ECONOMICS, FINANCE & ENTREPRENURESHIP SKILL – II

Semester II - Course Code: HSMC 202

Module – 1: Economics – 12 Lectures
Chapter – 1: CONCEPT OF NATIONAL INCOME
1.1 Understanding the working of an economy: Circular flow of Income
- Basic Two Sector Model
- Three Sector Model with Government
- Four Sector Open Economy Model with Government
1.2 National Income (both Market Price & Factor Cost & only basic ideas)
- GDP
- GNP
- NDP
- NNP
1.3 Meaning of Economic Problems (only basic ideas)
- Unemployment
- Inflation
Chapter – 2: MONEY & BANKING
2.1 Meaning of Money
2.2 Functions of Money
2.3 Types of Money
2.4 Banking (types of banking)
2.5 Reserve bank of India (RBI)
- Unemployment
2.6 Cash Reserve Ratio (CRR)
2.7 Bank Rate
2.8 Repo Rate
2.9 Reverse Repo Rate
2.10 Statutory Liquidity Ratio (SLR)

Prof. Sumit Bal – UEMK || sumit.bal@uem.edu.in || Page | 1

Chapter – 1: CONCEPT OF NATIONAL INCOME
1.A Concept & Meaning of National Income
National income means the value of goods & services produced by a country during a financial year.
It is the sum total of the values of all goods & services manufactured by the residents of the country
within its domestic boundaries or outside. It is the net result of all economic activities of any country
during a period of one year and is valued in terms of money. National income is an uncertain term
and is often used interchangeably with the national dividend, national output, and
national expenditure.

1.B Importance of National Income

i. For the Economy -National Income indicates the status of the economy & its data are regard as
Accounts of Economy. National Income Statics can help economists to formulate economic policies
for economic development of a country
ii. National Policy – National Income data forms the basis of National Policies like Employment
Policies, Industrial Policies, Agricultural Polices & others. Proper measures can be adopted to bring
the economy in a right path.
iii. Standard of Living – National Income data assist the Government in comparing the standard the
living amongst countries and people living in the same country at different time.
iv. Budget Preparation – Budget of country is highly dependent on Net National Income & its concept.
Government formulate yearly budget with the help of National Income Statics in order to avoid
cynical policies.
v. Distribution of Income–National Income Statics helps us to understand the distribution of income
in the country from the data related to Wages, Rent, Salaries, Interest & Profits. We can understand
the disparities of incomes of different section of society.

1.C Definition of National Income

i. Traditional Definition
According to Prof. Marshal “The labor 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 dividend.”
ii. Modern Definition
a. Gross Domestic Product (GDP) – It is the aggregate value of Goods & Services produced in a
country.
GDP Constitutes of: Wages & Salaries
Rent
Interest, & others
b. Gross National Product (GNP) – It is the estimated value of all Goods & Services produced by
a country’s residents & business
GNP Constitutes of: Consumer Goods & Services
Income arising from abroad, & others.
Definition: National income is defined as the total annual value of all the goods and services
produced by a country, measured in terms of money. National income data provides
a summary statement of a country’s aggregate economic activities. It not only helps
to measure the size and health of an economy but also to understand how it
functions.

Prof. Sumit Bal – UEMK || sumit.bal@uem.edu.in || Page | 2

1.1 Understanding the working of an economy: Circular flow of Income & Expense
The circular flow model demonstrates how money moves through society. The circular flow of
income is a way of representing the flows of money between the two main groups in society -
producers (firms) and consumers (households). Money flows from producers to workers as wages
and flows back to producers as payment for products. In short, an economy is an endless circular
flow of money. These flows are part of the fundamental process of satisfying human wants.

1.1A Significance of Circular Flow Model

i. Measurement of National Income
ii. Knowledge of Interdependence
iii. Unending nature of Economic Activities.
iv. Shows smooth functioning of the economy.
v. Helps to understand the problem of disequilibrium (1).
vi. Helps to find out leakages in the circular flow.
vii. Highlights the importance of monetary (2) and fiscal (3) flows.

Note: 01 - Equilibrium is a state in which market supply and demand balance each other, and as a result,
prices become stable. The opposite of this state is disequilibrium.

