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Some Basic Concepts of Macroeconomics

  • Final good: Item that is meant for final use and will not pass through any more stages of production or transformations is called a final good. We call this a final good because once it has been sold it passes out of the active economic flow. It will not undergo any further transformation at the hands of any producer. It may, however, undergo transformation by the action of the ultimate purchaser. In fact, many such final goods are transformed during their consumption. Thus, the tea leaves purchased by the consumer are not consumed in that form – they are used to make drinkable tea, which is consumed.
    • It is not in the nature of the good but in the economic nature of its use that a good becomes a final good. For example- cooking at home is not an economic activity, even though the product involved undergoes transformation. Home cooked food is not sold to the market. However, if the same cooking or tea brewing was done in a restaurant where the cooked product would be sold to customers, then the same items, such as tea leaves, would cease to be final goods and would be counted as inputs to which economic value addition can take place. Thus, it is not in the nature of the good but in the economic nature of its use that a good becomes a final good.
  • Consumption Goods: Final Goods like food and clothing, and services like recreation that are consumed when purchased by their ultimate consumers are called consumption goods or consumer goods. (This also includes services which are consumed but for convenience we may refer to them as consumer goods.)
  • Capital Goods: Final goods that are of durable character which are used in the production process. These are tools, implements and machines. While they make production of other commodities feasible, they themselves don’t get transformed in the production process. They are also final goods yet they are not final goods to be ultimately consumed. Unlike the final goods that we have considered above, they are the crucial backbone of any production process, in aiding and enabling the production to take place. These goods form a part of capital, one of the crucial factors of production in which a productive enterprise has invested, and they continue to enable the production process to go on for continuous cycles of production. These are capital goods and they gradually undergo wear and tear, and thus are repaired or gradually replaced over time.
  • Consumer Durables: Some commodities like television sets, automobiles or home computers, although they are for ultimate consumption, have one characteristic in common with capital goods – they are also durable. That is, they are not extinguished by immediate or even short period consumption; they have a relatively long life as compared to articles such as food or even clothing. They also undergo wear and tear with gradual use and often need repairs and replacements of parts, i.e., like machines they also need to be preserved, maintained and renewed. That is why we call these goods consumer durables.
  • Intermediate Goods: Of the total production taking place in the economy a large number of products don’t end up in final consumption and are not capital goods either. Such goods may be used by other producers as material inputs. Examples are steel sheets used for making automobiles and copper used for making utensils. These are intermediate goods, mostly used as raw material or inputs for production of other commodities. These are not final goods.
  • Flows: (Flows are defined over a period of time) Income, or output, or profits are concepts that make sense only when a time period is specified. These are called flows because they occur in a period of time. Therefore, we need to delineate a time period to get a quantitative measure of these. Since a lot of accounting is done annually in an economy, many of these are expressed annually like annual profits or production.
  • Stocks: (Stocks are defined at a particular point of time) Capital goods or consumer durables once produced do not wear out or get consumed in a delineated time period. In fact, capital goods continue to serve us through different cycles of production. The buildings or machines in a factory are there irrespective of the specific time period. There can be addition to, or deduction from, these if a new machine is added or a machine falls in disuse and is not replaced. These are called stocks. Stocks are defined at a particular point of time. However, we can measure a change in stock over a specific period of time like how many machines were added this year. Such changes in stocks are thus flows, which can be measured over specific time periods.
    • A particular machine can be part of the capital stock for many years (unless it wears out); but that machine can be part of the flow of new machines added to the capital stock only for a single year.
  • Example of Stock and Flow: Suppose a tank is being filled with water coming from a tap. The amount of water which is flowing into the tank from the tap per minute is a flow. But how much water there is in the tank at a particular point of time is a stock concept.
  • Gross Investment: A part of our final output that comprises of capital goods constitutes gross investment of an economy.
  • Depreciation: Depreciation is an annual allowance for wear and tear of a capital good.  In other words, it is the cost of the good divided by number of years of its useful life. Depreciation does not take into account unexpected or sudden destruction or disuse of capital as can happen with accidents, natural calamities or other such extraneous circumstances. Depreciation is also known as consumption of fixed capital.

