08 Mar

Fundamentals of Macro-Economics

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Contents

1. Classification of Goods:
   • Final Goods and Intermediate Goods
   • Consumption Goods and Capital Goods
2. Concepts and Components of Consumption Expenditure
3. Concepts and Components of Investments
4. Stocks and Flows
5. Factors of Production
6. Four Sectors of Economy
7. Inter-sectoral FLow
8. Circular Flow of Income

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1) CLASSIFICATION OF GOODS:

• • There are so many types of goods in the economy. Shoes, shirts, machines, farm tools, staplers, cement, minerals etc. These goods can be classified in two different ways:
    • Final Goods and Intermediate Goods, and
    • Consumption Goods and Capital Goods

A) FINAL GOODS AND INTERMEDIATE GOODS

• • Final Goods (also known as consumer goods or end products) are items that are purchased by households or businesses for direct consumption or use. They are ready for consumption and don’t require further processing or transformation.

» They can be classified in two types:

• • • Final Consumer Goods: Finally purchased by the consumers for the satisfaction of their wants.
      • Bread and Butter
    • Final Producer Goods: Finally purchased by producers and are generally used as fixed assets in the process of production.
      • Agri-tools used by farmers.

» Expenditure on final consumer goods by the households is called consumption expenditure and the expenses on final producer goods by the producers is called Investment Expenditure.

• • • Expenditure on Final Goods = Consumption Expenditure + Investment Expenditure.

» Note: Only final goods are included in the estimation of national product or national income.

• • • Intermediate Goods (also called producer goods) are used in production process to create other goods and services. They are not meant for final consumption but for further processing or assembly.

» E.g.

• • • Raw material, semi-finished materials, other products used during manufacturing.
    • Note: Shirt purchased by retailer from wholesaler for resale are intermediate goods. This is because value is still to be added to shirt through sale.

» Expenditure on intermediate goods by producers during an accounting year is called intermediate consumption or intermediate cost. If intermediate consumption is deducted from the value of output, we get ‘gross value addition’ (also called Gross Value Added, or Gross Product of the producer). Thus,

• • • Value of output – Intermediate consumption = Gross Value Added
• Note: The same goods may be final or intermediate
  » For e.g.
• • Onion bought by a household is a final good whereas Onion bought by a restaurant which is going to cook some food for customers and sell this food is an intermediate Good.

» What matters is the end use of the goods.

• • If the good is used by producer as raw material, it is an intermediate good. If it is purchased and resold, then also it is intermediate good.
  • If it is used by producer as a fixed asset (like chairs used in the classroom or tractors used by farmers), it is treated as final goods. Goods purchased by households for final consumption is to be treated as final goods.
• Question?
  » Purchase of a Display Screen always means the purchase of a final good. Do you Agree?

B) CONSUMPTION GOODS AND CAPITAL GOODS:

• Consumption Goods or Consumer Goods:
  • Consumer Goods are items that are produced and sold to satisfy the needs and wants of humans. E.g., sugar used by households.
• Consumption goods can be categorized in the following ways:

a. Durable Consumption Goods: Can be used for several years and are of relatively high value (e.g. TV, Car etc.)
b. Semi-Durable Consumption Goods: Can be used for around 1 year. E.g., Clothes, electric bulbs etc.
c. Non-durable or Single Use Consumption Goods: Used in a single act of consumption. (for.e.g. toothpaste, bread, butter, LPG etc.). They are of relatively low value.
d. Services: Non-material goods which satisfy human wants for e.g., medical services, legal services, househelp services etc.

• Capital Goods:
  • They are also known as producer goods and are used by businesses to produce other goods and services. They are not used for immediate consumption but for the production of additional goods and services. They are fixed assets of the producers and are repeatedly used in the process of production. They are also of high value.
    • E.g., Buildings, machinery, factories, vehicles used for business purposes etc.
  • They are used by the producers either for (i) the replacement of capital stock, or for (ii) addition to the capital stock.
  • Capital goods also involve depreciation.
  • Expenditure on capital goods is called investment expenditure.
• Note
  • Both consumption goods and capital goods are final goods and therefore are used in the estimation of national income.
• Question: All producer goods are not capital goods. Why?

2) CONCEPTS & COMPONENTS OF CONSUMPTION EXPENDITURE

• In macroeconomics, consumption expenditure refers to aggregate consumption expenditure in the economy.
• Consumers in an economy are broadly classified as: (i) Households (ii) Government (iii) non-profit private institutions (like NGOs, gurudwaras etc.)
• Aggregate Consumption Expenditure = Consumption expenditure by the households + consumption expenditure by the government + consumption expenditure by the nonprofit private institutions (NGOs, temples, mosques, gurudwaras etc.)

