Basic Concepts of Macroeconomics

What is Economics?

Economics is the Social Science that analyzes the production, distribution and consumption of goods and services. Broadly, Economics is a social science that studies human activities aimed at satisfying needs and wants. It encompasses production, distribution, trade and consumption of goods and services.

Economics is usually divided into two main branches:

• Microeconomics – which examines the economic behavior of individual actors such as consumer, business, households etc. to understand how decisions are made in the face of scarcity and what effects they have on larger economy.
• Macroeconomics – which studies the economy and its features like National Income, Employment, Poverty, Balance of Payments and Inflation.

What is Macroeconomics?

• Macroeconomics is a branch of economics which studies the economy as a whole. It deals with the performance, structure and behavior of economy at national or regional level.
• It studies about aggregated indicators such as GDP, Unemployment Rates and Price Indices to understand how the whole economy functions.
• It develops models that explain the relationship between such factors as National Income, Output, Consumption, Unemployment, Inflation, Savings, Investment, International Trade and International Finance.

Vital Process of an Economy

By Vital Process we mean process without which an economy cannot exist. There are three vital process of an economy:
1. Production
2. Consumption
3. Investment

A. Production
• In economy the word production includes not only the making of various goods but also the services. For all of us services are also as essential as the goods. In fact, some of the goods cannot be used unless the services are not provided such as Television or Radio cannot be used unless the services of artists or technicians are provided. Thus production includes the goods made and the services provided in an economy.
• There are some services which are provided by family members to themselves or to one another like cooking and washing clothes, cleaning the house, ironing clothes, polishing shoes and so on.
• Such services are also a part of production but when it comes to measurement of the value of these services, problems arise about getting the required data of the quantity and value of these services. As such, in practical estimates, these services are left out of production.
• Similarly, all leisure time, activities such as growing fruits, flowers and vegetables in garden are also excluded from production for the same reason.

B. Consumption
• It is defined as an activity concerned with using up of goods and services for direct satisfaction of wants. In other words, consumption is an act of satisfying one’s wants.
• Consumption also includes consumption of both goods and services. For Example: we consume food, clothes, furniture etc. We use services of tailors, barbers, washerman, repairers, tutors ect.
• Consumption activity takes place as soon as we buy these goods and services. In other words, by consumption we mean acquiring of goods and services for consumption.
• All purchases by households, with an exception of purchase of a house, are consumption purchases.

C. Investment
• Whatever is produced during a year is not generally acquired for consumption in that year and is kept for future use in order to acquire more monetary amount or benefits.
• Goods lying with production units as raw materials in the process of production to satisfy the demands are also investment which will bear the result in future.
• Investment in fixed capitals by production units like machines, equipments, vehicles, buildings etc. during the year which are also known as durable use goods. Such components are meant to production of goods which may or may not be used in the same year and are kept for future use are also known as investment.
• During a particular year the goods are exceeding the production because of investment in various levels.

Production, consumption and investment processes are interrelated in the following manner
• First, production is the source of consumption and investment. If there is no production there would be no consumption and investment. Given production, if there is more consumption less would be available for investment.
• Second, consumption provides motivation for production and investment. If there is no need for consumption, there is no need to invest and produce.
• Third, investment determines the level of production. The more we invest, the more we can produce.
• Fourth, saving is the major source of financing investment. More saving means more investment which in turn means more production leading to more consumption and investment.

There are two components responsible for the excess of goods (during a particular year)
1. Stock Investment: Addition to the stock of raw material, semi-finished goods and finished goods during a year is called stock investment or inventory investment. Such a stock at the beginning of the year is called opening stock and at the end of the year is known as closing stock.
– The excess of closing stock over the opening stock is called inventory investment.
– However, it is possible that during a particular year the production may be less than consumption. It implies that the closing stock is less than the opening stock. This is called negative investment or disinvestment.

2. Fixed Investment: Acquiring up of durable use producer goods by production units is called fixed investment such as adding new machines and equipments etc.
– Total investment equals the sum of inventory investment and fixed investment. The alternative name of investment is capital formation.

