1. NATIONAL INCOME: CONCEPTS AND MEASUREMENT

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1.1 Meaning and Definition

National Income refers to the total value of all final goods and services produced within a country during a given period (usually a year).
It measures the economic performance and living standard of a nation.

$$\text{National Income}=\sum (\text{Value of Final Goods and Services})$$

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1.2 Basic Concepts

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1.3 Measurement Methods

1. Output (Production) Method:

   • Measures total value added at each stage of production.

   • Suitable for industrial economies.

   $$NI=\sum (ValueofOutput-IntermediateConsumption)$$

2. Income Method:

   • Sums all factor incomes: wages, rent, interest, profit.

   $$NI=W+R+I+P$$

3. Expenditure Method:

   • Sums all expenditures on final goods & services.

   $$NI=C+I+G+(X-M)$$

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1.4 Difficulties in Measurement

• Double counting

• Non-monetized sector

• Illegal income and black money

• Imputed values (e.g., owner-occupied housing)

• Changing prices (inflation adjustment)

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⚙️ 2. DETERMINATION OF OUTPUT AND EMPLOYMENT

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2.1 Classical Theory of Employment (Say’s Law)

Core Assumptions:

• Flexible prices and wages

• Perfect competition

• Full employment is the normal situation

• Savings automatically equals investment via interest rate adjustment

• Money is neutral (only medium of exchange)

Say’s Law of Markets:

“Supply creates its own demand.”

Hence, no general overproduction is possible. Unemployment is voluntary.

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2.2 Keynesian Theory of Employment

Keynes (1936) rejected the classical view of automatic full employment.

Main propositions:

1. Employment depends on effective demand.

2. Effective Demand = Aggregate Demand (AD) = Aggregate Supply (AS).

3. Involuntary unemployment can persist due to deficiency of demand.

Aggregate Demand Function:

$$AD=C+I$$

Aggregate Supply Function:

$$AS=f(N)$$

Equilibrium Employment:
Occurs when

$AD=A\mathrm{S }$If

$AD<AS$, unemployment arises.

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2.3 Differences between Classical and Keynesian Models

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🏠 3. CONSUMPTION FUNCTION

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3.1 Definition

Proposed by Keynes, the consumption function shows the relationship between consumption (C) and income (Y):

$$C=f(Y)$$

or$$C=a+bY$$

where:

• $a$ = autonomous consumption (independent of income)

• $b$ = MPC = marginal propensity to consume

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3.2 Marginal and Average Propensities

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3.3 Psychological Law of Consumption (Keynes)

As income increases, consumption increases but by a smaller amount.

Thus:$\mathrm{ 0}<MPC<1$

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3.4 Determinants of Consumption

1. Income and wealth

2. Expectations and confidence

3. Distribution of income

4. Rate of interest

5. Fiscal policy

6. Credit availability

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3.5 Theories of Consumption

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💸 4. INVESTMENT FUNCTION

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4.1 Definition

Investment refers to expenditure on capital goods for future production.

$$I=f(r,MEC,Expectations)$$

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4.2 Types of Investment

1. Induced Investment: Depends on income level.

2. Autonomous Investment: Independent of income.

3. Gross vs. Net Investment: Gross includes replacement; net = gross – depreciation.

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4.3 Marginal Efficiency of Capital (MEC)

$$MEC=\frac{ExpectedAnnualReturns}{SupplyPriceofCapital}$$

Investment continues until

$MEC=RateofInterest$

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4.4 Determinants of Investment

• Rate of interest

• Business expectations

• Technological progress

• Demand for products

• Government policy

• Availability of credit

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🔁 5. MULTIPLIER AND ACCELERATOR

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5.1 Multiplier Concept (Kahn & Keynes)

An initial increase in investment leads to a multiple increase in income and employment.

$$k=\frac{1}{1-MPC}$$

or

$$\mathrm{\Delta }Y=k\cdot \mathrm{\Delta }I$$

Example:
If$\mathrm{ M}PC=0.8$ M, then

$k=5$;
→ ₹1 crore investment increases income by ₹5 crore.

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5.2 Accelerator Principle

Investment depends on the rate of change of output or income.

$$I_t=v(Y_t-Y_{t-1})$$

where$$

v = capital-output ratio.

The accelerator magnifies small changes in income into larger changes in investment.

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5.3 Interaction of Multiplier and Accelerator (Super-Multiplier)

When both effects combine, economic fluctuations amplify — explaining business cycles.

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💰 6. DEMAND FOR MONEY

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6.1 Classical Theory (Quantity Theory of Money)

$$MV=PT$$

• Money demand is only for transactions.

• $V$

  V and$\mathrm{ T}$

  T are constant → money supply determines price level.

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6.2 Keynesian Liquidity Preference Theory

Demand for money arises for:

1. Transactions motive (M₁)

2. Precautionary motive (M₂)

3. Speculative motive (M₃)

$$L=L_1(Y)+L_2(r)$$

At equilibrium:$$M=L(Y,r)$$

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6.3 Friedman’s Modern Quantity Theory

$$M_d=f(Y_p,r_m,r_b,r_e,{\pi }^e)$$

Money is treated as one of the assets; demand depends on permanent income and returns on other assets.

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💵 7. SUPPLY OF MONEY

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7.1 Definition

Money supply is the total stock of money (currency + deposits) available in the economy at a given time.