3) CONCEPTS & COMPONENTS OF INVESTMENTS

• Investments refers to increase in the stock of capital. Change in the stock of capital is called ‘capital formation’.
• Fixed Investment vs Inventory Investment:
  • Investment has two components: Fixed Investment and Inventory Investment
    • Fixed investment refers to increase in the stock of fixed assets (like plant and machinery) during an accounting year. It is also called fixed capital formation. This implies increase in the stock of capital formation in terms of fixed assets.
      • Significance of Fixed investment:
        • Raises production capacity; Leads to higher level of output -> leads to economic growth.
      • Inventory Investment refers to increase in inventory stock.
        • Inventory stock includes (i) Stock of finished goods (unsold once) (ii) semi-finished goods (iii) Raw materials.
        • Significance of inventory investment:
          • Ensures uninterrupted supply of inputs to producers.
          • Help in dealing with uncertainty of market.
          • Helps in dealing with increased demands quickly.
• Gross Investment, Net Investment and the Concept of Depreciation
  • Gross investment refers to total production of capital goods during the year. This include (i) capital goods used for the replacement of existing capital stock (which is worn out) and (ii) capital goods used as a net addition to the existing capital stock.
  • Gross investment = Net Investment + Depreciation (expenditure on replacement of worn-out fixed assets or replacement investments)
• Concept of Depreciation
  • Depreciation is a loss of value of fixed assets in use on account of:
    • Normal wear and tear
    • Accidental Damage
    • Expected Obsolescence (going down of value when fixed assets become obsolete due to change in technology or demand)
• It is also called consumption of fixed capital.
• Thus, due to depreciation, fixed asset needs to be replaced from time to time.

4) STOCKS AND FLOWS

• Meaning of Stock: A stock is a quantity measured at a particular point of time.
  • For e.g., Bank Balance; wealth; Capital; water in overhead tanks; amount of stored food; number of workers in a company; population of the country etc.
  • All such values are stock values as these are measured at a specific point of time.
• Meaning of Flow: A flow is quantity measured over a specified period of time.
  • For e.g., wages (per day or per month); flow of water (per second); production (per year); capital formation; interest on capital; sale; number of births etc.
• Note:
  • Flow impacts the stock. (e.g., greater the salary, more would be bank balance).
  • Stock impacts the flow (e.g., greater the capital, more will be annual production)
• Question: Which of the following is stock and which is flow?
  • Capital; Monetary Expenditure; A hundred rupee note; a family’s consumption of milk; services of a driver; production of cement; machinery of an automobile company.
• Note:
  • Capital is stock.
  • Investment is flow.

5) FACTORS OF PRODUCTION

•  In economy, factors of production are resources/inputs that are used to produce goods and services. These factors are inputs required in the production process and are essential for creating economic value.

The Four primary factors of production are:

• Land: It refers to all natural resources used in the production process. It includes not only the land area but also minerals, water, forests, and other natural resources that can be found on or beneath the land’s surface.
  • Rent is the payment made by producer to owner of the land.
• Labor: It refers to human efforts that go in the production of goods and services. This includes physical labour, skills, knowledge abilities of the workforce.
  • Wage is the payment made by the producer to the Laborers.
• Capital: Capital refers to the tool, machinery, equipment, building, and other physical assets that are used in the production process.
  • It includes both physical capital as well as financial capital. It is important for increasing the productivity and expanding the capacity of an economy.
  • Interest is the payment made by the producer to the capital owners.
  • Entrepreneurship: It represents human innovation, risk taking abilities etc that drive the production process. Entrepreneurs identify the opportunities, organize the other factors of production, and assume the risk associated with starting and managing the business. They play a critical role in economic development and growth.
    • Profit is the payment made by the producer to the entrepreneurs.
• A fifth factor of production: Some economists include technology and knowledge as a fifth factor of production, emphasizing the importance of innovation and information in modern economies.