Circular Flow of Income

There may be four kinds of contributions that can be made during the production of goods and services: 

  • Contribution made by human labour, remuneration for which is called wage
  • Contribution made by capital, remuneration for which is called interest
  • Contribution made by entrepreneurship, remuneration of which is profit
  • Contribution made by fixed natural resources (called ‘land’), remuneration for which is called rent.

In our model, simplified economy, there is only one way in which the households may dispose of their earnings – by spending their entire income on the goods and services produced by the domestic firms. The other channels of disposing their income are closed: we have assumed that the households do not save, they do not pay taxes to the government – since there is no government, and neither do they buy imported goods since there is no external trade in this simple economy. In other words, factors of production use their remunerations to buy the goods and services which they assisted in producing. The aggregate

Consumption by the households of the economy is equal to the aggregate expenditure on goods and services produced by the firms in the economy. The entire income of the economy, therefore, comes back to the producers in the form of sales revenue. There is no leakage from the system – there is no difference between the amount that the firms had distributed in the form of factor payments (which is the sum total of remunerations earned by the four factors of production) and the aggregate consumption expenditure that they receive as sales revenue.

In the next period the firms will once again produce goods and services and pay remunerations to the factors of production. These remunerations will once again be used to buy the goods and services. Hence year after year we can imagine the aggregate income of the economy going through the two sectors, firms and households, in a circular way.

When the income is being spent on the goods and services produced by the firms, it takes the form of aggregate expenditure received by the firms. Since the value of expenditure must be equal to the value of goods and services, we can equivalently measure the aggregate income by calculating the aggregate value of goods and services produced by the firms. When the aggregate revenue received by the firms is paid out to the factors of production it takes the form of aggregate income.

Methods of Calculating National Income

The uppermost arrow, going from the households to the firms, represents the spending the households undertake to buy goods and services produced by the firms. The second arrow going from the firms to the households is the counterpart of the arrow above. It stands for the goods and services which are flowing from the firms to the households. In other words, this flow is what the households are getting from the firms, for which they are making the expenditures.

In short, the two arrows on the top represent the goods and services market

  1. The arrow above represents the flow of payments for the goods and services,
  2. The arrow below represents the flow of goods and services.

Similarly, the two arrows at the bottom of the diagram similarly represent the factors of production market.

  1. The lower most arrows going from the households to the firms symbolize the services that the households are rendering to the firms. Using these services, the firms are manufacturing the output.
  2. The arrow above this, going from the firms to the households, represents the payments made by the firms to the households for the services provided by the latter.

Since the same amount of money, representing the aggregate value of goods and services is moving in a circular way, if we want to estimate the aggregate value of goods and services produced during a year we can measure the annual value of the flows at any of the dotted lines indicated in the diagram.

  1. We can measure the uppermost flow (at point A) by measuring the aggregate value of spending that the firms receive for the final goods and services which they produce. This method will be called the expenditure method.
  2. If we measure the flow at B by measuring the aggregate value of final goods and services produced by all the firms, it will be called product method.
  3. At C, measuring the sum total of all factor payments will be called income method.

In conclusion, there are three methods to calculate National Income:

  1. Income Method
  2. Expenditure Method
  3. Product Method

Note- These three ways of Calculating National Income were proposed by Simon Kuznets.

Calculation of Gross Domestic Product

Let us suppose that there are only two kinds of producers in the economy the wheat producers (or the farmers) and the bread makers (the bakers). The wheat producers grow wheat and they do not need any input other than human labour. They sell a part of the wheat to the bakers. The bakers do not need any other raw materials besides wheat to produce bread. Let us suppose that in a year the total value of wheat that the farmers have produced is Rs 100. Out of this they have sold Rs 50 worth of wheat to the bakers. The bakers have used this amount of wheat completely during the year and have produced Rs 200 worth of bread.

Now, the farmers had produced Rs 100 worth of wheat for which it did not need assistance of any inputs. Therefore, the entire Rs 100 is rightfully the contribution of the farmers. But the same is not true for the bakers. The bakers had to buy Rs 50 worth of wheat to produce their bread. The Rs 200 worth of bread that they have produced is not entirely their own contribution. To calculate the net contribution of the bakers, we need to subtract the value of the wheat that they have bought from the farmers. If we do not do this, we shall commit the mistake of ‘double counting’. This is because Rs 50 worth of wheat will be counted twice. First it will be counted as part of the output produced by the farmers. Second time, it will be counted as the imputed value of wheat in the bread produced by the bakers.

