National Income (NNP at factor cost) is derived from GNP by:

Subtracting depreciation, then subtracting indirect taxes and adding subsidies

Adding net factor income from abroad only

Adding depreciation and indirect taxes

Subtracting personal taxes only

The GDP deflator differs from the Consumer Price Index chiefly because:

It covers all domestically produced final goods and services, not a fixed consumer basket

It is measured monthly while CPI is measured annually

It is calculated only for imported goods

Say's Law, as invoked by classical macroeconomics, claims that:

The act of producing output generates income exactly equal to its value, so aggregate demand equals aggregate supply at every output level

Aggregate demand always exceeds aggregate supply

Wages are always rigid downward

Money supply has no effect on the price level

In the classical dichotomy, money determines:

Only the absolute (nominal) price level, leaving real variables to be determined by the real sector

The relative prices of all goods

In the Keynesian model, equilibrium output is determined by:

Effective (aggregate) demand — the point where planned output matches expected sales — with no guarantee this coincides with full employment

Aggregate supply alone, as under Say's Law

The full-employment level, guaranteed by flexible wages

In the linear consumption function C = a + bY, the average propensity to consume (APC):

Exceeds the MPC (b) and falls as income rises

Equals the MPC at every income level

Which of the following are assumptions of the classical macroeconomic model?

Say's Law holds — supply creates its own demand

Wages and prices are perfectly flexible

Money is neutral (a veil) with respect to real variables

Say's Law holds — supply creates its own demand

Wages and prices are perfectly flexible

Money is neutral (a veil) with respect to real variables

National Income, Classical and Keynesian Output Determination, and the Consumption-Investment Functions

Unit 2 moves from individual markets to the economy as a whole. This chapter covers national income concepts and measurement, the classical and Keynesian approaches to determining output and employment, and the consumption and investment functions that make up aggregate demand; the next two chapters cover the multiplier-accelerator and IS-LM, and inflation, business cycles, policy and rational expectations.

1. National Income: Concepts and Measurement

GDP (Gross Domestic Product) measures the market value of all final goods and services produced WITHIN a country's borders in a period, regardless of who owns the factors producing it. GNP (Gross National Product) adds net factor income from abroad to GDP, measuring output attributable to a country's OWN nationals wherever they work. NNP (Net National Product) subtracts depreciation (consumption of fixed capital) from GNP; National Income proper is NNP at factor cost, i.e. after removing indirect taxes and adding subsidies so that the measure reflects payments actually received by factors of production. Personal Income and Disposable Income further adjust for retained corporate profits, transfer payments and personal taxes to reach what households actually have to spend or save. Three methods — the product (value-added) method, the income method, and the expenditure method — should, in principle, give identical totals, since one agent's expenditure is another's income which is generated by production.

🧠 Real GDP, nominal GDP and the GDP deflator

Nominal GDP values current output at current prices; real GDP values current output at BASE-YEAR (constant) prices, isolating quantity change from price change. The GDP deflator = (Nominal GDP / Real GDP) × 100 is therefore itself a price index — broader than the Consumer Price Index because it covers all domestically produced goods and services, not a fixed consumer basket, and it is not subject to a fixed-weight substitution bias the way a Laspeyres-type CPI can be.

2. The Classical Theory of Output and Employment

Classical macroeconomics rests on Say's Law — 'supply creates its own demand' — and on perfectly flexible wages and prices, which together guarantee that the economy is always at (or rapidly returns to) full employment: any excess supply of labour is eliminated by a falling real wage, any excess supply of goods by falling prices. Money is treated as a VEIL over the real economy — the classical dichotomy holds that real variables (output, employment, the real wage, relative prices) are determined entirely in the real sector (by technology and factor endowments), while money only determines the absolute (nominal) price level, through the quantity theory of money (MV = PY, with V and Y taken as independent of M). Involuntary unemployment is therefore, in the classical view, not a sustained equilibrium possibility — only voluntary or frictional unemployment persists.

