Some Basic Concepts of Macroeconomics

CLASSIFICATION OF GOODS                         

1. final goods & intermediate goods

2. consumption or consumer goods & capital goods

FINAL GOODS
these are goods which have crossed the boundary line of production and are ready for
use by their final users.
final consumer goods = the goods which are ready for use by their final users and
consumers are their final users
                                                              ex :- bread and butter - used by consumers
final producer goods = the goods which are ready for use by their final users and
producers are their final users.
                                                            ex :- tractors and harvesters - used by farmers

consumption expenditure - expenditure  on final consumer goods by households

investment expenditure - expenditure on final producer goods by producers

INTERMEDIATE GOODS
are those goods which are within the boundary line of production, value is yet to be
added to these goods and these goods aren't yet ready for use by their final users.
intermediate consumption or intermediate cost - expenditure on intermediate goods by
the producers during an accounting year.
*GVA OR GROSS PRODUCT OF A PRODUCER*

SAME GOOD MAY BE FINAL OR INTERMEDIATE

The distinction depends on the end-use of the goods. If it is used by the producers as a
raw material, it is to be treated as an intermediate good. Also, if it is purchased and
resold by the producers, it is to be treated as an intermediate good. But if it is used by
the producer as a fixed asset (like a tractor used by the farmer), it is to be treated as a
final good. And, of course, goods purchased by the households for final consumption,
are to be treated as final goods.

DIFFERENCE BETWEEN INTERMEDIATE AND FINAL GOODS

Accounting year is the year during which production of goods and services is
estimated in the domestic economy. Or, it is the year during which national
product/national income is estimated for the country.

Q. 1. How would you find out whether a particular expenditure is an expenditure on

intermediate goods or on final goods?
Ans. Expenditure on final goods must lead to: (i) final consumption expenditure (C), or
(ii) investment expenditure (I). The expenditure which does not lead to C and I (like the
expenditure on raw material) is to be treated as an expenditure on intermediate goods.
Expenditure on intermediate goods leads to intermediate consumption or intermediate
cost.

Q. 2. Purchase of a car always means the purchase of a final good. Do you agree?
Ans. No. It depends on the end-use of the car. If it is purchased by a household, it is a
final good. It is like a consumer durable. If it is purchased by taxi-operators, then again it
is a final good, as it is to be finally used by the producer as a fixed asset. However, if the
car is purchased by a retail dealer from the factory for the purpose of resale, it is to be
treated as intermediate good.

CONSUMPTION OR CONSUMER GOODS

Consumption goods (or consumer goods) are those goods which are directly used for
the satisfaction of human wants.

(1) Durable Consumption Goods: Durable consumption goods are those goods which
can be used for several years and are of relatively high
                                                                     value. These goods are repeatedly used
before being discarded as useless. Ex:- tv, radio, car.
(2) Semi-durable Consumption Goods: Semi-durable consumption goods are those
goods which can be used for a period of one year or slightly
                                                                                 more. These goods are not of very
high value. ex :- clothes, furniture, electric goods.
(3) Non-durable or Single-use Consumption Goods: Non-durable or single-use
consumption goods are those goods which are used-up in a
                                                                                                           single act of
consumption. these goods are of relatively low value. ex:- bread, milk, petrol.
(4) Services: Services are those non-material goods which directly satisfy human wants.
ex:- doctor, lawyer.

CAPITAL GOODS
Are fixed assets of the producers. these goods are used in the process of production for
several years and are of high value. Use of these goods leads to depreciation (loss of
value of fixed assets when these are repeatedly used). Example: Plant and machinery.

ALL CAPITAL GOODS ARE PRODUCER GOODS, BUT ALL PRODUCER GOODS AREN'T
CAPITAL GOODS ??
= producer goods are those goods which are used in the production of other goods.
These goods include: (i) goods used as raw material by the
   producers, like wood used to make furniture, and (ii) goods used as fixed assets by the
producers, like plant and machinery.
fixed assets of the producers, goods used as raw material are not durable-use
goods. These are single-use producer goods: these cannot be repeatedly used in
the process of production. Thus, the same wood cannot be repeatedly used to
make furniture.
Fixed assets (or capital goods), on the other hand, are repeatedly used in the
process of production. These are durable-use producer goods.
if the end user of a durable good is household customer, it is durable-use
consumer good. On the other hand, if the end-user of a durable good is a
producer, it is a capital good.

