Business Cycles & the Determination of National Income

Weightage: Chapters 5 and 6 of ICAI's Paper 4 syllabus, roughly 16 marks. This is the first of the macroeconomic chapters, and its aggregates are assumed by public finance, the money market and international trade — so the definitions here are load-bearing for the rest of the paper.

Business cycles

A business cycle is a recurring pattern of fluctuation in aggregate economic activity — output, employment, income and trade — around the long-run trend of growth.

The fluctuations are recurrent but not periodic: they repeat but not at fixed intervals, and their duration and amplitude vary. They are also synchronised, affecting most sectors of the economy together, and international, transmitting between countries through trade and capital flows.

The phases

Expansion or boom. Output, employment, income and investment rise. Prices and profits rise, credit expands, and business confidence is high. Towards the end, capacity constraints and rising costs begin to bite.

Peak. The upper turning point, where expansion reaches its maximum and begins to reverse. Costs have risen, profit margins are squeezed, and optimism gives way to caution.

Contraction or recession. Output, employment and income fall. Investment declines, inventories accumulate, credit tightens and business confidence weakens.

Trough or depression. The lower turning point, where activity is at its minimum. Unemployment is high, prices are low, and there is widespread excess capacity.

Recovery. Activity begins to rise again as inventories are worked off, replacement investment resumes and confidence returns.

Causes

Internal or endogenous causes arise within the economic system: fluctuations in investment, the multiplier and accelerator interacting, changes in the money supply and credit, psychological factors such as waves of optimism and pessimism, and inventory cycles.

External or exogenous causes arise outside it: wars, technological innovations, changes in population, natural disasters and harvest failures, and political events.

Why they matter to business

The relevance to a chartered accountant's work is direct. Business cycles affect the timing of investment decisions, the availability and cost of credit, inventory policy, the reliability of forecasts, the valuation of assets, and the assessment of whether a client is a going concern. A firm expanding at the peak of a boom on the assumption that conditions will persist is the classic error the concept exists to guard against.

National income: the aggregates

This is the most examined part of the chapter, and every question turns on a definitional boundary. The aggregates differ from one another by exactly one adjustment each, and learning them as a chain rather than as a list is what makes them memorable.

The chain

Gross Domestic Product at market prices is the market value of all final goods and services produced within the domestic territory of a country during a year.

Subtract depreciation, which is the consumption of fixed capital:

Net Domestic Product = GDP − Depreciation

Add net factor income from abroad, which is the income earned by residents abroad less income earned by non-residents domestically:

Gross National Product = GDP + Net factor income from abroad

Net National Product = GNP − Depreciation

Subtract net indirect taxes, being indirect taxes less subsidies, to move from market prices to factor cost:

National Income = NNP at factor cost = NNP at market prices − Net indirect taxes

The two adjustments that matter most, because they are the two most examined distinctions in the entire macro half of the paper:

• Domestic against national turns on net factor income from abroad. Domestic concepts count production within the territory whoever produces it; national concepts count production by residents wherever they are.
• Market prices against factor cost turns on net indirect taxes. Market prices include indirect taxes and exclude subsidies; factor cost is what actually reaches the factors of production.

Further aggregates

Personal income is the income actually received by individuals, obtained from national income by subtracting corporate taxes, undistributed corporate profits and social security contributions, and adding transfer payments.

Disposable personal income is personal income less direct personal taxes — what households can actually spend or save.

Per capita income is national income divided by population, and is the standard measure for comparing living standards between countries, though it says nothing about distribution.

Methods of measurement

Three methods exist, and each measures the same total from a different side, so all three must give the same result.

The value added or product method sums the value added at each stage of production. Value added is the value of output less the value of intermediate consumption. The essential rule is to count only final goods, or equivalently only value added, to avoid double counting — including both the flour and the bread would count the wheat twice.

The income method sums the incomes earned by the factors of production: compensation of employees, rent, interest, and profit, together with mixed income of the self-employed.

The expenditure method sums the expenditure on final goods and services:

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

where $C$ is private final consumption expenditure, $I$ gross domestic capital formation, $G$ government final consumption expenditure, and $(X-M)$ net exports.