ℹ️ Note

Say's Law is sometimes stated more precisely as: the very act of producing output generates income exactly equal to the value of that output, so aggregate demand automatically equals aggregate supply at every level of output — it is a claim about the IMPOSSIBILITY of general overproduction, not merely a claim that individual markets clear.

3. The Keynesian Theory of Output and Employment

Keynes rejected both pillars of the classical model for a depression economy: wages and prices are sticky (downwardly rigid) rather than perfectly flexible, and the level of output is determined by EFFECTIVE DEMAND — the level of aggregate demand (C + I + G, in the simplest closed-economy form) at which firms' planned output matches what they expect to sell. Equilibrium output is where aggregate demand equals aggregate supply, and NOTHING in this mechanism guarantees that this equilibrium coincides with the full-employment level of output — the economy can settle into an equilibrium with involuntary unemployment persisting indefinitely, unless demand is deliberately raised.

Classical versus Keynesian output-employment determination
Feature	Classical	Keynesian
Wage/price flexibility	Perfectly flexible, so the economy self-corrects to full employment.	Sticky/rigid downward, so self-correction cannot be relied upon.
Determinant of output	Aggregate supply (Say's Law) — demand adjusts to whatever is supplied.	Effective (aggregate) demand — supply adjusts to whatever is demanded.
Role of money	A veil — determines only the nominal price level (classical dichotomy).	Not neutral in the short run — changes in money supply can affect real output via the interest rate and investment.

4. The Consumption Function and the Investment Function

Keynes's psychological law of consumption states that consumption rises with income but by less than the rise in income: C = a + bY, where a > 0 is autonomous consumption and 0 < b < 1 is the marginal propensity to consume (MPC). The average propensity to consume (APC = C/Y) exceeds the MPC and falls as income rises in this simple linear form, since the constant 'a' becomes a smaller share of total consumption. Investment demand depends on the marginal efficiency of capital (MEC) — the expected rate of return on an additional unit of capital — relative to the market rate of interest: investment is undertaken up to the point where MEC equals the interest rate, so planned investment is a DECREASING function of the interest rate, and shifts in business expectations shift the whole MEC schedule.

⚠️ MPC + MPS = 1, always

Since every rupee of additional income in this simple model is either consumed or saved, the marginal propensity to consume and the marginal propensity to save must sum to exactly 1 — a relationship NET tests numerically (given one, compute the other) and one that also fixes the value of the simple multiplier at 1/(1−MPC) = 1/MPS.

Key takeaways

GDP, GNP, NNP, National Income, Personal Income and Disposable Income form a chain of adjustments (net factor income from abroad, depreciation, indirect taxes/subsidies, retained profits, transfers, personal taxes); the product, income and expenditure methods should give identical totals.
The GDP deflator (Nominal/Real GDP × 100) is a broader price index than the CPI, covering all domestically produced output rather than a fixed consumer basket.
Classical theory (Say's Law, flexible wages/prices, money as a veil under the classical dichotomy) guarantees full employment; Keynesian theory (sticky wages/prices, output set by effective demand) allows equilibrium with persistent involuntary unemployment.
The Keynesian consumption function C = a + bY gives MPC (= b) below 1 and MPC + MPS = 1 always; investment is a decreasing function of the interest rate, undertaken up to MEC = interest rate.
APC exceeds MPC and falls as income rises in the linear consumption function, since autonomous consumption 'a' becomes a shrinking share of total consumption.

Practice questions (9)

Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.

