Chapter 2 – Some Basic Concepts of Macroeconomics

Introduction –

 In an economy through the production process, various types of goods and services are produced.
These goods and services produced are then sold to the consumers who in turn can be individuals or
enterprises.
 Further, the goods purchased by these entities can either be for final consumption or for further
processing i.e., to be used as inputs in the production process of other goods.

Goods can be classified into the following categories depending on their end use –

 Final Goods – Final goods are those goods which have crossed the boundary line of production and
are ready for use by their fin al users.
 The consumers and producers are the final users of final goods.
 Final goods are classified as final consumer goods and final producer goods
 Final consumer goods are finally purchased by the consumers for the satisfaction of their wants.
 Final producer goods are finally purchased by the producers and are generally used as fixed assets in
the process of production.

Note: (i) End-users of the goods can be producers as well as consumers. e.g., a sewing machine when
used by a household is a consumer good but when used by a tailor, is a producer good.
(ii) Durable capital goods purchased by the government for defence services are treated as
intermediate goods.

 Expenditure on final goods by the consumers is called Consumption Expenditure. Expenditure on

final producer goods by the producers is called Investment Expenditure. Accordingly,

Expenditure on Final Goods = Consumption Expenditure + Investment Expenditure

Production Boundary
 Production boundary is an Imaginary line around the production sector which depicts the natre of goods produced
in this sector.
 It is used to distinguish final goods and intermediate goods.
FLOW CHART DEPICTING PRODUCTION BOUNDARY
Farmer produces Mill owner produces Baker produces bread Bread worth
Wheat and sells it to flour and sells it to a and sells it to a `800 is a
a mill owner (`400) baker (`600) consumer (`800) final good

 Intermediate Goods – Intermediate goods are those goods (i) Which have yet not
crossed the boundary line of production, (ii) value is still to be added to these goods (iii)
which are yet not ready for use by their final users.
 In other words, intermediate goods are those goods which are purchased by one firm
from the other firm: (i) as raw material, or (ii) as goods for resale.
 Examples – (i) Shirts purchased by firm X from firm Y for resale are intermediate goods.
(ii) Wood purchased by a carpenter for making chairs is an intermediate
good.

 You may note that only final goods are included in the estimation of national product or national income.
 Value of intermediate goods ultimately becomes a part of the value of final goods.
 Accordingly intermediate goods are not included in the estimation of national product or
national income. Otherwise, there would be duplication in the estimation of national
product, called ‘Double Counting’ (counting the value of a good more than once).
 Expenditure on intermediate goods by the producers during an accounting year is called
Intermediate Consumption or Intermediate Cost.

Same Good May be Final or Intermediate

 The same good may be final or intermediate good. The distinction depends on the End-use of the
goods. If it is used by the producers as 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.
 To illustrate, sugar used as a raw material in the production of biscuits is an intermediate good. But
sugar used by the households in milk or tea is a final good. Likewise paper purchased by a student
is a final good and when purchased by a publisher (for making a book) is an intermediate good.

 Consumption Goods or Consumer Goods are those goods which are directly used for
the satisfaction of human wants. Example: Ice cream and milk as used by the
households.

 Consumption goods are broadly classified into four categories, as under:

 Durable Goods – Durable consumption goods are those goods which can be used for
several years and are of relatively higher value. These goods are repeatedly used
before being discarded as useless. TV, radio, car, scooter, washing machine are some
examples of durable consumption goods.
 Semi Durable 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. Clothes, furniture, crockery, electric goods, etc., are the examples of semi-
durable consumption goods.
 Non-durable 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 a relatively low
value. Bread, Ink, Domestic LPG, milk and petrol are some examples of non-durable
or single-use consumption goods.
 Non-material Goods or Services – Services are those non-material goods which
directly satisfy human wants. A few examples of services are the services of a doctor,
a lawyer, a domestic servant, etc.
 Capital Goods are the fixed assets of the producers. Example: Plant and machinery.
 As fixed assets, capital goods are repeatedly used in the process of production for
several years and are of high value.
 Even nuts and bolts (or nails and screws) are used for several years, but these are not
capital goods. Because these are of low value.
 Also, capital goods involve depreciation. It refers to loss of value of fixed assets (in
use) owing to their normal wear and tear.
 These goods are used by the producers either for (i) the replacement of capital stock,
or for (ii) addition to the capital stock.
Q. All producer goods are not capital goods. Why?
Ans. Producer goods 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 goods
include only fixed assets of the producers. These are durable-use producer goods. On
he 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

 In macroeconomics, consumption expenditure refers to aggregate consumption

expenditure in the economy.
 The consumers of an economy are broadly classified as:
(i) Households: Households buy consumer goods for the satisfaction of their wants.
(ii) The Government: The government buys consumer goods for distribution among
defence forces, for mid-day meals in the government schools, and such other
purposes.
(iii) Non-profit Private Institutions (like NGO, mosques, gurudwaras, and others):
Non-profit private institutions buy consumer goods for charity.