02 – Monetary relating to money or to its mechanism

03 - Fiscal policy is the means by which a government adjusts its spending levels and tax rates

1.1B Key Parts of Circular Flow Model (Components / Determinants / Agents of CFM)
i. Households – Households receive income through wages & salaries from their jobs &
investments & they then buy goods & services supplied by firms (consumer spending)
 It is person or group of people that share their income
 Requires Goods & Services to satisfy their personal wants.
 Owns all Resources (Labor, Capital, Land, Enterprise)
 The members of Households have 2 functions:
- They supply different factors of productions
- Members of Households also works as consumers
ii. Business – Business hire land, labor & capital inputs when making products for which they pay
wages & rent. Firms receive payment from consumers (creating revenues & profit).
 An organization that produces Goods & services for Sale
 Main objective is to maximize profit in the production process
 Uses resources provided by households to produce goods & services
 Sells those goods & Services to generate revenue
 The 2 main functions are as follows:
- Produces goods & services & supply them in Market
- Firms purchases inputs / raw materials from households to use them in the
production process

iii. Government – Government collects Taxes to fund spending on public services, e.g education,
healthcare, infrastructure development, welfare & defense.
 Just like households & firms the government also earns incomes & makes expenses
Prof. Sumit Bal – UEMK || sumit.bal@uem.edu.in || Page | 3
  The 2 main functions are as follows:
- Government earn revenues either from Tax or Non-Tax sources both from
Household & Firms
- Government provides essential public services such as maintenance of law & order,
defense, infrastructure development, etc.
iv. Financial Institutions – Financial Institutions mainly consists of Banks & other Financial
Institution that deals with monetary transactions.
 Consists of Bank & Non-Bank intermediaries who engage in borrowing (Savings from
Households) & lending of money (Loan to Business)
 The leakage that financial institutions provide in economy is the option for households
to save their money.
 The injection that financial institutions provide in economy is the option for Firms /
Business to borrow money
v. External Sectors – Basically involves Imports & exports.
 It consists of two kinds of international economic transactions i.e
- Export & Import of Goods & Services
- Inflow & Outflow of Capital

1.1C Types of Flow Model

a. Two Sector Model

 Households
 Firms

b. Three Sector Model

 Households
 Firms
 Government

c. Four Sector Model

 Households
 Firms
 Government
 External Sectors

d. Five Sector Model

 Households
 Firms
 Government
 External Sectors
 Financial Sectors
e. Alternatives Model
 Private Sectors
 Domestic Sectors
 Foreign Sectors
Prof. Sumit Bal – UEMK || sumit.bal@uem.edu.in || Page | 4
1.1C (a) Two Sector Model
 The Economy consists of two sectors – Household & Firm
 Household spends all their incomes on goods & services or consumptions. There is no
savings.
 All outputs produced by firms are purchased by households through their expenditure
 There is no Financial Sectors, Governments or foreign Sectors

Explanation of Figure

In the upper loop of this figure, the resources such as land, capital and entrepreneurial ability
flow from households to business firms as indicated by the arrow mark. In opposite direction
to this, money flows from business firms to the households as factor payments such as wages,
rent, interest and profits.

In the lower part of the figure, money flows from households to firms as consumption
expenditure made by the households on the goods and services produced by the firms, while
the flow of goods and services is in opposite direction from business firms to households.

Thus we see that money flows from business firms to households as factor payments and then
it flows from households to firms. Thus there is, in fact, a circular flow of money or income.
This circular flow of money will continue indefinitely week by week and year by year. This is

Prof. Sumit Bal – UEMK || sumit.bal@uem.edu.in || Page | 5

 how the economy functions. It may, however, be pointed out that this flow of money income
will not always remain the same in volume.

Equation: Y = C [Y = INCOME, C = RESOURCES]

E = O [E = EXPENSES, O = OUTPUT]

 The Household sectors supply their factors of production (Land, Labour, Capital, and
Enterprise) to the business sectors through the Factor Market (4).
 The Firm pays the reward to Household sector for their contribution to production in
kinds of Rent, Wages, Interest & Profits.
 The Firm supply their outputs or Goods & Services in the Product Market (5)
 Household sectors pay their Incomes for consumption expenditure

Note: 04. Factor Market: Factor Market refers to the Market for selling & purchasing or hiring of Factors of
Production like Land, Labor, etc.

05. Product Market: Product Market means the market in which the goods and services are supplying
& demanding.

Financial Market

Financial markets refer broadly to any marketplace where the trading of securities occurs,
including the stock market, bond market, forex market, and derivatives market, among others.
Financial markets are vital to the smooth operation of capitalist economies.

How Financial Market Works

 The savings of Household, Firms & Government sector gets accumulated in the financial
market.

 Financial market invest money invest money by lending out money to household, firms
& the government.

 The inflow of money in the financial market are equal to outflow of money.

 It makes the circular flow of income complete & continuous.

