Macroeconomics
Economics — Grade 11 | Unit 3 | NEB Nepal
Table Of Contents
Introduction
While microeconomics studies the behaviour of individual consumers and firms, macroeconomics steps back to examine the economy as a whole — the aggregate forces that determine national income, employment, the price level, money supply, and economic stability. Unit 3 of NEB Grade 11 Economics covers three interconnected macroeconomic topics: an introduction to macroeconomics and national income accounting (GDP, GNP, measurement methods), money and inflation, and government budget and fiscal policy. These topics are among the most policy-relevant in the entire course — directly connected to Nepal’s economic challenges of growth, inflation, and public finance management.
1. Introduction to Macroeconomics
1.1 Concept of Macroeconomics
According to John Maynard Keynes, whose General Theory of Employment, Interest and Money (1936) founded modern macroeconomics, “The theory of output as a whole — of employment as a whole — must be our starting point. We must understand the economy’s total performance before we can understand the performance of its parts.”
According to Kenneth E. Boulding, “Macroeconomics deals not with individual quantities as such but with aggregates of these quantities — not with individual incomes but with the national income as a whole, not with individual prices but with the price level, not with individual outputs but with total output.”
According to Paul A. Samuelson, “Macroeconomics is the study of the behaviour of the economy as a whole — of the forces that affect many firms, consumers, and workers simultaneously.”
Macroeconomics is concerned with economy-wide aggregates and the relationships among them — total output, total employment, the general price level, and the aggregate supply of and demand for money. Its central policy questions are: How do we achieve full employment? How do we maintain price stability? How do we sustain economic growth?
1.2 Macroeconomic Variables
The key macroeconomic variables are:
i. National Income / GDP: The total value of goods and services produced in an economy over a given period — the most comprehensive measure of economic activity.
ii. Employment and Unemployment: The proportion of the labour force that is productively employed. Full employment — one of the primary macroeconomic goals — means that all who want to work at prevailing wages can find jobs.
iii. Price Level and Inflation: The average level of prices across the economy. When the price level rises persistently, the economy experiences inflation; when it falls, deflation.
iv. Money Supply: The total quantity of money circulating in the economy — currency in circulation plus bank deposits. Controlled by the central bank (Nepal Rastra Bank in Nepal).
v. Interest Rate: The cost of borrowing money — determined by money supply, money demand, and central bank policy. Affects investment, consumption, and savings.
vi. Exchange Rate: The price of one currency in terms of another — affects imports, exports, and the balance of payments.
vii. Government Budget: The relationship between government revenue (taxes) and expenditure — a budget deficit occurs when expenditure exceeds revenue; a surplus when revenue exceeds expenditure.
1.3 Closed Economy and Open Economy
Closed Economy: An economy that does not engage in international trade or capital flows — it is entirely self-sufficient. No country today has a truly closed economy; it is a theoretical simplification.
According to Samuelson, “A closed economy is one which has no transactions with the rest of the world — no exports, no imports, no international capital flows. It is a useful theoretical abstraction.”
Open Economy: An economy that engages in international trade and capital flows — importing goods, exporting goods, receiving foreign investment, and sending capital abroad.
According to Mankiw, “In an open economy, spending on domestic output is affected not only by domestic decisions but also by decisions made abroad. Exports add to demand; imports reduce it.”
Nepal is a small open economy — highly dependent on international trade (particularly imports from India and China), remittances from abroad (approximately 25–27% of GDP), and foreign aid. Macroeconomic policy in Nepal must account for these international linkages.
2. National Income Accounting
2.1 Concept and Importance of National Income
According to Alfred Marshall, “The labour and capital of a country, acting on its natural resources, produce annually a certain net aggregate of commodities, material and immaterial, including services of all kinds. This is the true net annual income or revenue of the country or national dividend.”
According to Simon Kuznets, the economist who developed the modern system of national accounts, “National income is the net output of commodities and services flowing during the year from the country’s productive system in the hands of the ultimate consumers.”
