1. Basic concepts
Macroeconomics studies the economy as a whole through aggregates: national income, output, employment, the general price level.
- Consumption goods satisfy wants directly (food, clothes, services). Capital goods are fixed assets used in production for many years (machines, buildings, tools).
- Final goods are bought for final use (consumption or investment) and are not used up or resold in production in the year. Intermediate goods are used up as raw materials or resold. The classification depends on end use: sugar for a household is final, sugar for a sweet shop is intermediate.
- Stocks are measured at a point of time (capital, wealth); flows over a period (income, investment, depreciation). Flows change stocks.
- Gross investment = addition to capital goods and stocks in a year; depreciation (consumption of fixed capital) = loss in value from normal wear and tear and expected obsolescence; net investment = gross investment − depreciation.
| Basis | Kind of good | Example (imagined) |
|---|---|---|
| Satisfies wants directly | Consumption good | Rice, a shirt, a haircut bought by a family |
| Used to produce other goods for years | Capital good | A loom in a Varanasi weaving shed |
| Bought for final use (consumption or investment) | Final good | Paint bought by a family to paint its home |
| Used up or resold in production within the year | Intermediate good | Paint bought by a builder for flats he will sell |
| Stock | Flow | |
|---|---|---|
| Measured | At a point of time | Over a period of time |
| Time dimension | None (on 31 March) | Per day, month or year |
| Examples | Capital, wealth, money supply on a date | Income, investment, depreciation, consumption |
| Picture | Water in a tank | Water flowing in per minute |
Key terms
- Capital good
A durable good used repeatedly in production over many years; a final good.
- Intermediate good
A good used up in production or resold during the year.
- Stock
A variable measured at a point of time.
- Flow
A variable measured over a period of time.
- Depreciation
Fall in the value of fixed capital from normal wear and tear and expected obsolescence.
2. Circular flow of income (two-sector model)
Assumptions: only households and firms; households spend all their income on consumption (no saving); firms sell all output to households; no government and no foreign trade.
Real flows: factor services from households to firms; goods and services from firms to households.
Money flows: factor payments (rent, wages, interest, profit) from firms to households; consumption expenditure from households to firms.
Real and money flows move in opposite directions. Because the whole value of output is paid out as factor incomes and all income is spent on output, value of output = factor income = expenditure. This is why national income can be measured by three methods.
Key terms
- Real flow
Flow of factor services and of goods and services.
- Money flow
Flow of factor payments and of consumption expenditure.
3. Value added (product) method
- Value of output = sales + change in stock (closing stock − opening stock).
- GVA at MP = value of output − intermediate consumption.
- NVA at MP = GVA at MP − depreciation; NVA at FC = NVA at MP − net indirect taxes.
- Sum of GVA at MP of all producers in the domestic territory = GDP at MP.
Double counting happens when the value of intermediate goods is counted again inside final goods. Avoid it by adding only values added (or only final goods).
Precautions: include own-account production (grain kept for the family) and imputed rent of owner-occupied houses; exclude sale of second-hand goods (but include the commission), and exclude intermediate goods; exclude unpaid household services.
| Stage (imagined) | Value of sale (₹) | Value added (₹) |
|---|---|---|
| Cotton farmer → spinning mill | 300 | 300 |
| Spinning mill → garment unit (yarn) | 500 | 200 |
| Garment unit → households (shirts) | 900 | 400 |
| Total | 1,700 (double counts) | 900 = value of final shirts |
| Step (₹ lakh, imagined spinning mill) | Working | Result |
|---|---|---|
| Value of output | Sales 900 + change in stock 60 | 960 |
| GVA at MP | 960 − intermediate consumption 400 | 560 |
| NVA at MP | 560 − depreciation 40 | 520 |
| NVA at FC | 520 − net indirect taxes 20 | 500 |
Key terms
- Value added
Value of output minus intermediate consumption.
- Double counting
Counting the value of a good more than once while estimating output.
- Imputed rent
The estimated rent of a house lived in by its owner, counted as a service produced.
4. Income and expenditure methods
Income method: NDP at FC = compensation of employees (wages in cash and kind, employer's social security contribution) + operating surplus (rent and royalty, interest, profit) + mixed income of the self-employed. Add NFIA for national income.
- Exclude transfer incomes (pensions, scholarships, gifts), windfall gains (lottery) and capital gains on sale of assets.
- Include income in kind and imputed rent.
Expenditure method: GDP at MP = private final consumption expenditure + government final consumption expenditure + gross domestic capital formation (fixed capital + change in stock) + net exports (X − M).