Prof. Sumit Bal – UEMK || sumit.bal@uem.edu.in || Page | 6

 Circular Flow Model with Savings & Investments

SAVINGS INVESTMENTS

 When Household saves their expenses on  Business Firms borrow from financial
Goods & Services decline & the money markets for investments in Capital Goods
flow to Business Firms get reduced like Factories, Machines, Equipment

 With reduced money receipts firm will  Thus, saving again brought into the
hire fewer worker or reduce the Factor expenditures stream & as a result total
of Payments (Rent, Wages, etc.) flow of spending does not decrease

 This will lead to fall in Total Income of

Household.

 Thus, saving reduces the flow of money.

 Economics calls Savings – a leakage in  Economics calls Investment – a injection

Economy to Economy

Equilibrium Condition:

Y=C+S || Y=C+I || C+S=C+I || S=I

Y=INCOME || C=CONSUMPTION || S=SAVINGS || I=INVESTMENT

Prof. Sumit Bal – UEMK || sumit.bal@uem.edu.in || Page | 7

1.1C (b) Three Sector Model

 The Economy consists of three Sectors – Household, Firm& Government.

 Here, flow from the household sectors & producing sectors to Government Sector are in
the form of Taxes.
 The income received from the government sector flow to producing & household
sectors in the form of payments for Government purchases of goods & services as well
as payment from subsidies and transfer payments.

Equilibrium Condition:

Y=C+I+G

Y=INCOME || C=CONSUMPTION || I=INVESTMENT || G=GOVERNMENT SPENDING

Explanation of Figure
In our above analysis of money flow, we have ignored the existence of government for the sake
of making our circular flow model simple. This is quite unrealistic because government absorbs
a good part of the incomes earned by households. Government affects the economy in a
number of ways.

Here we will concentrate on its taxing, spending and borrowing roles. 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,
Prof. Sumit Bal – UEMK || sumit.bal@uem.edu.in || Page | 8
communication), on defense goods, and on education and public health and so on. These add to
the money flows where a box representing Government has been drawn. It will be seen that
government purchases of goods and services from firms and households are shown as flow of
money spending on goods and services.

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 labeled as tax payments.
This money flow includes all the tax payments made by households less transfer payments
received from the Government. Transfer payments are treated as negative tax payments.

Another method of financing Government expenditure is borrowing from the financial market.
This can be represented by the money flow from the financial market to the Government and is
labeled as Government borrowing (To avoid confusion we have not drawn this money flow
from financial market to the Government). Government borrowing increases the demand for
credit which causes rate of interest to rise.

The government borrowing through its effect on the rate of interest affects the behavior of
firms and households. Business firms consider the interest rate as cost of borrowing and the
rise in the interest rate as a result of borrowing by the Government lowers private investment.
However, households who view the rate of interest as return on savings feel encouraged to
save more

Prof. Sumit Bal – UEMK || sumit.bal@uem.edu.in || Page | 9

1.1C (c) Four Sector Model (Open Economy Model with Government)
 The Economy consists of four Sectors - Household, Firm, Government & External Sectors
/ Overseas Sectors.
 The foreign sector comprises (a) foreign trade (imports and exports of goods and services) and
(b) inflow and outflow of capital (foreign exchange)
 Each of the four sectors receives some payments from the other in lieu of goods and services
which makes a regular flow of goods and physical services. The addition of the foreign sector
transforms the model from a closed economy to an open economy

Why should we consider Fourth Sector?

 Economic/ Trade and Commerce relations with other countries

 Fourth sector = Foreign sector
 Exports and Imports of goods and services
 Exports and Imports of funds: Lending and Borrowing
 These activities create inflow and outflow of Money

How Money flows with Foreign Sector?

 Exports of goods and services + Borrowing foreign funds + Non-Debt Investments (6)
coming from foreign countries leads to INFLOW OF MONEY to domestic economy from
foreign countries.

 Imports of goods and services + Lending to foreign countries + Non-Debt Investments in

foreign assets leads to OUTFLOW OF MONEY from domestic economy to foreign
countries.
Note: 06. Non-Debt Investment means the investment incorporated in all Equities: Public – Private – Listed –
Unlisted – all investments recognized in the FDI policy & others

Prof. Sumit Bal – UEMK || sumit.bal@uem.edu.in || Page | 10

Explanation of Figure
This is the complete model of the circular flow of income that incorporates all the four
macroeconomic sectors. Along with the above three sectors it considers the effect of foreign
trade on the circular flow. With the inclusion of this sector the economy now becomes an ‘open
economy’. Foreign trade includes two transactions, i.e., exports and imports. Goods and
services are exported from one country to the other countries and imports come to a country
from different countries in the goods market. There is inflow of income to the firms and
government in the form of payments for the exports and there is outflow of income when the
firms and governments make payments abroad for the imports. The import payments and
export receipts transactions are done in the financial market.

