MARGINAL EFFICIENCY OF CAPITAL

Hello to all of u! i m supposed to write on marginal efficiency of capital, a concept first proposed by J.M. Keynes in his book (the general theory of output, employment and productivity). the concept is very simple to understand if u c it 4m finance perspective. MEC is nothing but the internal rate of return (IRR) of a project, only whn ur able to earn more than this irr or MEC (from now onwards) a person will b willing to invest in a project. thus MEC can be taken as a hurdle rate, which determines ur investment decision.

Below i hav given a overview of this concept, it follows directly from the book by charles woelfel, an authority in this area. It would be better if u people can read up on this and then revert back with ur doubts and queries.

That rate of discount which equates present value of net expected revenue from an investment of capital to its cost; a Keynesian concept. The concept plays a major role in the Keynesian theory of investment; the level of investment is determined by the marginal efficiency of capital relative to the rate of interest. If the marginal efficiency rate is higher than the rate of interest, investment will be stimulated; if not, investment will be discouraged. A fall in the rate of interest will stimulate investment, assuming the decline is below the given marginal efficiency rate. Marginal efficiency returns should then rise (based on higher anticipations of returns from investment), and such rise above a given prevailing rate of interest will stimulate investment.

The concept is based on the ordinary mathematical technique of computing present value of a given series of returns discounted at a specified discount rate. If an investment in equipment cost $4,450 and is expected to yield returns of $1,000 per year for five years, such returns,



$1,000 $1,000 $1,000 $1,000 $1,000
............ .............. .............. ............ .............
1 + r (1 + r)^2 (1 + r)^3 (1 + r)^4 (1 + r)^5

will equate with the cost of $4,450 for the investment if the rate of discount (marginal efficiency of capital) is 4%. If the prevailing interest cost of money to finance such investment is actually below 4%, the investment will be stimulated; if it is above 4%, the investment will be discouraged.

In income-expenditure analysis, the marginal efficiency of capital is a price factor in determining whether businesses are going to borrow and invest. The rate of interest is a passive factor because businesses do not borrow merely because the interest rate is low. A stable and material gap between the marginal efficiency of capital and the rate of return will result in an increase in the level of economic activity.

The marginal efficiency of capital is determined to some extent by the expectation of profits compared to the replacement cost of capital assets. The marginal efficiency of capital can ordinarily be improved by an increase in productivity, sales, or prices, or by a decrease in the costs of production. Generally, it is the relationship between the marginal efficiency of capital and the rate of interest that causes expansion, equilibrium, or contraction in the economy.

The term net expected revenue anticipations refers to net return over depreciation. Productivity theories of investment and their justification of interest date back at least to the work of the famous Austrian Bohm-Bawerk and the early work of Dr. Irving Fisher of Yale, but in the Keynesian schema the marginal efficiency of capital was adapted as one of the three major aspects of the Keynesian model, the other two being the liquidity preference concept of determination of interest rates and the consumption function.

By Raghunandan Behra

MONETARY POLICY GLOSSARY - IMPORTANT TOOLS

OMO: Open market operations are the means of implementing monetary policy by which a central bank controls its national money supply by buying and selling government securities, or other financial instruments. Monetary targets, such as interest rates or exchange rates, are used to guide this implementation. Newly created money is used by the central bank to buy in the open market a financial asset, such as government bonds, foreign currency, or gold. If the central bank sells these assets in the open market, the money supply decreases.

High Powered money: It is the money produced by the central bank and the Government and held by the public and banks. H ‘reserve money’. H is the sum of i) currency held by the public(C), ii) cash reserves of banks(R) & iii) other deposits of the Central bank(OD). High-powered money is a macroeconomic term referring to the monetary base — that is, to highly liquid money and includes currency and vault cash.

CRR: The reserve requirement (or required reserve ratio or cash reserve ratio) is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes. It would normally be in the form of fiat currency stored in a bank vault (vault cash), or with a central bank. These deposits are designed to satisfy cash withdrawal demands of customers. CRR is also called the Liquidity Ratio as it seeks to control money supply in the economy. An increase in CRR decreases the money with the banks and henece drains out excess liquidity from the system. Currently CRR is 5.00%.

