by the farmer) = Rs 250 per
year. Firm i can make the final expenditure on the following accounts (a) the final
consumption expenditure on the goods and services produced by the firm. We shall
denote this by Ci. We may note that mostly it is the households which undertake
consumption expenditure. There may be exceptions when the firms buy consumables to
treat their guests or for their employees (b) the final inves tment expenditure, Ii,
incurred by other firms on the capital goods produced by firm i. Observe that unlike the
expenditure on intermediate goods which is not included in the calculation of GDP,
expenditure on investments is included. The reason is that in vestment goods remain
with the firm, whereas intermediate goods are consumed in the process of production
(c) the expenditure that the government makes on the final goods and services produced
by firm. We shall denote this by GI. We may point out that the final expenditure
incurred by the government includes both the consumption and investment expenditure
(d) the export revenues that firm i earns by selling its goods and services abroad. This
will be denoted by Xi.
Thus the sum total of the revenues that t
total of final consumption, investment, government and exports expenditures received
by the firm

Let, C the aggregate final consumption expenditure of the entire economy.

Notice that a part of C is spent on imports of consumption goods. Let Cm denote
expenditure on the imports of consumption goods. Therefore, C Cm denotes that part
of aggregate final consumption expenditure that is spent on the domestic firms.
Similarly, let I Im stand for that part of aggregate final investment expenditure that is
spent on domestic firms, where I is the value of the aggregate final investment
expenditure of the economy and out of this Im is spent on foreign investment goods.
Similarly, G Gm stands for that part of aggregate final government expenditure that is
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spent on the domestic firms, where G is the aggregate expenditure of the government of
the economy and Gm is the part of G which is spent on imports.

Net
Gross domestic capital exports:
formation:
Exports -
Gross domestic fixed Imports
capital formation
Change in Stock (
opening closing stock)
Net Acquisition of
Valuables

For Example

Calculate

(i) Gross National Product at market price by Expenditure Method and (ii) Gross
Domestic Product at market price by Income Method:

Items (Rs. Crore)

(i)Private Final consumption expenditure 200

(ii)Government Final consumption expenditure 20

(iii)Gross Domestic Capital Formation 40

50
 (iv)Net exports ( -)5

(v)Wages and salaries 165

contribution to social security schemes 10

(vii)Profits 15

(viii)Interest 20

(ix)Indirect taxes 30

(x)Subsidies 5

(xi)Rent 15

(xii)Net factor income received from abroad 5

(xiii)consumption of fixed capital 5

Solution:

Gross National Product at market price (by Expenditure Method) =

Private Final consumption expenditure+ Government Final consumption
expenditure+Gross Domestic Capital Formation+ Net exports+ Net factor
income received from abroad

= Rs. 200crore+ Rs. 20 crore+ Rs. 40 crore+(-Rs. 5crore) + Rs. 5crore=

Rs. 260 crore

Gross Domestic Product at market price (by Income Method) =

contribution to social security schemes+
Profits+ Rent+ Interest+ Indirect taxes- Subsidies+ consumption of fixed capital

= Rs. 165crore+ Rs. 10crore+ Rs. 15crore+ Rs. 1crore+Rs.20crore +Rs.

30 crore- Rs. 5crore +Rs. 5crore = Rs. 255 crore
(3) Income Approach
Income approach is another alternative way of computing national income; this
method seeks to measure national income at the phase of distribution. In the production
process of an economy, the factors of production are engaged by the enterprises. They
are paid money incomes for their participation in the production. The payments
received by the factors and paid by the enterprises are wages, rent, interest and profit.

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National income thus may be defined as the sum of wages, rent, interest and profit
received or occurred to the factors of production in lieu of their services in the
production of goods. Briefly, national income is the sum of all income, wages, rents,
interest and profit paid to the four factors of production. The four categories of
payments are briefly described below:
(i) Wages: It is the largest component of national income. It consists of wages
and salaries along with fringe benefits and unemployment insurance.
(ii) Rents: Rents are the income from properly received by households.
(iii) Interest: Interest is the income private businesses pay to households who
have lent the business money.
(iv) Profits: Profits are normally divided into two categories (a) profits of
incorporated businesses and (b) profits of unincorporated businesses (sole

National Income = Compensation of employee + Operating Su rplus (Rent or

Royalty + Interest +profit) + Mixed income of self -employed + Net factor income from
abroad
Or
{Compensation of employee + Operating Surplus + Mixed income] = Net
Domestic Income or Net Domestic Products at Factor Cost (NDP FC )+ Net Factor
Income from Abroad
= [Compensation of employee + Operating Surplus + Mixed income + Net
Factor Income from Abroad] = Net National Income or Net National Products at
Factor Cost (NNP FC )
+ Depreciation
= Gross National Income or Gross National Products at Factor Cost (NNP FC )+
Net Indirect Taxes
= Gross National Products at Market Price (GNP MP )
Check Your Progress
Fill in the blanks

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 i. ______________measures national income as total spending on final goods
and services produced within nation during a year.
ii. ________________ method seeks to measure national income at the phase of
distribution.
iii. If we include depreciation in value added, then the measure of value added
that we obtain is called ___________
iv. Inventory is a_____________.
v. The value added of a firm is distributed among its four factors of production,
namely, labour, capital, ___________and _______________________is the
largest component of national income.

