Basic Economic Concepts

What is Economics?
Economics is the study of scarcity and choice

Scarcity means that there is a finite amount of a good or service (Basically they are limited).
Because something is limited, we need to make decisions regarding how we use and allocate our
resources.

So studying economics helps use to better make decisions regarding how to deal with the
condition of scarcity.

Before we begin, there are few more definitions we should learn. In addition to scarcity you
should know that:

Goods are tangible items, or products, such as Pop Tarts, automobiles and I Phones.

Services are intangible items such as a haircut, mowing a lawn, and a dentist visit.

Also, you should know the difference between scarcity and shortage. Shortage is a short term
condition of a limited amount of a resource. For example, if there is a frost in Florida and the
orange crop is destroyed, the supply of oranges will be limited, but only for that growing season.

One of the most important aspects of choice in Economics is the idea that every choice has
trade-off- what didn’t you choose. This is related to the concept of opportunity cost.

Opportunity Cost is your second choice-what you give up when you make a decision. For
example, if you choose to go to college, you give up the salary you could have earned if you go
directly into the work force. The salary you would give-up is the opportunity cost of going to
college. Remember that Economics is the study of scarcity and choice. The concept of
opportunity cost is an important element in economic choices.

The Factors of Production

In order to better understand how we make decisions regarding scarcity and choice, it is
important to understand how goods and services are produced. This is where the concept of the
factors of production comes in:

The Factors of Production are classifications of what goes into the making of a good
or service. They include:

*Land or Natural Resources which are products used in the production of goods and
services, come from the earth. Examples could include lumber or oil.

Natural resources can be characterized as either:

Renewable resources are resources that can be replenished, such as trees that
can be replanted.
 Nonrenewable resources are resources that cannot be replaced such as coal.

Labor or Human Resources is the work that goes into the production of a good or
service. When looking at this factor, we usually look at the number or workers and the
workers’ skills.

Capital is the term used for the items that are used to create a good or service. Examples
of this may include the building where a good is produced, or the tools utilized to create
a good or provide a service.

Entrepreneurship is the putting together of land labor and capital to create a good or
provide a service. This is basically the ideas that go into the process of creating a good or
providing a service.

Basic Economic Questions

Societies need to determine how to put all of the factors of production together to best deal
with the issue of scarcity. To do this they need to address these Basic Economic Questions:

What goods and services should be produced? What goods and services does
the society need? What goods and should the society produce? Should the society
specialize in particular products and trade for others?

How should goods and services be produced? How should the factors of
production be combined? What resources should be used? How should we utilize
our labor and capital?

Who should receive the goods and services? How should goods and services be
distributed? Should everyone receive them? If not how does society decide who
gets particular goods and services and who might not?

Types of Economic Systems

There are Three Economic Systems that societies have developed to address these questions.
They include:

A Traditional Economy that deals with these questions by relying on customs

and traditions. This type of economy is usually associated with cultures that
practice subsistence agriculture, with customs and economic roles being passed
down from generation to generation. An example of this might be some tribal
societies found in the Amazon River Basin.

A Command Economy answers these questions by having the government make

(or command) decisions pertaining to what is produced, how much is produced,
and how goods produced and services are provided. An example of this would be
the economic system developed in communists countries such as the old Soviet
Union.
 A Market Economy answers these questions by allowing the buyers and the
producers of goods and services to come to an agreement regarding what is
provided and bought in a society and what the price of a good or service should
be. In its purest form, this is the opposite of a command economy. In this system
decisions are made by individuals, not by the government.

In reality, it is probably impossible to find any society that in some way does not mix these
systems. So it is important that you understand that most societies would be classified as having
a Mixed Economic System.

A Mixed Economy utilizes aspects of different systems. For example, the United
States economic system, at its base, would be classified as a market economy.
Businesses are privately owned and consumers have the ability to make economic
decisions. However, the government does play a prominent role in regulated
businesses, and by providing services.

The Nation’s Economic goals

In the United States, most people would agree that our system should try to strive for the
following economic goals.

Freedom: Individuals have the write to save their money, buy what they want,
and to work at the jobs they choose. Businesses have the ability to create what
they want, make profits and own the means of production.

Efficiency: This goal reflects the ideal of using the countries factors of
production to their fullest extent.

Equity: While there may be disagreements regarding the ideal degree of

economic equality in our society, most agree that opportunities for economic
advancement should be available to all.

Security: Our market oriented system can leave some individuals behind.
Because of this, our government has created a safety net. This includes
programs such as Social Security, Medicare, Medicaid, unemployment
insurance, and welfare programs.

Growth: Increased production of goods and services creates economic growth

which provides increased income and less unemployment.

Price Stability: One of the major goals of the nation’s economic institutions is
to prevent extreme fluctuations in prices. Both rapid increases in price level
(inflation), and decreases in price level (deflation) can cause economic
problems. So government institutions should do their best to moderate the
changes in price level.

Full Employment: Allowing the economy to provide a sufficient number of jobs

is crucial to maintain a healthy economy and society.
How Do You Study Economics?
Now that we have covered the basics of Economics, we can now discuss how students of
economics study economic topics:

First you should understand how the discipline is organized: In general, Economics is separated
into two areas:

Microeconomics: Which basically analyzes individual business situations or

sectors of the economy. For this course the topics we will study will include
Supply and Demand, Elasticity (the degree to which prices impact behavior), and
Market Structures (the level of competition in a particular industry).