National Income (NNP at factor cost) is derived from GNP by:
1. Subtracting depreciation, then subtracting indirect taxes and adding subsidies
2. Adding net factor income from abroad only
3. Adding depreciation and indirect taxes
4. Subtracting personal taxes only
Show answer
Answer: A — Subtracting depreciation, then subtracting indirect taxes and adding subsidies
GNP minus depreciation gives NNP at market prices; removing indirect taxes and adding subsidies converts this to NNP at factor cost, which is National Income proper — the measure of what factors of production actually earned.
The GDP deflator differs from the Consumer Price Index chiefly because:
1. It covers all domestically produced final goods and services, not a fixed consumer basket
2. It is measured monthly while CPI is measured annually
3. It excludes services entirely
4. It is calculated only for imported goods
Show answer
Answer: A — It covers all domestically produced final goods and services, not a fixed consumer basket
The deflator's coverage is the whole of current domestic output (Nominal GDP/Real GDP × 100), which changes composition every year with output itself, unlike CPI's fixed representative basket.
Say's Law, as invoked by classical macroeconomics, claims that:
1. The act of producing output generates income exactly equal to its value, so aggregate demand equals aggregate supply at every output level
2. Aggregate demand always exceeds aggregate supply
3. Wages are always rigid downward
4. Money supply has no effect on the price level
Show answer
Answer: A — The act of producing output generates income exactly equal to its value, so aggregate demand equals aggregate supply at every output level
Say's Law rules out general overproduction: since producing output itself creates matching income, aggregate demand automatically tracks aggregate supply, which is precisely why classical theory sees no room for sustained involuntary unemployment.
In the classical dichotomy, money determines:
1. Only the absolute (nominal) price level, leaving real variables to be determined by the real sector
2. The level of full employment
3. The real wage rate
4. The relative prices of all goods
Show answer
Answer: A — Only the absolute (nominal) price level, leaving real variables to be determined by the real sector
The classical dichotomy separates the real sector (output, employment, real wage, relative prices — all determined by technology and endowments) from the monetary sector (which fixes only the nominal price level via the quantity theory) — money is a 'veil'.
In the Keynesian model, equilibrium output is determined by:
1. Effective (aggregate) demand — the point where planned output matches expected sales — with no guarantee this coincides with full employment
2. Aggregate supply alone, as under Say's Law
3. The money supply alone
4. The full-employment level, guaranteed by flexible wages
Show answer
Answer: A — Effective (aggregate) demand — the point where planned output matches expected sales — with no guarantee this coincides with full employment
Keynes's central departure from the classical model is exactly this: output settles at whatever level equates aggregate demand and aggregate supply, and there is no automatic mechanism forcing that level to be the full-employment one.
If the marginal propensity to consume is 0.75, the marginal propensity to save is:
1. 0.25
2. 0.75
3. 1.75
4. 0
Show answer
Answer: A — 0.25
Since every additional rupee of income is either consumed or saved in this model, MPC + MPS = 1 identically, so MPS = 1 − 0.75 = 0.25.
In the linear consumption function C = a + bY, the average propensity to consume (APC):
1. Exceeds the MPC (b) and falls as income rises
2. Equals the MPC at every income level
3. Is constant only if a = 0
4. Rises as income rises
Show answer
Answer: A — Exceeds the MPC (b) and falls as income rises
APC = C/Y = a/Y + b; as Y rises, a/Y shrinks toward zero so APC falls toward b (the MPC) but stays above it for any finite, positive income — APC = MPC only in the special case a = 0.
Which of the following are assumptions of the classical macroeconomic model?
1. Say's Law holds — supply creates its own demand
2. Wages and prices are perfectly flexible
3. Money is neutral (a veil) with respect to real variables
4. Output is determined by effective demand
Show answer
Answer: A — Say's Law holds — supply creates its own demand; B — Wages and prices are perfectly flexible; C — Money is neutral (a veil) with respect to real variables
The first three are classical assumptions; the fourth — output set by effective demand — is the specifically Keynesian departure from the classical model, not a classical assumption itself.
Name the concept — the expected rate of return on an additional unit of capital, equated to the interest rate at the investment-decision margin — that determines Keynesian investment demand.
Numerical answer — type the value.
Show answer
Answer: marginal efficiency of capital
The marginal efficiency of capital (MEC) is the expected return on an extra unit of capital; a firm invests up to the point where MEC equals the market interest rate, making investment a decreasing function of the interest rate.