Macro Economics

BMS SEM # 3

Introduction
Why do some countries have higher income than Others? Why are the incomes of some countries growing faster than others? How is income related to employment, wages , prices and interest rates? How do government affect income? Are higher incomes sure to make us better off?

Macro Economics
These are the questions that macroeconomists try to answer, and one of the ways they do is to studying income. The income that macro economists focus on is aggregate income the income of an entire economy.

The emphasis is on- intertemporal choices choices that have consequences across more than one period.

Measuring output
Before measuring income, we must consider how we are earning income. When an income gets earned , an economic unit must produce something like shoes, haircuts and entertainment. G & S produced are called production or output.

The addition of the values of all the goods produced in a particular period in a country is that country is thats aggregate output or the GDP.

 Let us for a moment suppose that there are only two goods in an economy (X & Y). IF X were produced in a year and sold for INR 12 each, and Y were produced and sold for INR 32.50 each, then aggregate output of the economy or the GDP in that year is (12 * 20) + (32.5 * 8) = INR 500.

 National income and related aggregates are basically measures of production activity.
Production Activity

Where?

Inside the Domestic territory

Outside the Domestic territory

Included in Domestic Product

Not Included in Domestic Product

Income which is included in Domestic Product ( Domestic Income)

Income which is not included in Domestic Product ( Domestic Income)

Profit earned by a foreign company in India

Profit earned by a Indian company in USA

Profit earned by branch of foreign bank in India Salaries to the residents of England working in Indian embassy in England Profit earned by Reliance Industries in India

Profit earned by branch of SBI in USA

Salaries to the Indian residents working in Pakistan embassy in India Rent paid by the embassy of England in India to an Indian resident. Rent received by Indian residents from his building in Singapore.

Rent received by Indian residents for their buildings rented out to foreigners in India.

Implications
Production activity of the residents of an economic territory is termed as national product. (GNP, NNP, etc.). National product includes production activities of the residents irrespective of whether they are performed within the economic territory or outside.

Production Activity

By Whom?

Normal Residents of the country

Non-resident of the Country

Included in the national Product

Not Included in national Product

Income not included in the national Product (national income)

Income included in the national Product (national income)

Profit earned by a foreign company in India

Profit earned by a Indian company in USA

Profit earned by branch of foreign bank in India Salaries to the residents of England working in Indian embassy in England Profit earned by an MNC of USA in India

Profit earned by branch of SBI in USA

Salaries to the Indian residents working in Pakistan embassy in India Rent paid by the embassy of Russia in India to an Indian residents Rent received by an Indian from his building in the Singapore

Rent received by foreigner from his building in India

Net factor Income from Abroad (NFIA)

It is difference between factor income earned from abroad by normal residents of a country and factor Income earned by non residents (foreigners) from that country. NFIA = Income from Abroad Income to Abroad.

NFIA

Income from Abroad

Income to Abroad

Factor income earned from rest of the world by residents

Factor income earned to rest of the world by residents

Residents contribution to production outside the economic territory

Non-Residents contribution to production inside the economic territory

Components NFIA
Net compensation to the employees: The difference between income received from work by residents from rest of the world and similar payments made to the non-residents, is termed as net compensation to the employees. Net income from property and entrepreneurship: It refers to the difference between income from property and entrepreneurship received by residents from rest of the world and similar payments made to non-residents.

 Net retained earnings: It refers to the difference between retained earnings of residents companies from abroad and retained earnings of non-residents companies located in the domestic territory.
Income from Abroad Income to Abroad NFIA Relation between NP and DP

More (>)

Positive

NP >DP

Less(<)
Equal (=)

Negative
Zero

NP < DP
NP = DP

NFIA CONCEPTS
(-)NFIA NET (+)NFIA Domestic

Final goods and Intermediate goods

Machine (final or intermediate good)

If Machines are bought by a household, then it is a final good. If Machines are bought by a firm for its own use, then it is a final good. If Machines are bought by a firm for resale, then it is an intermediate good.

