We now turn to the derivation of aggregate demand under fixed price of final goods and constant rate of interest in the economy. In order to hold price constant at any particular level, however, one must assume that the suppliers are willing to supply whatever amount consumers will demand at that price. If quantity supplied is either in excess of or falls short of quantity demanded at this price, price will change because of excess supply or demand. To avoid this problem, we assume that the elasticity of supply is infinite – i.e., supply schedule is horizontal – at the fixed price. Under such circumstances, equilibrium output will be solely determined by the aggregate amount of demand at this price in the economy. We call it effective demand principle. Note also the word short run. We assume that prices in the economy take some time to respond to the forces of excess supply or demand. In the mean time, producers try to update their production plans in order to avoid excess supply or demand. For instance, if they face an excess supply in the current production cycle they will plan to produce less in the next cycle so as to avoid accumulation of stocks in their warehouses. Note also that an individual producer is very small compared to the size of the national market and, therefore, she cannot affect market price on her own. An individual producer has to accept the price that prevails in the market. The aggregate price level in the economy changes only when adjustments in all markets of the economy fail to eliminate the excess demand or supply. Prices are, therefore, assumed to vary only in the long run.

A Point on the Aggregate Demand Curve

At a fixed price, the value of ex ante aggregate demand for final goods, AD, is equal to the sum total of ex ante consumption expenditure and ex ante investment expenditure. Under the effective demand principle, the equilibrium output of the final goods is equal to ex ante aggregate demand, as represented by equation 4.3

Y = A + c.Y

where A is the total value of autonomous expenditure in the economy. Let us consider a numerical example to derive the value of the aggregate demand and hence equilibrium output in the economy at a fixed price. Suppose the values of the autonomous expenditures are C = 40, I = 10 and the value of mpc, c = 0.8. What will be the equilibrium value of Y ? Consider Y = 200, as a trial solution. At this output, the value of the ex ante consumption expenditure is C = C + 0.8.Y = 40 + (0.8)200 = 200, ex ante investment expenditure is I = I = 10 and ex ante aggregate demand is AD = C + I = 200 + 10 = 210. At the level of output Y = 200 the value of ex ante aggregate demand is 210, which denotes a situation of excess demand. Clearly, Y = 200 is not the equilibrium level of output in the economy. Consider, next, the output level Y = 300. Calculations similar to the above case shows that the value of ex ante aggregate demand will be

A + cY = C + I + cY = 50 + (0.8)300 = 290.

The ex ante aggregate demand falls short of the output and there is excess supply. Hence, Y = 300 is also not the equilibrium level of output in the economy. Finally, consider Y = 250. At this output, AD = 50 + (0.8)250 = 250. We have ultimately hit the correct value of Y, at which aggregate demand equals aggregate supply. Y = 250 is, therefore, the equilibrium output of the economy at the fixed price-interest rate combination.

Effects of an Autonomous Change on Equilibrium Demand in the Product Market

What are the determinants of the equilibrium value of aggregate demand at fixed price? In other words, what governs whether the equilibrium aggregate demand would be 250 or 210 or 290 in the above example? The equilibrium output and aggregate demand at the fixed price-interest rate is derived by solving the equation Y = AD = A + cY . It is an equation involving only one variable, Y . The solution of the equation is

Y = 1– A c (4.4)

The value of Y will, therefore, depend on the values of the parameters on the right hand side, which are A and c in this case. In the above example, the equilibrium value of aggregate demand, 250, and hence the position of the single point on the aggregate demand schedule that we have derived so far, will depend on the values of these parameters. Compare the equation AD = A + cY with the equation of a straight line of the standard form: b = å + ma, as discussed in section 4.2. A is the intercept parameter and c is the slope parameter of this equation. When c increases, the straight line representing the equation of aggregate demand will swing upwards. On the other hand, as A increases, the straight line will shift in parallel upwards. However, A is only a composite term, representing the sum of C and I , which are, therefore, the truly shifted parameters of the AD line. Suppose I increases from 10 to 20. What will happen to equilibrium output and aggregate demand?
The Multiplier Mechanism

Clearly, 250 is no longer the equilibrium value of output or aggregate demand. With I = 20, aggregate demand in the economy will be equal to 40 + 20 + (0.8) 250 = 260 from equation (4.4), which is greater than the output Y = 250 by the amount of the increment in the autonomous investment (Ä I = 10). There is excess demand in the economy and producers will have to run down their inventory to meet this extra demand. Thus, in the next production cycle, they revise their production plan upwards, i.e. increase the value of their planned supply of output by 10 to restore equilibrium in the final goods market. In the absence of a government imposing indirect taxes or disbursing subsidies, the value of the total output of final goods or GDP is equal to National Income. The production of final goods employs factors such as labour, capital, land and entrepreneurship. In the absence of indirect taxes or subsidies, the total value of the final goods output is disbursed among different factors of production – wages to labour, interest to capital, rent to land etc. Whatever is left over is appropriated by the entrepreneur and is called profit. Thus the sum total of aggregate factor payments in the economy, National Income, is equal to the aggregate value of the output of final goods, GDP. In the above example the value of the extra output, 10, is distributed among various factors as factor payments and hence the income of the economy goes up by 10. When income increases by 10, consumption expenditure goes up by (0.8)10, since people spend 0.8 (= mpc) fraction of their additional income on consumption. Hence, in the next round, aggregate demand in the economy goes up by (0.8)10 and there again emerges an excess demand equal to (0.8)10. Therefore, in the next production cycle, producers increase their planned output further by (0.8)10 to restore equilibrium. When this extra output is distributed among factors, the income of the economy goes up by (0.8)10 and consumption demand increases further by (0.8)210, once again creating excess demand of the same amount. This process goes on, round after round, with producers increasing their output to clear the excess demand in each round and consumers spending a part of their additional income from this extra production on consumption items – thereby creating further excess demand in the next round.

