Some Basic Concepts of

Macroeconomics
Chapter 1
What is Macroeconomics?

 The term Macro in English has its origin in the Greek term Makros which means Large.
 In the context of macroeconomics, 'large' means economy as a whole. Thus,
macroeconomics is defined as that branch of economics which studies economic issues
or economic problems at the level of an economy as a whole.
 It studies such economic questions that concern the welfare of all residents of a country.
These questions are like of employment for the residents, growth of output in the economy,
the problem of price rise (called inflation) or the problem of depression (lack of demand
for goods and services across different sectors of the economy) and so on.
SCOPE OF MACROECONOMICS
 Estimation of National income and Related Aggregates: Macroeconomics deals with the
definition and estimation of national income and its related aggregates like GDP (Gross
Domestic Product) and NDP (Net Domestic Product).
 Theory of Employment: Macroeconomics studies the theories related to employment.
Keynesian theory of employment is of notable significance in this context. It explains the
causes of unemployment, and suggests the possible remedies to combat it.
 Theory of Money: Creation of money (or creation of credit) by the commercial banks is an
important component of macroeconomics. Linked to it, is the role of Central Bank of a
country (RBI in India) in regulating the supply of money in the economy.
 Theory of General Price Level-Inflationary and Deflationary Gaps: Macroeconomics
studies the trend path of the general price level leading to inflationary and deflationary gaps in
the economy.
 Role of the Government (or Government Budget): Macroeconomics studies how
government budget impacts the level of economic activity in the economy.
 Exchange Rate and Balance of Payments: Determination of exchange rate and the role of
export and import in the balance of payments are an important element of the scope of
macroeconomics.
SIGNIFICANCE OF MACROECONOMICS

 Description of the Economy

 Roadmap of Growth and Development
 Economic Stability
 BoP (Balance of Payments) Status
 Problems of Poverty and Environmental Pollution
 Policy Formulation
CLASSIFICATION OF GOODS

Broadly, goods are classified in two ways:

 Final Goods and Intermediate Goods
 Consumption Goods and Capital Goods
 Final Goods are those goods which have crossed the boundary line of production and are
ready for use by their final users.
 Final Goods are of two types – Final consumer goods and Final producer goods
 Expenditure on final consumer goods by the households is called consumption
expenditure. Expenditure on final producer goods by the producers is called investment
expenditure.
CLASSIFICATION OF GOODS
 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 are yet not ready for use by their
final users.
 Intermediate goods are those goods which are purchased by one firm from the other
either for resale or for use as a raw material.
 Value of intermediate goods ultimately becomes a part of the value of final goods.
Example: When a carpenter buys wood worth Rs 10,000 and converts it into chairs worth
Rs 20,000, then the value of chairs (final goods) includes the value of wood (intermediate
good).
 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).
The 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 the good is used by producers as a raw material, it is to be treated as an intermediate
good.
 If is purchased and resold by the producer, it is an intermediate good.
 If it is used as a fixed asset by the producer (example: a tractor used by a farmer), it is a
final good.
 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. But when purchased by a publisher (for making
books), it is an intermediate good.
What Matters is the End-use of Goods

 End-use of the goods is the principal basis of classifying the goods as intermediate goods
and final goods.
 You are to check what end-use a good is put to.
 If it is used by the producers as a raw material, it is to be treated as an intermediate good.
 If it is purchased and resold by the producers, it is to be treated as an intermediate good.
 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 final goods and
intermediate goods
Consumption Goods or Consumer Goods

 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
Types of consumer goods

 Durable Consumption Goods: Durable consumption goods are those goods which can be
used for several years and are of relatively high value. For example, TV, radio, car,
scooter, washing machine etc.
 Semi-durable Consumption Goods: Semi-durable consumption goods are those goods
which can be used for a period of one year or slightly more. Clothes, furniture, crockery,
electric goods, etc.
 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. For example, the
bread that you eat is used-up in a single act of consumption.
 Services: Services are those non-material goods which directly satisfy human wants. A few
examples of services are the services of a doctor, lawyer, domestic servant, etc.
Capital Goods