Consumer Goods
Goods which satisfy the consumers.
Consumer Goods

Durable goods (can be used again and again in consp. over a considerable period of time) Mobile Phones, T.V, Cars etc.

Semi- durable goods( Can be used for limited period of time) Shoe, Clothes, Crockery.

Non-durable goods ( Single act of consp.) Bread, Milk, paper, food grains, vegetables etc

Services Barbers, Doctors, Teachers, Hotels, banks etc.

Producer Goods
Producer Goods

Capital goods Single used goods ( single act of production)

( Durable-use goods)
Which help in production of other goods and services.

Intermediate goods ( Oil, electricity, coal, iron, and steel etc.)

Final goods (Machine, Tools, equipments, tractors etc.)

 Factor Income: It refers to income which is received as reward for the factor services in the process of production. For e.g. rent, wages, interest, Profit etc. Transfer Income: It is not received as a reward for the services. No services is rendered for transfer income. For e.g. gifts in cash, scholarship to students, unemployment allowances, old age pensions, etc.

Depreciation
It refers to loss or fall in the value of fixed assets on account of normal wear and tear, change in technology, accidental damages, etc. in the process of production. It is also known as Consumption of fixed capital (CFC) or Capital Consumption Allowances (CCA) or Replacement Cost (RC).

Investment
It is also termed as capital formation. Investment means addition to the stock of capital of the economy. For e.g. addition or creation of physical assets, addition to inventories of goods, etc.

Gross Investment and Net Investment

(-) D GI (+) D NI

 Net Indirect Taxes (NIT): It is the differences between the indirect taxes and subsidies. Indirect taxes (IT) Subsidies (S) NIT = IT - S

Market Price and Factor Cost

Market Price (MP)= FC + NIT or FC + IT S Factor cost (FC) = MP NIT or MP IT + S
(-) NIT MP (+) NIT N

 Sum total of expenditure incurred on final goods and services by normal residents of a country during a period of one year.

Expenditure

National Income

Income

Output

Sum total of factor income( rent, wages , Interest , Profit) earned by normal residents of a country during a period of time

Sum total of market value of goods and services produced by normal residents of a country during a period of one year

Aggregates of National Income

GDP MP: It is the value of all goods and services produced within the domestic territory of a country during a period of one year. GNP MP: It is the value of all goods and services produced within the domestic territory of a country inclusive of or along with net factor income from abroad (NFIA) during a period of one year. i.e. produced by a normal residents of a country. GNP MP = GDP MP + NFIA

 NDP MP: It is the value of all goods and services produced within the domestic territory of a country exclusive of the depreciation during a period of one year. NDP MP = GDP MP - Depreciation (D) NNP MP: It is the value of all goods and services produced within the domestic territory of a country inclusive of or along with net factor income from abroad (NFIA) and exclusive of the depreciation during a period of one year. NNP MP = GDP MP Depreciation + NFIA NNP MP = GNP MP Depreciation NNP MP = NDP MP + NFIA

 NDP FC: or( Domestic Income ): It is the sum total of factor incomes ( rent, wages, interest, profits) generated within the domestic territory of a country during the period of one year. NDP FC = NDP MP - NIT GDP FC =It is the sum total income of all factors generated within the domestic territory of a country inclusive of depreciation during a period of one year. GDP FC = NDP FC + D GDP FC = GDP MP NIT GDP FC = GDP MP IT + S

 Gross National Product at factor cost: It is the sum total income of all factors generated within the domestic territory of a country inclusive of depreciation and NIFA during a period of one year. GNP FC = NDP FC + Depreciation + NFIA GNP FC = GNP MP NIT GNPFC= GNP MP IT + S