SLR: Statutory Liquidity Ratio or SLR refers to the amount that all banks required to maintain in cash or in the form of Gold or approved securities. Here by approved securities we mean, bond and shares of different companies. This Statutory Liquidity Ratio is determined as percentage of total demand and percentage of time liabilities. Time Liabilities refer to the liabilities, which the commercial banks are liable to pay to the customers on their anytime demand. The liabilities that the banks are liable to pay within one month's time, due to completion of maturity period, are also considered as time liabilities. Statutory Liquidity Ratio (SLR) is a term used in the regulation of banking in India. It is the amount which a bank has to maintain in the form:

1. Cash

2. Gold valued at a price not exceeding the current market price

3. Unencumbered approved securities (Government securities or Gilts come under this) valued at a price as specified by the RBI from time to time.

Currently SLR is 25.00%.

Bank Rate: It is also referred to as the discount rate, is the rate of interest which a central bank charges on the loans and advances that it extends to commercial banks and other financial intermediaries. Changes in the bank rate are often used by central banks to control the money supply. Currently bank rate is 6.00%.

REPO Rate: Repo rate is the rate at which our banks borrow rupees from RBI. To temporarily expand the money supply, the central bank decreases repo rates (so that banks can swap their holdings of government securities for cash); to contract the money supply it increases the repo rates. Alternatively, the central bank decides on a desired level of money supply and lets the market determine the appropriate repo rate. Currently Repo rate is 4.75%.

Reverse Repo Rate: Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from banks. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to these attractive interest rates. It can cause the money to be drawn out of the banking system. Currently Reverse Repo rate is 3.25%.

The post is contributed By Aditya Manishi

TRANSMISSION MECHANISM OF MONETARY POLICY

Continued from previous post "MONETARY POLICY"

The transmission mechanism of monetary policy changes looks like a stepwise process. Due to change in real money supply people find their portfolios in disequilibrium due to which adjustments take place and finally the asset prices and interest rates change. If interest rates become unattractive then demand for money increases i.e. people hold larger part of their wealth as money. Lower interest rates encourage investment and spending, leading to an increase in aggregate output.

Therefore, the decision to lower CRR and SLR is an attempt by the RBI to make more funds available for lending. While when it reduces other rates s.a. reverse repo, bank rate etc. then it is trying to reduce the cost at which the credit is made available to the borrowers. Thus, all these instruments affect credit creation in the system. Inflationary pressures arise when there is too much liquidity chasing too little goods. In such a case the monetary authority has to reconsider its policy stance and decide whether it needs to tighten the policy or not.

During 1980 to 1985 US monetary authority excersised tight control over money supply which resulted in high rates of interest as compared with the rest of the world. This led to capital inflows into the economy due to high retuns provided by US financial assets. As a result dollar saw a constant appreciation during this time period. Currency appreciation became a concern for Fed as US began losing its competitive advantage in the international markets and the domestic market was flooded with cheap imported goods. This led to job-losses and hence the government was forced to reconsider its policy stance. In such a scenario the central bank can intervene, conduct monetary policy operations such that the supply of domestic currency increases to normal levels and hence the exchange rates would eventually come down.

There have been such situations where inspite of a favouravle monetary policy, the central bank could not influence the eonomic situation and the credit offtake remained poor. India too witnessed such a situation.

Also, there is a situation known as liquidity trap when monetary policy becomes ineffective. What do you understand by liquidity trap? Do you think the fiscal policy could be a relief in such a case as that of India’s (i.e. very little credit offtake), if it is used to supplement the effects of monetary policy?

I would also like you all to think about the role of monetary policy in the financial markets stability and exchange rate management !!! Hopefully some of you would ponder over it and write back….It can answer the needs of checking inflation, growth as well as stability of the capital markets by this process.

More to come on this topic.....

MONETARY POLICY

The recent crisis had a deep impact on the Indian economy as well s.t. the economic growth rate came down to 6.4% from 9%. Business confidence had hit rock bottom. Though very less, but still it seemed that there was credit demand in the economy. The banks and financial institutions were reluctant to lend (looking at the scenario in US). RBI decided that it will have to step in and increase the availability of credit in the market, infuse liquidity and lower the interest rates so that credit can be made easily available. Thus, in multiple phases RBI reduced key interest rates s.a. CRR was brought down to 5% from 9%, SLR was reduced to 24% (down by 1%), repo and reverse repo rates were reduced etc. It infused liquidity near Rs. 2 lakh crores (approx. 3% of the GDP) in the market. It also conducted open market operations for sale of bonds. All this was also necessary to bring down the call rates that had reached 20% and hence were making it difficult for the real sector to grow.