Macroeconomics: Which analyzes the broad aspects of a country’s economy.

In this area we will study GDP, unemployment, inflation and the government’s
tools to deal with economic circumstances. Also, included in this topic will be
topics pertaining international trade.

One important thing to know about Economics is the fact that opinions are intertwined
with facts, and economists are influenced by their political leanings. Because of this, it is
very important to separate factual statements from statements containing opinions.
Statements of fact (Positive Statements) would be statements such as “the
unemployment rate has decreased by 1%”. Statements including opinion (Normative
Statements) are usually prescriptive. An
example of this would be “The government should decrease taxes to improve the
economy”. Understanding the differences between these types of statements will help
you to better analyze economic positions.

So how do economists analyze the economy?

First it is important to understand that Economics is a Social Science. Because of

this there can be many variables that can impact a particular outcome. So
economists need to utilize the concept of Ceteris Paribus, which means all else
being equal. What this means is that economic analysis minimizes the number of
variables considered. The reason for this is that limiting variables helps to provide
a simplified model to explain certain economic circumstances.

Here are a couple of models to show you how this works.

The first model is the Production Possibilities Curve or the PPC.

The Production Possibilities Curve can demonstrate the idea that decisions have
trade-offs and opportunity costs. The PPC is a graphic representation of an economic
trade-off which can demonstrate the opportunity cost of a decision.
 Below is a PPC:

Good A

This model simplifies the choices in an economy. This economy can choose between 2 goods.
Good A and Good B. The curved line represents the maximum amount of production that can
be achieved considering all possible combinations of Good A and Good B. At point A the
country can produce 125 units of good A, and 200 units of good B. If the country then chooses
to produce 250 units of good B (point B), the country must give up 25 units of good A:
moving from 125 units to 100 units. So the opportunity cost of producing 50 more units of
good B (200-250) is 25 units of good A. Hopefully this shows you how a simplified model can
demonstrate the concept of opportunity cost.

The PPC can also demonstrate the level of efficiency an economy is operating at. Here is another
PPC:

Good A

Good B
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Basic economic concepts
Remember the curved line represents the maximum production of all possible
combinations of good A and good B. Point B (on the line) is a location that is efficient:
meaning that all the factors of production in an economy are being fully utilized. Point
A is inefficient: meaning that the factors of production are not being fully utilized.
Point A also represents a recession because the country is producing less than it is
capable of. In addition, Point A represents an economic situation with less than full-
employment.
Point C is unobtainable given the current factors of production because it is
beyond the maximum amount of production of both goods A and B.

So there is our first model, the PPC. It simplified an economy by only looking at two
goods, but this simplification allows for a clear analysis of opportunity cost. It also
provides a graphic representation of both efficient and inefficient allocation of resources,
and unobtainable production given the current factors of production.

Our next model is The Circular Flow Diagram

The Circular Flow Diagram is a simplified model that demonstrates how

money and goods and services move through the economy.
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Basic economic concepts
This diagram represents the economic interaction between individuals and businesses.
The top of the diagram represents the Market for Goods and Services. In this market,
individuals spend their money (consumer spending) and in return they receive goods
and services. The bottom of the diagram represents the Factor Market. In this market,
individuals provide labor (a factor of production). In return, individuals receive
payment (wages). The model also demonstrates the flow of money. The blue inner
circle shows how money flows from consumers to businesses and from businesses back
to individuals in return for their productive services. The red outer circle shows how
goods and services flow through the economy. Individuals provide services (labor) to
the businesses and businesses provide goods and services to individuals.

This simplified model of the economy will be important to understanding economic

interactions and later the course will help students in their understanding of how
Gross Domestic Product (GDP) is calculated.

Recap: What is Economics All About?

Economics is the study of scarcity and choice. Making decisions regarding scarcity we
need to understand the factors of production and the three economic questions. In
dealing with these economic questions, different economic systems have been
developed. In the U.S. market system, we strive to meet the nation’s economic goals. To
better meet our economic goals, economists have developed simplified models to
provide a deeper understanding of economic circumstances.
 Macroeconomics
National Income Accounts

National income accounts (NIAs) are fundamental aggregate statistics in macroeconomic

analysis. The ground-breaking development of national income and systems of NIAs was one
of the most far-reaching innovations in applied economics in the early twentieth century. NIAs
provide a quantitative basis for choosing and assessing economic policies as well as making
possible quantitative macroeconomic modeling and analysis. NIAs cannot substitute for
policymakers’ judgment or allow them to evade policy decisions, but they do provide a basis
for the objective statement and assessment of economic policies.
Combined with population data, national income accounts can provide a measure of well-being
through per capita income and its growth over time. Also, NIAs, combined with labor force data,
can be used to assess the level and growth rate of productivity, although the utility of such
calculations is limited by NIAs’ omission of home production, underground activity, and illegal
production. Combined with financial and monetary data, NIAs provide a guide
to inflation policy. NIAs provide the basis for evaluating government policy and can rationalize
political challenges to incumbents by people who are dissatisfied with measurable aspects of the
government’s policies. In emerging and transition economies, implementing a dependable and
accurate system of NIAs is a crucial step in developing economic policy.