 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. Example: Plant and machinery.
 These goods are used by the producers either for (i) the replacement of the capital stock, or
for (ii) addition to the capital stock.
 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.
 Capital goods involve depreciation. It refers to loss of value of fixed assets (in use) owing
to their wear and tear.
All Machines are not Capital Goods

 It must be borne in mind that all machines are not capital goods. A sewing machine in a
tailoring shop is a fixed asset of the tailor; it is a capital good. But the same machine with a
consumer household is not a capital good. It is simply a durable use consumer good
 While identifying goods as capital goods, we must make sure about their end-user. If the
end-user of a durable good is a household consumer, 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.
All Capital Goods are Producer Goods, But all
Producer Goods are not Capital Goods
 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 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.
Difference between Consumer goods and
Capital goods
Stock and Flow

 Stocks: Variables whose magnitude is measured at a particular point of time are called
stock variables.
 Flows: Variables whose magnitude is measured over a period of time are called flow
variable.
Concept and component of Investment

 Investment refers to capital formation, or a process that increases the stock of capital.
 Investment has two components: Fixed Investment and Inventory Investment
 Fixed Investment Refers to increase in the stock of fixed assets (like plant and machinery)
of the producers during an accounting year. Fixed investment is also called fixed capital
formation.
 Significance of Fixed Investment :
▪ Fixed investment raises production capacity of the producers
▪ Fixed investment leads to higher level of output in the economy
▪ Higher level of output leads to higher rate of economic growth/GDP growth
component of Investment
 Inventory Investment
At a point of time, producers hold the stock of:
-Finished goods (unsold goods)
- Semi Finished goods
- Raw material
This is called inventory stock. Change in inventory stock during the year is called inventory
investment of producers.
 Significance of Inventory Investment
▪ Ensures uninterrupted supply of inputs to the producers
▪ With enough stock of raw material, the producers can avoid uncertainties of the market.
▪ Enables the producers to meet the potential (future) demand for their product.
Gross Investment, Net Investment and The
Concept of Depreciation
 Gross Investment = Net investment+ Depreciation (expenditure on the replacement of
worn-out fixed assets or replacement investment)
 Net Investment = Gross investment - Depreciation
Concept of Depreciation

 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. Because of depreciation, fixed
assets need to be replaced from time to time.
Depreciation reserve fund

 Depreciation reserve fund refers to that fund which the producers keep 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.
 It might be caught into a low level equilibrium trap: a situation when low income causes
low demand, and low demand causes low output; and once again low income
Purchased for
₹100000

Expected Lifetime is
20 Years

Then annual provision is

100000/20 = ₹5000
Expected and Unexpected Obsolescence
Depreciation and Capital Loss
4 Sectors of the Economy
 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 entrepreneurial skill) from the households.
 Government Sector: It includes: government as a welfare agency, and government as a
producer. Government as a welfare agency performs such welfare functions as of law and
order and defence.
 The External Sector, also called the REST OF THE WORLD Sector: It includes: all
such activities which are related to import and export of goods, and the flow of capital
between the domestic economy and rest of the world.
Circular Flow of Income and its Phases
 Circular Flow of income refers to the
unending flow of the activities of production,
income generation and expenditure involving
different sectors of the economy.
 The three phases of circular flow:
a. Production of goods and services causes
generation (or distribution) of income.
b. Income causes expenditure (or disposition.)
c. By generating demand, expenditure once again
causes production.
 The flows of production, income and
expenditure form a circularity with no
beginning or no end. Which is why it is called
circular flow.
Circular Flow of Income in a two Sector Economy
 A pictorial illustration of the flow of income and product among various sectors of the economy
is called Circular Flow of Income.
 Assumption:
•There are only two sectors in the economy, namely Household and Firm
•Household is the sole consumer and Firm is the sole producer in the economy
•There are no leakages and injections in the economy
 This can be explained by the help of the following diagram
In the upper loop of the diagram
•Households provide factor services like land, labour, capital and enterprise to the firms.
•By using these the firm produce goods and service and provides to the households
In the lower loop of the diagram
•The firms make payment for the factor service to the households in the form of rent, wage, interest
and profits
•Households make payment to the firm in the form of consumption expenditure
Real Flow and Money Flow
 Real flows refer to the flow of goods and  Money flows refer to the flow of money
services among different sectors of the across different sectors of the economy.
economy.