Equilibrium Condition:

Y = C + I + G + NX
Y=INCOME || C=CONSUMPTION || I=INVESTMENT || G=GOVERNMENT SPENDING
NX=NET EXPORT = EXPORTS (E) – IMPORTS (M)

Prof. Sumit Bal – UEMK || sumit.bal@uem.edu.in || Page | 11

 Injection & Leakage with the Circular Flow

INJECTIONS LEAKAGES

 Investment in Capital Goods  Savings

 Export of Goods & Services  Import of Goods & Services

 Government Spending  Taxation

 These are 3 types of Injection of Extra  These are 3 types of leakages or

Spending into the Circular Flow withdrawal from the Circular Flow

Prof. Sumit Bal – UEMK || sumit.bal@uem.edu.in || Page | 12

1.2 National Income – Concept of Market Price & Factor Cost

Market Price – Amount paid by Buyer to purchase any Goods & Services

Factor Cost – Amount received by Factor Owner / Producers

Prof. Sumit Bal – UEMK || sumit.bal@uem.edu.in || Page | 13

 BASIS NATIONAL INCOME AT MARKET PRICE NATIONAL INCOME AT FACTOR COST

Definition It refers to the total Market Value of all
the Final Goods & Services produced
by the normal resident of a country
both within the domestic territory as
well as outside the country
It refers to the aggregate of all factor
incomes earned by those factors of
production that are normal residents
of a country both within the domestic
territory as well as abroad.

Indirect It takes into account the impact of It does not take into consideration the
Tax & Indirect Taxes & Subsidies impact of Indirect Taxes & Subsidies
Subsidies

1.2 Measures of National Income

Measures
of National
Gross Domestic Product (GDP)
Income
Gross National Product (GNP)
Net Domestic Product (NDP)
Net National Product (NNP)

1.2A Gross Domestic Product (GDP)

Definition - Gross Domestic Product (GDP) is the total monetary or market value of all the
finished goods and services produced within a country's borders in a specific time period.
 Gross Domestic Product (GDP) is the monetary value of all finished goods and services made
within a country during a specific period.
 The Goods & Services can be produced by a resident of that country or by any foreigner, but
has to be produced inside the country
 GDP provides an economic snapshot of a country, used to estimate the size of an economy
and growth rate.
 GDP counts only New Domestic Production
 GDP Excludes:
- Goods & Services used as inputs for the production of final goods (Intermediate
Goods & Services) are not included in GDP
- Resale of used products – Secondhand goods
- Household Chores - Tasks such as cleaning, washing, coking & ironing that have to
be done regularly at home
Prof. Sumit Bal – UEMK || sumit.bal@uem.edu.in || Page | 14
 Example of GDP
 An Indian Company TATA MOTORS manufactures a Car in India. It is counted under GDP in
India
 A Japanese Company HONDA MOTORS manufactures a Car in India. It is counted under GDP
in India
 An Indian Company TATA MOTORS manufactures a Car in USA. It is counted under GDP in
USA & not in India.

1.2A (i) Components of GDP

 [C] Consumption / Private Consumption
 [I] Investment / Country’s Business Spending in Capital
 [G] Government’s Spending / Government Expenditure
 [NX] Net Export / National Export [Total Export (X) – Total Import (M)]
 CALCULATION OF GDP = C + I + G + NX

1.2A (ii) Types of GDP

GDP

Real GDP Nominal GDP Actual GDP Potential GDP

Real GDP Nominal GDP Actual GDP Potential GDP

It is calculated by It is calculated valuing Actual GDP is the Potential GDP is a

valuing the Goods & the Goods & Services measurement of a calculation of a
Services, according to produced by the country’s economy at country’s economy
Market Price of any country in a Financial the current moment in under ideal conditions,
previous year, which is Year, according to time. like a steady currency,
termed as base year for prevalent market price low inflation, and full
calculation (current price level). employment.

Real GDP is a Nominal GDP is

calculation of GDP that calculated with
is adjusted for inflation. inflation.

Prof. Sumit Bal – UEMK || sumit.bal@uem.edu.in || Page | 15

1.2A (iii) GDP Price Deflector

 The GDP price deflator, also known as the GDP deflator, measures the changes in prices
for all of the goods and services produced in an economy.
 Using the GDP price deflator helps economists compare the levels of real economic
activity from one year to another.

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑒𝑐𝑡𝑜𝑟 = 𝑋 100
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 =
𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑒𝑐𝑡𝑜𝑟

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 = 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑋 𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑒𝑐𝑡𝑜𝑟

Prof. Sumit Bal – UEMK || sumit.bal@uem.edu.in || Page | 16