All of these measures were aimed at creating a market environment conducive for the smooth availability of credit to the productive sectors of the economy at viable rates. This was essential as the credit markets had dried up post the US subprime crisis. Mentioned above are various means through which a country’s central bank conducts its monetary policy. Monetary policy deals with the management of money supply in the economy which in turn has its bearing on the economic activity. Not only ecoomic activity, it has influence on the exchange rates, inflation rate, capital flows by means of affecting interest rates which ultimately affect economic growth. The central thrust of India’s monetary policy has been sustained economic growth with price stability.

The nominal supplies of money and bank credit growth are highly fragile to policy manipulations by the central banks. Any change in these variables can have a significant impact on the availability, allocation and offtake of credit in an economy, thus affecting its growth rate. This will in turn affect employment, real output, price level and distribution of income and wealth in the society.

Say in an economy the consumers are reluctant to spend leading to fall in demand, also the lending institutions are not willing to lend due to loss of business confidence (which may lead to an increase in call market rates of interest since the demand for credit still exists). In such a situation the economic activity comes to a standstill as the projects stand waiting in the absence of capital, output has to be lowered and hence unemployment rate increases. It is at this time that the monetary authority needs to intervene and introduce changes in policy through the various tools mentioned above. The central bank can increase the money supply by cutting down some of the key rates i.e. Repo rate, reverse repo rate, Cash Reserve Ratio, Statutory liquidity ratio etc. When the money supply in the economy increases, there is a danger of inflation going up while at the same time it helps increase the level of output and reduces interest rates. When open market operations are conducted by the central bank in which it buys bonds in exchange for money, thus increasing the stock of money (as it may pay for this purchase of bonds by printing money). Due to purchase of bonds their price in the market increases and hence the yield reduces (return/price). It is only in this situation people are prepared to hold a smaller fraction of their wealth as bonds and a larger fraction as money. So in case of expansionary monetary policy the output level increases as due to a reduction in interest rates the investment spending increases. A point to be noted here is that if money demand is highly sensitive to rate of interest then in such cases a given change in money supply requires a small change in interest rates for the change to be absorbed. Thus, the effect of open market operations conducted above would be very small on investment.

Continued in the post titled "Transmission Mechanism of Monetary Policy"......

The G as in Keynes - then and now

Govt expenditure that we hear of in the Keynesian framework included expenditure on public works, infrastructure and industrial production so as to stimulate or trigger the multiplier..at the same time facilitate the ground for private domestic investment (I). What motivates private investment? Definitely the profit motive, but also the joy of creating and controlling production and the 'animal spirits'...which symbolises the thrill of risk taking -- Keynes said 'knowing better than the market what the future will bring forth.'

Interest rates are not the only stimulus to investment...this is similar to the fact that price of a commodity is not the only reason why people buy (or not buy) it. Interest elasticity (responsiveness) is another issue we looked at today w r t the 'liquidity trap'. If investment is interest in-sensitive, then changing interest for borrowing or lending purposes will not work as stimulus. What stimulates I in the liquidity trap mode? The reason one reached such low levels of interest rate is in an attempt to stimulate investment. But investment did not respond..What will it take invt to restart? Let us bring in Keynes' G here. He says..one way to stimulate pvt I is to help incentivise I with duty cuts, waivers, exemptions that help the private enterprise reduce its cost of production. This will help it reduce the final price it offers to the customer that may in turn help increase demand for product..(Whew!!! heavy)

The other way is to make G the source of expenditure (public projects). What is the ill-effect of this route? We call it 'Crowding out'. What is this effect? When the govt decides to incur expenditure, it comes in direct conflict with the private enterprise trying to borrow..and this may in turn reduce the excess liquidity and raise interest rates. Now the coming in of govt expenditure is fine..the question we need to ask is what is the purpose of this expenditure? Was it on conspicuous govt excesses or was it on works that had abilities to create jobs and lead to demand generation. If the answer is yes..it may actually help private enterprise revive in the next cycle. The second effect is that with the rise in interest rates, idle household saving may move into productive investments and the fund crunch may be a very short term phenomenon.