We shall conclude the fixed price-interest rate analysis of the final goods market with an interesting counter-intuitive fact – or a ‘paradox’. If all the people of the economy increase the proportion of income they save (i.e. if the mps of the economy increases) the total value of savings in the economy will not increase – it will either decline or remain unchanged. This result is known as the Paradox of Thrift – which states that as people become more thrifty they end up saving less or same as before. This result, though sounds apparently impossible, is actually a simple application of the model we have learnt. Let us continue with the example. Suppose at the initial equilibrium of Y = 250, there is an exogenous or autonomous shift in peoples’ expenditure pattern – they suddenly become more thrifty. This may happen due to a new information regarding an imminent war or some other impending disaster, which makes people more circumspect and conservative about their expenditures. Hence the mps of the economy increases, or, alternatively, the mpc decreases from 0.8 to 0.5. In aggregate demand, AD = A + cY , by an amount equal to (0.8 – 0.5) 250 = 75. This can be regarded as an autonomous reduction in consumption expenditure, to the extent that the change in mpc is occurring from some exogenous cause and is not a consequence of changes in the variables of the model. But as aggregate demand decreases by 75, it falls short of the output Y * 1 = 250 and there emerges an excess supply equal to 75 in the economy. Stocks are piling up in warehouses and producers decide to cut the value of production by 75 in the next round to restore equilibrium in the market. But that would mean a reduction in factor payments in the next round and hence a reduction in income by 75. As income decreases people reduce consumption proportionately but, this time, according to the new value of mpc which is 0.5. Consumption expenditure, and hence aggregate demand, decreases by (0.5)75, which creates again an excess supply in the market. In the next round, therefore, producers reduce output further by (0.5)75. Income of the people decreases accordingly and consumption expenditure and aggregate demand goes down again by (0.5)2 75. The process goes on. However, as can be inferred from the dwindling values of the successive round effects, the process is convergent. What is the total decrease in the value of output and aggregate demand?

Income Determination

We have so far discussed about the national income, price level, rate of interest etc. in an ad hoc manner – without investigating the forces that govern their values. The basic objective of macroeconomics is to develop theoretical tools, called models, capable of describing the processes which determine the values of these variables. Specifically, the models attempt to provide theoretical explanation to questions such as what causes periods of slow growth or recessions in the economy, or increment in the price level, or a rise in unemployment. It is difficult to account for all the variables at the same time. Thus, when we concentrate on the determination of a particular variable, we must hold the values of all other variables constant. This is a stylisation typical of almost any theoretical exercise and is called the assumption of ceteris paribus, which literally means ‘other things remaining equal’. You can think of the procedure as follows – in order to solve for the values of two variables x and y from two equations, we solve for one variable, say x, in terms of y from one equation first, and then substitute this value into the other equation to obtain the complete solution. We apply the same method in the analysis of the macroeconomic system.

In the blog on National Income Accounting, we have come across terms like consumption, investment, or the total output of final goods and services in an economy (GDP). These terms have dual connotations. In Chapter 2 they were used in the accounting sense – denoting actual values of these items as measured by the activities within the economy in a certain year. We call these actual or accounting values ex post measures of these items. These terms, however, can be used with a different connotation. Consumption may denote not what people have actually consumed in a given year, but what they had planned to consume during the same period. Similarly, investment can mean the amount a producer plans to add to her inventory. It may be different from what she ends up doing. Suppose the producer plans to add Rs 100 worth goods to her stock by the end of the year. Her planned investment is, therefore, Rs 100 in that year. However, due to an unforeseen upsurge of demand for her goods in the market the volume of her sales exceeds what she had planned to sell and, to meet this extra demand, she has to sell goods worth Rs 30 from her stock. Therefore, at the end of the year, her inventory goes up by Rs (100 – 30) = Rs 70 only. Her planned investment is Rs 100 whereas her actual, or ex post, investment is Rs 70 only. We call the planned values of the variables – consumption, investment or output of final goods – their ex ante measures. In a theoretical model of the economy the ex ante values of these variables should be our primary concern. If anybody wants to predict what the equilibrium value of the final goods, output or GDP will be it is important for her to know what quantities of the final goods people plan to demand or supply. We must, therefore, learn about the determinants of the ex ante values of consumption, investment or aggregate output of the economy.

Ex Ante Consumption:

What does planned consumption depend on? People spend a part of their income on consumption and save the rest. Suppose your income increases by Rs 100. You will not use up this entire extra income but save a certain fraction, say 20 per cent, of it to build up a cushion of savings for the period when you cease to earn income, or for meeting large expenses in future. Different people plan to save different fractions of their additional incomes (with the rich typically saving a greater proportion of their income than the poor), and if we average these we may arrive at a fraction which will give us an idea of what proportion of the total additional income of the economy people wish to save as a whole. We call this fraction the marginal propensity to save (mps). It gives us the ratio of total additional planned savings in an economy to the total additional income of the economy. Since consumption is the complement of savings (additional income of the economy is either put into additional savings or used for extra consumption by the people), if we subtract the mps from 1, we get the marginal propensity to consume (mpc), which, in a similar way, is the fraction of total additional income that people use for consumption. Suppose, mpc of an economy is c, where 0 < c < 1. If the total income of the economy increases from 0 to Y , then total consumption of the economy should be

C = c (Y – 0) = c.Y

However, it is not precisely so. We have forgotten something here. If the income of the economy in a certain year is zero, the above equation tells us that the economy has to starve for an entire year, which is, obviously, an outrageous idea. If your income is zero in a certain period you use your past savings to buy certain minimum consumption items in order to survive. Hence we must add the minimum or subsistence level of consumption of the economy in the above equation, which, therefore, becomes

C = C + c.Y (4.1)

where C > 0 is the minimum consumption level and is a given or exogenous item to our model, which, therefore, is treated as a constant. The equation tells us that as the income of the economy increases above zero, the economy uses c proportion of this extra income to increase its consumption above the minimum level.

Ex Ante Investment:

Investment is defined as addition to the stock of physical capital (such as machines, buildings, roads etc., i.e. anything that adds to the future productive capacity of the economy) and changes in the inventory (or the stock of finished goods) of a producer. Note that ‘investment goods’ (such as machines) are also part of the final goods – they are not intermediate goods like raw materials. Machines produced in an economy in a given year are not ‘used up’ to produce other goods but yield their services over a number of years. Investment decisions by producers, such as whether to buy a new machine, depend, to a large extent, on the market rate of interest. However, for simplicity, we assume here that firms plan to invest the same amount every year. We can
write the ex ante investment demand as

I = I (4.2)

where I is a positive constant which represents the autonomous (given or exogenous) investment in the economy in a given year.