- Exclude spending on intermediate goods, second-hand goods, financial assets (shares, bonds) and transfer payments.
| Component | What it includes |
|---|---|
| Compensation of employees | Wages and salaries in cash, payments in kind (free meals, housing), employer's contribution to social security |
| Operating surplus | Rent and royalty, interest, profit (dividends + corporate tax + retained earnings) |
| Mixed income of the self-employed | Earnings of farmers, shopkeepers, doctors in private practice, where labour and capital returns cannot be separated |
| Sum | NDP at factor cost (domestic income); add NFIA for national income |
| Component | Who spends | Symbol |
|---|---|---|
| Private final consumption expenditure | Households and non-profit institutions | C |
| Government final consumption expenditure | Government (salaries, services provided free) | G |
| Gross domestic capital formation | Firms and others: fixed capital + change in stock | I |
| Net exports | Rest of the world: exports − imports | X − M |
| Sum | GDP at market price | C + I + G + (X − M) |
| Item | Counted? | Why |
|---|---|---|
| Imputed rent of an owner-occupied house | Yes | A housing service is produced |
| Grain kept by a farmer for his family | Yes | Own-account production |
| Free meals given to staff | Yes | Compensation in kind |
| Old-age pension, scholarship | No | Transfer payment |
| Sale of a second-hand car | No (commission yes) | Produced in an earlier year |
| Purchase of shares or bonds | No (brokerage yes) | Financial asset; nothing produced |
| Unpaid housework, lottery prize | No | Non-market service; windfall gain |
Key terms
- Compensation of employees
Everything paid by employers for work: cash wages, payments in kind and social security contributions.
- Operating surplus
Rent, interest and profit earned by enterprises.
- Mixed income
Income of the self-employed in which returns to labour and capital cannot be separated.
- Transfer payment
A payment received without giving any good or service in return.
5. National income aggregates
Domestic territory: the political frontiers plus territorial waters and airspace, ships and aircraft run by residents, fishing vessels and oil rigs in international waters, and the country's embassies and military bases abroad. Foreign embassies and international organisations located in the country are excluded.
Normal resident: ordinarily resides in the country and has the centre of economic interest there.
NFIA = factor income earned by normal residents from abroad − factor income paid to non-residents.
Net indirect taxes (NIT) = indirect taxes − subsidies.
| From | To | Adjustment |
|---|---|---|
| Gross | Net | − depreciation |
| Domestic | National | + NFIA |
| Market price | Factor cost | − NIT |
National income = NNP at FC = GDP at MP − depreciation + NFIA − NIT.
| Pair | Difference between them | Adjust by |
|---|---|---|
| Gross ↔ Net | Gross includes depreciation | Depreciation |
| Domestic ↔ National | Territory vs normal residents | Net factor income from abroad (NFIA) |
| Market price ↔ Factor cost | Market price includes net indirect taxes | Net indirect taxes (indirect taxes − subsidies) |
| Part of India's domestic territory | Not part of it |
|---|---|
| Land, territorial waters and airspace of India | Foreign embassies and consulates in India |
| Indian embassies, consulates and military bases abroad | Offices of international organisations in India |
| Ships, aircraft and fishing boats run by residents between countries or in international waters | Factories of Indian companies located abroad |
Key terms
- Domestic territory
The economic territory of a country within which factor incomes are counted as domestic.
- Normal resident
A person or institution that ordinarily resides in a country and whose centre of economic interest lies there.
- NFIA
Factor income from abroad minus factor income to abroad.
- National income
Net national product at factor cost.
6. Real and nominal GDP, the deflator, and welfare
- Nominal GDP: output valued at current prices. Real GDP: output valued at base-year (constant) prices; it changes only when output changes.
- GDP deflator = (nominal GDP ÷ real GDP) × 100: a price index for all goods and services produced.
- Real GDP = (nominal GDP ÷ deflator) × 100.
GDP and welfare. Welfare is the well-being of people. GDP is an imperfect index because of:
- Distribution of GDP: growth may benefit a few.
- Non-monetary exchanges: unpaid domestic work and barter are not counted.
- Externalities: harm (pollution) is not subtracted and benefits (a public garden) are not added.
A rise in real GDP is therefore a useful but incomplete sign of a rise in welfare.
| Good (imagined town) | 2020 quantity × price | 2024 quantity × price | 2024 quantity × 2020 price |
|---|---|---|---|
| Mangoes (kg) | 1,000 × 50 | 1,100 × 60 | 1,100 × 50 |
| Bicycles | 20 × 4,000 | 25 × 4,400 | 25 × 4,000 |
| Total (₹) | 1,30,000 | 1,76,000 (nominal) | 1,55,000 (real) |
| Limitation of GDP as a welfare index | Example (imagined) | Effect |
|---|---|---|
| Distribution of GDP | Output rises, but gains go to a few owners | Most people may be no better off |
| Non-monetary exchanges | Unpaid care at home, grain swapped in a village | Welfare understated |
| Negative externalities | Smoke from a kiln harms nearby families | Welfare overstated |
| Positive externalities | A park built by a firm used by the whole street | Welfare understated |
Key terms
- Real GDP
GDP at base-year prices.
- GDP deflator
Ratio of nominal to real GDP multiplied by 100.
- Externality
A benefit or harm caused to others for which no payment is made.
Exam tips
Common mistakes
- Calling a good "final" or "intermediate" without naming its use and buyer.
- Taking sales as value of output and forgetting the change in stock (which can be negative).
- Adding transfer payments, second-hand sales or share purchases; forgetting commissions, imputed rent and own-account production.
- Mixing up NFIA from abroad (add) and to abroad (subtract).
- Using indirect taxes instead of net indirect taxes.
- Saying a rise in nominal GDP means more output.
How marks are usually awarded
- 1 mark: one correct option or term.
- 3 and 4 marks numericals: formula, substitution and answer with unit; step marks are given even if the final figure slips.
- 5 marks: five clear points or a full numerical with every step; welfare answers end with a judgement.
Data in SOYL practice are imagined; your board paper will give its own figures.