 Net National Product FC : It is the sum total income of all factors generated within the domestic territory of a country inclusive of NFIA during a period of one year. In other words, it is the sum total of the factor income generated by the normal residents of the country during the period of one year. NNPFC is also called as national Income NNPFC = National Income NNP FC =NDP FC + NFIA NNP FC = NNP MP - NIT

GROSS (G)

Depreciation (D) (-) Depreciation (D) (+)

NET (N)

DOMESTIC (DP)

NFIA ( + ) NFIA ( - )

NATIONAL (NP)

NIT ( - ) MP NIT ( + ) FC

 Income from domestic product accruing to private sector( DP private sector): It refers to that portion of domestic product at factor cost which accrues to the private sector in a period of one year.
DP private sector = NDPFC Income from DP accruing to public sector( PS ).

 Income from domestic product to public sector (DP public sector): It refers to that part of domestic product at a factor cost which accrues to the public sector in a period of one year. DP public sector = NDPFC Income from domestic product accruing to private sector.

Income of the public sector has two components:

Income from property (P) and entrepreneurship (E) accruing to government administrative departments (PE).
Surplus or Savings Enterprises (NDS). of non-departmental

DP public sector = PE + NDS

Domestic Product
Or Domestic income (NDP FC)

Income from domestic product to public sector (DP public sector)

Income from domestic product accruing to private sector (DP private sector)

Income from property (P) and entrepreneurship (E) accruing to government administrative departments (PE).

Surplus or Savings of nondepartmental Enterprises (NDS).

Private Income
It is the total of factor income and transfer incomes received from all sources by private sector within and outside the country during a period of one year. Two types Factor income Transfer Income

Factor income
DP private sector: Income from domestic product accruing to private sector (Earned inside the domestic territory ). NFIA: ( Earned outside the domestic territory).

Transfer Income
Interest on National debt (IND): Government borrowings ----- pay interest on public Debt----- used for consp. Purpose by PVT. Sector. It is a type of transfer income as it does not contribute to the production process.(Unearned income from inside the domestic territory Current transfers from Government (TP GOVT.): Subsidies, grants, and other social benefits include all unrequited, non-repayable transfers on current account to private and public enterprises; Net current transfers from rest of the world: Net current transfers from abroad is equal to the unrequited transfers of income from nonresidents to residents minus the unrequited transfers from residents to nonresidents. Data are in current local currency. ( NTPROW) (unearned outside the domestic territory).

Two ways of calculating private Income

Private Income= Domestic product private sector + NFIA + TP GOVT + IND + NTP ROW. Private Income= NNP FC( National Income) Income from domestic product accruing to public sector + TP GOVT + IND + NTP ROW. As NNPFC includes the factor income within the country and factor income from abroad of public sector and private sector both so there is only need to deduct the income of public sector alone

Private Income

Earned Income Or

Unearned Income Or

Factor Income

Transfer Income

Inside domestic territory

Outside Domestic territory

Inside domestic territory

Outside Domestic territory

DP Private sector

NFIA

TP govt.

NTP ROW

Private Income

Personal Income
It is the sum of earned income and transfer income received by the individual or household from all sources within and outside the country. It is the income actually received by persons from all sources in form of factor incomes and current transfer payments during a year. It consists of both factor income and transfer income but excludes that part of Private income which does not belong to individuals or households.

This concept is helpful in knowing the potential purchasing power of the households. It is used to measure the consumer welfare.
It is obtained by deducting the undistributed profits (UDP) and corporation tax (CPT) from private income

 Undistributed profits/ retained earnings of private sector ( UDP ) These are retained by the firm for further investment and future expansion of the firms. Undistributed profits are also known as retained earnings of private sector and savings of private corporate sector.

 Corporation Tax / Corporate Tax/Corporate profit Tax (CPT) It is the tax imposed by the government on profits earned. CPT is paid to the government it is not received by the households.