DIFFERENCE BETWEEN CONSUMPTION AND CAPITAL GOODS

Both consumption goods and capital goods have one common characteristic: that are
final goods, and therefore, included in the estimation of national income.
Q. All producer goods are not capital goods. Why?
Ans. Producer good s include: (i) goods used as raw material, like wood used to make
furniture, and (ii) goods used as fixed assets, like plant and machinery. Capital good s
include only fixed assets of the producers . These are durable-use producer goods. On
the other hand, goods used as raw material are single-use producer goods. These are
not repeatedly used in the process of production. Accordingly, all producer goods are
not capital goods.

CONCEPT AND COMPONENTS OF CONSUMPTION EXPENDITURE

Who are the consumers in an economy?
These are broadly classified as: (i) households,
                                                                 (ii) the government
                                                                 (iii) non-profit private institutions (like NGO,
temples, mosques, gurudwaras, and others).
Households buy consumer goods for the satisfaction of their wants
The government buys consumer goods for distribution among defence forces, for
midday meals in the government schools, and such other purposes.
Nonprofit private institutions buy consumer goods for charity.

CONCEPT AND COMPONENTS OF INVESTMENT

Investment refers to increase in the stock of capital.
Change in the stock of capital is called 'capital formation'. Accordingly, investment is
also defined as capital formation.
From the viewpoint of the economy as a whole, investment refers to total production of
capital goods during an accounting year. These goods may be used either for the
replacement of existing capital stock or for adding to the existing capital stock.

FIXED INVESTMENT
Fixed investment refers to increase in the stock of fixed assets (like plant and machinery)
of the producers during an accounting year.
Significance:-
(i) Fixed investment raises production capacity of the producers.
(ii) By raising production capacity of the producers, fixed investment leads to higher
level of output in the economy.
(iii) Higher level of output (because of fixed investment) leads to higher rate of
economic growth, popularly known as GDP growth.

INVENTORY INVESTMENT
At a point of time, producers hold the stock of (i) finished goods (unsold goods), (ii)
semi-finished goods (goods which are in the process of production), and (iii) raw
material. This is called ' inventory stock'. Change in inventory stock during the year is
called inventory investment of the producers.
Significance:-
Inventory investment primarily consists of investment in terms of the stock of (i) raw
material, and (ii) finished goods.
The stock of raw material is significant because:
(i) It ensures uninterrupted supply of inputs to the producers.
(ii) With enough stock of raw material, the producers can avoid day-to-day purchases
from the market. Accordingly, uncertainties of the market        (relating to price and
availability of the raw material) are avoided.
The stock of finished goods is significant because it enables the producers to meet the
potential (future) demand for their product.

Desired inventory stock - refers to planned inventory stock. This is maintained by the
producers to meet the future demand.
Undesired inventory stock - on the other hand, refers to unplanned inventory stock. It
arises because demand for the product turns out to be                                                     
           lower than expected. Unplanned inventory stock leads to losses.

GROSS INVESTMENT, NET INVESTMENT, AND THE CONCEPT OF

DEPRICIATION
Gross investment refers to total production of capital goods during the year.
(i) capital goods used for the replacement of existing capital stock (which is worn-out)
(ii) capital goods used as a net addition to the existing capital stock.

Capital goods used for the replacement of existing capital stock refers to '
depreciation'.
Capital goods used as net addition to the existing capital stock is called 'net
investment'.
*Depreciation is also called replacement investment and consumption of fixed
capital*
Only net investment leads to addition to the stock of capital. Depreciation only
replaces the worn out fixed assets. it helps to maintain the existing stock of
capital.
significance of net investment:-
net investment enhances production capacity, generates opportunities of employment,
promotes efficiency of labour and accelerates GDP growth.

DIFFERENCE BETWEEN GROSS AND NET INVESTMENT

Both gross investment as well as net investment include: ( i ) fixed investment, and ( ii )
inventory investment.

Q. How does higher rate of net capital formation lead to higher level of
productivity/efficiency of labour?
Ans. Higher rate of net capital formation implies greater availability of capital ( in terms
of machines) per unit of labour. Aided by machines, efficiency of labour definitely
increases. This precisely is the reason why labour in developed countries ( like USA) is
more efficient than in less developed countries like India.