Ex Ante Aggregate Demand for Final Goods:

In an economy without a government, the ex ante aggregate demand for final goods is the sum total of the
ex ante consumption expenditure and ex ante investment expenditure on such goods, viz. AD = C + I. Substituting the values of C and I from equations (4.1) and (4.2), aggregate demand for final goods can be written as

AD = C + I + c.Y

If the final goods market is in equilibrium this can be written as

Y = C + I + c.Y

where Y is the ex ante, or planned, supply of final goods. This equation can be further simplified by adding up the two autonomous terms, C and I , making it

Y = A + c.Y (4.3)

where A = C + I is the total autonomous expenditure in the economy. In reality, these two components of autonomous expenditure behave in different ways. C , representing subsistence consumption level of an economy, remains more or less stable over time. However, I has been observed to undergo periodic fluctuations. A word of caution is in order. The term Y on the left hand side of equation (4.3) represents the ex ante output or the planned supply of final goods. On the other hand, the expression on the right hand side denotes ex ante or planned aggregate demand for final goods in the economy. Ex ante supply is equal to ex ante demand only when the final goods market, and hence the economy, is in equilibrium. Equation (4.3) should not, therefore, be confused with the accounting identity of Chapter 2, which states that the ex post value of total output must always be equal to the sum total of ex post consumption and ex post investment in the economy. If ex ante demand for final goods falls short of the output of final goods that the producers have planned to produce in a given year, equation (4.3) will not hold. Stocks will be piling up in the warehouses which we may consider as unintended accumulation of inventories. It is not a part of planned or ex ante investment. However, it is definitely a part of the actual addition to inventories at the end of the year or, in other words, an ex post investment. Thus even though planned Y is greater than planned C + I, actual Y will be equal to actual C + I, with the extra output showing up as unintended accumulation of inventories in the ex post I on the right hand side of the accounting identity. At this point, we can introduce a government in this economy. The major economic activities of the government that affect the aggregate demand for final goods and services can be summarized by the fiscal variables Tax (T) and Government Expenditure (G), both autonomous to our analysis. Government, through its expenditure G on final goods and services, adds to the aggregate demand like other firms and households. On the other hand, taxes imposed by the government take a part of the income away from the household, whose disposable income, therefore, becomes Yd = Y – T. Households spend only a fraction of this disposable income for consumption purpose. Hence, equation (4.3) has to be modified in the following way to incorporate the government

Y = C + I + G + c (Y – T )

Note that G – c.T , like C or I , just adds to the autonomous term A . It does not significantly change the analysis in any qualitative way. We shall, for the sake of simplicity, ignore the government sector for the rest of this chapter. Observe also, that without the government imposing indirect taxes and subsidies, the total value of final goods and services produced in the economy, GDP, becomes identically equal to the National Income. Henceforth, throughout the rest of the chapter, we shall refer to Y as GDP or National Income interchangeably.

Monetary Policy and RBI

Instruments of Monetary Policy and the Reserve Bank of India

It is clear from the discussion in the previous blog that the total amount of money stock in the economy is much greater than the volume of high powered money. Commercial banks create this extra amount of money by giving out a part of their deposits as loans or investment credits. It is also evident that the total amount of deposits held by all commercial banks in the country is much larger than the total size of their reserves. If all the account-holders of all commercial banks in the country want their deposits back at the same time, the banks will not have enough means to satisfy the need of every accountholder and there will be bank failures. All this is common knowledge to every informed individual in the economy. Why do they still keep their money in bank deposits when they are aware of the possibility of default by their banks in case of a bank run (a situation where everybody wants to take money out of one’s bank account before the bank runs out of reserves)? The Reserve Bank of India plays a crucial role here. In case of a crisis like the above it stands by the commercial banks as a guarantor and extends loans to ensure the solvency of the latter. This system of guarantee assures individual account-holders that their banks will be able to pay their money back in case of a crisis and there is no need to panic thus avoiding bank runs. This role of the monetary authority is known as the lender of last resort.

Apart from acting as a banker to the commercial banks, RBI also acts as a banker to the Government of India, and also, to the state governments. It is commonly held that the government, sometimes, ‘prints money’ in case of a budget deficit, i.e., when it cannot meet its expenses (e.g. salaries to the government employees, purchase of defense equipment from a manufacturer of such goods etc.) from the tax revenue it has earned. The government, however, has no legal authority to issue currency in this fashion. So it borrows money by selling treasury bills or government securities to RBI, which issues currency to the government in return. The government then pays for its expenses with this money. The money thus ultimately comes into the hands of the general public (in the form of salary or sales proceeds of defense items etc.) and becomes a part of the money supply. Financing of budget deficits by the governments in this fashion is called Deficit Financing through Central Bank Borrowing. However, the most important role of RBI is as the controller of money supply and credit creation in the economy. RBI is the independent authority for conducting monetary policy in the best interests of the economy – it increases or decreases the supply of high powered money in the economy and creates incentives or disincentives for the commercial banks to give loans or credits to investors. The instruments which RBI uses for conducting monetary policy are as follows.

Open Market Operations:

RBI purchases (or sells) government securities to the general public in a bid to increase (or decrease) the stock of high powered money in the economy. Suppose RBI purchases Rs 100 worth government securities from the bond market. It will issue a cheque of Rs 100 on itself to the seller of the bond. The seller will deposit the cheque in her bank, which, in turn, will credit the seller’s account with a balance of Rs 100. The bank’s deposits go up by Rs 100 which is a liability to the bank. However, its assets also go up by Rs 100 by the possession of this cheque, which is a claim on RBI. The bank will deposit this cheque to RBI which, in turn, will credit the bank’s account with RBI with Rs 100.

Total liability of RBI, or, by definition, the supply of high powered money in the economy has gone up by Rs 100. If RBI wishes to reduce the supply of high powered money it undertakes an open market sale of government securities of its own holding in just the reverse fashion, thereby reducing the monetary base.

Bank Rate Policy:

As mentioned earlier, RBI can affect the reserve deposit ratio of commercial banks by adjusting the value of the bank rate – which is the rate of interest commercial banks have to pay RBI – if they borrow money from it in case of shortage of reserves. A low (or high) bank rate encourages banks to keep smaller (or greater) proportion of their deposits as reserves, since borrowing from RBI is now less (or more) costly than before. As a result banks use a greater (or smaller) proportion of their resources for giving out loans to borrowers or investors, thereby enhancing (or depressing) the multiplier process via assisting (or resisting) secondary money creation. In short, a low (or high) bank rate reduces (or increases) rdr and hence increases (or decreases) the value of the money multiplier, which is (1 + cdr)/(cdr + rdr). Thus, for any given amount of high powered money, H, total money supply goes up

Varying Reserve Requirements:

Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) also work through the rdr-route. A high (or low) value of CRR or SLR helps increase (or decrease) the value of reserve deposit ratio, thus diminishing (or increasing) the value of the money multiplier and money supply in the economy in a similar fashion.