According to the Central Bureau of Statistics (CBS) of Nepal, “National income refers to the total monetary value of all final goods and services produced within an economy in a given period, typically one year.”
National income is important because it:
- Measures the overall economic performance of a country
- Enables comparison of living standards across countries and over time
- Informs government policy on taxation, spending, and development planning
- Reflects the productive capacity and well-being of a nation’s population
2.2 Key National Income Concepts
i. Gross Domestic Product (GDP)
GDP is the total market value of all final goods and services produced within the geographical boundaries of a country during a given period, regardless of the nationality of the producers.
According to Samuelson and Nordhaus, “GDP is the most comprehensive measure of a nation’s total output — the market value of all final goods and services produced by an economy in a given year.”
Formula: GDP = C + I + G + (X − M)
Where: C = Private consumption; I = Gross private investment; G = Government expenditure; X = Exports; M = Imports; (X − M) = Net exports
In Nepal’s context: Nepal’s GDP (2079/80) was approximately NPR 4.9 trillion, with consumption dominating (approximately 90%), reflecting Nepal’s low investment and savings rates.
ii. Gross National Product (GNP)
GNP is the total market value of all final goods and services produced by the residents (nationals) of a country during a given period, regardless of whether production occurred inside or outside the country.
Formula: GNP = GDP + Net Factor Income from Abroad (NFIA)
Net Factor Income from Abroad (NFIA) = Factor income received from abroad − Factor income paid to foreigners
For Nepal: GNP > GDP because Nepal receives substantial remittances (wages earned by Nepali workers abroad) — which add to GNP but not to GDP. Nepal’s remittances constitute approximately 25–27% of GDP — making the GNP-GDP difference significant.
iii. Net National Product (NNP)
NNP accounts for the depreciation (wear and tear) of capital assets during the production process.
Formula: NNP = GNP − Depreciation (Capital Consumption Allowance)
Depreciation represents the reduction in the value of capital goods (machinery, buildings, vehicles) through use and obsolescence. NNP gives a more accurate picture of sustainable production — it measures what is left after maintaining the existing capital stock.
iv. National Income (NI) at Factor Cost
Formula: NI = NNP at Market Price − Net Indirect Taxes (Indirect Taxes − Subsidies)
National income at factor cost represents the income earned by the factors of production (wages + rent + interest + profit) — the rewards to land, labour, capital, and entrepreneurship for their contribution to production.
v. Personal Income (PI)
Personal income is the total income received by individuals and households from all sources — before payment of personal income taxes.
Formula: PI = NI − Retained earnings of corporations − Corporate taxes − Social security contributions + Transfer payments (pensions, social security benefits, government subsidies to individuals)
vi. Disposable Income (DI)
Disposable income is the income available to households for consumption and saving — after payment of personal taxes.
Formula: DI = PI − Personal Direct Taxes
vii. Per Capita Income (PCI)
Per capita income is the average income per person — national income divided by total population.
Formula: PCI = National Income / Total Population
According to the World Bank, per capita income is the most commonly used measure for comparing living standards across countries. Nepal’s per capita income (approximately USD 1,300–1,400 in 2023) places it in the lower-middle income category.
2.3 Nominal GDP and Real GDP
Nominal GDP is GDP measured at current prices — the prices prevailing in the year of measurement. It is also called GDP at current prices.
Real GDP is GDP measured at constant prices — the prices of a fixed base year. It removes the effect of inflation, reflecting only changes in actual output.
GDP Deflator: The ratio of nominal GDP to real GDP, multiplied by 100. It measures the average price level of all goods and services in the economy.
Formula: GDP Deflator = (Nominal GDP / Real GDP) × 100
Or: Real GDP = (Nominal GDP / GDP Deflator) × 100
Example: If Nepal’s nominal GDP grows by 10% but inflation is 6%, real GDP grows by approximately 4% — meaning actual output grew by 4%, while prices accounted for the remaining 6% of nominal growth.