Personal Disposable Income (PDI)

It is that part of personal income which is available to the households or individuals to be used the way they like. In other words it refers to that part of personal income which is actually available to households for consumption and savings. PDI = Personal Income DT MR

 Direct Tax (DT)/Personal tax: Income tax, wealth tax, house tax, etc. Miscellaneous Receipts of the government administrative departments (MR) These are compulsory payments by the household in form of fees and fines.

 PDI is the income available to the households which they can spend on consumption or can save. In other words PDI = C + S

 PDI = Domestic product private sector + NFIA + TP GOVT + IND + NTP ROW Undistributed profits - Corporate taxes Direct taxes Miscellaneous receipts.
PDI = NNP FC( National Income) Income from domestic product accruing to public sector + TP GOVT + IND + NTP ROW Undistributed profits - Corporate taxes Direct taxes Miscellaneous receipts.

National Disposable income (NDI)

It is the maximum income available from all sources that a nation can spend on consumption and savings during a year. In other words, it refers to net income at market price available to the country at disposal It is obtained by the sum total of national Income at market price and net current transfers from rest of the world.

(NDI) Two Types

Net National Disposable Income (NNDI) NNDI = NNP FC + NIT + NTP ROW.

Gross National Disposable Income (GNDI) GNDI = NNDI + Depreciation. GNDI = NNP FC + NIT + NTP ROW + D.

NIT (-)
NNP FC

NIT (+) NTP ROW (+)

NTP ROW (-)

NNDI

NNDI

D (+)

D (-)

GNDI

Value Added method Classification of Production Units:

Identify all the production units in the domestic economy and classify them into three sectors: Primary sector Secondary sector Tertiary Sector

 It is the difference between value of firms output and the value of intermediate consumption.{(Gross value added at Market price) GVAMP}. GVAMP = Value of output Intermediate consumption

Value of output
Market value of G & S during a period of one year. Value of output = P * Q How value of output is measured: Vale of output = sales If entire output is sold. Value of output = sales + change in stock ( Stock). If the entire output is not sold and some output remains unsold in an accounting year. Stock = closing stock - opening stock

Intermediate Consumption
Value of non factor inputs ( other than factor input like land, capital, entrepreneurship), used in the production is termed as intermediate consumption. Generally it includes raw-material, fuel, power, etc.)

Estimation of GVAMP of each Industrial sector

So GVAMP = Value of output - Intermediation cost . And So GVAMP of industrial units are summing up of all production unit falling in each sector.

Estimation of GDPMP
By adding up GVAMP of all Industrial sectors we get GDPMP Sum of total of all production sectors, is called GDPMP. GDPMP = GVPMP of PS + GVAMP of SS + GVAMP of TS OR GDPMP = GVA1 + GVA2 + GVA3 +-----------GVA n OR GDPMP = GVAA + GVAB + GVAC +-----------GVA n

GVAMP = GDPMP PS= primary sector SS= Secondary sector TS= Tertiary sector 1, 2, 3, ------- n Firms A, B, C, ------- n Firms GVA Gross Value Added.

Estimation of National Income

NNPFC= GDPMP D + NFIA - NIT
Estimation Value Addition
Enterprise Output Value of Output (Rs.) 500 1000 Intermediate consumption (Rs.) 200 500 Value Added (Rs.) 300 500

Farmer Mill

Wheat Flour

Baker
Consumer Total

Bread
Bread

1500
1700 4700

100
1500 3200

500
200 1500

Value Added method is also called as product method or Industrial method or industrial origin method or net output method or inventory method or commodity service method.

Income Method
Estimation of NDPFC (Domestic income) It is the sum total of factor incomes generated by all the production units located within the domestic territory of a country during a period of one year. Components of NDPFC Compensation of Employees ( COE ) Operating Surplus ( OS ) Mixed Income (MI )

Compensation of Employees (COE)

Wages salaries in cash: It includes basic pay, bonus, commission, dearness allowances (DA), house rent allowances (HRA), Leave travelling allowances (LTA), sick leave allowances etc.