One question - is it better to raise disposable incomes of people or reduce corporate taxes to stimulate an economy in recession? The answer to this question is important because it leads to different effects on the Demand generation process. Excess money in people's hands may put undue pressure on prices of the (limited) goods. While surplus spending potential in the firm may help increase production and thereby jobs and the virtuous cycle. If the economy's problem is inventory pile up and no demand --- give money to people. Will they spend if taxes fell for them or would they also postpone consumption? In order to stimulate consumption, there should be disincentive to saving or a favourable business environment. So the govt needs to make sure that the private I is stimulated simultaneously so that people's confidence grows and they spend.

One last question (this one I will not answer) - Why is a bail-out package different from a fiscal stimulus? If I made sense to you thus far..you will have this answer...Keep thinking and reading!!

FISCAL POLICY

Fiscal policy is an important macroeconomic tool that is used by the government to influence the economic acitivity. This policy operates through changes in government expenditures and revenues. This policy has its initial impact on the goods market. If we revisit the national income account identity we have a component there called as government spending (G). Government conducts fiscal policy by changing government spending and tax rates (source of revenue for government).

When the consumer confidence is low i.e. people are not willing to spend, the demand for goods and services declines. In such a situation firms see a lot of inventory pile up. They are forced to cut down production, reduce employment and may be at times go for partial shut downs. Due to high attritions and wage cuts purchasing power in the hands of the consumers decreases. This adds to the problem leading to shrinking of the size of the economy and hence the GDP growth rate also comes down. The wheel of economic activity freezes as there is no fresh demand creation and no further expansion.

In such a scenario the role of fiscal policy becomes important. The government in such cases can step up its spending on public works or infrastructure projects (core sector which has the potential of generating employment in the economy). The basic idea is to stimulate demand by providing purchasing power to the consumer. Another way of conducting the fiscal policy is by changing tax rates. The latest budget saw the government deciding to raise the minimum taxable income limit. This will lead to an increase in the disposable income (income less taxes) in the hands of the consumers which is expected to be spent on consumption of goods and services.

The fiscal stimulus works through its primary and secondary effects. Say for instance, government initiates a construction project (say the airport construction, long term in nature i.e. at least a year long) in the city of Hyderabad. The immediate effect of such a move will be employment generation i.e. in the form of recruitment of workers, engineers etc. Also, demand for raw-material like steel, cement etc. will be generated, thus benefiting the allied sectors as well. When wages will be paid out to the workers, they will get purchasing power in their hands which will be spent on consumption of goods and services (s.a. clothes, fmcg, food, automobiles, etc.). The amount of income that will be spent is cY i.e. marginal propensity to consume times the income (marginal propensity to consume, MPC, can be defined as increase in consumption per unit increase in income, say for instance out of every Re 1 increase in income an individual spends Rs. 0.80, then his/her MPC is 0.8). Hence, consumption demand will be stimulated which in turn will stimulate the economic activity in other sectors as well (i.e. consumer durables and non-durables). These are the secondary effects of government expenditure increase (expansionary fiscal policy). Thus, the wheel of econimc activity is again set in motion. The phenomenon of multiplier works here i.e. the result of Rs. 1 million increase in G is more than that i.e. 1/1-c times where c is the marginal propensity to consume. So, if we assume c as 0.8 then multiplier is 5 and the impact of G will be 5 x Rs. 1 million.

Another dormant tool of fiscal policy is transfer payments given by the government in the shape of social security allowances and grants etc, Government can also use taxation and transfers to very well encourage or discourage few sectors and industries, control imports and exports activity etc.

One drawback of fiscal policy is crowding out of private investment i.e. a decline in private investment due to rise in interest rates resulting from increase in government expenditure. An increase in G leads to increases in income and rate of interest. Since rate of interest is the cost of investment, there is a decline in investment. The problem is aggravated if government borrows excessively to finance its fiscal expansion. This process can be understood better with the help of IS-LM framework.

Are the Germans really small spenders?

After the discussion on the Germany case today, I would like to address a couple of questions on the consumption behavior of the Germans who belong to an industrialized, well-developed and progressive state. The MPCs of people in such countries tends to be relatively low - reasons being they have already achieved a high level of consumption and their incremental consumption needs are not high value. They tend to be more savings (investment) oriented after their consumption needs are well satisfied. Comparing Germany's low spending behavior to the high spending Chinese or Indians may not be fair comparison whatsoever.

