BASIC ISSUES ON MACRO ECONOMICS

The Circular Flows of National Income – Two Sector Model:

The households are represented by the rectangle labelled “Households” and the business
sector by rectangle labelled “Firms”, with their respective characteristics. A line drawn from
the household to the firms divides the diagram into two parts – the upper half represents
the factor market and the lower half represents the commodity market. Both markets
generate two kinds of flows – product flows and money flows.

In the factor market the arrow ‘FOP’ shows the flow of factors of production (FOP) from the
household to the firms. This makes the factor flow shown by a continuous arrow. The factor
flow causes another and a reverse flow, that is, the money flow in the form of factor
incomes (wages, interest, rent and profits) from the firms to the household. Since all factor
payments are made in terms of money, the flow of factor incomes represents money flow.

In commodity market, the goods and services produced by the firms flow from the firms to
the households. The payment made by the households for the goods and services creates
money flow. Note again that goods and money flows in the commodity market too flow in
opposite direction. The flows in continuity, we find circularity in the flows. By combining the
continuous arrows in the goods and factor markets, we get the circular flow of goods.

Three Sector Model**

The circular flow income in three sector economy includes households, firms and
government sector. The government act as a both firm and consumer. As a firm or producer
government produces goods and services for the economy.
Between Household and Government: The money from the government to households
flows in an economy in two forms. First, in the form of transfer payments, such as old age
pensions, scholarships, etc. Second, in the form of factor payments for hiring factor services
of the households. This money flows back from households to the government in the form
of direct taxes, such as interest tax, income tax, etc.

Between Firms and Government: The money from firms to the government flows in an
economy in the form of direct and indirect taxes. However, the money from the
government to the firms flows into an economy in the form of subsidies. In this case, the
government grants subsidies to the firms and makes payments to the firms for the purchase
of goods and services produced by them. 

The financial market also plays an important role in a three-sector economy, as the
government saves a part of their earned income and deposits the same in the financial
market. Besides, the government also borrows money from the financial market so it can
meet its expenditures. 

*Measurement of National Income*

There are 3 methods of measuring National Income – 1. Production Method Or Value

Added Method, 2. Expenditure Method, 3. Income Method.

0 S F C
500 + 2000 + 5000 = 7500 WRONG
Production Method OR Value Added Method:

Value Added = Sales – Return

(500-0) + (2000-500) + (5000-2000) = 500 + 1500 + 3000 = 5000 CORRECT

Sales = Value of Output

Purchase = Value of Intermediate Consumption

Therefore,

Value Added = Value of Output – Value of Intermediate Consumption + Closing stock –

opening stock

Formula:

Value Added by:

Primary Sector ***

Secondary Sector ***

Tertiary Sector ***

GDPMP ***

(-) Depreciation/ ***

consumption of fixed cap.

NDPMP ***

(-) Indirect tax ***

(+) Subsidies ***

NDPFC ***
+ Net factor income from abroad ***

National Income or NNPFC ***

GDPMP = Gross Domestic Production at Market Price

NDPFC = Net Domestic Production at Factor Cost
NNPFC = Net National Production at Factor Cost
Expenditure Method:

Y ={ C + I + G + (X-M)} = GDPMP

C = Consumption
I = Investment and/or Gross Capital and/or Change in Stock
G = Government Expenditure
X = Export
M = Import
(X – M) = Net Export

Formula:

C = Private Final Consumption Expense ***

I = Investment ***
G = Government Expenditure ***
(X-M) = Net Export ***

GDPMP ***

(-) Depreciation/ ***

consumption of fixed cap.

NDPMP ***

(-) Indirect tax ***

(+) Subsidies ***

NDPFC ***
+ Net factor income from abroad ***

National Income or NNPFC ***

Income Method:

Operating Surplus ***

+ Compensation of Employees ***
+ Mixed Income of Self Employed ***

NDPFC ***
+ Net Factor Income from Abroad ***

National Income OR NNPFC ***

NDPMP = NDPFC + Indirect Taxes – Subsidiaries

GDPMP = NDPMP + Depreciation
*Inflation*

Inflation refers to a broad rise in price of goods and services across the economy over
time, eroding purchasing power for both business and consumers. In other words your
rupee will not go as far today as it did yesterday.

Causes of Inflation:

1. Demand Pull Inflation – When demand for commodity in the market exceeds supply,
the excess demand push up the price.
2. Cost Push Inflation – When factor prices rise, the cost of production rise.