Wages and salaries in kind: It refers to all non-monetary advantages and facilities given by the employers like accommodation, free medical and educational facilities, free or subsidized food, uniforms, free transportations, imputed interest on interest free loans, free provision of goods and services produced by the employees, etc.

 Employees contribution to social security schemes. It is the supplementary labour income in the form of employers contribution ( not of employees) towards social security schemes for employees such as provision for provident fund, group insurance, gratuity, etc.

 COE = Wages salaries in cash + Wages and salaries in kind + Employees contribution to social security schemes.

Operating Surplus
It is the income earned from the ownership and control of capital. It is known as income from property and entrepreneurship. A) Income from property

1. Rent and Royalty Rent is defined as the amount receivable by landlord from a tenant for the use of his land. Royalty is defined as the amount receivable by a landlord for granting the leasing rights of sub-soil assets( For example Deposits of coal, iron, natural gas, etc.) and for use of patents, copyrights, trade marks, etc.)

2. Interest The amount payable to the owners of financial assets in the production unit. The production unit uses these assets for production and in turn makes interest payments-imputed or actual.

B) Income from entrepreneurship Income earned by the entrepreneur from entrepreneurship in the form of profits is known as income entrepreneurship. Profits is residual factor payment to the owners of a production unit. The production units use profit for Dividend payments Undistributed profits Corporate profits

 Dividend payments: It is the part of profit which is distributed among the shareholders according to their shareholding ratios. It is also called as distributed profits. Undistributed profits: It is that part of profit which is retained by the firms for future use or for business expansion. It is also known as savings or surplus of corporate sector or retained earnings. Corporate Profit Tax (CPT) It is that part of profit which is paid to the government in the form of a profit tax. It is also known as corporate tax or corporation tax.

Operating Surplus

Income from property

Income from Entrepreneurs hip

Rent

Royalty

Interest

Profit

Dividend (D)

Undistributed profit (UDP)

Corporate Profit Tax (CPT)

Mixed Income of Self Employees

It refers to the incomes of self-employed persons for using their factor services ( labour, Land, Capital, Entrepreneurship) to produce goods and services. These incomes are mixed in terms of wages, rent, Interest, profits. In case where factor payment is estimable but not in different components, an additional factor payment is called as mixed income. This problem mainly arise mainly in case of selfemployed people like Doctors, CAs, consultants, etc.

 Domestic income (NDPFC) = COE + OS + MI Estimation of National Income NNPFC= NDPFC + NFIA

Income Method

National income (NNPFC)

Domestic Income(NDPFC)

NFIA

COE

OS

MI

Wages and salaries in cash

Rent and Royalty Wages and salaries in Kind Employees contribution to Social security contribution

Interest

Profit

Dividend

UDP

CPT

Expenditure Method
It is measure din terms of expenditure on the purchase of final goods and services produced in the economy during a accounting year.

It is also called as Consumption and Investment method or Income Disposable method. Expenditure on consumption and Investment constitute the value of the final product.

Steps Involved
A) Identification of Economic Units Incurring Final Expenditure All the economic units which incur expenditure on final products are divided into four groupsi. Households ii. Business sector iii. Government sector iv. Rest of the world

B) Classification or components of Final Expenditure i. Private Final Consumption Expenditure ii. Investment Expenditure(I) or Gross Domestic Capital Formation (GDCF) or Gross Investment. iii. Government Final Expenditure. iv. Net Exports ( X-M).

Private Final Consumption Expenditure

It refers to the expenditure on final goods and services by the individuals, households and private non-profit institutions serving households like schools, clubs, Charitable Hospitals, help age, etc. It is divided into three major sub categories: Expenses on Durable Goods (T.V, Car, Computer etc.)

Expenses on Non-Durable Goods (Food, Beverages, etc.)

Expenses on services ( Transportation, Medical, etc.)