Sterilisation by RBI:

RBI often uses its instruments of money creation for stabilising the stock of money in the economy from external shocks. Suppose due to future growth prospects in India investors from across the world increase their investments in Indian bonds which under such circumstances, are likely to yield a high rate of return. They will buy these bonds with foreign currency. Since one cannot purchase goods in the domestic market with foreign currency, a person who sells these bonds to foreign investors will exchange her foreign currency holding into rupee at a commercial bank. The bank, in turn, will submit this foreign currency to RBI and its deposits with RBI will be credited with equivalent sum of money. What kind of adjustments take place from this entire transaction? The commercial bank’s total reserves and deposits remain unchanged (it has purchased the foreign currency from the seller using its vault cash, which, therefore, goes down; but the bank’s deposit with RBI goes up by an equivalent amount – leaving its total reserves unchanged). There will, however, be increments in the assets and liabilities on the RBI balance sheet. RBI’s foreign exchange holding goes up. On the other hand, the deposits of commercial banks with RBI also increase by an equal amount. But that means an increase in the stock of high powered money – which, by definition, is equal to the total liability of RBI. With money multiplier in operation, this, in turn, will result in increased money supply in the economy. This increased money supply may not altogether be good for the economy’s health. If the volume of goods and services produced in the economy remains unchanged, the extra money will lead to increase in prices of all commodities. People have more money in their hands with which they compete each other in the commodities market for buying the same old stock of goods. As too much money is now chasing the same old quantities of output, the process ends up in bidding up prices of every commodity – an increase in the general price level,
which is also known as inflation.

RBI often intervenes with its instruments to prevent such an outcome. In the above example, RBI will undertake an open market sale of government securities of an amount equal to the amount of foreign exchange inflow in the economy, thereby keeping the stock of high powered money and total money supply unchanged. Thus it sterilises the economy against adverse external shocks. This operation of RBI is known as sterilisation.
Money supply is, therefore, an important macroeconomic variable. Its overall influence on the values of the equilibrium rate of interest, price level and output of an economy is of great significance. We take up these issues in the next blog.

Exchange of commodities without the mediation of money is called Barter Exchange. It suffers from lack of double coincidence of wants. Money facilitates exchanges by acting as a commonly acceptable medium of exchange. In a modern economy, people hold money broadly from two motives – transaction motive and speculative motive. Supply of money, on the other hand, consists of currency notes and coins, demand and time deposits held by commercial banks, etc. It is classified as narrow and broad money according to the decreasing order of liquidity. In India, the supply of money is regulated by the Reserve Bank of India (RBI) which acts as the monetary authority of the country. Various actions of the public, the commercial banks of the country and RBI are responsible for changes in the supply of money in the economy.
RBI regulates money supply by controlling the stock of high powered money, the bank rate and reserve requirements of the commercial banks. It also sterilises the money supply in the economy against external shocks.

Money Creation by the Banking System

In this section we shall explore the determinants of money supply. Money supply will change if the value of any of its components such as CU, DD or Time Deposits changes. In what follows we shall, for simplicity, use the most liquid definition of money, viz. M1 = CU + DD, as the measure of money supply in the economy. Various actions of the monetary authority, RBI, and commercial banks are responsible for changes in the values of these items. The preference of the public for holding cash balances vis-´a-vis deposits in banks also affect the money supply. These influences on money supply can be summarised by the following key ratios.

The Currency Deposit Ratio:
The currency deposit ratio (cdr) is the ratio of money held by the public in currency to that they hold in bank deposits. cdr = CU/DD. If a person gets Re 1 she will put Rs 1/(1 + cdr) in her bank account and keep Rs cdr/(1 + cdr) in cash. It reflects people’s preference for liquidity. It is a purely behavioural parameter which depends, among other things, on the seasonal pattern of expenditure. For example, cdr increases during the festive season as people convert deposits to cash balance for meeting extra expenditure during such periods.

The Reserve Deposit Ratio:
Banks hold a part of the money people keep in their bank deposits as reserve money and loan out the rest to various investment projects. Reserve money consists of two things – vault cash in banks and deposits of commercial banks with RBI. Banks use this reserve to meet the demand for cash by account holders. Reserve deposit ratio (rdr) is the proportion of the total deposits commercial banks keep as reserves. Keeping reserves is costly for banks, as, otherwise, they could lend this balance to interest earning investment projects. However, RBI requires commercial banks to keep reserves in order to ensure that banks have a safe cushion of assets to draw on when account holders want to be paid. RBI uses various policy instruments to bring forth a healthy rdr in commercial banks. The first instrument is the Cash Reserve Ratio which specifies the fraction of their deposits that banks must keep with RBI. There is another tool called Statutory Liquidity Ratio which requires the banks to maintain a given fraction of their total demand and time deposits in the form of specified liquid assets. Apart from these ratios RBI uses a certain interest rate called the Bank Rate to control the value of rdr. Commercial banks can borrow money from RBI at the bank rate when they run short of reserves. A high bank rate makes such borrowing from RBI costly and, in effect, encourages the commercial banks to maintain a healthy rdr.

Commercial Banks:

Commercial Banks accept deposits from the public and lend out this money to interest earning investment projects. The rate of interest offered by the bank to deposit holders is called the ‘borrowing rate’ and the rate at which banks lend out their reserves to investors is called the ‘lending rate’. The difference between the two rates, called ‘spread’, is the profit that is appropriated by the banks. Deposits are broadly of two types – demand deposits, payable by the banks on demand from the account holder, e.g. current and savings account deposits, and time deposits, which have a fixed period to maturity, e.g. fixed deposits. Lending by commercial banks consists mainly of cash credit, demand and shortterm loans to private investors and banks’ investments in government securities and other approved bonds. The creditworthiness of a person is judged by her current assets or the collateral (a security pledged for the repayment of a loan) she can offer.

High Powered Money:
The total liability of the monetary authority of the country, RBI, is called the monetary base or high powered money. It consists of currency (notes and coins in circulation with the public and vault cash of commercial banks) and deposits held by the Government of India and commercial banks with RBI. If a member of the public produces a currency note to RBI the latter must pay her value equal to the figure printed on the note. Similarly, the deposits are also refundable by RBI on demand from deposit-holders. These items are claims which the general public, government or banks have on RBI and hence are considered to be the liability of RBI. RBI acquires assets against these liabilities. The process can be understood easily if we consider a simple stylised example. Suppose RBI purchases gold or dollars worth Rs 5. It pays for the gold or foreign exchange by issuing currency to the seller. The currency in circulation in the economy thus goes up by Rs 5, an item that shows up on the liability side of the balance sheet. The value of the acquired assets, also equal to Rs 5, is entered under the appropriate head on the Assets side. Similarly, RBI acquires debt bonds or securities issued by the government and pays the government by issuing currency in return. It issues loans to commercial banks in a similar fashion. We are now ready to explain the mechanism of money creation by the monetary authority, RBI. Suppose RBI wishes to increase the money supply. It will then inject additional high powered money into the economy in the following way. Let us assume that RBI purchases some asset, say, government bonds or gold worth Rs H from the market. It will issue a cheque of Rs H on itself to the seller of the bond. Assume also that the values of cdr and rdr for this economy are 1 and 0.2, respectively. The seller encashes the cheque at her account in Bank A, keeping Rs 2 H in her account and taking Rs 2 H away as cash. Currency held by the public thus goes up by 2 H . Bank A’s liability goes up by Rs 2 H because of this increment in deposits. But its assets also go up by the same amount through the possession of this cheque, which is nothing but a claim of the same amount on RBI. The liability of RBI goes up by Rs H, which is the sum total of the claims of Bank A and its client, the seller, worth Rs 2 H and Rs 2 H , respectively. Thus, by definition, high powered money increases by Rs H. The process does not end here. Bank A will keep Rs 0.2 2H of the extra deposit as reserve and loan out the rest, i.e. Rs (1– 0.2) 2H = Rs 0.8 2 H to another borrower3. The borrower will presumably use this loan on some investment project and spend the money as factor payment. Suppose a worker of that project gets the payment. The worker will then keep Rs 0.8 4H as cash and put Rs 0.8 4H in her account in Bank B. Bank B, in turn, will lend Rs 0.64 4H . Someone who receives that money will keep 0.64 8H in cash and put 0.64 8H in some other Bank C. The process continues ad infinitum.