What is excluded, and why

The exclusions are examined regularly and are worth learning as a list:

• Transfer payments — pensions, scholarships, unemployment benefits — because no good or service is produced in exchange. They redistribute income rather than create it.
• Sale of second-hand goods, because the production was counted in the year it occurred. Only the dealer's commission, being a current service, is included.
• Sale and purchase of financial assets such as shares and bonds, because these are transfers of ownership rather than production. Brokerage is included.
• Intermediate goods, which are captured in the value of the final goods.
• Non-market production, such as unpaid domestic work, because it is not transacted and cannot be valued.
• Illegal activities and the unrecorded economy, which escape measurement rather than being excluded in principle.

Difficulties in measurement

The non-monetised sector is large in developing economies, so subsistence production and barter go unrecorded. Illiteracy and inadequate record-keeping make data unreliable. The unorganised sector is difficult to survey. Double counting is a persistent risk. Depreciation must be estimated rather than observed. And the treatment of government services, which have no market price, requires them to be valued at cost.

The determination of national income

The Keynesian framework

The central proposition is that in the short run, output and employment are determined by aggregate demand rather than by aggregate supply. If aggregate demand is insufficient, the economy can settle at an equilibrium with substantial unemployment — an underemployment equilibrium — and will not automatically correct itself. This was the central departure from classical economics, which held that supply creates its own demand.

Equilibrium occurs where aggregate demand equals aggregate supply, or equivalently where planned saving equals planned investment.

The consumption function

Consumption depends primarily on disposable income:

$C=a+bY$

where $a$ is autonomous consumption, the consumption that occurs even at zero income, and $b$ is the marginal propensity to consume.

Average propensity to consume is total consumption divided by total income:

$APC=\frac{C}{Y}$

Marginal propensity to consume is the fraction of any additional income that is consumed:

$MPC=\frac{\Delta C}{\Delta Y}$

The psychological law of consumption states that as income rises, consumption rises but by less than the increase in income. So MPC lies between 0 and 1, and APC falls as income rises.

Since income is either consumed or saved:

$MPC+MPS=1,APC+APS=1$

The multiplier

An increase in investment raises income by more than the increase itself, because the initial recipients spend part of their new income, which becomes income for others, who spend part of it in turn.

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

$\Delta Y=k\times \Delta I$

The multiplier is larger the larger the MPC, because a greater share of each round's income is passed on. If MPC is 0.8, the multiplier is 1 ÷ 0.2 = 5, so an additional 100 crore of investment raises income by 500 crore. If MPC is 0.5, the multiplier is 2.

The process works in reverse as well: a fall in investment reduces income by a multiple of the fall, which is part of why recessions deepen.

Leakages reduce the multiplier's value in practice. Saving is the leakage the formula captures, but taxation and imports also divert income from the domestic circular flow, so the realistic multiplier is smaller than the simple formula suggests.

Equilibrium and the gaps

Equilibrium income need not be the full employment level. Two gaps are examined:

• A deflationary gap exists where aggregate demand falls short of what is required for full employment. Output and employment are below capacity, and the remedy is to raise demand — through government spending, tax cuts or monetary easing.
• An inflationary gap exists where aggregate demand exceeds what the economy can produce at full employment. Since output cannot rise further, the excess demand raises prices instead, and the remedy is to reduce demand.

The paradox of thrift follows from the same framework. If everyone attempts to save more, consumption falls, so aggregate demand falls, so income falls — and at the lower income, total saving may be no greater, or even less, than before. What is prudent for an individual may be damaging for the economy in aggregate, and this is a standard examination point because it is counter-intuitive.

How this chapter is examined

Expect questions identifying the phases of the business cycle and their features; distinguishing GDP from GNP and market prices from factor cost; identifying which items are excluded from national income and why; the three methods of measurement and the double counting problem; the relationship between APC, MPC, APS and MPS; the computation of the multiplier from the MPC; and the deflationary and inflationary gaps.

The recurring errors are confusing domestic with national concepts, subtracting rather than adding net factor income from abroad, including transfer payments or second-hand sales in national income, and computing the multiplier as 1 divided by MPC rather than 1 divided by (1 − MPC).