Investment Expenditure (I) or GDCF Or Gross Investment

Investment expenditure is the expenditure on investment or capital goods. Capital goods are produced by firms, by households ( purchase of residential houses) OR BY GOVERNMENT. It refers on the purchase of final goods by the producers. These goods are to be further used in the process of production. Investment expenditure is the expenditure on investment on capital goods. Investment can also termed as Gross domestic capital formation.(GDCF) Investment expenditure is divided into two categories. i. Gross domestic Fixed Capital Formation (GDFCF) or Gross Fixed Capital Investment(GFCI).

ii.

Change in Stock or Inventory Investment

Gross domestic Fixed Capital Formation (GDFCF) or Gross Fixed Capital Investment(GFCI).
It refers to the expenditure on fixed assets It is divide into three sub-parts. Expenditure on business fixed investment. It includes expenditure on the purchase of new plant, machinery, factories, transport equipments etc. Expenditure on residential houses Expenditure on construction and purchase of new houses by households. Government Expenditure on public fixed Investment. Expenditure on construction of roads, canals, schools, hospitals, etc. by the government.

 GDFCF = Business fixed investment + Govt. fixed Invt. + Investment on residential construction by households.

Change in Stock or Inventory Investment

It refers to net change in stock of final goods, semi-final goods, raw-materials etc. It is calculated by taking the difference between the closing stock and opening stock of the year. I = GDFCF (Gross domestic Fixed Capital Formation ) + Change in stock. I = Business fixed investment + Expenditure on residential houses + Government Expenditure on public fixed Investment.

Gross Domestic Capital Formation (GDCF) Or Gross capital formation Or Gross Investment

Net Domestic Capital Formation(NDCF)

Net domestic fixed capital formation

Depreciation

Change in stock or inventory investment

Expenditure on business fixed investment.

Expenditure on residential houses

Government Expenditure on public fixed Investment.

Closing Stock

Openin g Stock

I =GDCF I = NDCCF + Depreciation I = NDFCF + Depreciation + in Stock I = GDFCF + in Stock

 Government Final Expenditure. It refers to expenditure on final goods and services by the government. It is expenditure on administration, defence, expenditure on maintenance of law and order, expenditure on social welfare services, education, sanitation, etc. Net Exports Net exports are the difference between the value of goods and services exported to other countries and the value of goods and services imported from other countries

Overall measures C) Estimation of GDPMP

1) GNP MP = C+I+G + (X-M) +(R-P) OR GDP + Net factor income from Abroad 2) GDP MP = C+I+G+(X-M) OR GDPMP -Net factor income from Abroad

3) NNP MP = GNPMP -Depreciation

4) NDP = GDPMP -Depreciation

5) GNP FC = GNP MP-indirect Taxes + subsidies 6) GDP FC = GDP MP - indirect Taxes + subsidies

7) NNP FC or national Income = NNP MP -indirect Taxes + subsidies

8) NDP FC = NDP MP -indirect Taxes + subsidies

Expenditure Method Components of Final Expenditure Private Consumption Expenditure (C ) Government final Consumption Expenditure (G ) Net Exports X-M

Gross domestic capital formation(GCCF) Or Gross Investment (I )

GDPMP

GDFCF

Change in Stock or
Inventory Investment

Expenditure on business fixed investment

Expenditure on residential houses

Government Expenditure on public fixed Investment

Closing Stock

Opening Stock

Two Sector Model

Three measures of national output

Expenditure
the sum of expenditures in the economy

Income
the sum of incomes all factor incomes

Output
the sum of output (value added) produced in the economy All three approaches are should give you the same final figure for national output
94

Three sector Model

Leakages from the Circular Flow

Leakages (in terms of flow of payment)
money paid to the households but not returned to firm Or flow of payments that started from firms but did not return back to firms e.g. household savings, net taxes and imports

96

Circular Flow Between Firms and Households (corresponding flow of payments)