The increment in total money supply exceeds the amount of high powered money initially injected by RBI into the economy. We define money multiplier as the ratio of the stock of money to the stock of high powered money in an economy, viz. M/H. Clearly, its value is greater than 1. We need not always go through the round effects in order to compute the value of the money multiplier. We did it here just to demonstrate the process of money creation in which the commercial banks have an important role to play. However, there exists a simpler way of deriving the multiplier. By definition, money supply is equal to currency plus deposits
M = CU + DD = (1 + cdr )DD
where, cdr = CU/DD.
Assume, for simplicity, that treasury deposit of the Government with RBI is zero. High powered money then consists of currency held by the public and reserves of the commercial banks, which include vault cash and banks’ deposits with RBI. Thus
H = CU + R = cdr.DD + rdr.DD = (cdr + rdr)DD

Narrow and Broad Money

Legal Definitions: Narrow and Broad Money

Money supply, like money demand, is a stock variable. The total stock of money in circulation among the public at a particular point of time is called money supply. RBI publishes figures for four alternative measures of money supply, viz. M1, M2, M3 and M4. They are defined as follows

M1 = CU + DD
M2 = M1 + Savings deposits with Post Office savings banks
M3 = M1 + Net time deposits of commercial banks
M4 = M3 + Total deposits with Post Office savings organisations (excluding National Savings Certificates)

where, CU is currency (notes plus coins) held by the public and DD is net demand deposits held by commercial banks. The word ‘net’ implies that only deposits of the public held by the banks are to be included in money supply. The interbank deposits, which a commercial bank holds in other commercial banks, are not to be regarded as part of money supply.

M1 and M2 are known as narrow money. M3 and M4 are known as broad money. These gradations are in decreasing order of liquidity. M1 is most liquid and easiest for transactions whereas M4 is least liquid of all. M3 is the most commonly used measure of money supply. It is also known as aggregate monetary resources.


In a modern economy money consists mainly of currency notes and coins issued by the monetary authority of the country. In India currency notes are issued by the Reserve Bank of India (RBI), which is the monetary authority in India. However, coins are issued by the Government of India. Apart from currency notes and coins, the balance in savings, or current account deposits, held by the public in commercial banks is also considered money since cheques drawn on these accounts are used to settle transactions. Such deposits are called demand deposits as they are payable by the bank on demand from the accountholder. Other deposits, e.g. fixed deposits, have a fixed period to maturity and are referred to as time deposits. Though a hundred-rupee note can be used to obtain commodities worth Rs 100 from a shop, the value of the paper itself is negligible – certainly less than Rs 100. Similarly, the value of the metal in a five-rupee coin is probably not worth Rs 5. Why then do people accept such notes and coins in exchange of goods which are apparently more valuable than these? The value of the currency notes and coins is derived from the guarantee provided by the issuing authority of these items. Every currency note bears on its face a promise from the Governor of RBI that if someone produces the note to RBI, or any other commercial bank, RBI will be responsible for giving the person purchasing power equal to the value printed on the note. The same is also true of coins. Currency notes and coins are therefore called fiat money. They do not have intrinsic value like a gold or silver coin. They are also called legal tenders as they cannot be refused by any citizen of the country for settlement of any kind of transaction. Cheques drawn on savings or current accounts, however, can be refused by anyone as a mode of payment. Hence, demand deposits are not legal tenders.


Money is the most liquid of all assets in the sense that it is universally acceptable and hence can be exchanged for other commodities very easily. On the other hand, it has an opportunity cost. If, instead of holding on to a certain cash balance, you put the money in a savings account in some bank you can earn interest on that money. While deciding on how much money to hold at a certain point of time one has to consider the trade off between the advantage of liquidity and the disadvantage of the foregone interest. Demand for money balance is thus often referred to as liquidity preference. People desire to hold money balance broadly from two motives.
The Transaction Motive:

The principal motive for holding money is to carry out transactions. If you receive your income weekly and pay your bills on the first day of every week, you need not hold any cash balance throughout the rest of the week; you may as well ask your employer to deduct your expenses directly from your weekly salary and deposit the balance in your bank account. But our expenditure patterns do not normally match our receipts. People earn incomes at discrete points in time and spend it continuously throughout the interval. Suppose you earn Rs 100 on the first day of every month and run down this balance evenly over the rest of the month. Thus your cash balance at the beginning and end of the month are Rs 100 and 0, respectively. Your average cash holding can then be calculated as (Rs 100 + Rs 0) ÷ 2 = Rs 50, with which you are making transactions worth Rs 100 per month. Hence your average transaction demand for money is equal to half your monthly income, or, in other words, half the value of your monthly transactions.

Consider, next, a two-person economy consisting of two entities – a firm (owned by one person) and a worker. The firm pays the worker a salary of Rs 100 at the beginning of every month. The worker, in turn, spends this income over the month on the output produced by the firm – the only good available in this economy! Thus, at the beginning of each month the worker has a money balance of Rs 100 and the firm a balance of Rs 0. On the last day of the month the picture is reversed – the firm has gathered a balance of Rs 100 through its sales to the worker. The average money holding of the firm as well as the worker is equal to Rs 50 each. Thus the total transaction demand for money in this economy is equal to Rs 100. The total volume of monthly transactions in this economy is Rs 200 – the firm has sold its output worth Rs 100 to the worker and the latter has sold her services worth Rs 100 to the firm. The transaction demand for money of the economy is again a fraction of the total volume of transactions in the economy over the unit period of time.