Importance of the distinction: Real GDP is the appropriate measure for comparing economic performance over time — nominal GDP growth can be misleading if it largely reflects inflation rather than actual increased production.
2.4 Methods of Measuring National Income
National income can be measured by three equivalent methods — each approaching the circular flow of income from a different angle. In principle, all three methods should yield the same result.
Method 1 — Product Method (Output Method / Value Added Method)
This method measures national income by summing the value added at each stage of production across all sectors of the economy.
Value added = Value of output − Value of intermediate inputs
By summing value added (rather than gross output), double-counting is avoided — intermediate goods used in production are not counted again in the final product.
Sectors in Nepal: Agriculture (approximately 25–28% of GDP), industry/manufacturing (approximately 15%), services (approximately 57–60%).
According to Simon Kuznets, “The value-added method is the most direct approach to measuring national output — it captures the contribution of each sector without the distortion of double-counting.”
Method 2 — Income Method (Factor Income Method)
This method measures national income by summing all factor incomes earned in production:
NI = Wages and Salaries + Rent + Interest + Profit + Mixed Income of self-employed
Each payment corresponds to a factor of production: wages for labour, rent for land, interest for capital, profit for entrepreneurship.
Difficulties in Nepal: Much of Nepal’s economic activity is informal — smallholder farmers, street vendors, domestic workers — whose incomes are not formally recorded, making income method measurement difficult and requiring extensive survey-based estimation.
Method 3 — Expenditure Method
This method measures national income by summing all final expenditures in the economy:
GDP = C + I + G + (X − M)
Where: C = household consumption expenditure; I = gross private investment (including inventory changes); G = government consumption expenditure; X − M = net exports (exports minus imports).
In Nepal’s case: Consumption dominates (approximately 90% of GDP), investment is low (approximately 25% of GDP), government expenditure is moderate, and net exports are persistently negative (Nepal imports far more than it exports). Remittances fill the gap — enabling consumption beyond what domestic production would support.
2.5 Difficulties in Measuring National Income in Nepal
Nepal faces significant practical difficulties in accurately measuring national income:
i. Large Informal Sector: A large share of Nepal’s economic activity — subsistence agriculture, informal trade, domestic service, casual labour — occurs outside the formal recorded economy. Estimating the value of unrecorded production requires extensive and costly surveys.
ii. Subsistence Agriculture: When Nepali hill farmers grow food for their own consumption (not for sale), this output has no market price — it must be imputed at estimated market values, introducing inaccuracy.
iii. Non-Monetized Economy: In remote areas, barter transactions and non-cash exchanges are common — these are difficult to record and value.
iv. Lack of Reliable Data: Nepal’s statistical system — managed by the Central Bureau of Statistics — has limited coverage in remote areas. Data collection is infrequent and methodologically constrained.
v. Double-Counting Risk: Without comprehensive records of intermediate inputs across all sectors, there is risk of counting the value of intermediate goods more than once.
vi. Valuation of Government Services: Government services (education, health, security) are valued at their cost rather than market price — since many are provided free. This may understate or overstate their true value.
vii. Underground Economy: Illegal activities (smuggling, black markets) and unreported income contribute to GDP but cannot be officially measured — leading to underestimation of actual economic activity.
3. Money and Inflation
3.1 Money: Meaning and Functions
According to Alfred Marshall, “Money is any commodity which has general acceptability as a medium of exchange and can be used to measure and store value.”
According to Crowther, “Money is anything that is generally acceptable as a means of exchange and at the same time acts as a measure and a store of value.”
According to D.H. Robertson, “Money is anything which is widely accepted in payment for goods, or in discharge of other kinds of business obligation.”
3.2 Functions of Money
Primary Functions:
i. Medium of Exchange: Money’s most fundamental function — it eliminates the double coincidence of wants required by barter, enabling any good to be exchanged for money and money exchanged for any other good. According to Jevons, “Money is the lubricant of the economic machine — without it, exchange is enormously costly and inefficient.”
ii. Measure of Value (Unit of Account): Money provides a common unit of measurement — all goods and services can be expressed in terms of money price, enabling comparison of value and rational economic calculation.