Therefore, the net contribution made by the bakers is, Rs 200 – Rs 50 = Rs 150. Hence, aggregate value of goods produced by this simple economy is Rs 100 (net contribution by the farmers) + Rs 150 (net contribution by the bakers) = Rs 250.

The term that is used to denote the net contribution made by a firm is called its value added.

Therefore, the value added of a firm is:

 Value of production of the firm – Value of intermediate goods used by the firm.

If we include depreciation in value added then the measure of value added that we obtain is called Gross Value Added.

If we deduct the value of depreciation from gross value added we obtain Net Value Added.

Unlike gross value added, net value added does not include wear and tear that capital has undergone. For example, let us say a firm produces Rs 100 worth of goods per year, Rs 20 is the value of intermediate goods used by it during the year and Rs 10 is the value of capital consumption. The gross value added of the firm will be, Rs 100 – Rs 20 = Rs 80 per year. The net value added will be, Rs 100 – Rs 20 – Rs 10 = Rs 70 per year.

Inventory: In economics, the stock of unsold finished goods, or semi-finished goods, or raw materials which a firm carries from one year to the next is called inventory. Inventory is a stock variable. It may have a value at the beginning of the year; it may have a higher value at the end of the year. In such a case inventories have increased (or accumulated). If the value of inventories is less at the end of the year compared to the beginning of the year, inventories have decreased (decumulated). We can therefore infer that the-

Change of inventories of a firm during a year º production of the firm during the year – sale of the firm during the year.

Observe that since production of the firm º value added + intermediate goods used by the firm, we get, change of inventories of a firm during a year ≡ value added + intermediate goods used by the firm – sale of the firm during a year. Change in inventories takes place over a period of time. Therefore, it is a flow variable. Change in inventories may be planned or unplanned. In case of an unexpected fall in sales, the firm will have unsold stock of goods which it had not anticipated. Hence there will be unplanned accumulation of inventories. In the opposite case where there is unexpected rise in the sales there will be unplanned dissimulation of inventories.

Investment: Inventories are treated as capital. Addition to the stock of capital of a firm is known as investment. Therefore, change in the inventory of a firm is treated as investment.

There can be three major categories of investment-

  1. First is the rise in the value of inventories of a firm over a year which is treated as
    investment expenditure undertaken by the firm;
  2. The second category of investment is the fixed business investment, which is defined as the addition to the machinery, factory buildings, and equipment employed by the firms.
  3. The last category of investment is the residential investment, which refers to
    the addition of housing facilities.

In conclusion, we may say that the monetary value of all final goods and services produced in a country in a year is called Gross Domestic Product or GDP. In expenditure method it is calculated as follows

GDP= C+I+G+X

Where, C= Final Consumption, I= Investment, G= Government expenditure on the final goods and services and X= The export revenue that earns by selling goods and services abroad.

Calculating National Income

Gross National Product: Gross Domestic Product measures the aggregate production of final goods and services taking place within the domestic economy during a year. But it left the account of earning made by Indian citizens leaving abroad or by the factor of production owned by Indian. In the same way we must have to exclude the factor income earned by foreigners working within the domestic economy. For this we required another macroeconomic variable that s Gross National Product (GNP).

GNP = GDP + Factor Income earned by the domestic factor employed in the rest of the world – factor Income earned by the factors of production of the rest of the world employed in the domestic economy.

Hence,

GNP = GDP + Net Factor Income from Abroad

Net National Product: If we deduct depreciation from the GNP then we get Net National Product (NNP)

NNP = GNP + Depreciation

Factor Cost (FC): It refers to costs of factors of production viz. rent of land, interest of capital, wages of employees and profit for entrepreneurship.

Market Price (MP): It is the price the customer actually pays. It includes the components of indirect taxes and of subsidies. 