NIAs, to be most useful, require honest and timely publication. Long-delayed information is of

no use either in making policy or in monitoring the efficacy of policies already implemented.
Delay frequently implies that the government has something to hide. Indeed, once released, NIAs
can enforce their own discipline. That is, obfuscation cannot be maintained by altering or
exaggerating one aspect of NIAs, say investment or growth of total income, since each such
number is related to others, and consistency is a check on the accuracy of the components.
Because the data cannot easily be faked, autocrats are loathe to publish their countries’ NIAs and
either proscribe or delay their release. Turkmenistan’s dictator, for example, does not report to
the IMF, and the governments of Myanmar (1999) and Zimbabwe (2000) ceased reporting NIAs.
Conversely, nation-states that are committed to democracy report their NIAs, warts and all—for
example, Croatia or Nigeria and proto-states such as Montenegro or Kosovo—laying bare the
economic policy issues that confront them.

Measuring National Income

National income is the total market value of production in a country’s economy during a year. It
can be measured alternatively and equivalently in three ways:

● The value of expenditures

● The value of inputs used in production.

● The sum of value added at each level of production.

That the first two measures are identical can be seen by considering that any good—say, a loaf of
bread—can be equivalently valued as either the price that is paid for it in the market by the final
consumer or as the distributed factor payments—to labor (wages) and to capital (rent, interest,
 Macroeconomics
National Income Accounts

and profit)—used in its production. Since national output is the sum of all production, the total
value will be the same whether added up by final expenditure or by the value of inputs (including
profit) used in their production. The equivalence of the last measure can be seen by noting that
the value of every final good is simply the sum of the value added at each stage of production.
Again, consider a loaf of bread: Its value is the sum of the value of labor at each successive stage
of production and other ingredients added by the farmer (wheat production), the miller (grinding
to flour), the baker (flour plus other ingredients), and the grocer (distribution services).1

The broadest and most widely used measure of national income is gross domestic product
(GDP), the value of expenditures on final goods and services at market prices produced by
domestic factors of production (labor, capital, materials) during the year. It is also the market
value of these domestic-based factors (adjusted for indirect business taxes and subsidies)
entering into production of final goods and services. “Gross” implies that no deduction for the
reduction in the stock of plant and equipment due to wear and tear has been applied to the
measurements and survey-based estimates. “Domestic” means that the GDP includes only
production by factors located in the country—whether home or foreign owned. GDP includes the
production and income of foreigners and foreign-owned property in the home country and
excludes the production and incomes of the country’s own citizens or their property located
abroad. “Product” refers to the measurement of output at final prices as observed in market
transactions or of the market value of factors (inclusive of taxes less subsidies) used in their
creation. Only newly produced goods—including those that increase inventories—are counted in
GDP. Sales of used goods and sales from inventories of goods produced in prior years are
excluded, but the services of dealers, agents, and brokers in implementing these transactions are
included.

Measured by expenditures, GDP is the sum of goods and services produced during the period.
Total output comprises four groups’ purchases of final goods and services: households purchase
consumption goods; businesses purchase investment goods (and retain unsold production as
inventory increases); governments purchase goods and services used in public administration
and welfare transfers; and foreigners purchase (net) exports. There is substantial uniformity in
the shares of consumption and investment (the sum of capital expenditures and inventories)
across nations with quite disparate income levels. As Table 1 shows, household consumption
accounts for the largest share of GDP, an average of 65 percent for the nine countries considered;
when added to government consumption, the share approximates 80 percent. Investment (gross
capital formation plus increases in inventories) typically accounts for around 20 percent,
although rapidly developing countries such as Thailand have higher investment and lower
consumption shares. With few exceptions—for example, oil-exporting countries such as
Nigeria—net exports are typically within plus or minus 5 percent of GDP. Five of the countries
shown had average trade deficits during the fourteen-year period.

Table 1 Percentage Shares of Components of GDP for Selected Countries, 1990–2003

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National Income Accounts

1.. Income classes by per capita income level from World Bank indicators. The income
classes are: low income (l), $765 or less; lower middle income (lm), $766–$3,035; upper
middle income (um), $3,036–$9,385; and high income (h), $9,386 or more.

Country and Household Government Capital Change in Net

World Bank Consumption Consumption Formation Inventories Exports
Income
Class1

Chile (um) 63.2 11.2 23.4 1.1 1.1

Egypt (lm) 74.6 11.1 18.9 1.8 −6.4
France (h) 54.6 23.6 19.7 0.8 1.4
Morocco 68.4 18.0 22.3 −4.2 −4.6
(lm)
Nigeria (l) 73.1 5.6 7.9 1.4 12.1
Poland (um) 62.2 18.0 20.6 0.7 −1.4
Thailand 55.2 10.4 32.3 0.8 1.3
(lm)
Turkey (um) 69.1 12.8 22.6 −1.0 −3.5
United States 67.8 15.4 18.5 0.4 −2.1
(h)
Average 65.3 14.0 20.7 0.2 −0.2

Measured by inputs, GDP is the sum of payments to domestic factors of production—wages,

salaries, rent, interest, and profit, where profit is gross of the depreciation of domestic fixed
capital—plus indirect business taxes less net subsidies to business. Because the value of any
good or service is the sum of its inputs plus profit, the sum of the labor services, capital services
(gross profit including depreciation), and indirect taxes less net business subsidies must equal the
value of output, GDP. The third method of measurement is the sum of value added at each stage
of production of each of these final goods and services.