Secondary Functions:
iii. Store of Value: Money can be saved and used for future purchases. Unlike perishable goods, money retains its value over time (subject to inflation). This function underlies saving, investment, and the financial system.
iv. Standard of Deferred Payment: Money enables credit transactions — debts can be incurred today and repaid in money in the future. This function underlies the entire system of credit, lending, and banking.
Contingent Functions:
v. Transfer of Value: Money enables the transfer of purchasing power across time and space — through remittances, inheritance, and financial transfers. Nepal’s large remittance economy (approximately USD 9–10 billion annually) depends fundamentally on money’s transfer function.
vi. Basis of Credit: Modern banking and financial systems are built on money — banks create credit by lending multiples of their deposits, and the entire financial system rests on confidence in money.
3.3 Types of Money
i. Commodity Money: Money with intrinsic value — the commodity itself has value independent of its use as money. Historical examples: gold coins, silver coins, cowrie shells. Nepal’s traditional use of copper and silver coins is an historical example.
ii. Paper Money (Fiat Money): Currency notes issued by the government or central bank — their value is backed by government authority and public confidence, not by any physical commodity. Nepal’s currency (Nepali Rupee) is fiat money issued by Nepal Rastra Bank.
iii. Bank Money (Credit Money): Deposits in commercial banks — transferable by cheque, electronic transfer, or debit card. Bank money constitutes the majority of the money supply in modern economies.
iv. Near Money (Quasi Money): Assets that are highly liquid but not directly usable as a medium of exchange — savings deposits, treasury bills, government bonds. They can be quickly converted into money.
3.4 Money Supply: Narrow and Broad Money
Narrow Money (M1): The most liquid forms of money — currency in circulation (notes and coins) plus demand deposits (current account deposits that can be withdrawn on demand).
M1 = Currency in Circulation + Demand Deposits
Broad Money (M2): M1 plus less liquid bank deposits — savings deposits, time deposits, and other near-money instruments.
M2 = M1 + Savings Deposits + Time Deposits + Other Deposits
Nepal Rastra Bank publishes monthly data on M1 and M2. Nepal’s M2 has grown rapidly in recent years, reflecting the expansion of the banking system and financial deepening.
3.5 Quantity Theory of Money (Fisher’s Equation)
According to Irving Fisher, the quantity theory of money states that there is a direct proportional relationship between the money supply and the price level.
Fisher’s Equation of Exchange: MV = PT
Where:
- M = Money supply (total quantity of money in circulation)
- V = Velocity of circulation (average number of times each unit of money is used in transactions per period)
- P = Average price level
- T = Total volume of transactions (real output)
Implications: If V and T remain constant, an increase in M leads to a proportional increase in P — doubling the money supply doubles the price level. This is the monetarist explanation of inflation.
According to Milton Friedman, the leading proponent of monetarism, “Inflation is always and everywhere a monetary phenomenon — it is produced by a more rapid increase in the quantity of money than in output.”
Limitations of the Quantity Theory:
- V (velocity) is not constant — it changes with financial innovations, interest rates, and expectations
- T may change with M — increased money supply can stimulate real output in the short run (Keynesian critique)
- In practice, the relationship between M and P is less mechanical than Fisher’s equation implies
3.6 Inflation
According to Samuelson and Nordhaus, “Inflation is a rise in the general level of prices — a period in which most prices are rising.”
According to A.C. Pigou, “Inflation exists when money income is expanding more than in proportion to the increase in earning activity.”