We may formulize-

FC = MP- Indirect Taxes + Subsidies

MP = FC +Indirect taxes – subsidies OR MP = FC + Net Indirect Tax

Now Back to National Income-

It is to be noted that GDP, GNP, NNP, etc are evaluated at market prices. Through the expression given above, we get the value of NNP evaluated at market prices. But market price includes indirect taxes. When indirect taxes are imposed on goods and services, their prices go up. Indirect taxes accrue to the government. We have to deduct them from NNP evaluated at market prices in order to calculate that part of NNP which actually accrues to the factors of production. Similarly, there may be subsidies granted by the government on the prices of some commodities (in India petrol is heavily taxed by the government, whereas cooking gas is subsidized). So we need to add subsidies to the NNP evaluated at market prices. The measure that we obtain by doing so is called Net National Product at factor cost or National Income.

National Income = Net National Product at Factor Cost

National Income= NNP at market prices- (Indirect taxes- subsidies)

National Income= NNP at market prices- net indirect taxes

Net Indirect Taxes= Indirect taxes – subsidies

Note- Net factor income from abroad is zero then GDP=GNP

Calculating Personal Income

The part of NI which is received by households is called Personal Income (PI). To calculate- First, let us note that out of NI, which is earned by the firms and government enterprises, a part of profit is not distributed among the factors of production. This is called Undistributed Profits (UP). We have to deduct UP from NI to arrive at PI, since UP does not accrue to the households. Similarly, Corporate Tax, which is imposed on the earnings made by the firms, will also have to be deducted from the NI, since it does not accrue to the households. On the other hand, the households do receive interest payments from private firms or the government on past loans advanced by them. And households may have to pay interests to the firms and the government as well, in case they had borrowed money from either. So, we have to deduct the net interests paid by the households to the firms and government. The households receive transfer payments from government and firms (pensions, scholarship, prizes, for example) which have to be added to calculate the Personal Income of the households.

Thus,

Personal income (PI) = NI – Undistributed profits – Net interest payments made by households – Corporate tax + Transfer payments to the households from the government and firms.

Personal Disposable Income: PI is not the income over which the households have complete say. They have to pay taxes from PI. Personal Disposable Income is the part of the aggregate income which belongs to the households. They may decide to consume a part of it, and save the rest.

If we deduct the Personal Tax Payments (income tax, for example) and Non-tax Payments (such as fines) from PI, we obtain what is known as the Personal Disposable Income.

Thus,
Personal Disposable Income (PDI) = PI – Personal tax payments – Non-tax payments.

Diagrammatic representation of the subcategories of aggregate Income

NFIA: Net Factor Income from Abroad, D: Depreciation, ID: Indirect Taxes, Sub: Subsidies, UP: Undistributed Profits, NIH: Net Interest Payments by Households, CT: Corporate Taxes, TrH: Transfers received by Households, PTP: Personal Tax Payments, NP: Non-Tax Payments.

Problems in Calculating National Income

The Problems are:

  1. Exclusion of Real Transactions
  2. The Value of Leisure
  3. Cost of Environmental Damage
  4. The Underground Economy
  5. Transfer Payments and Capital Gains
  6. Valuation of Inventories
  7. Self-Consumption
  8. Lack of Official Records
  9. Imputed Income
  10. Valuation of Government Service.

National Income Estimation in India

  • In 1868, the first attempt was made by Dadabhai Naoroji to estimate the National Income of India. He in his book “Poverty and Un-British Rule in India”, estimated Indian Per Capita annual Income at a level of Rs 20.
  • Soon after independence, the Government of India appointed the National Income Committee in Aug 1949 under the chairmanship of Prof PC Mahalanobis to compile authoritative estimates of National Income. The committee submitted its report in 1951 and the final report in 1954. According to this report, the total National Income of the country was estimated at a level of Rs 8,650 crore and per capita Income at a level of Rs 246.90.  The final report appeared in 1954 gave estimates of national income during the period 1950-1954.  For further estimation of National Income, the Government established Central Statistical Organization (CSO) in 1951, which now regularly publishes national income data.
  • As National Income is calculated in terms of money value, it could undergo changes from year to year as the price can increase or decrease. Thus, for purpose of comparison, National Income is calculated also at constant price with a base year. The base year adopted in India now is 2011-12 and current prices are converted to the base year prices (the base year is changed every five years).
  • The New System of National Accounts, which came into effect from January 2015, follows the international practice (UN system of National Accounts) of using Gross Value Added (GVA) at base prices. This has resulted in some overstatement of GDP growth in 2014-15.
  • The Central Statistical Organization under the Ministry of Statistics and Programme implementation, Government of India, is responsible for estimating National Income.

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