(Introductory Macro Economics) Chapter 3-Money and Banking

SOME BASIC CONCEPTS OF MACROECONOMICS

  • The economic wealth, or well-being, of a country thus does not necessarily depend on the mere possession of resources; the point is how these resources are used in generating a flow of production and how, as a consequence, income and wealth are generated from that process. 
  • from the smallest items like pins or buttons to the largest ones like airplanes, automobiles, giant machinery or any saleable service like that of the doctor, the lawyer or the financial consultant – the goods and services produced are to be sold to the consumers.
  • The consumer may, in turn, be an individual or an enterprise and the good or service purchased by that entity might be for final use or for use in further production. When it is used in further production it often loses its characteristic as that specific good and is transformed through a productive process into another good.
  • An item that is meant for final use and will not pass through any more stages of production or transformations is called a final good.
  • Two types in final goods: Consumption Goods and Capital Goods.

Consumption Goods: 

  • Goods like food and clothing, and services like recreation that are consumed when purchased by their ultimate consumers 
  • Are called consumer goods also.
  • includes services which are consumed but for convenience we may refer to them as consumer goods.

Capital Goods: 

  • goods that are of durable character which are used in the production process.
  • E.g. tools, implements and machines.
  • they make production of other commodities feasible
  • don‟t get transformed in the production process.
  • They are also final goods yet they are not final goods to be ultimately consumed.

Consumer durables: 

  • some commodities like television sets, automobiles or home computers,
  • they are for ultimate consumption, have one characteristic in common with capital goods – also durable
  • are not extinguished by immediate or even short period consumption; 
  • have a relatively long life as compared to articles such as food or even clothing.
  • 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. 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. 
  • Intermediate Goods are not Final Goods.
  • The sum total of the monetary value of these diverse commodities gives us a measure of final output.

Question: Why we measure only final goods not intermediate goods?

Answer: since we are dealing with value of output, we should realize that the value of the final goods already includes the value of the intermediate goods that have entered into their production as inputs. Counting them separately will lead to the error of double counting. Whereas considering intermediate goods may give a fuller description of total economic activity, counting them will highly exaggerate the final value of our economic activity.

  • 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. 
  • Stocks are defined at a particular point of time. 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.
  • Wear and tear of capital is called depreciation. 
  • New addition to capital stock in an economy is measured by net investment or new capital formation, which is expressed as Net Investment = Gross investment – Depreciation. 
  • Depreciation is it is the cost of the good divided by number of years of its useful life.
  • Founding father of modern economics: Adam Smith

CIRCULAR FLOW OF INCOME AND METHODS OF CALCULATING NATIONAL INCOME 

  • four kinds of contributions that can be during the production of goods and services

(a) contribution made by human labour, remuneration for which is called wage

(b) contribution made by capital, remuneration for which is called interest

(c) contribution made by entrepreneurship, remuneration of which is profit

(d) contribution made by fixed natural resources (called „land‟), remuneration for which is called rent. 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.
  • 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.
  • 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.
  • 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.
  • 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 Fig. 2.1: 
  • Circular Flow of Income in a Simple Economy firms, for which they are making the expenditures.
  • In short, the two arrows on the top represent the goods and services market – the arrow above represents the flow of payments for the goods and services, the arrow below represents the flow of goods and services. 
  • The two arrows at the bottom of the diagram similarly represent the factors of production market.
  • The lower most arrow going from the households to the firms symbolizes the services that the households are rendering to the firms. 
  • Using these services the firms are manufacturing the output.
  • 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. 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. 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. At C, measuring the sum total of all factor payments will be called income method.