The second issue to ponder over would be if taxing the people's income and reducing their spending power is being compensated in the form of subsidized spending on education and healthcare. Does it make sense for the State to get money out of the hands of spenders to compensate the unproductive non-spenders? Consumption follows in a business cycle. It is production and improved productivity that will lead the movement out of stagnant growth periods.

Germany seems to be in a state of what is 'steady-state growth' where growth in specific leading sectors has already reached a high point and marginal growth is sort of inconsequential. Do they need a shift in focus? If so for a country with 70% of GDP coming out of services, a nation that is highly industrialised (30% from industry), what do you think is the way forward? What should be Germany's focus for the next decade based on what you have read in the case? Do you think it is the end of the road and that they would need another war to bring that "Aufklarung"?

Will look forward to your views......

Measuring Happiness - the Economics Way

I am sure by now all of you have gone through the Bhutan Happiness story - one question to all who think happiness is not an economics variable....We have debated in class as to why GDP may or may not be a good measure of growth and progress. Wangchuk's thoughts on happiness and its link to GDP inspired a series of variables and concepts to measure well-being. If human welfare is the purpose of the state's economic activities, then why shouldn't it be important to measure that well-being.

The case discusses some contrast between income and happiness. Is it really a decision variable? Do we measure happiness by the number and quality of goods we can buy? Are we confusing being satiated with being happy? Does it make sense for a country like Bhutan to brag about being happy when the Americans have spent millions of dollars to find ways to improve their national well being (even if that meant fighting wars)?

I would like a debate on why happiness is definitely an economic variable and why measuring it is part of measuring the growth of a nation. Also keep in mind the seven areas of wellness of GNH when you articulate your view....

Archana

Index of Industrial Production

IIP is a quantitative measure of status of Industrial production in an economy for a given period of time as compared to a reference period. It details out the growth in various sectors in the economy. The Indian IIP focuses on sectors namely Mining, Manufacturing, electricity and general. The current base year used for IIP is 1993-1994. It is published monthly by CSO (Central Statistical Organization).

The index is computed using the weighted arithmetic mean of quantity relatives with weights being allotted to various items in proportion to value added by manufacture in the base year by using Laspeyre’s Index.

General scope of IIP as recommended by the United Nation’s Statistical Organization (UNSO) includes mining, manufacturing, electricity, construction and gas sectors. The present composition of Indian IIP has only three of these due to constraints in data availability on construction and gas sectors. There is an alternate classification also on the basis of use called as Use-Based Classification which classifies sectors into following categories i.e. Basic goods, Capital goods, Intermediate goods, Consumer non-durables and Consumer durables.

The first official attempt to compute and release IIP was made by the office of economic advisor, Ministry of Commerce and Industry with base year of 1937 covering 15 important industries, accounting for 90% of total production of the selected industries. The structure of industry has changed manifold since then and hence there was always a requirement to revise the base year. The successive base years since 1937 have been 1946, 1951, 1956, 1960, 1970, 1980-81 and 1993-94. This is further expected to be revised to2004-05.

It suffers with problems related to quality, availability and compilation of data.

Base Revision

It is expected that the base of IIP will be revised to year 2004-05 which would lead to a new improved series containing improved datapoints, updated product portfolio and revised weights. This revision is a part of government’s move to shift the base year of all the key statistics to a common base. The base year for WPI is currently 1993-94, GDP is 1999-2000 while that of IIP is 1993-94. The new IIP series is expected by the end of the year. In this revision mobile manufacturing will not be included in IIP as it started in India post 2006. There are many issues that can arise due it. Telecommunications sector in India contributes around 2% to GDP (including services). Moreover, mobile phone penetration is on a rise in India which is expected to further increase the scope of mobile manufacturing. In 2006 India produces 31 million mobile phones while it rose to 100 million in 2008. Thus, it forms a significant part of the manufacturing sector and its inclusion would lead to better representation of the sector in the index.
Therefore, mospi is thinking of including mobile manufacturing in the category of landlines. Similarly, ways are being devised to include LCD TV sets in the category of colour TVs.
It includes 534 items that account for 80% of the output of the manufacturing industry.