The Importance of NIA Data in Policy and Development Analysis

The development of NIA statistics provided the potential for converting economic policymaking
from a rule-of-thumb-based guessing game to a quantitatively based science. Yet, policy remains,
in part, a normative decision process, and rival politicians, as advocates of conflicting policy
agendas, frequently assess the economy’s performance differently and argue for divergent
 Macroeconomics
National Income Accounts

policies, even when citing the same NIA data. People’s disagreements often are based on
the distribution of income as opposed to its average level. Nevertheless, quantitative assessments
of the economy and its growth bring discipline to the discussion.

The importance of accurate and accessible NIA is implicit in an observation made by a West
African policymaker: “What cannot be measured cannot be managed.” Of course, implementing
measurability does not imply that all economic processes are manageable; and, in the case of
government expenditures, unlike the other components of GDP, there is no way to assess value
from observing voluntary market transactions. Because government expenditures are neither
voluntarily elicited nor priced in the market, they are valued at cost, which is primarily the cost
of labor. The capital cost of the buildings and land used is not included.

Limitation of NIA as a Gauge of Welfare

Per capita GDP is frequently used as a measure of welfare, both for indicating the rate of
improvement over time and for comparisons across nations. Yet per capita GDP is an imperfect
indicator of welfare of the representative individual. GDP does not account for nonmarket
production in the household—for example, meal preparation, cleaning, laundry, and child care.
Therefore, when these activities are, because of greater labor force participation, shifted to the
market—as restaurant meals and semiprepared foods in grocery stores, cleaning and laundry
services, and day care—the change in the value of production is overstated due to the decline in
nonmarket (household) production. Second, gray market and illegal activities—such as
production and distribution of marijuana or gambling—can be significant sources of sustenance
in economies but are not included. Third, in benign climates, clothing and heating are less costly,
so comparing across countries (or across regions within large states) will distort the relative level
of well-being. Fourth, government services, because not subject to a market test, will typically be
worth less than they cost, even though cost is used as a measure of value. Fifth, per capita
income—an average measure—can be a misleading image of the representative resident’s
well-being if the distribution of income is very unequal. A better measure is the median income
level and, for many analytic purposes, the income level by quintiles of the income distribution;
however, such distributional measures cannot be directly obtained from GDP data and population
and require separate surveys. Another limit on per capita income as a measure of well-being is
that it flies in the face of the way people think about having children. Most young couples see
themselves as being better off when they have their first baby, even though the immediate impact
is a 33 percent drop in the family’s per capita income.

History of NIA
An indication of NIAs’ impacts on economics is that the third and fifteenth Nobel Prizes in
economic science were awarded largely for contributions to the development of national income
statistics—to simon kuznets in 1969 and to richard stone in 1984. Their citations also noted the
men’s advocacy roles in persuading the United States and United Kingdom to devote adequate
resources to produce and maintain timely and accurate NIA data.

Working for the U.S. Commerce Department in the 1930s, Kuznets had developed time series of
national income in order to develop a quantitative basis for studying and measuring economic
 Macroeconomics
National Income Accounts

growth and the shifts in production from agriculture to industry to services. Interestingly,

Kuznets parted with the department because it refused to include estimates of household
production. paul samuelson once quipped that the size of the U.S. GDP could be dramatically
increased if housewives would simply contract out with their neighbors (reciprocally) to provide
cleaning and cooking services. In fact, this very omission of household production has overstated
the rise in national output of the economy due to the increase in women’s labor force
participation from around 25 percent in the late 1930s to about 60 percent in 2003. Kuznets also
strenuously objected to counting all government spending on goods and services as part of GDP
because he regarded most such expenditures to be intermediate, not final, products.

In contrast to Kuznets, Stone developed a double-entry accounting system, also in the 1930s and
1940s, partly driven by the British government’s war effort. His social accounting matrix
implemented many cross-checks on the validity of components of national income and, in so
doing, derived means of measuring them. He demonstrated, empirically as well as theoretically,
that national income could be measured as either the market value of final product or the total of
the gross factor incomes used in producing it. Stone’s structure became the foundation for the
United Nations System of National Accounts (SNA), first published in 1953, providing a
uniform basis for all countries to report national output. Virtually all nations now use his system
of national accounts.

National Income Accounting in Pakistan

A system of national accounts consists of a coherent, consistent and interrelated set of economic
accounts for sectors or sub-sectors of the economy as a whole. It provides a set of concepts,
definitions and classifications within a broad accounting framework. It is designed for purposes
of economic analysis and policy-making, including the formulation and monitoring of economic
programmes and development planning. Data of a scientific, technological or social nature can
be systematically related to economic data within the framework of an overall system of
accounts.
In Pakistan, the national accounts are prepared as per guidelines provided by the United Nations
System of National Accounts (UNSNA). The first United Nations System of National Accounts
(SNA) was published in 1953. The UN recommended countries to compile their economic
accounts within the SNA framework to achieve consistency and facilitate international economic
comparison.  SNA has been revised several times to take account of these wider concerns. The
latest version of the system was completed in 1993 and provides measures of production,
income, consumption, savings, capital formation and their financing for individual sectors and
for the economy as a whole.  SNA is a powerful and flexible tool to provide the detailed
economic information required to meet analytical and policy needs.
The first estimates of national accounts of Pakistan were prepared by the Economic Advisor’s
Office in 1949.  On the setting up of the Central Statistical Office (CSO) in 1950, the job was
transferred to CSO, now Federal Bureau of Statistics (FBS). Since then the FBS has been
preparing different series of national accounts at current and constant prices.
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National Income Accounts