The two-person economy described above can be looked at from another angle. You may perhaps find it surprising that the economy uses money balance worth only Rs 100 for making transactions worth Rs 200 per month. The answer to this riddle is simple – each rupee is changing hands twice a month. On the first day, it is being transferred from the employer’s pocket to that of the worker and sometime during the month, it is passing from the worker’s hand to the employer’s. The number of times a unit of money changes hands during the unit period is called the velocity of circulation of money. In the above example it is 2, inverse of half – the ratio of money balance and the value of transactions.

We are ultimately interested in learning the relationship between the aggregate transaction demand for money of an economy and the (nominal) GDP in a given year. The total value of annual transactions in an economy includes transactions in all intermediate goods and services and is clearly much greater than the nominal GDP. However, normally, there exists a stable, positive relationship between value of transactions and the nominal GDP. An increase in nominal GDP implies an increase in the total value of transactions and hence a greater transaction demand for money.

The Speculative Motive:

An individual may hold her wealth in the form of landed property, bullion, bonds, money etc. For simplicity, let us club all forms of assets other than money together into a single category called ‘bonds’. Typically, bonds are papers bearing the promise of a future stream of monetary returns over a certain period of time. These papers are issued by governments or firms for borrowing money from the public and they are tradable in the market. Consider the following two-period bond. A firm wishes to raise a loan of Rs 100 from the public. It issues a bond that assures Rs 10 at the end of the first year and Rs 10 plus the principal of Rs 100 at the end of the second year. Such a bond is said to have a face value of Rs 100, a maturity period of two years and a coupon rate of 10 per cent. Assume that the rate of interest prevailing in your savings bank account is equal to 5 per cent. Naturally you would like to compare the earning from this bond with the interest earning of your savings bank account. The exact question that you would ask is as follows: How much money, if kept in my savings bank account, will generate Rs 10 at the end of one year? Let this amount be X. This amount, Rs X, is called the present value of Rs 10 discounted at the market rate of interest. Similarly, let Y be the amount of money which if kept in the savings bank account will generate Rs 110 at the end of two years. Calculation reveals that it is Rs 109.29 (approx.). It means that if you put Rs 109.29 in your savings bank account it will fetch the same return as the bond. But the seller of the bond is offering the same at a face value of only Rs 100. Clearly the bond is more attractive than the savings bank account and people will rush to get hold of the bond. Competitive bidding will raise the price of the bond above its face value, till price of the bond is equal to its PV. If price rises above the PV the bond becomes less attractive compared to the savings bank account and people would like to get rid of it. The bond will be in excess supply and there will be downward pressure on the bond-price which will bring it back to the PV. It is clear that under competitive assets market condition the
price of a bond must always be equal to its present value in equilibrium. Now consider an increase in the market rate of interest from 5 per cent to 6 per cent. The present value, and hence the price of the same bond, will become 107.33 (approx.)

It follows that the price of a bond is inversely related to the market rate of interest. Different people have different expectations regarding the future movements in the market rate of interest based on their private information regarding the economy. If you think that the market rate of interest should eventually settle down to 8 per cent per annum, then you may consider the current rate of 5 per cent too low to be sustainable over time. You expect interest rate to rise and consequently bond prices to fall. If you are a bond holder a decrease in bond price means a loss to you – similar to a loss you would suffer if the value of a property held by you suddenly depreciates in the market. Such a loss occurring from a falling bond price is called a capital loss to the bond holder. Under such circumstances, you will try to sell your bond and hold money instead. Thus speculations regarding future movements in interest rate and bond prices give rise to the speculative demand for money. When the interest rate is very high everyone expects it to fall in future and hence anticipates capital gains from bond-holding. Hence people convert their money into bonds. Thus, speculative demand for money is low. When interest rate comes down, more and more people expect it to rise in the future and anticipate capital loss. Thus they convert their bonds into money giving rise to a high speculative demand for money. Hence speculative demand for money is inversely related to the rate of interest.

As mentioned earlier, interest rate can be thought of as an opportunity cost or ‘price’ of holding money balance. If supply of money in the economy increases and people purchase bonds with this extra money, demand for bonds will go up, bond prices will rise and rate of interest will decline. In other words, with an increased supply of money in the economy the price you have to pay for holding money balance, viz. the rate of interest, should come down. However, if the market rate of interest is already low enough so that everybody expects it to rise in future, causing capital losses, nobody will wish to hold bonds. Everyone in the economy will hold their wealth in money balance and if additional money is injected within the economy it will be used up to satiate people’s craving for money balances without increasing the demand for bonds and without further lowering the rate of interest below the floor rmin. Such a situation is called a liquidity trap. The speculative money demand function is infinitely elastic here.


The first and foremost role of money is that it acts as a medium of exchange. Barter exchanges become extremely difficult in a large economy because of the high costs people would have to incur looking for suitable persons to exchange their surpluses. Money also acts as a convenient unit of account. The value of all goods and services can be expressed in monetary units. When we say that the value of a certain wristwatch is Rs 500 we mean that the wristwatch can be exchanged for 500 units of money, where a unit of money is rupee in this case. If the price of a pencil is Rs 2 and that of a pen is Rs 10 we can calculate the relative price of a pen with respect to a pencil, viz. a pen is worth 10 ÷ 2 = 5 pencils. The same notion can be used to calculate the value of money itself with respect to other commodities. In the above example, a rupee is worth 1 ÷ 2 = 0.5 pencil or 1 ÷ 10 = 0.1 pen. Thus if prices of all commodities increase in terms of money which, in other words, can be regarded as a general increase in the price level, the value of money in terms of any commodity must have decreased – in the sense that a unit of money can now purchase less of any commodity. We call it a deterioration in the purchasing power of money. A barter system has other deficiencies. It is difficult to carry forward one’s wealth under the barter system. Suppose you have an endowment of rice which you do not wish to consume today entirely. You may regard this stock of surplus rice as an asset which you may wish to consume, or even sell off, for acquiring other commodities at some future date. But rice is a perishable item and cannot be stored beyond a certain period. Also, holding the stock of rice requires a lot of space. You may have to spend considerable time and resources looking for people with a demand for rice when you wish to exchange your stock for buying other commodities. This problem can be solved if you sell your rice for money. Money is not perishable and its storage costs are also considerably lower. It is also acceptable to anyone at any point of time. Thus money can act as a store of value for individuals. Wealth can be stored in the form of money for future use. However, to perform this function well, the value of money must be sufficiently stable. A rising price level may erode the purchasing power of money. It may be noted that any asset other than money can also act as a store of value, e.g. gold, landed property, houses or even bonds (to be introduced shortly). However, they may not be easily convertible to other commodities and do not have universal acceptability.