Concept and Components of Investment

 Investment refers to increase in the stock of capital. Thus:

I=∆K
Here, I = Investment
K = Capital Stock
∆ K = Change in capital stock
during the year.

 Change in stock of capital is called capital formation. Accordingly, investment is

also defined as capital formation.
 From the point of view of the economy as a whole, investment refers to total
production of capital goods during an accounting year.

Components of Investment

 Fixed Investment – It refers to increase in stock of fixed assets (like plant and
machinery) of the producers during an accounting year. Example: If at the beginning of
the year 2022, a producer has stock of 8 machines and at the end of the year 2022, he has
a stock of 10 machines, then the stock of his fixed assets increases by 2 machines during
the year 2022.
 Fixed investment is also called fixed capital formation.

Significance of Fixed Investment

 Raising the production capacity of the producers.
 Higher level of output in the economy.
 Higher rate of economic growth, popularly known as GDP growth.
 Enables the producers to meet the potential demand for the product.

 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 raw material. This is called inventory stock. Change in inventory stock
during the year is called inventory investment of the producers.
 Change in inventory stock during the year is called inventory investment of the
producers.
Significance of Inventory Investment
 Inventory investment primarily consists of investment in terms of stock of (i) raw
material, and (ii) finished goods.
 The stock of raw material is significant because:
(i) Uninterrupted supply of inputs to the producers.
(ii) Avoid day-to-day purchases from the market. 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 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 Depreciation

 Gross investment refers to total production of capital goods during the year. This
includes, (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.
 Capital goods used for replacement of existing capital stock refers to depreciation.
 Capital goods used as net addition to the existing capital stock is called ‘net investment.

Significance of Net Investment

 Raises the stock of capital
 Generate opportunities of employment
 Net investment is a net rise in production capacity of the economy, GDP growth is
accelerated.
 It may however be noted that the actual inventory stock at a time may not be the desired
inventory stock. A part of it may be undesired. A producer may have expected to sell
10000 units of umbrella but he could sell only 5000 owing to the lack of demand.
 In such a case 5000 units of umbrella is the undesired inventory stock that leads to losses.
 Desired Inventory Stock - It refers to planned inventory stock. This is maintaiuned by
the producer to meet the future demand.
 Undesired inventory Stock - It refers to the stock arising as a result of the demand for a
product being lower than expected. This type of stock leads to losses.

Concept of Depreciation
 While fixed assets are in use, they go down in value owing to (i) normal wear and tear,
and (ii) accidental damages (beyond their routine repairs and maintenance.
 They go down in value also when they become obsolete or outdated due to change in
demand or change in technology, i.e., expected obsolescence.
 Depreciation is the loss of value of fixed assets in use on account of: (i)
normal wear and tear, (ii) accidental damages, and (iii) expected
obsolescence.
 Depreciation is also called ‘Consumption of Fixed Capital’
Factors Responsible for Depreciation The various factors that cause
depreciation can be broadly grouped into the following two categories.

1. Expected Factors 2. Unexpected Factors

 1. Expected Factors: These are the factors that are generally expected by the business entities. In other
words, every firm expects some depreciation due to these factors. Such factors include:

a. Normal wear and tear- With continuous usage, the machinery is exposed to normal wear and tear.
b. Change in Technology- With the advent of new and advanced technology, the machinery using old
technology becomes obsolete. Thus, the old machinery requires replacement.
c. Change in demand- With the coming up of new and advanced technology, the demand pattern
generally shifts in favour of products using the new technology. Thus, the old product, equipments and
the machinery using the older technology need to be replaced by the new ones.

2. Unexpected Factor: These are the factors that are generally not expected by the business entities.
Such factors include

a. Natural Calamities such as earthquake, flood, etc.

b. Change in the Market Situations such as recession, depression, etc.

Hence, due to the above explained factors some part of the new capital assets/goods goes into the
replacement or repairing of the existing capital stock. This part of the capital that takes account of expected
and unexpected lowering of value of capital is called Deprecation.

Related Concepts of Depreciation

1. Consumption of Fixed Capital - It refers to the lowering of the value of fixed assets while it is in use. It
is inclusive of the expected lowering of capital value. It implies depreciation that occurs on account of
factors such as normal wear and tear, change in technology and change in the demand patterns.