For improvement of national accounts, several groups and committees were set up from time to
time, the prominent being the National Income Commission-1963 and IBRD Statistical
Mission-1969. As a result the national accounts of Pakistan have undergone modifications and
improvements at various stages with respect to timeliness, data availability, coverage and
statistical techniques involved in their computation.  In 1972-73, FBS undertook an exercise for
switching over the base from 1959-60 to 1969-70. These estimates were presented before the
National Accounts Committee but could not be adopted due to inconsistencies in the estimates of
manufacturing sector. The Committee directed the FBS to prepare estimates with 1975-76
base.  The estimates with base 1975-76, on improved data availability, concepts and
methodology were prepared for the year 1975-76 through 1983-84 and presented before the
Committee but could not be adopted by it due to persistent inconsistencies.  Despite successive
efforts for the improvement of national accounting in Pakistan, the desired results have not been
achieved. In particular the revised UN System of National Accounts–1968 could not be
implemented even though nearly two decades have elapsed since their adoption.  During the year
1984-85, the NEC decided to shift the base to 1980-81.  Accordingly a Committee on National
Accounts was constituted to review the present methodology for preparation of National
Accounts and to propose improvements considered necessary by the Committee. The result was
the 1980-81 base completed in 1988.
Efforts were made from time to time to shift the base from 1980-81 but due to one reason or the
other, the work was postponed.  Finally, in 2003, the NAC decided to shift the base year from
1980-81 to 1999-2000.
Sectoral Estimation of GNP/GDP:
GDP in Pakistan is estimated as per guidelines provided by the SNA. For the purpose of GDP
estimation by sectoral activities (current & constant prices), product, income and expenditure
approaches are applied. The economy is divided into the following sectors.

(a) Production Sectors

(i) Agriculture
● Major Crops
● Minor Crops
● Livestock
● Fishing
● Forestry

(ii) Industry
● Mining & Quarrying
● Manufacturing
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National Income Accounts

1. Large-Scale
2. Small-Scale
3. Slaughtering

● Construction
● Electricity, Gas and Water Supply

(b) Service Sectors

● Transport, Storage & Communications
● Wholesale & Retail Trade
● Finance and Insurance
● Ownership of Dwellings
● Public Administration & Defence
● Community, Social & Private Services

GDP is computed by a combination of product, income and expenditure methods.  Product

method is applied to compute value added in agriculture, mining and quarrying, manufacturing,
electricity & gas distribution, wholesale & retail trade and ownership of dwellings whereas
income method is used to work out income accruing from transport, storage & communication,
finance and insurance, public administration & defense and services sectors. Expenditure
method is used to estimate value added in construction based on investment made and the
co-efficient of value added relating to investment.

GNP/GDP Approaches Sectors

Product method Agriculture, mining and quarrying; manufacturing;
electricity and gas distribution; wholesale and retail
trade; and ownership of dwellings.
Income method Transport; storage and communication; finance and
insurance; public administration and defence; and
service sector.
Expenditure method Used to estimate value added in construction on
basis of investment made and the co-efficient of
value added relating to investment.
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National Income Accounts

Gross Fixed Capital Formation (GFCF):

As per system of national Accounts SNA 1993 the gross fixed capital formation is measured by
the total value of a producer’s acquisitions, less disposals of fixed assets during the accounting
period plus certain additions to the value of non-produced assets realized by the productive
activity of institutional units. Fixed assets are tangible or intangible assets produced as outputs
from processes of production that are themselves used repeatedly or continuously in other
processes of production for more than one year.
The estimates of GFCF in Pakistan are primarily constructed separately for private and public
sectors by economic activity as well as by capital assets. It comprises expenditure incurred on the
acquisition of fixed assets, replacement, additions and major improvements of fixed capital viz.
land improvement, buildings, civil and engineering works, machinery, transport equipment and
furniture and fixture. The methodology used to estimate GFCF in private and public sectors
including general government is given in the succeeding paragraphs:
Private Sector: Estimates of private sector are computed by a combination of approaches i.e.
commodity flow approach, expenditure approach (Survey Method) and financial approach.
Commodity flow approach that uses the net availability of capital goods in value terms from
domestic production and imports and exports, duly adjusted for various margins, is applied to the
following three sectors.
(i)                  Agriculture
(ii)                Construction
(iii)               Transport  
Expenditure approach (Survey Method) is applied to the following sectors:
(i)                  Mining & Quarrying
(ii)                Large Scale Manufacturing (In-Production)
(iii)               Small & Household Manufacturing Industries
(iv)              Wholesale & Retail Trade
(v)                Financial Corporate Sector
(vi)              Ownership of Dwellings
(vii)             Services
Financial approach is used to estimate GFCF in under-construction large scale manufacturing
establishments, livestock farming, poultry farming, and fishing supplemented by survey method.
Public Sector: The estimates of gross fixed capital formation in the public sector are compiled
based on data received from all the autonomous institutions by sub-sectors of the economy.
 Macroeconomics
consumption function and multiplier
Consumption
When we eat food, wear clothing, or go to a movie, we are consuming some of the output of the
economy. All forms of consumption together make up two-thirds of GDP. Because consumption
is so large, macroeconomists have devoted much energy to studying how households decide how
much to consume.
Households receive income from their labor and their ownership of capital, pay taxes to the
government, and then decide how much of their after-tax income to consume and how much to
save. The income that households receive equals the output of the economy Y. The government
then taxes households an amount T. (Although the government imposes many kinds of taxes,
such as personal and corporate income taxes and sales taxes, for our purposes we can lump all
these taxes together.) We define income after the payment of all taxes, Y − T, as disposable
income. Households divide their disposable income between consumption and saving.
We assume that the level of consumption depends directly on the level of disposable income. The
higher the disposable income, the greater the consumption.