CONCEPT OF DEPRICIATION
Depreciation is the loss of value of fixed assets in use on account of:
(i) normal wear and tear
(ii) accidental damages
(iii) expected obsolescence

Depreciation reserve fund refers to that fund which the producers keep for
replacement investment.
significance:-
Depreciation reserve fund is a fund to replace the worn-out fixed assets. It fulfills the
need for replacement investment. Lack of depreciation reserve fund implies the lack of
replacement investment. Accordingly, overall investment (gross investment) in the
economy tends to fall. This leads to a fall in the level of output. The level of income and
employment will also fall. The economy will slip into a state of 'economic slowdown'.

a low level equilibrium trap: a situation when low income causes low demand, and low
demand causes low output; and once again low income.

EXPECTED AND UNEXPECTED OBSOLESCENCE

Expected obsolescence has two components:
(i) Loss of value of fixed assets when these become obsolete/outdated owing to change
in technology. Example: A plant producing black and            white TVs becomes
obsolete when technology is discovered to produce colour TVs.
(ii) Loss of value of fixed assets when these become obsolete/outdated owing to change
in demand. Example: A plant producing rubber shoes            becomes obsolete when
demand shifts from rubber shoes to leather shoes.

Unexpected obsolescence occurs owing to

(i) natural calamities (like earthquake, floods or fire)
(ii) fall in market value of the assets when there is economic recession.

Loss of value of fixed assets owing to unexpected obsolescence is called 'capital loss'.
These losses are not a part of depreciation or depreciation reserve fund.

DIFFERENCE BETWEEN EXPECTED AND UNEXPECTED OBSOLESCENCE

DIFFERENCE BETWEEN CONSUMPTION OF FIXED CAPITAL AND CAPITAL
LOSS

Q. 1. Distinguish between depreciation and depreciation reserve fund.

Ans. Depreciation is the loss of fixed assets in use on account of: (i) normal wear and
tear, (ii) accidental damages, and (iii) expected or foreseen obsolescence. On the other
hand, depreciation reserve fund is a provision of funds to cope with depreciation losses.
These funds are used for the replacement of fixed assets when these are worn-out or
when these become obsolete/outdated.

Q. 2. What is current replacement cost?

Ans. It refers to the estimated value of depreciation for all the producing units in the
economy, during the period of an accounting year.
STOCK AND FLOW
A stock is a quantity measured at a particular point of time. Capital and quantity of
money are notable examples of stock variables.

A flow is a quantity measured over a specified period of time. All these values/quantities
are 'flows ' as these are measured per unit of time period (an hour, a day, a month , a
year, etc . ) . Income , expenditure , production , consumption and interest are notable
examples of flow.

*Exports and imports are taken as flow variables.

Examples:-

DIFFERENCE BETWEEN STOCK AND FLOW

your stock of savings depends upon your flow of deposits into your saving account.
Likewise, your flow of withdrawals depends upon your stock of savings. Thus, there is a
mutual dependence between stocks and flows.
Q. Are the following Stocks or Flows?
(i) Investment, (ii) Monetary Expenditure, (iii) A Hundred Rupee Note, (iv) A Family's
Consumption of Sugar, (v) Services of a Tutor, (vi) Production of Cement, (vii) Machinery
of a Sugar Mill.
Ans. (i) Investment: It is a flow concept because it is related to a period of time.
(ii) Monetary Expenditure: It is a flow concept because it is related to a period of time.
(iii) A Hundred Rupee Note: It is a stock concept because it is a component of supply of
money.
(iv) A Family's Consumption of Sugar: It is a flow concept because consumption relates
to a period of time.
(v) Services of a Tutor: It is a flow concept because it is related to a period of time.
(vi) Production of Cement: It is a flow concept because it is related to a period of time.
(vii) Machinery of a Sugar Mill: It is a stock concept because it relates to a point of time.

FOUR SECTORS OF THE ECONOMY

(1) Household Sector: It includes consumers of goods and services. Households are also
the owners of the factors of production.
{2) Producer Sector: It includes all producing units (firms) in the economy. For the
production of goods and services, the firms hire/purchase               factors of production
(land, labour, capital and entrepreneurial skill) from the households.
{3) Government Sector: It includes: (i) Government as a welfare agency, and (ii)
Government as a producer. Government as a welfare agency                performs such
welfare functions as of law & order and defence.
{4) The External Sector {also called Rest of the World Sector): It includes all such activities
which are related to export and import of goods, and          the flow of capital between
the domestic economy and rest of the world.