According to Milton Friedman, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
Types of Inflation:
i. Demand-Pull Inflation: Arises when aggregate demand exceeds aggregate supply — “too much money chasing too few goods.” According to Keynes, “Demand-pull inflation occurs when the economy is at full employment and additional spending cannot be met by increased output.”
ii. Cost-Push Inflation: Arises when production costs rise — wages, raw materials, energy — pushing up prices from the supply side. Nepal experiences cost-push inflation when petroleum prices rise internationally, since Nepal imports virtually all its petroleum.
iii. Structural Inflation: Arises from structural bottlenecks in the economy — inadequate supply capacity in specific sectors. Nepal’s food price inflation is partly structural — inadequate agricultural productivity, poor transport infrastructure, and limited cold chain create supply constraints that push prices up.
iv. Imported Inflation: Arises from rising prices of imported goods. Nepal is highly vulnerable to imported inflation from India, which supplies the majority of Nepal’s consumer goods and industrial inputs.
Effects of Inflation:
i. Reduces purchasing power: Fixed income earners (pensioners, salaried employees) suffer as prices rise faster than wages.
ii. Redistribution of income: Debtors gain (they repay loans in cheaper money); creditors lose. Asset holders gain; cash holders lose.
iii. Uncertainty and reduced investment: High inflation creates uncertainty about future prices — discouraging long-term investment.
iv. Balance of payments deterioration: If Nepal’s inflation exceeds India’s, Nepali exports become less competitive and imports increase.
v. Shoe leather costs: The cost of time and effort spent in minimizing cash holdings when inflation is high.
Deflation is a sustained fall in the general price level — the opposite of inflation. While it may seem beneficial, deflation is dangerous: it encourages consumers to delay purchases (expecting prices to fall further), reducing demand and potentially creating a deflationary spiral. Japan’s “Lost Decade” of the 1990s is the classic example of the damage deflation can cause.
Inflation in Nepal: Nepal’s inflation is influenced by Indian inflation (through the pegged exchange rate with the Indian Rupee), domestic supply constraints, government spending, and import prices. Nepal Rastra Bank targets inflation management as a primary monetary policy objective.
4. Government Budget and Fiscal Policy
4.1 Government Budget
According to Samuelson and Nordhaus, “The government budget is a statement of the government’s spending plans and the taxes it plans to collect to finance those plans — it is the central tool of fiscal policy.”
According to A.C. Pigou, “The government budget is a comprehensive financial plan that sets out the government’s income and expenditure for the coming fiscal year — it is the primary instrument for allocating public resources.”
Nepal’s government presents the annual budget on the first day of Ashadh (approximately mid-June) — one of the most anticipated economic events in Nepal, as it determines public investment, tax rates, subsidies, and social expenditure for the coming fiscal year.
Components of the Government Budget:
i. Revenue Budget: Government income from taxes (income tax, VAT, customs, excise) and non-tax sources (fees, dividends from public enterprises, foreign grants).
ii. Capital Budget: Government expenditure on capital formation — infrastructure (roads, hydropower, airports, irrigation), public buildings, and investment in public enterprises. Also includes government borrowing to finance capital expenditure.
Budget balance situations:
- Balanced Budget: Government revenue = Government expenditure
- Budget Surplus: Government revenue > Government expenditure (government saves)
- Budget Deficit: Government revenue < Government expenditure (government borrows)
Nepal consistently runs a budget deficit — spending exceeds domestic revenue, with the gap financed by foreign aid, foreign loans, and domestic borrowing.
4.2 Fiscal Policy
According to Samuelson and Nordhaus, “Fiscal policy refers to the use of government expenditure and taxation to influence the macroeconomic performance of an economy — its output, employment, and price level.”
According to John Maynard Keynes, “The government can and should use fiscal policy — changes in government spending and taxation — to stabilize the economy, stimulating demand during recessions and restraining it during booms.”
Keynes’s Multiplier Effect: According to Keynes, an increase in government spending generates a multiplied increase in national income — because the initial spending becomes income for recipients, who spend a fraction of it, creating further rounds of income and spending.
Multiplier = 1 / (1 − MPC) where MPC = Marginal Propensity to Consume
Types of Fiscal Policy:
i. Expansionary Fiscal Policy: Increasing government expenditure and/or reducing taxes to stimulate aggregate demand — used during recessions and periods of high unemployment. According to Keynes, “The government is the spender of last resort — when private spending collapses, government must step in.”
ii. Contractionary Fiscal Policy: Reducing government expenditure and/or increasing taxes to reduce aggregate demand — used to combat inflation and overheating.
iii. Neutral Fiscal Policy: Maintaining current spending and tax levels — neither stimulating nor restraining the economy.