The Product or Value Added Method

  • In Product or Value Added Method we calculate the aggregate annual value of goods and services produced (if a year is the unit of time).
  • The term that is used to denote the net contribution made by a firm is called its value added.
  • We have seen that the raw materials that a firm buys from another firm which are completely used up in the process of production are called “intermediate goods”.
  • Therefore the value added of a firm is, value of production of the firm – value of intermediate goods used by the firm. 
  • The value added of a firm is distributed among its four factors of production, namely, labour, capital, entrepreneurship and land.
  • Therefore wages, interest, profits and rents paid out by the firm must add up to the value added of the firm
  • Value added is a flow variable.
  • depreciation, is also known as consumption of fixed capital.
  • Since the capital which is used to carry out production undergoes wear and tear, the producer has to undertake replacement investments to keep the value of capital constant.
  • The replacement investment is same as depreciation of capital. 
  • 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.
  • 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).
  • the change of inventories of a firm during a year ≡ production of the firm during the year – sale of the firm during the year.
  • Inventories are treated as capital.
  • Addition to the stock of capital of a firm is known as investment.
  • change in the inventory of a firm is treated as investment.
  • three major categories of investment.
  • 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. 
  • Second category of investment is the fixed business investment, which is defined as the addition to the machinery, factory buildings, and equipment’s employed by the firms.
  • last category of investment is the residential investment, which refers to the addition of housing facilities.
  • 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 de-cumulation of inventories.
  • If we sum the gross value added of all the firms of the economy in a year, we get a measure of the value of aggregate amount of goods and services produced by the economy in a year (just as we had done in the wheat-bread example). Such an estimate is called Gross Domestic Product (GDP). Thus GDP ≡ Sum total of gross value added of all the firms in the economy.

Expenditure Method

  • An alternative way to calculate the GDP is by looking at the demand side of the products known as Expenditure Method.

(a) the final consumption expenditure on the goods and services produced by the firm.

(b) the final investment expenditure, incurred by other firms on the capital goods produced by firm 

(c) the expenditure that the government makes on the final goods and services produced by firm. 

(d) the export revenues that firm i earns by selling its goods and services abroad.  

  • the sum of final expenditures in the economy must be equal to the incomes received by all the factors of production taken together (final expenditure is the spending on final goods, it does not include spending on intermediate goods).
  • follows from the simple idea that the revenues earned by all the firms put together must be distributed among the factors of production as salaries, wages, profits, interest earnings and rents.
  • GNP ≡ GDP + Factor income earned by the domestic factors of production 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 factor income from abroad = Factor income earned by the domestic factors of production 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). 
  • depreciation does not become part of anybody’s income.
  • If we deduct depreciation from GNP the measure of aggregate income that we obtain is called Net National Product (NNP). Thus NNP ≡ GNP – Depreciation.
  • Net National Product at factor cost or National Income. Thus, NNP at factor cost ≡ National Income (NI ) ≡ NNP at market prices – (Indirect taxes – Subsidies) ≡ NNP at market prices – Net indirect taxes (Net indirect taxes ≡ Indirect taxes – Subsidies)
  • 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
  • However, even PI is not the income over which the households have complete say. They have to pay taxes from PI. 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.

National Disposable Income and Private Income

  • Apart from these categories of aggregate macroeconomic variables, in India, a few other aggregate income categories are also used in National Income accounting.
  • National Disposable Income = Net National Product at market prices + Other current transfers from the rest of the world.
  • National Disposable Income is that it gives an idea of what is the maximum amount of goods and services the domestic economy has at its disposal.
  • Current transfers from the rest of the world include items such as gifts, aids, etc.
  • Private Income = Factor income from net domestic product accruing to the private sector + National debt interest + Net factor income from abroad + Current transfers from government + Other net transfers from the rest of the world.
  • Many commodities have two sets of prices.
  • One is the retail price which the consumer actually pays.
  • other is the wholesale price, the price at which goods are traded in bulk.
  • These two may differ in value because of the margin kept by traders.
  • Goods which are traded in bulk (such as raw materials or semi-finished goods) are not purchased by ordinary consumers. Like CPI, the index for wholesale prices is called Wholesale Price Index (WPI).
  • In countries like USA it is referred to as Producer Price Index (PPI). 
  • Notice CPI (and analogously WPI) may differ from GDP deflator because 
  1. The goods purchased by consumers do not represent all the goods which are produced in a country. GDP deflator takes into account all such goods and services.
  2. CPI includes prices of goods consumed by the representative consumer, hence it includes prices of imported goods. GDP deflator does not include prices of imported goods.
  3. The weights are constant in CPI – but they differ according to production level of each good in GDP deflator.

GDP AND WELFARE

  • GDP is the sum total of value of goods and services created within the geographical boundary of a country in a particular year.
  • It gets distributed among the people as incomes (except for retained earnings).
  • So we may be tempted to treat higher level of GDP of a country as an index of greater well-being of the people of that country (to account for price changes, we may take the value of real GDP instead of nominal GDP). But there are at least three reasons why this may not be correct
  • Distribution of GDP – how uniform is it
  • Non-monetary exchanges
  • Externalities: Externalities refer to the benefits (or harms) a firm or an individual causes to another for which they are not paid (or penalized).

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