Recently Released IIP figures

IIP numbers released this October indicated that industrial output expanded by 10.4% in the month of August, 22-month high. The figure stood at 1.7% at same time last year. If we look at individual sector growth rates then manufacturing grew at 10.2% while electricity too saw a growth of 10.6%. Mining was the best performer which grew by 12.9% during August. Out of 17 industries, 14 showed signs of growth. Consumer durables grew by 22.3% due to increased production of television and refrigerators, basic goods by 10%, intermediate goods saw growth of 14.3% and capital goods expanded by 8.3% which is good indicator of increased investment activity in the economy. There can be various factors that lead us to the magical figure of 10.4% (while raising few questions in our minds). Few of these are:

• Stimulus measures by the Government: The impact of various stimulus measures by the government. Reports indicate that government has released stimulus packages worth Rs 3 lakh crore in 2008-09 and 2009-10. The Rs. 1,86,000 crore stimulus package is assumed to have boosted demand for infrastructure. Adding to these efforts RBI pumped more than Rs. 2 lakh crore in to the system to bring down interest rates. Concentrating on the monetary policy, if we analyse the actual amount of credit offtake and the excess liquidity still existing in the economy do we have enough reasons to believe that in times of low confidence the monetary policy works? How far was it necessary for the government to supplement it with fiscal expansion? Is the double digit inflation rate, as indicated by CPI, a result of these measures? Is it justifiable?
• Base effect: Could this high number simply be a result of the base effect i.e. weak numbers in the reference period?
• Real growth in core sector and picking up of exports: India’s core sector clocked reasonablt healthy growth of 7.1% in August 2009 comapred to 2.1% (year on year basis). Out of the six industris that comprise the sector, cement production grew by 17.6% (highest among all), coal 12.9% (YoY) and electricity grew by 9.8%. Infrastrucure growth stood at 7.1% which is a positive sign for the economy indicating revival of demand, spending and confidence in the economy. Also, there are new low cost housing projects coming up in the country (s.a. Tata’s new project in Mumbai) which are being supported by government. This has also generated a lot of FII interest in the Indian stock market especially in real estate, heavy capital goods and infrastructure stocks. What is the impact of global recovery (if at all any) in this growth of the Indian core sector? Also, a revival in the international demand for our exports is a major reason for growth in exports.

India's National Income Accounting

The link given below provides information about India's GDP and its composition.
http://www.mospi.nic.in/sdrsum0.htm

We need to appreciate the fact that the changing composition of India's GDP can have a lot of implications for our economy. The share of agriculture is around 16%, while the majority comes from services and manufacturing (the third largest contributor). The data in the tables will give you GDP numbers in absolute terms as well as percentage. The focus is more on GDP at current and constant prices.

Though the share of agriculture is declining, but the population employed in agriculture is still around 50%. There have been some significant changes in the past s.a. increase in per capita income, changes in demand patterns etc. (not considering the recessionary time period) due to the development of manufacturing and services sectors. What does it indicate to a businessman exploring opportunities in Indian economy? What do the future managers and entrepreneurs (i.e. you all) think about it?

More to come on this topic.....

You are welcome to share your observations, suggestions, analysis or opinion....... :)

Human Development Index

HDI is a measure of human development in an economy/country. The growth of an economy can be measured using various indicators s.a. GDP growth rate, IIP, etc. The real purpose of growth is to improve the lives/standard of living of the citizens of a country. The benefits of economic prosperity should trickle down to the masses in terms of better opportunities for income, employment and education. All the indicators mentioned above do not directly measure this welfare as they only indicate the monetary aspect of it. Therefore, we need an indicator like Human Development Index (HDI) which can be used to measure human development and rank countries accordingly.


HDI considers three dimensions:

• Life expectancy at birth, a measure of health and longevity
• Knowledge and education gauged using adult literacy ratio, primary, secondary and tertiary gross enrollment numbers (with one-third weighting)
• Standard of living measured using natural log of par capita GDP at PPP.

Is HDI doing a really good job of gauging the non-monetary aspects? Is something missing? Take a close look at the three dimensions mentioned above and think..........

National Income Accounting

National income accounts provide the formal structure for macroeconomic theory. It starts with the circular flow of income model, is based on national income accounting identity and helps us arrive at certain economic characteristics that affect business climate.
To begin with we provide you with some relevant topics that are important before we try to relate business and economy.

