Short Notes: Introduction to Macroeconomics

Macroeconomics

Macroeconomics is derived from Greek Prefix “macr(o)” meaning “large” + economics. It is a branch of economics dealing with the performance, structure, behavior, and decision making of the entire economy. This includes a national, regional, or global economy. Microeconomics and Macroeconomics are two most general fields in Economics.

What is the difference between Microeconomics and Macroeconomics?

Microeconomics is primarily focused on the Individual Agents i.e. Firms and Consumers and how their behaviors determine Price and Quantities in specific markets.

Macroeconomics is a broad field of study. It studies Aggregated Indicators such as GDP, Unemployment Rates, and Price Indices to understand how the whole economy functions. Macroeconomists develop models that explain relationship between factors such as National Income, Output, Consumption, Unemployment, Inflation, Saving, Investment, International Trade and International Finance.

Macroeconomics models and their forecasts are used by both Governments and large corporations to assist in the development and evaluation of economic policy and business strategies.

Fiscal Policy and Monetary Policies are good examples of how economic management is achieved through these government strategies. It is also vital to point out here that to avoid major Economic Shocks, such as Great Depression, Recession, Melt down etc., Government makes adjustments through policy changes, they hope, will stabilize the economy.

Some Basic Concepts

Computation of National Income is important as it reflects the leveled growth & development of any country. But before you introduce children with the concept, meaning and definition of National Income/GDP and other related terms, introduce and explain the basic concepts/terms which will invariably be used in the computation of National Income. These concepts are explained briefly as under:

Final Goods and Intermediate Goods

Final Goods

Final goods are those goods which are ready for use by their final users. Or Final goods are those goods which have crossed the boundary line of production. No value is to be added to these goods by way of further processing or resale. For example, consumption of milk or vegetables by the consumer households. Final goods are further classified as:

(i) Final consumer goods: goods which are finally used by the consumer households. Like, milk, bread, car, washing machine, as used by the consumer households.

(ii) Final producer goods: goods which are finally used by the producers/firms. Like, plant and machinery, building, as used by the firms/producers.

Final consumer goods are purchased or used by the consumers for the satisfaction of their wants. Whereas, final producer goods are purchased or used by the producers for further production.

Intermediate Goods

Intermediate goods are those goods which are not ready for use by their final users. Or Intermediate goods are those goods which are within the boundary line of production. Value is yet to be added to these goods by way of further processing or resale.

Example: Raw material purchased by one firm from the other firm for further production is an intermediate good.

Distinction between Final Goods and Intermediate Goods

The main difference between final goods and intermediate goods lies in the end-use of the good. The same good may be a final good or an intermediate good, depending on its end-use. For example, use of petrol by the consumer household is regarded as a final good. But the petrol used by some travel agency is regarded as an intermediate good.

In brief, the main differences between intermediate goods and final goods are as follow:

Intermediate Goods

Final Goods

1. These are used for the production of other goods and services in the form of raw material. 1. These are not used as raw materials for the production of other goods and services.
2. These may purchased for resale. 2. These are not purchased for resale.
3. These goods are within the production boundary. 3. These goods are out of the production boundary.

 

Consumer Goods and Capital Goods

Consumer or Consumption Goods

Goods used by the consumer household for the satisfaction of their wants are known as consumer goods. These goods directly satisfy the needs of the consumers. These goods are used as final goods by their final users, viz. consumers. Expenditure on these goods by the consumers is called final consumption expenditure.

Consumers goods can be classified as:

(i) Durable consumers goods, which can be repeatedly used for several years and which are of relatively high value. Example:TV, washing machine, car, etc.

(ii) Semi-durable consumers goods, which can be used for a period of nearly one year. Example: clothes, shoes, crockery, etc.

(iii) Non-durable goods , which can be used only once. Example: milk, vegetables, etc.

(iv) Services, which are non-material goods and directly satisfy human wants.

Example: services of a doctor, teacher, lawyer etc.

Capital Goods

Final goods as used by the producers are called capital goods. In other words, final goods are those fixed assets which are repeatedly used by the producers in the production process for several years and which are of relatively high value.

Example: plant and machinery and building.

Investment

Investment or capital formation refers to increase in the existing stock of capital during an accounting year.

Or

Investment refers to the expenditure incurred by the producers on the purchase of capital goods such as machinery, plant and the like.

Or

Investment by a firm implies addition to its production capacity in terms of its additional acquisition of produced means of production during an accounting year.

Investment is of two types:

(i) fixed investment, and

(ii) inventory investment.

Fixed Investment or Fixed Capital Formation

Fixed investment refers to the increase in the existing stock of fixed assets of the producers during the period of an accounting year.

Fixed investment is the acquision of fixed assets or the assets in terms of durable use producer goods.

Fixed investment generally occurs in the form of addition to the stock of capital goods like plant and machinery, building, land improvement, etc. This type of investment adds to production capacity of the producers.

Inventory Investment

Inventory investment is the change in the stock (stock of finished goods, semi-finished goods and raw material) of the producers during an accounting year.