Money and Banking - Introduction

Money is the commonly accepted medium of exchange. In an economy which consists of only one individual there cannot be any exchange of commodities and hence there is no role for money. Even if there are more than one individual but they do not take part in market transactions, such as a family living on an isolated island, money has no function for them. However, as soon as there are more than one economic agent who engage themselves in transactions through the market, money becomes an important instrument for facilitating these exchanges. Economic exchanges without the mediation of money are referred to as barter exchanges. However, they presume the rather improbable double coincidence of wants. Consider, for example, an individual who has a surplus of rice which she wishes to exchange for clothing. If she is not lucky enough she may not be able to find another person who has the diametrically opposite demand for rice with a surplus of clothing to offer in exchange. The search costs may become prohibitive as the number of individuals increases. Thus, to smoothen the transaction, an intermediate good is necessary which is acceptable to both parties. Such a good is called money. The individuals can then sell their produces for money and use this money to purchase the commodities they need. Though facilitation of exchanges is considered to be the principal role of money, it serves other purposes as well. Following are the main functions of money in a modern economy.


Can the GDP of a country be taken as an index of the welfare of the people of that country? If a person has more income he or she can buy more goods and services and his or her material well-being improves. So it may seem reasonable to treat his or her income level as his or her level of well-being. 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

1. Distribution of GDP – how uniform is it:
If the GDP of the country is rising, the welfare may not rise as a consequence. This is because the rise in GDP may be concentrated in the hands of very few individuals or firms. For the rest, the income may in fact have fallen. In such a case the welfare of the entire country cannot be said to have increased. For example, suppose in year 2000, an imaginary country had 100 individuals each earning Rs 10. Therefore the GDP of the country was Rs 1,000 (by income method). In 2001, let us suppose the same country had 90 individuals earning Rs 9 each, and the rest 10 individual earning Rs 20 each. Suppose there had been no change in the prices of goods and services between these two periods. The GDP of the country in the year 2001 was 90 × (Rs 9) + 10 × (Rs 20) = Rs 810 + Rs 200 = Rs 1,010. Observe that compared to 2000, the GDP of the country in 2001 was higher by Rs10. But this has happened when 90 per cent of people of the country have seen a drop in their real income by 10 per cent (from Rs 10 to Rs 9), whereas only 10 per cent have benefited by a rise in their income by 100 per cent (from Rs 10 to Rs 20). 90 per cent of the people are worse off though the GDP of the country has gone up. If we relate welfare improvement in the country to the percentage of people who are better off, then surely GDP is not a good index.

2. Non-monetary exchanges:
Many activities in an economy are not evaluated in monetary terms. For example, the domestic services women perform at home are not paid for. The exchanges which take place in the informal sector without the help of money are called barter exchanges. In barter exchanges goods (or services) are directly exchanged against each other. But since money is not being used here, these exchanges are not registered as part of economic activity. In developing countries, where many remote regions are underdeveloped, these kinds of exchanges do take place, but they are generally not counted in the GDPs of these countries. This is a case of underestimation of GDP. Hence GDP calculated in the standard manner may not give us a clear indication of the productive activity and well-being of a country.

3. Externalities:
Externalities refer to the benefits (or harms) a firm or an individual causes to another for which they are not paid (or penalised). Externalities do not have any market in which they can be bought and sold. For example, let us suppose there is an oil refinery which refines crude petroleum and sells it in the market. The output of the refinery is the amount of oil it refines. We can estimate the value added of the refinery by deducting the value of intermediate goods used by the refinery (crude oil in this case) from the value of its output. The value added of the refinery will be counted as part of the GDP of the economy. But in carrying out the production the refinery may also be polluting the nearby river. This may cause harm to the people who use the water of the river. Hence their utility will fall. Pollution may also kill fish or other organisms of the river on which fish survive. As a result the fishermen of the river may be losing their income and utility. Such harmful effects that the refinery is inflicting on others, for which it does not have to bear any cost, are called externalities. In this case, the GDP is not taking into account such negative externalities. Therefore, if we take GDP as a measure of welfare of the economy we shall be overestimating the actual welfare. This was an example of negative externality. There can be cases of positive externalities as well. In such cases GDP will underestimate the actual welfare of the economy.


One implicit assumption in all this discussion is that the prices of goods and services do not change during the period of our study. If prices change, then there may be difficulties in comparing GDPs. If we measure the GDP of a country in two consecutive years and see that the figure for GDP of the latter year is twice that of the previous year, we may conclude that the volume of production of the country has doubled. But it is possible that only prices of all goods and services have doubled between the two years whereas the production has remained constant. Therefore, in order to compare the GDP figures (and other macroeconomic variables) of different countries or to compare the GDP figures of the same country at different points of time, we cannot rely on GDPs evaluated at current market prices.
For comparison we take the help of real GDP. Real GDP is calculated in a way such that the goods and services are evaluated at some constant set of prices (or constant prices). Since these prices remain fixed, if the Real GDP changes we can be sure that it is the volume of production which is undergoing changes. Nominal GDP, on the other hand, is simply the value of GDP at the current prevailing prices. For example, suppose a country only produces bread. In the year 2000 it had produced 100 units of bread, price was Rs 10 per bread. GDP at current price was Rs 1,000. In 2001 the same country produced 110 units of bread at price Rs 15 per bread. Therefore nominal GDP in 2001 was Rs 1,650 (=110 × Rs 15). Real GDP in 2001 calculated at the price of the year 2000 (2000 will be called the base year) will be 110 × Rs 10 = Rs 1,100. Notice that the ratio of nominal GDP to real GDP gives us an idea of how the prices have moved from the base year (the year whose prices are being used to calculate the real GDP) to the current year. In the calculation of real and nominal GDP of the current year, the volume of production is fixed. Therefore, if these measures differ it is only due to change in the price level between the base year and the current year. The ratio of nominal to real GDP is a well known index of prices. This is called GDP Deflator. Thus if GDP stands for nominal GDP and gdp stands for real GDP then, GDP deflator = GDP gdp . Sometimes the deflator is also denoted in percentage terms. In such a case deflator = GDP gdp × 100 per cent. In the previous example, the GDP deflator is 1,650 1,100 = 1.50 (in percentage terms this is 150 per cent). This implies that the price of bread produced in 2001 was 1.5 times the price in 2000. Which is true because price of bread has indeed gone up from Rs 10 to Rs 15. Like GDP deflator, we can have GNP deflator as well. There is another way to measure change of prices in an economy which is known as the Consumer Price Index (CPI). This is the index of prices of a given basket of commodities which are bought by the representative consumer. CPI is generally expressed in percentage terms. We have two years under consideration – one is the base year, the other is the current year. We calculate the cost of purchase of a given basket of commodities in the base year. We also calculate the cost of purchase of the same basket in the current year. Then we express the latter as a percentage of the former. This gives us the Consumer Price Index of the current year vis-´a-vis the base year. For example let us take an economy which produces two goods, rice and cloth. A representative consumer buys 90 kg of rice and 5 pieces of cloth in a year. Suppose in the year 2000 the price of a kg of rice was Rs 10 and a piece of cloth was Rs 100. So the consumer had to spend a total sum of Rs 10 × 90 = Rs 900 on rice in 2000. Similarly, she spent Rs 100 × 5 = Rs 500 per year on cloth. Summation of the two items is, Rs 900 + Rs 500 = Rs 1,400.