Some important concepts:

Stock vs. Flow Variables

• Stock Variables: those measuring how much of something exists at aparticular point in time.
• Flow Variables: those measuring changes in stock variables over time.

To start with we look at the first basic measure of national output i.e. GDP (Gross Domestic Product) - It is the value of all final goods and services produced in the economy/country within a given period (generally a year). The output of each of the goods produced is valued at market prices and added together to get GDP.
The value of total output in an economy identically equals the value of total income (based on the circular flow diagram).

National Income Accounting Identity
GDP (expenditure approach)= C+I+G+NX
C: Consumption expenditure
I: Investment expenditure
G: Government Spending
NX: Net exports (Exports - Imports)
If NX > 0, trade surplus
If NX < 0, trade deficit

Methods of Measuring GDP

• Expenditure Approach
  Based on the expenditure done by various sectors in the economy.
  C: Household spending on Goods & Services (G&S) including durables, nondurables, services.
  I: Spending by firms and HH on new capital.
  Namely plants, equipment, inventory and new housing.
  (DO NOT confuse with investment used in every day language.)
  1) Inventory Investment: change in the value of inventories businesses have on hand.
  2) Fixed Investment: Of a more permanent nature than inventory.
  a) Nonresidential: spending done by firms for new capital
  b) Residential: apartments, private homes.
  NOTE: I is gross investment: includes both replacement of worn out capital (K) as well as addition of new K. In other words, depreciation of K is not subtracted (if did subtract out then would have net I).
  G: Gov’t purchases of G&S. Includes imputed values of public goods (e.g. parks). Imputed values calculated as the cost of providing the good. Transfer payments too are not included.
  Also interest payments by G excluded (not considered payments
  for current services; rather considered a transfer).
  NX = EX-IM: Total demand for domestic G&S by ROW.
  EX: Exports: G&S sold to ROW
  IM: Imports: Purchases of G&S by US from ROW.
  Imports are subtracted because not produced in home.
• Value Added Approach
  Disaggregate GDP by which industry produced the value added associated with output. The value added is the value of the firm’s output minus the value of its purchases from other firms.
  For instance consider a single industry economy: Bread making
  Farmer grows wheat and sells it for Rs.10/gm to flour maker. Value added here is Rs 10. Flour maker sells the flour to baker for Rs 15. Value added is Rs.(15-10) = Rs. 5. The baker makes bread out of it and sells to the retailer for Rs. 22. Value added at this stage is Rs.(22-15) = Rs. 7. The retailer sells the bread to customers for Rs. 25. Value added here is Rs. (25-22) = Rs. 3. Thus, total value added in the economy is Rs.(10+5+7+3) = Rs. 25.
  Therfore, GDP = #Bread Loaves * Rs. 25
• Income Approach
  This approach is based on the income earned by the agents involved in economic activity(the suppliers of labour, capital etc.) According to the simple circular flow diagram that total expenditures (on G&S) equals total income. We will call total income National Income (NY). It includes:
  a) Compensation of employees (wages, social security and pension contributions)
  b) Proprietors income (unincorporated business income)
  c) Rental income (which includes imputed rent of homeowners since still providing services)
  d) Corporate profits (incorporated business income)
  e) Net interest (interest paid to HH by businesses and interest paid by ROW to HH and businesses.
  Note: interest payments by HH & G not included since not connected with provision of G&S)

NY does not exactly equal GDP. We must adjust NY by
· adding depreciation (capital consumption allowance)
· adding indirect taxes (sales, customs duties, license fees, etc.)
· subtracting subsidies
· adding net factor payment to the ROW
Therefore, GDP = NY + Depn + (Indirect Taxes - Subsidies) + Net Factor Payment to ROW

Other Measures: NNP, NY, PY, Yd
GDP is the most comprehensive measure of aggregate output for an economy but there are other measures which are also of interest.
GDP
- Net Factor Payment to ROW
=GNP
- Depn
=NNP
- (indirect taxes - subsidies)
- statistical error
=NY
- retained corporate earnings
- Social Security contributions
+ interest payments made by G and consumers
+ transfer payments (including social security)
=Personal Income = C + S + T
- personal income taxes
=Disposable Income = Yd = C + S = take home pay (its different from fat CTC inclusive packages :) )