Given the Following Data and Using Income Method Calculate

(i) Net Domestic Income (ii) Gross Domestic Income (iii) Net National
Income (iv) Net National Product at Market Price.

Items
(Rs.Crore)

i. Indirect Taxes 9000

ii. Subsidies 1,800

iii. Depreciation ,700

iv. Mixed Income of self-employed 28,000

v. Operating surplus
10,000

vi.Net Factor Income from Abroad ( -) 300

vii. Compensation of Employees

24,000

Solution

Net Domestic Income = Mixed Income of self-employed+ operating surplus

+ Compensation of Employees

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= Rs. 28000 crore+ Rs. 10,000 crore+ Rs. 24,000 crore = Rs. 62, 000 crore

Ans: Rs. 62,000 crore

Gross Domestic Income = Net Domestic Income + Depreciation

= Rs. 62,000+ Rs. 1,7// crore = Rs. 63,700 crore Ans: Rs. 63,700 crore

Net National Income = Net Domestic Income+ Net Factor Income from
Abroad

= Rs. 62,000 crore+ (- Rs. 300 crore) = Rs. 61,700 crore Ans: Rs. 61,700 crore

Net National Product at Market Price = Net National Income+ I ndirect Taxes-
Subsidies

Rs. 61,700 crore+ Rs. 9,000 crore- Rs. 1,800 crore= Rs. 68,900 crore = Ans:
Rs. 68,900 crore

Precautions in Different Methods

Precautions for Product Method or Value Added Method

There are certain precautions which are to be taken to avoid miscalculation of

national income using this method. These in brief are:

(i) Problem of double counting: When we add up the value of output of various
sectors, we should be careful to avoid double counting. This pitfall can be avoided by
either counting (he final value of the output or by including the extra value that each
firm adds to an item.

(ii) Value addition in particular year: While calculating national income, the
values of goods added in the particular year in question are added up. The values which
had previously been added to the stocks of raw material and goods have to be ignored.
GDP thus includes only those goods, and services that are newly produced within the
current period.

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 (iii) Stock appreciation: Stock appreciation, if any, must be deducted from
value added. This is necessary as there is no real increase in output.

(iv) Production for self-consumption: The production of goods for self-

consumption should be counted while measuring national income. In this method, the
production of goods for self-consumption should be valued at the prevailing market
prices.

Precautions for Expenditure Method:

While estimating national income through expenditure method, the following

precautions should be taken:

(i) The expenditure on second hand goods should not be included as they do not
contribute to the current year's production of goods.

(ii) Similarly, expenditure on purchase of old shares and bonds is not included as
these also do not represent expenditure on currently produced goods and servi ces.

(iii) Expenditure on transfer payments by government such as unemployment

benefit, old age pensions, interest on public debt should also not be included because no
productive service is rendered in exchange by recipients of these payments.

Precautions for Income Approach

While estimating national income through income method, the following

precautions should be undertaken.
(i) Transfer payments such as gifts, donations, scholarships, indirect taxes should
not be included in the estimation of national income.
(ii) Illegal money earned through smuggling and gambling should not be
included.
(iii) Windfall gains such as prizes won, lotteries etc. is not be included in the
estimation of national income.

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 (iv) Receipts from the sale of financial assets such as shares, bonds should not be
included in measuring national income as they are not related to generation of income
in the current year production of goods.

Why Three Methods of Computing/Measuring National Income Are Equal?

The three approaches used for measuring national income give the same result.
The reason is the market value of goods and services produced in a given period by
definition are equal to the amount that buyers must spend to purchase them. So the
product approach which measures market value of goods and services produced and the
expenditure approach which measures spending should give the same measure of
economic activity.

n equal the total income generated by the

economic activity. Thus, total expenditure must equal total income generated implying
that the expenditure and income approach must also produce the same result .