Thus,
C = C (Y − T).
This equation states that consumption is a function of disposable income. The relationship
between consumption and disposable income is called the consumption function.
The marginal propensity to consume (MPC) is the amount by which consumption changes when
disposable income increases by one dollar. The MPC is between zero and one: an extra dollar of
income increases consumption, but by less than one dollar. Thus, if households obtain an extra
dollar of income, they save a portion of it. For example, if the MPC is 0.7, then households
spend 70 cents of each additional dollar of disposable income on consumer goods and services
and save 30 cents. Figure 3-5 illustrates the consumption function. The slope of the consumption
function tells us how much consumption increases when disposable income increases by one
dollar. That is, the slope of the consumption function is the MPC.

What Is the Consumption Function?

The consumption function, or Keynesian consumption function, is an economic formula that
represents the functional relationship between total consumption and gross national income. It
was introduced by British economist John Maynard Keynes, who argued the function could be
used to track and predict total aggregate consumption expenditures.

Understanding the Consumption Function

The classic consumption function suggests consumer spending is wholly determined by income
and the changes in income. If true, aggregate savings should increase proportionally as gross
domestic product (GDP) grows over time. The idea is to create a mathematical relationship
between disposable income and consumer spending, but only on aggregate levels.

The stability of the consumption function, based in part on Keynes' Psychological Law of
Consumption, especially when contrasted with the volatility of investment, is a cornerstone of
Keynesian macroeconomic theory. Most post-Keynesians admit the consumption function is not
stable in the long run since consumption patterns change as income rises.
 Macroeconomics
consumption function and multiplier
Calculating the Consumption Function
The consumption function is represented as:

C = A + MD
where:
C=consumer spending
A=autonomous consumption
M=marginal propensity to consume
D=real disposable income​

Assumptions and Implications

Much of the Keynesian doctrine centers around the frequency with which a given population
spends or saves new income. The multiplier, the consumption function, and the marginal
propensity to consume are each crucial to Keynes’ focus on spending and aggregate demand.

The consumption function is assumed stable and static; all expenditures are passively determined
by the level of national income. The same is not true of savings, which Keynes called
“investment,” not to be confused with government spending, another concept Keynes often
defined as investment.

For the model to be valid, the consumption function and independent investment must remain
constant long enough for national income to reach equilibrium. At equilibrium, business
expectations and consumer expectations match up. One potential problem is that the
consumption function cannot handle changes in the distribution of income and wealth. When
these changes, so too might autonomous consumption and the marginal propensity to consume.

Other Versions
Over time, other economists have made adjustments to the Keynesian consumption function.
Variables such as employment uncertainty, borrowing limits, or even life expectancy can be
incorporated to modify the older, cruder function.

For example, many standard models stem from the so-called “life cycle” theory of consumer
behavior as pioneered by Franco Modigliani. His model made adjustments based on how income
and liquid cash balances affect an individual's marginal propensity to consume. This hypothesis
stipulated that poorer individuals likely spend new income at a higher rate than wealthy
individuals.

Milton Friedman offered his own simple version of the consumption function, which he called
the “permanent income hypothesis.” Notably, the Friedman model distinguished between
permanent and temporary income. It also extended Modigliani’s use of life expectancy to
infinity.
 Macroeconomics
consumption function and multiplier
More sophisticated functions may even substitute disposable income, which takes into account
taxes, transfers, and other sources of income. Still, most empirical tests fail to match up with the
consumption function’s predictions. Statistics show frequent and sometimes dramatic
adjustments in the consumption function.
 Macroeconomics
determination of equilibrium level of income and output
Determination of equilibrium level of income and output

According to the Keynesian Theory, equilibrium condition is generally stated in terms of

aggregate demand (AD) and aggregate supply (AS). An economy is in equilibrium when
aggregate demand for goods and services is equal to aggregate supply during a period.

So, equilibrium is achieved when:

AD = AS … (1)

We know, AD is the sum of Consumption (C) and Investment (I):

AD = C + I … (2)

Also, AS is the sum of consumption (C) and saving (S):

AS = C + S … (3)

Substituting (2) and (3) in (1), we get:

C+S=C+I
Or S = I

It means, according to Keynes, there are Two Approaches for determining the equilibrium level
of income and employment in the economy:
It must be noted that Equilibrium level of income and employment can also be determined
according to ‘Classical Theory’. However, the scope of syllabus is limited to the Keynesian
theory.

Two Approaches for Determination of Equilibrium Level:

The two approaches to determine equilibrium level of income, output and employment in the
economy are:

1. Aggregate Demand-Aggregate Supply Approach (AD-AS Approach)

2. Saving-Investment Approach (S-I Approach)

It must be kept in mind that AD, AS, Saving and Investment are all planned or ex- ante variables.