2. Capital Loss - It refers to the lowering of the value of fixed assets while it is not in use. It implies
depreciation that occurs unexpectedly due to factors such as natural calamities, change in market situation,
etc.

3. Current Replacement Cost – It refers to the value of depreciation That is estimated for all the producing
units in the economy during an accounting year

Stock Variables and Flow Variables

A variable is quantity that is likely to change over time. In other words, a variable assumes different values
over different points of time. Various variables used in the study of economics, can be divided into the
following two categories.

1. Stock variables
2. Flow variables

Stock Variables

A variable is said to be a stock variable, if it is measured at a particular point of time. Such variables do not
have an element of time attached with them. In other words, they are measured only at a single point of time.
For example, capital balance as on March 31, 2010.

Flow Variable

A variable is said to be a flow variable, if it is measured over (during) a period of time. Since such variables
are measured over a time interval, it can be said that they have an element of time attached to them.
For example, income earned during the month of March.
A More Familiar Example for Stock and Flow

An example of stock can be the amount or level of water in a tank. At any point of time the amount or the
level of water in a tank can be measured. Similarly, the capital is also a stock variable, as the capital can also
be measured at any point of time.

Now, if water is flowing out of the tank through a tap, then the level of water will change over time. The
difference in the water level over an interval of time say between 9:00 to 9:30 is an example of a flow
variable. Similarly, net investment gives the difference in the investment level over a period of time.

Four Sectors of the Economy

From the macro point of view, economy is often divided into four sectors, viz.,

• Household Sector: It includes consumers of goods and services. Households are also the owners of the
factors of production.

• 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 entrepreneur skill) from
the households.

• 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.

• 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 the rest
of the world.

Intersectoral Interdependence:

• Each sector of the economy depends on the other in one way or the other. This is called Intersectoral
interdependence. Following observations highlight the 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 household and the producer sectors for its tax and non-tax
revenue.
• Producers and households depend on the government for administrative services, besides law and order
and defence .

Intersectoral Flows

• Intersectoral interdependence leads to Intersectoral flows, either in the form of good 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’.
• Real Flows - Real flows refer to the flow of goods and services among different sectors of the economy.
Flow of factor services from the 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 Flows – 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 purchase of factor services)
and flow of money from the household sector to the producer sector (on account of purchase of goods
and services) are examples of money flows.
Diagrammatic Presentation of Real Flows & Money Flows

The figure below shows –

(i) Flow of goods sold by the firms to the households.
(ii) Flow of factor services rendered by the households to the producers.
(iii) Flow of money from the households to the producers for the purchase of goods.
(iv) Flow of money from the producers to the households for the purchase of factor
services.
• Money flow from households to the producers ( for the purchase of goods) is a reciprocal of real flow of
goods from the producers to the households.
• Money flow from the producers to the households (as payments for factor services) is a reciprocal of real
flow of factor services from the households to the producers.

Circular flow of Income

• Circular flow of Income refers to the unending flow of 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 the 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.

Three Phases of Circular Flow

1. Phase of production: It means production of goods and services by the producers sector.
2. Phase of distribution: It corresponds to the flow of income in terms of rent, interest, profit and wages
from producer sector to household sector and
3. Phase of deposition: It refers to the expenditure on the purchase of goods and services by the households
and the other sectors.

Total production of goods and services by firms generates factor income for the household sector(in terms of
rent, interest, profit and wages),all income is ultimately spent on purchase of goods and services by the
household sector and expenditure by
household sector causes further production. 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.
 Circular Flow Model in a Two Sector Economy

Assumptions of the model

The circular flow model as in figure 5, is based on the following 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 areno exports and
imports.
(iv) There is no government in the domestic economy.

• A closed economy is the one which does not have economic relations with the 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. It exports goods
and services to rest of the world and also makes import of goods and services.

•This model offers the following observations:

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

(iv) Briefly, 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 that keeps this circular flow always in a state of circularity.

Significance of Circular Flow Model

The study of Circular flow of Income is important due to the following reasons:
(i) Estimation of National Income: Circular flow model facilitates the estimation of
national income.
 National income is the some total of factor incomes (rent+profit+interest+wages) flowing from the
producers to the households of the country.
 It may even be defined as the market value of the goods and services flow from the producers to trhe
other sectors of the economy.
 Further, it may be defined as the sum total of expenditure on the goods and services produced by the
producer sector.
(ii) Knowledge of Intersectoral Interdependence: A circular flow model helps
understand interdependence among different sectors of the economy. We learn how
consumers are dependent on households and vice versa.
Please note that the circular flow of income is also called circular flow of money