7.3. Problems in the Measurement of National Income

According to Kuznets, the measurement of national income is a complicated

problem and is best with the following difficulties:

1. Non-availability of statistical material: Some persons like electricians,

plumbers, etc., do some job in their spare time and re ceive income. The state
finds it very difficult to know the exact amount received from such services. This
income which, should have been added to the national income is not recorded
due to {be lack of full information of statistics material.
2. The danger of double counting: While computing the national income, there is
always the danger of double or multiple counting. If care is not taken in
estimating the income, the cost of the commodity is likely to be counted twice or
thrice and national income will be overestimated.

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 3. Non-marketed services: In estimating the national income, only those services
are included for which the payment is made. The unpaid services, or non -
marketed services are excluded from the national income.

Difficulty in Assessing the Depreciation Allowance

The deduction of depreciation allowances, accidental damages, repair, and

replacement charges from the national income is not an easy task. It' requires high
degree of judgment to assess the depreciation allowance and other charges.

1. Housing: A person lives in a rented house. He pays $5000 per month to the
landlord. The income of the landlord is recorded in the national income. Let us
suppose that the tenant purchases the same house from the landlord. Now the
income of the owner occupant has increased by $5000. Is it not justifiable to
include this income in the national income? Should or should not this income be
recorded in the national income is still a controversial question.
2. Transfer earnings: While measuring the national income, it shoul d be seen that
transfer payments should not become a part of national income. The payments
made as relief allowance, pensions, etc. do not contribute towards current
production. So they should be excluded from national income.
3. Self-consumed production: In developing countries, a significant part of the
output is not exchanged for money in the market. It is either consumed directly
by producers or bartered for other goods This unorganized and non -monetized
sector makes calculation of national income difficu lt.
4. Level changes: National income is measured in money terms. The measuring rod
of-money itself does not remain stable. This means that national income can
change without any change in output.

Problems of Measurement in Under Developed Countries

The national income in under-developed countries like Pakistan, Afghanistan,

etc., cannot be accurately measured due to the following reasons:

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 (i) Self-consumed-bartered consumption: Some of the transactions of
agricultural goods in the villages are done without th e use of money. The statisticians,
therefore, cannot measure the exact amount of the transactions for inclusion in the
national income.

(ii) No systematic accounts maintained: Most of the producers do not keep any
record of the sale of the products in the market. This makes the task of national income
still more complicated.

(iii) No occupational classification: There is no occupational specialization in

the under-developed countries. People receive income by working in various capacities.
One person sometimes works as carpenter and at another time as mason. The
statisticians cannot accurately measure the income of such persons.

(iv) Unreliable data: The statisticians themselves do not feel the importance of
figures which they collect They also do not take much pains for getting the reliable
data. The figures of national Income are, therefore, not up -to-date in the under-
developed countries.

Conceptual Difficulties

1. Inclusion of Services: There has been some debate about whether to include
services in the counting of national income, and if it counts as output. Marxian
economists are of the belief that services should be excluded from national
income, most other economists though are in agreement that services should be
included.
2. Identifying Intermediate Goods: The basic concept of national income is to only
include final goods, intermediate goods are never included, but in reality it is
very hard to draw a clear cut line as to what intermediate goods are. Many goods
can be justified as intermediate as well as final goods depending on their use.
3. Identifying Factor Incomes: Separating factor incomes and non -factor incomes is
also a huge problem. Factor incomes are those paid in exchange for factor

58
 services like wages, rent, interest etc. Non-factor are sale of shares selling old
cars property etc., but these are made to look like factor incomes and hence are
mistakenly included in national income.
4. Services of Housewives and other similar services: National income includes
those goods and services for which paym ent has been made, but there are scores
of jobs, for which money as such is not paid, also there are jobs which people do
themselves like maintain the gardens etc., so if they hired someone else to do
this for them , then national income would increase, th e argument then is why are
these acts not accounted for now, but the bigger issue would be how to keep a
track of these activities and include the in national income.

Practical Difficulties

1. Unreported Illegal Income: Sometimes, people don't provide all th e right

information about their incomes to evade taxes so this obviously causes
disparities in the counting of national income.
2. Non Monetized Sector: In many developing nations, there is this issue that goods
and services are traded through barter, i.e. without any money. Such goods and
services should be included in accounting of national income, but the absence of
data makes this inclusion very difficult.

Determinants of National Income or Factors Affecting the National Income

There are many determinants or factors that is influence the size of the national
income. These are the followings:

(i) The stock of factors of production: One of the very important factors which
influence the size of the national income is the quality and quantity of the country's
stock of factors of production. The factors of production are land, labor, capital and
organization. Land supplies man with gifts of nature. It provides him with agricultural
goods and. raw material for production. The production of land depends upon fertility
of the soil, latitude, climate and irrigation system in the country. If the land is fertile

59
and is not handicapped in any way say by salinity, water logging, shortage of rainfall
and adverse climate, the size of the national income will be quite large, if the quality of
land is poor, the size of the national income will be small.