Inventory investment generally occurs in the form of addition to the stock of unsold goods or of raw material or of semi-finished goods. This type of investment is essential to cope with uncertainties of the market.

Gross Investment and Net Investment

Gross Investment

Total expenditure incurred on capital goods during an accounting year is called gross investment. Gross investment includes net investment and depreciation.

Gross investment = Net investment + Depreciation

Net Investment

Net investment is the increase in capital stock during an accounting year. It does not include money spent on the replacement of worn-out capital.

Net investment = Gross investment – Depreciation (expenditure on the replacement of worn-out assets)

The only difference between the two (gross investment and net investment) is that while gross investment includes depreciation of fixed assets during the year, net investment does not. Thus,

Net investment = Gross investment – Depreciation

Net investment implies increase in production capacity of the producers. It is a sign of growth and development.

Depreciation

The value of fixed assets tends to (decrease) due to normal wear and tear, accidental damages and expected obsolescence. This decrease in value of fixed assets (while in use) is called Depreciation.

Consumption of fixed capital or depreciation is the loss in the value of fixed capital due to normal wear and tear, foreseen obsolescence and normal rate of accidental damage.

Expected obsolescence means loss of value of fixed capital assets due to change in technique of production or due to change in demand for goods and services produced. For example, with the introduction of diesel engines, the steam engines of the railways are gradually becoming obsolete. This is called technological obsolescence. Similarly, due to introduction of terylene, the demand for nylon cloth went down rapidly. The machinery which was used to manufacture nylon cloth became obsolete. This type of obsolescence makes machines lose their value. It is a part of depreciation.

If the worn-out capital due to depreciation is not replaced with new fixed capital there will be a fall in production capacity of the enterprises. As such every enterprise allocates funds to cope with depreciation losses. This fund is known is Depreciation Reserve Fund.

Capital Loss

There is another concept related to the loss in the value of fixed capital. It is known as capital loss. The capital loss is the loss of value of fixed capital due to natural calamities like flood, earthquake, fire, theft, or depletion of natural resources, called unforeseen (unexpected) obsolescence. The main difference between capital loss and consumption of fixed capital is that in the case of former there is loss in the value of fixed capital without being used in production while in case of the latter, loss is due to use of the fixed capital in the process of production.

Stock and Flow Variables

A stock variable is measured at a particular point of time. Examples of stock variables are: total deposits with a bank, quantity of money supply, wealth, and water in a reservoir.

A flow variable is measured during a period of time. The variable is mentioned against time dimension as per day, per year, per month, etc.For example, consumption per month, income per year, water in a river.

Circular Flow of Income

The circular flow of income refers to exchange of goods & services and money across different sectors of the economy, i.e., firms, households and the government.

Significance: The study of circular flow of income highlights the relation and interdependence among different sectors of the economy and the way in which each sector contributes to the national output.

This flow of income is circular as well as continuous because the payment of one sector becomes the receipt of the other sector and the production activity (involving payments and receipts) has been continuous since time immemorial.

Circular Flow in a Two Sector Model

Assumptions:

(i) There are only 2 sectors in the economy: households and producers.

(ii) There are no savings by households.

(iii) Firms sell all their goods to the households.

(iv) There are no purchases by the government.

(v) There is no foreign trade.

Real and Money Flows: Two Sector Model of Circular Flow

Real Flow

In a barter economy when money is not there, households render their factor services to the firms and get goods and services in return from the firms. The flow of factor services and goods and services is called real flow.

 

Money Flow

In this model, factor services are rewarded in the form of wages, rent, interest and profit. Accordingly, money flows from firms to the households by way of factor payments. Similarly, households make payments to the firm for the purchase of goods and services. Two sector circular flow model thus operates as under:

Two Sector Model when Savings are introduced

The household saving does not reduce the aggregate spending if it is loaned to the business/firms sector for investment. But if households intend to save more than firms intend to invest, then output will fall, and the circular flow of income will tend to shrink.

Similarly, output increases when intended investment exceeds intended savings. In such a situation circular flow of income tends to expand.

Three Sector Model (Households, Firms and Government)

The government in modern welfare states participates actively in economic activities by levying taxes on households and firms and giving them subsidies. It also runs enterprises and buys goods and services Expenditure by the government adds to the circular flow, which now takes the following form:

Four Sector Model (Households, Firms, Government and Rest of the World)

In modern times all countries of the world have economic relations with the rest of the world, largely through exports and imports. International loans and economic aids (loans and grants) are also quite common. Labour and capital also move across the borders, causing the flow of factor incomes from (and to) the rest of the world.

Net transfer payments received from the rest of the world and net factor income received from the rest of the world make difference to the size of national income or output. Accounting for transactions with rest of the world, the circular flow model takes the following form:

Leakages and Injections in Circular Flow

Leakages are those uses of incomes which cause a contraction in the circular flow. Examples: savings, taxes and imports. Injections on the other hand refer to those autonomous expenditures which cause expansion in the circular flow. Examples:investment spending, government spending and exports.

If injections exceed leakages, the income level starts to rise whereas if leakages exceed injections, income level starts to decline.

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