Objectives of Fiscal Policy in Nepal:
- Achieving high and sustainable economic growth
- Maintaining price stability
- Reducing poverty and inequality
- Developing infrastructure and productive capacity
- Mobilizing domestic resources (reducing dependence on foreign aid)
- Achieving macroeconomic stability (manageable deficit, sustainable debt)
Instruments of Fiscal Policy:
i. Government Expenditure:
- Current/Recurrent expenditure: Wages of civil servants, operation of government services, interest on debt
- Capital/Development expenditure: Investment in roads, schools, hospitals, hydropower, irrigation — the most development-impactful component
- Transfer payments: Social security, pensions, subsidies to households and enterprises
ii. Taxation:
- Direct taxes: Income tax, corporate tax — progressive, paid directly by the taxpayer
- Indirect taxes: VAT, customs, excise — regressive, embedded in the price of goods
Limitations of Fiscal Policy in Nepal:
i. Implementation lag: The time between identifying the need for policy action and actually implementing spending changes — in Nepal, budget execution rates are often low, particularly for capital expenditure.
ii. Revenue constraints: Nepal’s tax-to-GDP ratio is approximately 22–24% — limiting the fiscal space for public investment without borrowing.
iii. Crowding out: Government borrowing to finance deficits may raise interest rates, reducing private investment.
iv. Dependence on foreign aid: A significant portion of Nepal’s capital budget is financed by foreign aid — making fiscal policy partly dependent on donor decisions.
v. Leakages: In an open economy, some fiscal stimulus leaks abroad through imports rather than stimulating domestic production.
5. Macroeconomics in the Nepali Context
i. Nepal’s GDP and Growth: Nepal’s economy has achieved average growth of approximately 4–5% annually in recent years — well below the 7–8% needed to achieve middle-income status by 2030. Growth has been driven primarily by remittances and consumption, rather than productive investment — a structurally fragile growth pattern.
ii. Remittances and National Income: Nepal’s GNP significantly exceeds its GDP due to remittances. The approximately USD 9–10 billion received annually from migrant workers constitutes the largest single source of foreign exchange and a primary driver of household consumption and poverty reduction.
iii. Inflation Management: Nepal Rastra Bank targets inflation in the 5–7% range. Nepal’s inflation is heavily influenced by Indian inflation (due to the fixed exchange rate with the Indian Rupee at 1.6:1) and by domestic supply constraints — particularly in food and energy.
iv. Budget Deficit and Public Debt: Nepal’s fiscal deficit has ranged from 3–5% of GDP in recent years. Public debt has been growing — external debt constitutes approximately 25–30% of GDP. Fiscal sustainability requires improving tax revenue mobilization and development expenditure execution.
v. Fiscal Policy for Development: Nepal’s annual budget is the primary instrument of development policy. Priorities include hydropower development (to end load shedding and generate export revenue), road connectivity, agricultural modernization, and social protection — all requiring sustained capital expenditure that Nepal’s fiscal capacity struggles to finance.
Conclusion
Macroeconomics provides the framework for understanding Nepal’s most pressing economic challenges — low growth, persistent inflation, fiscal deficits, and dependence on remittances. The concepts of national income accounting, money supply and inflation, and fiscal policy are not merely academic tools — they are the analytical foundations on which Nepal’s economic policy debates are conducted.
As John Maynard Keynes observed, “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else.” For Nepal’s students of economics, understanding macroeconomic concepts is preparation for informed citizenship — the capacity to evaluate government policies, understand economic conditions, and contribute to the national conversation about Nepal’s economic future.
Prepared for NEB Grade 11 Economics — Unit 3: Macroeconomics Aligned with the National Curriculum Framework 2076, Curriculum Development Centre, Sanothimi, Bhaktapur