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7.2 Measures of Money Supply (India – RBI Classification)

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7.3 High-Powered Money (Reserve Money)

$$H=C+R$$

where
C = currency held by public,
R = reserves of banks with the central bank.

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7.4 Money Multiplier

$$m=\frac{1}{CR+RR}$$

Total money supply:

$$M=m\times H$$

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🏦 8. IS–LM MODEL APPROACH

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8.1 IS Curve (Investment–Saving Equilibrium)

Represents equilibrium in the goods market:

$$Y=C(Y)+I(r)+G$$

Downward-sloping — as interest rate ↓, investment ↑, output ↑.

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8.2 LM Curve (Liquidity–Money Equilibrium)

Represents equilibrium in the money market:

$$M\mathrm{/}P=L(Y,r)$$

Upward-sloping — as income ↑, demand for money ↑ → higher interest rate.

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8.3 General Equilibrium

The intersection of IS and LM curves gives simultaneous equilibrium in both goods and money markets.

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8.4 Fiscal and Monetary Policy in IS–LM

• Fiscal Policy: Shifts IS curve (ΔG or ΔT).

• Monetary Policy: Shifts LM curve (ΔM).

• Crowding-out effect: Expansionary fiscal policy may raise interest rates, reducing private investment.

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📈 9. INFLATION AND PHILLIPS CURVE

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9.1 Inflation

Definition:
Sustained rise in general price level over time.

$$InflationRate=\frac{P_t-P_{t-1}}{P_{t-1}}\times 100$$

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9.2 Types of Inflation

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9.3 Phillips Curve (A.W. Phillips, 1958)

Shows an inverse relationship between unemployment and inflation.

Short-run Phillips Curve (SRPC):
Inflation ↓ → Unemployment ↑.

Long-run Phillips Curve (LRPC):
Vertical at natural rate of unemployment (NAIRU).

Milton Friedman:
Argued no long-run trade-off — expectations adjust.

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9.4 Expectations-Augmented Phillips Curve

$$\pi ={\pi }^e-\beta (u-u_n)$$

where
π = actual inflation, πᵉ = expected inflation, u = unemployment, uₙ = natural rate.

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🔄 10. BUSINESS CYCLES

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10.1 Definition

Business cycles are recurrent fluctuations in economic activity (output, employment, income) around the long-term growth trend.

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10.2 Phases

1. Expansion – rising output, investment, employment.

2. Peak – full employment, inflationary pressure.

3. Recession – decline in output and demand.

4. Trough – lowest point; high unemployment.

5. Recovery – renewed growth begins.

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10.3 Theories of Business Cycles

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🏛️ 11. MONETARY AND FISCAL POLICY

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11.1 Monetary Policy

Definition: Actions by the central bank to control money and credit to achieve economic stability.

Instruments:

• Quantitative: CRR, SLR, Bank Rate, OMO, Repo.

• Qualitative: Credit control, moral suasion, margin requirements.

Objectives:

• Price stability

• Employment

• Economic growth

• Exchange rate stability

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11.2 Fiscal Policy

Definition: Government policy related to taxation, expenditure, and borrowing to influence economic activity.

Fiscal Deficit:

$$FiscalDeficit=TotalExpenditure-(RevenueReceipts+Non-debtCapitalReceipts)$$

Fiscal Deficit=Total Expenditure−(Revenue Receipts+Non−debt Capital Receipts)

Crowding Out:
Higher government spending may raise interest rates, reducing private investment.

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12. RATIONAL EXPECTATIONS HYPOTHESIS (REH)

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12.1 Concept

Proposed by John Muth (1961) and popularized by Robert Lucas (1972).

People form expectations about the future using all available information, including knowledge of government policies.

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12.2 Implications

• Markets are forward-looking and efficient.

• Systematic policy changes (like predictable monetary expansion) have no real effect on output or employment — only on prices.

• Economic agents do not make systematic errors.

$$Y=Y^{\ast }+\alpha (\pi -{\pi }^e)$$

→ If expectations are correct,

$\pi ={\pi }^e$, hence$\mathrm{ Y}=Y^{\ast }$

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12.3 Policy Ineffectiveness Proposition (Lucas)

Under rational expectations, anticipated fiscal and monetary policies are neutral; only unexpected policies can influence real variables.

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12.4 Critique of Rational Expectations

1. Overly idealized: assumes perfect information processing.

2. Empirical evidence: short-run effects of policy still observed.

3. Bounded rationality: humans have cognitive limits (Herbert Simon).

4. Sticky prices and wages: prevent instant adjustment.

Summary Table — Unit 2: Macroeconomics

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📚 SUGGESTED READINGS

1. Mankiw, N.G. – Macroeconomics

2. Dornbusch & Fischer – Macroeconomics

3. Ahuja, H.L. – Modern Economics

4. Froyen, R. – Macroeconomics: Theories and Policies

5. D.N. Dwivedi – Macroeconomics: Theory and Policy

6. Blanchard, O. – Macroeconomics

7. Snowdon & Vane – Modern Macroeconomics: Its Origins, Development and Current State

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📚 SUGGESTED READINGS

1. Mankiw, N.G. – Macroeconomics

2. Dornbusch & Fischer – Macroeconomics

3. Ahuja, H.L. – Modern Economics

4. Froyen, R. – Macroeconomics: Theories and Policies

5. D.N. Dwivedi – Macroeconomics: Theory and Policy

6. Blanchard, O. – Macroeconomics

7. Snowdon & Vane – Modern Macroeconomics: Its Origins, Development and Current State