(ii) Labor: The second factor of production, i.e., labor is by no means less
important. This can be judged from it that if land is not aided by human labor, it cannot
produce anything except the wild vegetation. The size of the national income greatly
depends upon the quality and quantity of labor in t he country. If the labor is efficient
and its size is consistent with the means of subsistence, the size of the national income
will be large and if the labor is underfed, under clothed and under -housed unskilled,
and has no ambition to rise, the size of the national income will be small.

(iii) Capital: The volume of production is also very much influenced by the
quality and quantity of capital available in the country. Capital now -a-days is
considered to be the lifeblood of the modern industry. If the capi tal consists of
primitive tools, the size of the national income cannot be large. But if modern types of
plants are used for production, then they can enhance the productive capacity of a
country.

(iv) Enterprise: The size of the national income also greatly depends upon! the
number and skill of the entrepreneurs. If the captains of the industries! are efficient,
they will combine; the various factors of production to the! optimum proportion and so
the volume of total production will be quite large, if mana gerial skill is lacking in the
country, the size of the national income will be small.

(v) State of technical knowledge: State of technical knowledge is also one of

the very important factors which influence the size of the national income. The methods
of production now-a-days have become so much roundabout that unless advance
technical knowledge is available in the Country, they cannot be adopted. The
roundabout methods of production have considerably increased the production capacity
of the country. If the state of technical knowledge is poor in the country, the size of the

60
national income will be small, but if advance technical knowledge is available, then the
size of the national income will be large.

(vi) Political Stability: Political instability greatly hampers economic progress.

If there is political stability in the country, the production can be maintained at the
highest level. The size of the national income will be large. In case of political
instability, the production will be adversely affected and so the size of the national
income will be small.
Check your progress
Write True or False against the sentences
1. Gross Domestic Products at Market Price (GDP MP ) + Depreciation = Net
Domestic Products at Market Price (NDP MP ) Net Indirect Taxes.
2. The expenditure approach measures national income as total spending on final
goods and services produced within nation during a year.
3. National Income = Compensation of employee + Operating Surplus (rent or
royalty + interest + profit) + Mixed income of self-employed - Net factor income
from abroad
4. The volume of production is not very much influenced by the quality and
quantity of capital available in the country.
5. Net National Income = Net Domestic Income+ Net Factor Income from Abroad
3.4. Summary
National income measures are often quoted in newspapers and other forms of
media. They are observed by governments, international agencies, research institutions
and business community. Even students and households are interested to how their
country has performed economically. Historical national income figures are usually
examined although there are also some individuals interested in predicting future GDPs.
The chapter reminds students that despite the usefulness, there are problems associated
with using national
performances. Mostly used as a secondary data, users are generally not aware of the
detailed methodology in collecting national income and the magnitude of errors made
3.5. Glossary
61
 Consumption expenditure (C): Consumption expenditure is the largest
component of national income. It includes expenditure on all goods and services
produced and sold to the final consumer during the year.

Investment expenditure (I): Investment is the use of today's resources to

expand tomorrow's production or consumption. Investment expenditure is expenditure
incurred on by business firms on (a) new plants, (b) adding to the stock of inventories
and (c) on newly constructed houses.

Government expenditure (G): It is the second largest component of national

income. It includes all government expenditure on currently produced goods and
services but excludes transfer payments while computing national income.
Wages: It is the largest component of national income. It consists of wages and
salaries along with fringe benefits and unemployment insurance.
Rents: Rents are the income from properly received by households.
Interest: Interest is the income private businesses pay to households who have
lent the business money.
Profits: Profits are normally divided into two categories (a) profits of
incorporated businesses and (b) profits of unincorporated businesses (sole