Spending on goods and services

Leakages

Households

Firms

Factor incomes
97

Injections into the Circular Flow

Injections (in terms of flow of payment)
are revenue for firms not from sales to household
e.g. investment by firms, government purchases and exports

98

Saving investments identity in National Income Accounts

Simple economy niether govt Nor foreign trade value of output sold in economy Y = C+I What happens to unsold output (i)

This leads to increase inventories of goods

which is treated as actual investment. GNP From viewpoint of its allocation between C+S Since National income Y = C+S (ii)

From identities (i) and (ii) we get

C+I=Y=C+S Left hand side C+I=Y Components of Agg . demand) Right hand side Y=C+S (Allocation at N.I to either C or S) so value of output produced or sold equal to total Y received Income received is Spent on goods & Services produced in, Now Substracting the C from both sides I=S Simple economy I = S

Relation of investment and saving The portion of household income that is not consumed is called personal saving. These funds are channeled to business firms in two ways:

1. They buy business bonds or stocks 2. They deposit savings in financial intermediaries to be lent to business firms Saving is a leakage from the income used for consumption expenditures. This leakage must be balanced by an injection on non-consumption spending in the form of private investment.

With government and foreign agents

Need to account for :
a. Government purchases of goods and services. b. Government payments for factor services (wages, rent, interest). c. Transfer payments between different agents. d. Firms and households pay taxes to government. e. Taxes paid on income, property, goods and services. f. Transactions with the foreign sector.

Four Sector Model

Transactions with foreign sector

Includes sales of goods and services, assets, and transfers Exports - sales of domestically produced goods to other countries Imports - goods bought from other countries

With Government sector

Total Exp = C + I +G - (i)

Total income received allocated

Y = C + S+T ----- (ii)

Since expenditure must be equal Income received From equ (i) and (ii) C + I+G = C+S+T ---- (iii) Since C cancels out

I + G = S+T - (iv)
By rearranging we obtain G- T = S -I ----- (v)

If Govt budget is not balanced G > T (Budget deficit) Govt borrow from financial market For this purpose, pvt invt < Savings

Govt borrowing reduces pvt investment

Govt borrowing crowds out pvt invt

 Leakages and Injections Note that

C + S + T = C + I +G +NX -C -C

S + T I + G + NX (4) Leakages (S+T) must be exactly balanced by injections of non consumption spending (I+G+NX) Equation 4 is the magic equation. Its technical name the leakages-injection) identity. If there is a budget deficit (T-G) < 0 then, I + NX S < 0 (T-G)

If T<G, the government is running a deficit, there are 3 implications 1. Budget deficit could make (I) smaller. 2. Budget deficit requires that (S) must rise to avoid any downward pressure on total investment (I+NX). 3. If S does not increase, to avoid a decline in (I+NX), there must be more borrowing from foreigners and a decline in lending to foreigners. e.g., T G = (I + NX) - S -1.8 = (17.8 1) 18.4 (deficit financed by foreign borrowing (-NX), and S to be greater than I) 4.4 = (20.8 4) 12.4 (surplus with greater borrowing (-NX) allowed I to increase to 20.8 greater than S) -4.6 = (15.9 4.9) 15.6 (deficit with greater borrowing allowed I to be greater than S)

The government budget and the twin deficits Rearrange eq. 4 to show the uses of a government budget surplus T G = (I + NX) S (5) If T>G, there are 3 ways that a government budget surplus can be used 1. A budget surplus allows private savings to decline without a need for a decline of total investment (I+NX). 2. A budget surplus can stimulate domestic investment (I) 3. a budget surplus can boost foreign investment (NX) or if NX is negative, reduce borrowing from foreigners.

Thus in open economy National Income = C + I + G + X n Xn represents net exports (X-M) N. I can either be consumed, saved or paid as Taxes Therefore C + I + G + X n = C + S+T Is, C is Common on both sides I + G + X n = S+T

Shows sum of pvt Invt , Govt Exp and X-M is equal

to the sum of savings and tax revenue.