Assumptions:
 Macroeconomics
determination of equilibrium level of income and output
Before we proceed further, let us first state the various assumptions made in determination of
equilibrium output:

(i) The determination of equilibrium output is to be studied in the context of two-sector model
(households and firms). It means, it is assumed that there is no government and foreign sector.

(ii) It is assumed that investment expenditure is autonomous, i.e., investments are not influenced
by level of income.

(iii) Price level is assumed to remain constant.

(iv) Equilibrium output is to be determined in context of short-run.

Aggregate Demand-Aggregate Supply Approach (AD-AS Approach):

According to the Keynesian theory, the equilibrium level of income in an economy is determined
when aggregate demand, represented by C + I curve is equal to the total output (Aggregate
Supply or AS).

Aggregate demand comprises of two components:

1. Consumption expenditure CC):
It varies directly with the level of income, i.e. consumption rises with increase in income.

2. Investment expenditure (I):

It is assumed to be independent of the level of income, i.e. investment expenditure is
autonomous. So, AD curve is represented by (C + I) curve in the income determination analysis.
Aggregate supply is the total output of goods and services of the national income. It is depicted
by a 45° line. Since the income received is either consumed or saved, the

AS curve is represented by the (C + S) curve.

The determination of equilibrium level of income can be better

understood with the help of the following schedule and diagram:

Table 8.1 Equilibrium by AD and AS Approach:

Amount in Rs crores

Employment Income Consumption Saving Investment AD AS Remarks

(Lakhs) (V) (C) (S) (I) C+ C+
l S
 Macroeconomics
determination of equilibrium level of income and output
0 0 40 -40 40 80 0 AD > AS

10 100 120 -20 40 160 100 AD > AS

20 200 200 0 40 240 200 AD > AS

30 300 280 20 40 320 300 AD > AS

40 400 360 40 40 400 400 Equilibrium

(AD=AS)

50 500 440 60 40 480 500 AD < AS

60 600 520 80 40 560 600 AD < AS

In Fig. 8.1, the AD or (C +1) curve shows the desired level of expenditure by consumers and
firms corresponding to each level of output. The economy is in equilibrium at point ‘E’ where (C
+ I) curve intersects the 45° line.

1. ‘E’ is the equilibrium point because at this point, the level of desired spending on consumption
and investment exactly equals the level of total output.

2. OY is the equilibrium level of output corresponding to point E.

 Macroeconomics
determination of equilibrium level of income and output
3. In Table 8.1, the equilibrium level of income is Rs 400 crores, when AD (or C +1) = AS = Rs
400 crores.

4. It is a situation of ‘Effective Demand’. Effective demand refers to that level of AD which

becomes ‘effective’ because it is equal to AS.

If there is any deviation from the equilibrium level of output, i.e. when planned spending (AD) is
not equal to planned output (AS), then a process of readjustment will start in the economy and
the output will tend to adjust up or down until AD and AS are equal again.

When planned spending (AD) is more than planned output (AS), then (C + I) curve lies above
the 45° line. It means that consumers and firms together would be buying more goods than firms
are willing to produce. As a result, the planned inventory would fall below the desired level.

To bring the inventory back to the desired level, firms would resort to increase in employment
and output until the economy is back at output level OY, where AD becomes equal to AS and
there is no further tendency to change.

When AD is less than AS:

When AD < AS, then (C +1) curve lies below the 45° line. It means that consumers and firms
together would be buying less goods than firms are willing to produce. As a result, the planned
inventory would rise. To clear the unwanted increase in inventory, firms plan to decrease the
employment and output until the economy is back at output level OY, where AD becomes equal
to AS and there is no further tendency to change.

It must be noted that equilibrium level may or may not be at the level of full employment, i.e.
equilibrium is possible even at a level lower than the full employment level.

For instance, in Table 8.1, employment level is 40 lakhs corresponding to equilibrium income of
Rs 400 crores. It is not the full employment level since employment increases even after the
equilibrium level.

Saving-Investment Approach (S-l Approach):

According to this approach, the equilibrium level of income is determined at a level, when
planned saving (S) is equal to planned investment (I).

Let us understand this with the help of following schedule and diagram:
Table 8.2 Equilibrium by Saving and Investment Approach
 Macroeconomics
determination of equilibrium level of income and output
Amount in Rs crores

Income Consumption Saving Investment Remarks

(Y) (C) (S) (I)

0 40 -40 40 S<1

100 120 -20 40 S<1

200 200 0 40 S<1

300 280 20 40 S<1

400 360 40 40 Equilibrium

(S=1)

500 440 60 40 S>1

600 520 80 40 S>1

In Fig 8.2, Investment curve (I) is parallel to the X-axis because of the autonomous character of
investments. The Saving curve (S) slopes upwards showing that as income rises, saving also
rises.
1. The economy is in equilibrium at point ‘E’ where saving and investment curves intersect each
other.
2. At point ‘E’, ex-ante saving is equal to ex-ante investment.
3. OY is the equilibrium level of output corresponding to point E.
4. In Table 8.2, the equilibrium level of income is Rs 400 crores, when planned saving – planned
investment = RS 400 crores.
If there is any deviation from the equilibrium level of income, i.e., if planned saving is not equal
to the planned investment, then a process of readjustment will start which will bring the economy
back to the equilibrium level.