3.6. Check Your Progress

1. Define product method in detail.
2. What are the main precautions required to be taken in estimating national income
through the product method?
3. What are the main precautions required to be taken in estimating national income
through the expenditure method?
4. What are the main problems in calculating national income?
5. Explain the determinants of national income.
6. Calculate (i) National Income by Income Method and (ii) Output Method from the
following data:
Items (Rs. Crore)
(i)Value of output of primary sector 1000
(ii)Value of putput of other sectors 400
62
 (iii)Raw materials etc. Purchased by the primary sector 500
(iv) Raw materials etc. Purchased by the other sector 300
(v) Factor income from rest of the world 10
(vi) Factor income paid to the rest of the world 15
(vii)Depreciation 55
(viii)Indirect taxes 100
(ix)Subsidies 20
(x)Mixed Income of the self-employed 200
(xi)Compensation of the employees 170
(xii)Rent 40
(xiii)Interest 30
(xiv)Profit 25
7. Calculate
(i) Net Domestic Product at factor cost by output method and (ii) National Income by
income method from the following data:
Items (Rs. Crore)
(i)Value of output 800
(ii)Value of intermediate consumption 400
(iii)Subsidies 10
(iv)Indirect taxes 60
(v) Factor income received from abroad 10
(vi) Factor income paid abroad 20
(vii) Mixed income for self-employed 120
(viii) Rent and royalty 40
(ix) Interest and profit 20
(x)wages and salaries 110
(xi) Consumption of fixed capital 50
emes 10
8. Calculate
(i) Gross Domestic Product at Market Price (ii) Gross Nation Product at Market
Price from the following data by Expenditure Method:
Items (Rs. Lakh)
(i)Personal final consumption expenditure 50
(ii)Government final consumption expenditure 50
(iii)Gross domestic fixed capital formation 45
(iv)Increase in stock 5
(v)Exports of goods and services 8
(vi)Imports of goods and services 6
(vii)Consumption of fixed capital 6
(viii) Net factor income from abroad 5
(ix) Net indirect taxes 20

63
Structure
4.0. Objective
4.1. Introduction
4.2. The Phases of Trade Cycle
4.3. Characteristics of the Trade Cycles
4.4.
4.5. Policies for Trade Cycles
4.6. Summary
4.7. Glossary
4.8. Check Your Progress
---------------------------------------------------------------------------------------------------------------------
4.0. Objectives
In this, chapter, we will analyze the various phases of the trade cycle and its impact on
employment. An analysis of business cycle helps us to understand the relationship between real
GDP, unemployment, and inflation.
4.1. Introduction
Trade cycle means the cyclical fluctuations or the ups and down in aggregate economic activity.
Different theories have been presented to explain the causes of Trade Cycle. Every businessman
knows that, after ten or twelve years, the production machinery receives a rude shock, which
throws it out for a number of years. There are upward swing and then downward swing in
business. The periods of business prosperity alter with periods of adversity. Every boom is
followed by a slump, and vice versa. This is a trade cycles. In simple words trade cycle means
64
the whole course of trade or business activity, which passes through all phases of prosperity and
adversity.
Among the various causes, one of the major cause of it is usually ignored i.e. the
Inequality. Inequality and Trade Cycle are closely related. Inequality in income distribution is
one of the major causes of the trade cycle. Inequality may cause the trade cycle and also speed-
up the intensity of the different phases of trade cycle, caused by some other factors.
4.2. The Phases of Trade Cycle
4.2.1. Depression
Inequalities give further impetus to the process of reduction in output, employment,
income, demand and prices. During depression, due to the decline in income and employment,
the majority of poor population, which hardly meets their livelihood, becomes poorer and their
pur
the fundamental background of the fall in the general level of prices. So, businessmen face
losses. Overall economic activity declines and economy reaches to its lowest or standstill point.
4.2.2. Revival
The depression may prolong for a long period of time, if there is a severe inequality. But sooner

revival. Because during depression, consumption and demand reaches to their minimum point

and the wear & tear expenditures or replacement cost on semi-durable goods leads to increase in
demand. To meet this demand, investment and output tends to grow, employment is generated.
And process of revival becomes cumulative. As a result, level of employment, income, demand
and output rise steadily. Business activity increases and revival turns into boom and the cycle
completes.
4.2.3. Boom
We start with an example of a typical economy, where there is the inequality in the income

holds
hold only the 20%-25% of the income and constitute the 80% of the total population
s have
most of income in their hands. So, they increase the investment. As a result the income of the
65
people increases, due to the multiplier effect of this investment. So, the aggregate demand,
employment, price level and output go on to rise. Aggregate economic activity increases. Prices