Consumption Expenditure and Saving
Wages, salaries, rents, interests and profits earned by an individual has two alternatives: Consumption Expenditure and Saving.

1. Consumption Expenditure: It’s a part of the income is spent on acquiring goods and services for satisfaction of wants.

2. Saving: The unspent part of income is called saving. Thus saving equals excess of income over expenditure. The saving is in the form of money.

3. Saving = Income – Consumption Expenditure

4. Why do people do save?
a. For emergency expenses on illness, old age or any other unexpected expenditure.
b. The main motive is to earn interest income by lending these savings. It gives them an additional source of income in future years.
c. Savings play an important role in production process. In fact saving is a major source of financing investment. Higher the savings more the possibility of investment. Investment means acquiring goods and services for production. Savings are used to acquire investment goods. So, saving is the foundation of investment.

Other Basic Terminologies
A. Final Goods
• The commodity produced by an enterprise is being sold out to the consumers. In the process the commodity goes under various transformations through productive processes into other goods before being sold to the consumers for Final Use. Such an item that is meant for final use and will not pass through any more stages of production or transformation is called a Final Good.
• Why Final Good? Once sold to the consumer, it passes out of the active economic flow and will not undergo further transformation by the action of the ultimate purchaser. 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.
• For example: A car sold to a Consumer is a final good; the components such as tyres sold to the car manufacturer are not; they are intermediate goods used to make the final goods. The same tyres, if sold to a consumer, would be final goods.

Final goods are divided into two parts: Consumption Goods and Capital Goods
a) Consumption Goods
• Tangible goods that are produced and subsequently purchased for direct consumption to satisfy the current human needs or wants.
• Example: Food, Clothing, Cigarettes, Pen, TV Set, and Radio etc.
• Similarly, services rendered to consumers by hotels, retailers, barbers etc. are Consumer Services as they satisfy the immediate needs of the consumers.
• Consumer Goods are divided into two categories: Durable Goods and Non-Durable Goods
• Durable Goods: This can be used in consumption again and again over a considerable period of time. e.g., chair, car, fridge, shoes, TV set etc.
• Non-Durable Goods: are like single use goods which are used up by consumers in a single act of consumption, e.g., milk, fruits, matches, cigarettes, coal, etc.

b) Capital Goods
• Capital goods are fixed assets of producers which are repeatedly used in production of other goods and services. Alternatively durable goods which are bought for producing other goods but not for meeting immediate needs of the consumer are called capital goods.
• These goods are of durable character.
• For Example: tools, implements, machinery, plants, tractors, buildings, transformers, etc.
• Capital Goods are used for generating income by production units. While they make production of other goods possible, they themselves do not get transformed (or merged) in the production process. Capital Goods undergo wear and tear and need repairs or replacement over time.
• Capital Goods are the backbone of production processes as they aid and enable production to go on continuously.
• Capital goods are purchased by the business enterprises either for maintenance or addition to their capital stock so as to maintain or expand the flow of their production.

B. Intermediate Goods
• Goods that are used by a business in the production of other goods or services. It is also referred to as producer goods. Intermediate Goods are used to make Consumer Goods.
• For Example: Timber and steel rods are intermediate products because they are sold by the timber merchant or the steel dealer to the builder who uses them to produce the final product – a house or a building.

C. Depreciation
• Almost everything we see around us has a useful life because it is being used up little by little every day or will become outdated as technology changes. This ‘using up’ is called depreciation.
• In other words, ‘The monetary value of an asset decreases over the time due to use, wear and tear or obsolescence. This decrease is measured as Depreciation.’
• When the value of asset(s) erodes completely the capital asset has to be either replaced or repaired. Expenses incurred for replacing and repairing are called depreciation expenditure.
• Therefore, Gross Investment = Net Investment + Depreciation
• Net Investment will increase the production capacity and output of a nation, but not by depreciation expenditure. So we have, NNP = GNP – Depreciation.
• The governments of the economies decide and announce the rates by which assets depreciate and a list is published, which is used by the different sections of the economy to determine the real levels of depreciations in different assets.