INTERSECTORAL FLOWS
Each sector of the economy depends on the other in one way or the other. This is called
intersectoral interdependence.
The household sector depends on the producer sector for the supply of goods and
services, needed for consumption.
 The producer sector depends on the household sector for the supply of factors of
production (also called factor services). These are needed for the production of
goods and services.
The government sector depends on the producer and household sectors for its tax
and non-tax revenue.
Producers and households depend on the government for administrative services,
besides law & order and defence.

REAL FLOW
Real flows refer to the flow of goods and services among different sectors of the
economy.

Flow of factor services from household sector to the producer sector or the flow of
goods and services from the producer sector to the household sector are examples of
real flows.

MONEY FLOW
Money flows refer to the flow of money across different sectors of the economy.

Flow of factor payments by the producer sector to the household sector (on account of
the purchase of factor services) and flow of money from the household sector to the
producer sector (on account of the purchase of goods and services) are examples of
money flows.

Q. Money flows are opposite to real flows. How?

Ans. Money flows are opposite to real flows. Because money flows are in response to
the real flows.
Example: There is a real flow of goods and services from the producers to the
households. It is in
response to it, that the households make payments to the producers. So that, money
flows from
the households to producers in terms of consumption expenditure. Likewise, there is a
real flow of
factor services from the households to the producers. It is in response to it, that the
producers make
payments to the households. So that, money flows from producers to the households in
terms of
factor payments.

CIRCULAR FLOW OF INCOME

Circular flow of income means the circularity of the flows of production, income and
expenditure in any economy.
refers to the unending flow of the activities of production, income generation and
expenditure involving different sectors of the economy, the producers and the
households in particular. Each activity is the cause as well as the consequence of the
other activity. Production in the producing sector generates income for the households
who are owners of the factors of production Expenditure by the households generates
demand for further production. Accordingly, production, income generation and
expenditure keep chasing each other like three dots continuously moving in a circle.
 Production of goods and services causes generation (or distribution) of income.
Income causes expenditure (or disposition).
By generating  demand , expenditure once again causes production .
Consequently, again there is generation of income and disposition (or
expenditure) of income.
The flows of production, income and expenditure form a circularity with no
beginning or an end. which is why it is called circular flow.

PHASE OF PRODUCTION
Production refers to ' value addition'. Phase of production in the circular flow means the
process of value addition by the producing sector.
Example :- When wood worth rs 5, 000 is converted into chairs worth rs 10, 000, there is
value addition worth rs 5, 000 (= rs 10,000 - rs 5,000).

PHASE OF INCOME GENERATION (PHASE OF DISTRIBUTION)

For rendering their factor services to the producers, the households get factor
payments: rent for land, interest for capital, wages/salaries
for labour and profit for entrepreneurship.

PHASE OF DISPOSITION/EXPENDITURE
When households buy the final goods, there is consumption expenditure. When
producers buy the final goods, there is investment expenditure. Thus, in phase-3 , there
is disposition (or expenditure) of income as a consequence of the generation of income
in phase-2.
Consumption expenditure and investment expenditure generate demand for goods and
services in the economy. This again causes production of goods and services, and
consequently the generation of income.

Considering the three phases together, we find that in a two sector economy:
Production (the value of goods and services)
= Income generated
= Expenditure (in terms of C and I)
this is called triple identity.

A closed economy is the one which does not have economic relations with rest of the
world. There are no exports/imports of goods and services.
An open economy is the one which has economic relations with the rest of the world
and also makes import of goods and services.

ASSUMPTIONS:-
(i) There are only two sectors in the economy namely, households and producers.
(ii) The households spend their entire income, so that there are no savings.
(iii) The domestic economy is a closed economy, so that there are no exports and
imports.
(iv) There is no government in the domestic economy.

OBSERVATIONS:-
(i) Factor payments by firms = Value addition by the firms. Thus, value addition is
converted into factor incomes (= rs 10 crore).
(ii) Total production of goods and services by firms = Total expenditure on goods and
services by the household sector. Thus, all income is                    converted into
expenditure on goods and services (= rs 10 crore).
(iii) Value addition = Income generated = Expenditure on goods and services
Hence, the triple identity.

one can observe from the Circular Flow Model that: value added is converted into
income and income is converted into expenditure. It is this conversion process which
keeps the circular flow always in a state of circularity.

SIGNIFICANCE:-
(1 ) Estimation of National 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 also be
defined as the market value of the goods and services flowing from producers to other
sectors of the economy.
(2) Knowledge of lntersectoral Interdependence: A circular flow model helps understand
interdependence among different sectors of the economy. We learn how consumers are
dependent on producers and vice versa.