Overall economic activity takes momentum. The output, employment, demand and Price level
reaches to its peak point. Economy e
4.2.4. End of Boom
Just as depression created the conditions for recovery, similarly the boom conditions
generate their own checks. All idle factors have been employed and further demand for them
must raise their prices, but the quality available now is inferior. Less efficient workers have to be
taken on higher wages. Rate of interest rises and so, also the prices of the essential materials. As
a consequence, costs take an upward swing. They overtake prices and the profits margins are
first narrowed & then beginning to disappear. The boom conditions are thus almost at an end.
4.2.5. Crisis
Now starts the downward course. Fearing that the era of profits has come to a close,
businessmen stop ordering further equipment and materials. The government applies the axe
mercilessly. The bankers insist on repayment. The bottlenecks appear and stocks accumulate.
Desire for liquidity increases all round. This accentuates the depression. This phase of the trade
cycle is known as the crisis.
4.2.6. Slump
The crisis is the period of utmost suffering for businessman. But they recover in course of
time from the stunning blow. Their commitment is liquidated somehow and business enterers
into the stage of what has already been described as depression or slump.
4.3. Characteristics of the Trade Cycles
4.3.1. Its cyclical in nature
The first characteristic is that the trade cycle occurs periodically at fairly regular intervals. The
interval is not a precise one but the degree of regularity is sufficient to demonstrate the
periodicity of a trade cycle. There is a general consensus of opinion that the cycle takes seven to
ten years nearly to complete it.
4.3.2. General synchronism
The Second characteristic is synchronism. The business world is one economic unit, like a living
organism. An attack on one part has an impact on the other parts. If one firm is in grief those
66
who deal with it cannot remain unaffected and they in turn, will affect others with who they may
be in commercial intercourse. Thus, depression passes from one industry to another. A time
comes when all industries in all districts and all firms in the country are engulfed. Few can
escape the deluge.
4.4. ry of Trade Cycle
Kaldor subscribes to the view that fluctuations in the level of trade cycles take place due to
the interaction of multiplier and accelerator but uses a modified and more realistic form of
lysis the level of activity means the level of

accumulation by raising the productive capacity affects the investment decisions of the
entrepreneurs. The effect of the capital accumulation on the investment decision of the
entrepreneurs makes the investment function non-linear in the real world.
Kaldor explains the occurrence of trade cycles through saving and investment, which by
their interaction determines the level of activity, that is, the level of national output, employment
and income. Kaldor uses the ex-ante concepts of saving and investment, since it is the ex-ante
saving and ex-ante investment that determine the level of economic activity and not the ex-post
or realized saving and investment. Ex-ante investment means planned net addition to the stock of
fixed capital and inventories of goods. This ex-ante investment differs from the realized, actual
or ex-post investment by the amount of unintended accumulation or dis-accumulations of
inventories of goods which arise due to the difference between the planned and realized sales of
goods. Ex-ante saving means the savings planned by the people for a period if they had
accurately forecast their incomes. Therefore, unexpected changes in the level of income will
make the realized or ex-post saving different from the planned or ex-ante saving.

Kaldor explains the stability or instability of the level of economic activity and the course
of the trade cycle. He takes first the cases of linear saving and investment functions. Condition 1,
Figure 1.1 where linear saving and investment functions are shown and where the investment
curve II is more steeply inclined than the saving curve SS. The two functions intersect at point C
and seem to determine the level of income YO. But this equilibrium between ex-ante saving and
ex-ante investment is quite unstable. This is because in the figure if once the equilibrium
between saving and investment is disturbed, the economy will move either towards hyper-
67
inflation or towards collapse. Thus, if as a result of some change, ex-ante investment exceeds ex-
ante saving, (Figure 1.1), then the level of activity will go on rising unchecked and will
ultimately result in hyper-inflation. If some disturbance sends the system towards the right of the
cross between saving and investment in Figure 1.1 so that ex-ante saving exceeds ex-ante
investment, then the level of income or activity will go on falling unchecked and will ultimately
collapse. Thus the situation depicted in Figure 1.1 with liner investment curve more steeply
inclined than the saving curve is quite unstable; any disturbance in the equilibrium situation
either sends the system towards hyperinflation or towards collapse. Since such instability is not
actually found in the real world, Kaldor rule out this case.

Y I Y S I
S

C C
S II S
O X O X

Fig-1.1 UNSTABLE Fig-1.2 STABLE

Now, take Figure 1.2 were also saving and investment curve are intersecting at point C
and determine the level of income YO. But in Figure 1.2, investment curve II is less steeply
inclined than the saving curve SS so that the equilibrium between them at point C or at the level
of income YO is quite stable. For example, if as a result of some disturbance, the level of
income rises beyond equilibrium income YO, ex-ante saving exceeds ex-ante investment which
will tend to reduce the income to the equilibrium level YO. If in Figure 1.2 the income falls
below YO, ex-ante, investment will exceed ex-ante saving and as a result the level of income
will rise to Y. Thus, the equilibrium is quite stable in Figure 1.2 where investment curve. But
such stability is also not realistic because economic system in the real world shows great
68
instability. We thus see both the cases depicted in Figure 1.1 and 1.2 having liner ex-ante saving
and investment functions are quite unrealistic and therefore Kaldor rules them out. Kaldor point
out that in the real world both the saving and investment functions are non-linear and explain
trade cycles or fluctuations in the economic activity with non-linear saving and investment
functions.
The interaction between the non-linear saving function SS and the non-linear investment
function II is shown in Figure 1.3. Equilibrium at point B is quite unstable both upward and
downward. Above point B, investment exceeds saving and, therefore, once as a result of some
disturbance investment exceeds saving, the income will go on moving upward till point C is
reached, and below point B saving exceeds investment and any disturbance which moves the
system below point B, the level of activity will go on moving downward till point A is reached.
Above point C saving exceeds investment and therefore, if the system goes above point C, it will
come back to it. Therefore, the system is stable upward. On the other hand, below point C,
investment exceeds saving and, therefore, any disturbance which sends the system below point
C. Thus, the level of activity at point C is also stable downward. It, therefore, follows that the
level of activity is in stable equilibrium at point C.