When saving is more than Investment:

If planned saving is more than planned investment, i.e. after point ‘E’ in Fig. 8.2, it means that
households are not consuming as much as the firms expected them to. As a result, the inventory
rises above the desired level. To clear the unwanted increase in inventory, firms would plan to
reduce the production till saving and investment become equal to each other.

When saving is less than Investment:

 Macroeconomics
determination of equilibrium level of income and output
If planned saving is less than planned investment, i.e. before point ‘E’ in Fig. 8.2, it means that
households are consuming more and saving less than what the firms expected them to. As a
result, planned inventory would fall below the desired level. To bring the inventory back to the
desired level, firms would plan to increase the production till saving and investment become
equal to each other.
 Macroeconomics
Inflation
Inflation is a force that affects everyone’s lives—even if they’re not aware of it. When prices rise
too much—or prices rise but paychecks don’t—people see a negative effect on their purchasing
power and quality of life. That’s the most immediate way inflation affects us all.

What Is Inflation?
Inflation is the steady increase in the price of goods and services over time. It devalues units of
currency (like the U.S. Dollar), resulting in consequences like higher cost of living. Think about
how much a candy bar cost when you were a little kid. Now, think about how much that same
candy bar costs today. Or, think about how much it cost to rent an apartment in New York City in
the 1970s. Now think of how much it costs today. That price level increase is inflation.

Example of Inflation
One of the most straightforward examples of inflation in action can be seen in the price of milk.
In 1913, a gallon of milk cost about 36 cents per gallon. One hundred years later, in 2013, a
gallon of milk cost $3.53—nearly ten times higher.

This increase is not due to milk becoming more scarce, or more expensive to make. In fact, the
opposite is true. Instead, this price reflects the gradual decrease in the value of money as a result
of inflation.

How Does Inflation Work?

The causes of inflation are various and complicated. Generally, however, there are two basic
types of inflation:

1. Demand-pull inflation. Demand-pull inflation results from an increase in aggregate

demand for certain goods and services. So, for example, Apple can charge increasingly
higher prices for their phones because they’re increasingly popular. Demand-pull
inflation can be stem from a growing economy, increased government spending, or
overseas economic growth.
2. Cost-push inflation. Cost-push inflation results from a decrease in aggregate supply of
certain goods and services, often due to an increase in the cost of production, raw
materials, or labor. This type of situation could be seen when wildfires in California
resulted in rapidly rising prices for air filters being sold online.

What Are the Pros and Cons of Inflation?

High inflation has a wide range of negative consequences for economies. When labor wages
can’t keep up with the rate of inflation of retail prices, the purchasing power of those wages
decreases.

This is a particular challenge for low-income families, for whom any price increase can have
serious consequences. In turn, workers’ demands for wage increases can lead to an increase in
labor costs, resulting in lower profits for businesses. All of these effects of inflation can create a
high degree of uncertainty in an economy, leading to decreased investment from entrepreneurs.
 Macroeconomics
Inflation
Nevertheless, inflation isn’t always a bad thing: in fact, a stable economy needs a stable level of
inflation. Economists understand that while high inflation is a real danger, low inflation is
dangerous as well. Just as high inflation can lead to permanently high interest rates, low inflation
can lead to permanently low interest rates. Permanently low interest rates limits the ability of the
Federal Reserve (also called the Fed, the central bank of the United States) to increase the
strength of the economy in very bad times, which can lead to long, deep Recessions.

How Is Inflation Measured?

The Consumer Price Index (CPI) is a measure of inflation used by the US Bureau of Labor
Statistics. The BLS surveys 23,000 businesses and records the prices of 80,000 items every
month to log fluctuations and increases in goods and services. These include:

● Retail
● Transportation
● Gas prices
● Healthcare
● Food
● Housing
● Education

The Consumer Price Index tracks U.S. inflation rates, along with their impact on cost of living
and purchasing power. These numbers help statisticians and economists understand the overall
health of the economy.

What Is the Difference Between Inflation and Deflation?

Negative inflation—or deflation—occurs when the supply of goods or services is higher
than the demand for those goods or services. This generally happens because the consumer base
has less money or credit than they previously had. This results in falling prices for consumer
goods and services.

A great example of deflation is the Great Depression, during which the cost of goods fell because
people did not have access to money or credit due to unemployment, the stock market crash, and
other

What Is Hyperinflation?
A mild or moderate annual inflation rate is normal even when the economy is running smoothly.
When inflation increases to excessively high and accelerating rates, however, it’s known as
hyperinflation.

Perhaps the most famous example of hyperinflation took place in Germany in the 1920s. After
World War I, Germany’s opponents demanded reparations, and forbade Germany from paying
those debts in its own currency. To get around this problem, the German government printed
more money to buy foreign currency they could put toward reparations. This monetary policy of
printing so much money quickly devalued the German mark, which led to hyperinflation.
 Macroeconomics
Inflation

Pakistan Inflation Rate

● Pakistan inflation rate for 2019 was 10.58%, a 5.5% increase from 2018.

● Pakistan inflation rate for 2018 was 5.08%, a 0.99% increase from 2017.
● Pakistan inflation rate for 2017 was 4.09%, a 0.32% increase from 2016.
● Pakistan inflation rate for 2016 was 3.77%, a 1.24% increase from 2015.