6) FOUR SECTORS OF ECONOMY

• From macro-economic point of view, Economy is often divided into four sectors: 1) Household Sector 2) Producer Sector (Business Sector) 3) Government Sector 4) External Sector (Foreign Sector)
  • Household Sector:
    • It represents the individual consumers and families within the economy. I.e., All the 140 crores plus population residing in India will constitute India’s household sector.
    • They are consumers of goods and services.
    • They are also owners of factors of production and thus receive income through wages, rents, interests, profit etc.
    • They use this income to purchase goods and services for personal consumption.
  • Business Sector (Producer Sector/ Private sector):
    • • They include businesses, firms etc. involved in production of goods and services and owned by private individuals.
      • They include manufacturing units, service providers and all other types of businesses. They generate output, create jobs, and contribute to economic growth.
      • For production purposes, the firms hire/purchase factors of production (land, labour, capital, entrepreneurial skills) from households.
      • Note:
        • Reliance Industries is business sector, but Mukesh Ambani is part of Household sector.
        • A PSU is part of government sector, but employee of PSU (as an individual) is part of household sector.
  • Government Sector: It encompasses government at all levels (Central, state, local etc.). They collect revenue through taxes, fees, etc. and they fund public goods and services, such as infrastructure, education, healthcare, and defense.
    • Government sector may act as both a welfare agency as well as a producer.
  • External Sector (Foreign Sector): This sector represents economic interaction with the rest of the world including the import and exports of goods, services or capital.

7) INTER-SECTORAL FLOW

• The four sectors of economy depend on each other. This is called inter-sectoral dependence.
  • The household sector depends on business sector for supply of goods and services, needed for the consumption.
  • The Producer sector/Business sector depend on household sector for the supply of factors of production.
  • The government sector depends on household sector and business sector for tax and non-tax revenue.
  • Producer and Household depend on government for administrative services, law & order, defence etc.
• This intersectoral dependence leads to intersectoral flow, either in the form of goods and services or in the form of money.
• Intersectoral flow in the form of money is called money flow and intersectoral flow in the form of goods and services is called ‘Real flow.’
  • E.g., of real flow:
    • Household sector supplies Factor Services (Land, Labour, Capital and Entrepreneurship) to Producer Sector and Producer Sector supplies goods and services to household sector.

• E.g., of money flow:
  • Following figure shows money flow in terms of (i) flow of money in households to the producers (firms) for the purchase of goods, and (ii) flow of money from the producers to the households for the purchase of factor services.

• Money flow is reciprocal of the real flow. Thus, money flow from households to the producers (for the purchase of goods) is a reciprocal of the real flow of goods from the producer to the households. Likewise, money flow from producer to household (as payment for factor services) is a reciprocal of the real flow of factor services from the household to the producers.
• Note: Money flows are opposite to real flows as they are in response to the real flows.

8) CIRCULAR FLOW OF INCOME

• For simplification purpose, let’s assume that there are only two sectors in an economy – the Household sector and the Producer Sector (firms/Businesses).
  • In every economy three activities never stop:
    1. Production of Goods and Services
    2. Generation of Income (in terms of wages, interest, rent and profit)
    3. Expenditure (in terms of consumption expenditure and investment expenditure)
  • Circular Flow of Income in a simple two sector economy

• Circular flow of income refers to the unending flow of the activities of production, income generation and expenditure involving different sectors of economy.
  • Phase of Production: It refers to value addition done by business firms. The producing sector hires/purchases factors of production from the household who are the owners of these factors (land, labour, capital and entrepreneur). The factor inputs are used along with non-factor inputs (e.g., raw material etc.) for the production of goods and services.
  • Phase of Income Generation: For rendering their factor services to the producers, the household get factor payments: rent for land, interest for capital, wages for labour and profit for entrepreneurship.
  • Phase of Expenditure: The income generated is disposed of on the purchase of final goods and services.
    • When households buy the final goods, there is consumption expenditure.
    • When producers buy the final goods, there is investment expenditure.
• This expenditure (both consumption and investment) will generate demand for goods and services which will again cause production, which will in turn cause income generation further leading to expenditure (consumption + investment) and this process goes on and on. Therefore, it is called circular flow.
• Also note that, the three types of flows, Production (output), Income and Expenditure (in terms of Cand I) are always equal to each other for a particular period of time giving rise to what is called the triple identity:
  • Production (the value of goods and services) = Income Generated = Expenditure (in terms of C and I).
• Significance of Circular Flow:
  • Estimation of Nation Income: Circular flow model facilitates the estimation of national income. National income is the sum total of factor incomes (rent + profit + wages + interest) flowing from producers to households of a country.
    • It may be defined as market value of goods and services flowing from producers to other sectors of the economy.
    • Further, it may be defined as the sum total of all expenditure on the goods and services produced by the producer sector.
  • Knowledge of inter-sectoral dependence: A circular flow model helps understand interdependence among different sectors of the economy.
• Circular Flow of Income (where some saving and thus investment is there)

• Circular Flow of Income in an Open Economy with Government and Foreign Sector.