A glance at point A in Figure 1.3, will reveal than it also represents a stable equilibrium,
above point A saving exceeds saving which means that the level of activity will tend to rerun to
point A if any disturbance, causing movement either upward or downward, occurs. It, therefore,
69
follows that both the extreme points, C representing boom period and A representing depression,
are stable equilibrium points. This means that economy should tend to be in stable equilibrium at
either a very high or a very low level of activity. In the capitalist system of the real world there
occurs, if Government does not take any steps, self-generating trade cycles. That is, a good deal
of instability is found in the capitalist system in the real world. But the stability at these two
extreme levels of activity seems to be necessary if the saving and investment functions remain
fixed and also if the non linear saving and investment function are actually of the shape as
shown in Figure 1.3. Kaldor show that these shapes of the two functions approximate to the real
world situation.
According to Kaldor, when the level of investment is very high, production of consumer goods
increases and as a result both consumption and saving increase. This means that saving function
curve SS will shift upward when the high level of activity is reached. Besides, with a high level of
investment the opportunities for further investment may become temporarily restricted and as a
result of this investment function curve II tends to shift downward.

The economy will not go below point A in Figure 1.5, because, as explained above,
saving and investment are in stable equilibrium at point A. Thus, when the economy is at a high
level of activity, at point C, the saving function curve SS tends to move downward and
consequently the point C tends to move down and point B tends to move up as in Figure 1.4,
70
until they meet each other at the combined point BC as in Figure 1.5. It will be seen from Figure
1.5, that saving exceeds investment on both sides of the combined point BC, which means that
the level of activity at the combined point BC is unstable downward. Thus, because saving
exceeds investment at the combined point BC, the contraction in the level of activity will not
stop at point BC but will continue further until point A is reached.

According to Kaldor, reversal movement of the cycle will start because the investment function
curve will shift downward. This creates opportunities for more investment, which cause the
investment function curve to move upward with the level of activity at A, as the investment
function curve II moves upward relatives to the saving function curve SS, the point B will
separate from point C and tend to move towards A as in Figure 1. 6(a). The investment function
curve II will go on shifting upward till combined point AB is reached as in Figure -1.6(b). But
the combined point AB is unstable upward, for above combined point AB, investment exceeds
saving. As a result, the expansion in the level of activity will not stop at point AB but will
continue until once again point C is reached. Now, with the point C representing again the
situation of boom having been reached, the investment opportunities once again will become
restricted and as a result the movement of contraction in the level of activity will start once
again and the whole process of contraction and then expansion will be repeated again, as
brought out above. This is how Kaldor shows that the occurrence of trade cycles in a free market
capitalist economy is self-generating.

71
4.5. Policies for Trade Cycles

Governments use macroeconomic policies to achieve their economic objectives. These

policies influence trade cycles and thus help government attain macroeconomic goals. These
policies are given below: -

4.5.1. Corrective Measure

Lack of unanimity as to the policy to be followed to eliminate trade cycle, is even moving
marked than the lack of unanimity about the causes thereof. For a complicated malady no simple
remedy can be prescribed. For preventing or avoiding crisis, the remedy will depend on the
diagnosis. Influences of climatic factors on the supply of raw materials cannot be ruled out
altogether.
4.5.2. Monetary Policy
All modern societies use money as the medium of exchange. Since money can be
exchanged for goods and services. It can also be regarded as a financial asset- a store of value.
There are various definitions of money stock, but generally speaking, money consists of financial
assets with a high degree of liquidity (that is, money or assets that can be quickly converted into
money with little or no loss of purchasing power). The monetary system of a country consists of
those institutions that create such assets. The monetary system of a country consists of those
institutions that create such assets. The monetary policy of a country is formulated and
implemented by its central bank (in India, the Reserve Bank of India). It is used to influence the
total quantity of money, interest rates and total volume of credit in the trade cycles.

4.5.3. Fiscal Policy

Fiscal policy refers to the policy of the government with respect to its spending (or
expenditure) and mobilization of resources (an important source of revenue being taxes).
Government expenditure consists of purchases and transfer payments. Government purchases
refer to spending on goods and services such as the construction of roads and dams, salaries to
public servants, etc. Government spending has a positive effect on the overall spending in the
economy and thus influences the GDP level. Government, therefore, uses its spending as a tool
to control the level of economic activity in the country. Taxation is another important instrument
72
of fiscal policy, which affects the economy in two ways. Changes in the tax structure have a
isposable incomes, which in turn affects the amount they spend on
goods and services and the amount they save. An increase or decrease in private consumption
and saving affects the overall output and investment in the economy in the short as well as the
long run. Taxation also affects the prices of goods and services and factors of production. For
example, if a low tax is levied on business profits, businessmen will be encouraged to invest in
capital goods, which will spur investment and speed up trade cycles.

4.5.4. International Trade Policy

Trade policies relate to tariff and non- tariff trade regulations that limit or promote the
imports and exports of a country. The last part of the 20th century witnessed an increase in the
pace of globalization, century which made many world economies highly dependent on
international trade. Trade policy that was hitherto called the import-export policy was renamed
export-import policy. The government announced a long term export-import policy for a period
of five years synchronizing with the 8th five-year plan. The policy laid down a wide range of
measures for restructuring the various export promotion schemes. It also recommended the
simplification and streamlining of procedures so as to ensure greater transparency and efficiency
in the system.

4.5.5. Exchange Rate Policy

The international trade of a country is affected by its foreign exchange rate. The foreign

foreign currency. The exchange rate Policy of a country forms a part of its monetary policy.
Different countries follow different exchange rate is fixed against currencies whose exchange
rate is determined purely by supply and demand.

4.5.6. Price and Income Policy

A price and income policy is used to influence the working of the prices of some goods
and services and determine the wages. The government takes these measures to control inflation,

73
and protect jobs in the domestic market. These measures should be temporary otherwise they
may lead to distortions and inefficiencies in the trade cycles.

4.5.7. Employment Policy

Employment policies are aimed at generating employment opportunities. In India, the
government takes up projects that require huge labor force during non-agricultural seasons, when
employment in rural areas in low, similarly, the government sometimes provides free training
facilities to unskilled labor to make them fit for new skilled jobs.
4.6. Summary
In this chapter, we discussed that the trade cycle is a swing in total national output,
income and employment. It usually has two phases: recession and expansion. It is difficult to
predict the duration and timing of trade cycles. During expansion, production increases in all
sectors of the economy and so do employment opportunities. Some of the forces that come into
play during expansion lead to recession. The general rise in costs relative to prices is an
important factor leading to recession. Recession ultimately leads to depression and there is
substantial fall in the production of goods and services and the level of employment. During
recovery, there will be more employment opportunities and income will go up which in turn will
lead to more demand for goods and service. There will be an upward movement in the price, thus
encouraging investment and growth in the economy. There are many theories, which explain the

and aggregate supply curves explain trade cycles better. Shifts in aggregate demand causes trade
cycle fluctuations in output, employment and prices. The economy suffers recession or even
depression when a shift in aggregate demand causes downturns in business. When there is an
upturn in economic activities, it would lead to inflation. Other theories concentrate on the
behavior of investors, cycles in public expenditure and the behavior of money supply. But no
theory has successfully explained and predicted the trade cycles.
4.7. Glossary
Aggregate demand It is determined by the aggregate price level and influenced by domestic
investment, exports, government spending the consumption function, and the money supply.
Aggregate demand (AD) - The curve showing the relationship between the quality of goods and
services that people are willing to buy and the aggregate price level, other thing equal.
74
Balance of Trade-
or exports, including such items as foodstuffs, capital goods and automobiles.

Trade cycles- fluctuations in total national output, income and employment, usually lasting for a
period of 2 to 10 years, marked by widespread and simultaneous expansion or contraction in
many sector of the economy.

Change in demand- An increase or decrease in the quantity demanded over a range of prices.
Shown by a shift of the demand curve.

Deflation- A fall in the general level of prices.

Equilibrium price- A price at which at quantity supplied equals the quantity demanded.

Gross domestic product, nominal- The value at current market prices, of the total final output
produced inside a country during a given year.

Inflation- The inflation rate is the percentage of annual increase in a general price level.

Marginal cost- The increase in total cost consequent upon a one-unit increase in the production
of a good.

Price What must be paid to acquire the right to possess and use a good or service

Profit-
4.8. Check Your Progress
1. What is trade cycle, explain its main characterizes?
2.
3. Discuss the objectives of monetary policy. How far can a suitable monetary policy bring
business revival?
4. Discuss what you consider to be the most satisfactory explanation of the trade cycle?
5. Discuss the various measures, which should be adopted to fight business fluctuations?
6. Explain the need for and limitations of fiscal policy as means of reading economic
stability?
7. Discuss the various phases of the business cycle. How do variations in savings and
investment affect the course of a cycle?

75