Now suppose the prices of a kg of rice and a piece of cloth has gone up to Rs 15 and Rs 120 in the year 2005. To buy the same quantity of rice and clothes the representative will have to spend Rs 1,350 and Rs 600 respectively (calculated in a similar way as before). Their sum will be, Rs 1,350 + Rs 600 = Rs 1,950. The CPI therefore will be 1,950 1,400 × 100 = 139.29 (approximately).

It is worth noting that many commodities have two sets of prices. One is the retail price which the consumer actually pays. The 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.


Gross Domestic Product measures the aggregate production of final goods and services taking place within the domestic economy during a year. But the whole of it may not accrue to the citizens of the country. For example, a citizen of India working in Saudi Arabia may be earning her wage and it will be included in the Saudi Arabian GDP. But legally speaking, she is an Indian. Is there a way to take into account the earnings made by Indians abroad or by the factors of production owned by Indians? When we try to do this, in order to maintain symmetry, we must deduct the earnings of the foreigners who are working within our domestic economy, or the payments to the factors of production owned by the foreigners. For example, the profits earned by the Korean-owned Hyundai car factory will have to be subtracted from the GDP of India. The macroeconomic variable which takes into account such additions and subtractions is known as Gross National Product (GNP). It is, therefore, defined as follows 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). We have already noted that a part of the capital gets consumed during the year due to wear and tear. This wear and tear is called depreciation. Naturally, 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

It is to be noted that all these variables 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 subsidised). 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.
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)

We can further subdivide the National Income into smaller categories. Let us try to find the expression for the part of NI which is received by households. We shall call this Personal Income (PI). 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.

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. 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.

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. The idea behind 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

Income Method

As we mentioned in the beginning, 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). This 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. Let there be M number of households in the economy. Let Wi be the wages and salaries received by the i-th household in a particular year. Similarly, Pi, Ini, Ri be the gross profits, interest payments and rents received by the i-th household in a particular year.

It may be worth examining how the households dispose off their earnings. There are three major ways in which they may do so. Either they consume it, or they save it, or pay taxes with it (assuming that no aid or donation, ‘transfer payment’ in general, is being sent abroad, which is another way to spend their incomes). Out of the GDP, a part is consumed and a part is saved (from the recipient side of the incomes). On the other hand, from the side of the firms, the aggregate final expenditure received by them (≡ GDP) must be equal to consumption expenditure and investment expenditure. The aggregate of incomes received by the households is equal to the expenditure received by the firms because the income method and expenditure method would give us the same figure of GDP. Since consumption expenditure cancels out from both sides, we are left with aggregate savings equal to the aggregate gross investment expenditure

Expenditure Method

An alternative way to calculate the GDP is by looking at the demand side of the products. This method is referred to as the expenditure method. In the farmerbaker example that we have described before, the aggregate value of the output in the economy by expenditure method will be calculated in the following way. In this method we add the final expenditures that each firm makes. Final expenditure is that part of expenditure which is undertaken not for intermediate purposes. The Rs 50 worth of wheat which the bakers buy from the farmers counts as intermediate goods, hence it does not fall under the category of final expenditure. Therefore the aggregate value of output of the economy is Rs 200 (final expenditure received by the baker) + Rs 50 (final expenditure received by the farmer) = Rs 250 per year. Firm i can make the final expenditure on the following accounts (a) the final consumption expenditure on the goods and services produced by the firm. We shall denote this by Ci. We may note that mostly it is the households which undertake consumption expenditure. There may be exceptions when the firms buy consumables to treat their guests or for their employees (b) the final investment expenditure, Ii, incurred by other firms on the capital goods produced by firm i. Observe that unlike the expenditure on intermediate goods which is not included in the calculation of GDP, expenditure on investments is included. The reason is that investment goods remain with the firm, whereas intermediate goods are consumed in the process of production (c) the expenditure that the government makes on the final goods and services produced by firm i. We shall denote this by Gi. We may point out that the final expenditure incurred by the government includes both the consumption and investment expenditure (d) the export revenues that firm i earns by selling its goods and services abroad. This will be denoted by Xi . Thus the sum total of the revenues that the firm i earns is given by RVi ≡ Sum total of final consumption, investment, government and exports expenditures received by the firm I ≡ Ci + Ii + Gi + Xi

Let C be the aggregate final consumption expenditure of the entire economy. Notice that a part of C is spent on imports of consumption goods. Let Cm denote expenditure on the imports of consumption goods. Therefore C – Cm denotes that part of aggregate final consumption expenditure that is spent on the domestic firms. Similarly, let I – Im stand for that part of aggregate final investment expenditure that is spent on domestic firms, where I is the value of the aggregate final investment expenditure of the economy and out of this Im is spent on foreign investment goods. Similarly G – Gm stands for that part of aggregate final government expenditure that is spent on the domestic firms, where G is the aggregate expenditure of the government of the economy andGm is the part of G which is spent on imports

In product method we calculate the aggregate annual value of goods and services produced (if a year is the unit of time). How to go about doing this? Do we add up the value of all goods and services produced by all the firms in an economy? The following example will help us to understand. Let us suppose that there are only two kinds of producers in the economy. They are 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. What is the value of total production in the economy? If we follow the simple way of aggregating the values of production of the sectors, we would add Rs 200 (value of production of the bakers) to Rs 100 (value of production of farmers). The result will be Rs 300. A little reflection will tell us that the value of aggregate production is not Rs 300. 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. 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.

Here all the variables are expressed in terms of money. We can think of the market prices of the goods being used to evaluate the different variables listed here. And we can introduce more players in the chain of production in the example and make it more realistic and complicated. For example, the farmer may be using fertilisers or pesticides to produce wheat. The value of these inputs will have to be deducted from the value of output of wheat. Or the bakers may be selling the bread to a restaurant whose value added will have to be calculated by subtracting the value of intermediate goods (bread in this case). We have already introduced the concept of depreciation, which 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. 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. It is to be noted that while calculating the value added we are taking the value of production of firm. But a firm may be unable to sell all of its produce. In such a case it will have some unsold stock at the end of the year. Conversely, it may so happen that a firm had some initial unsold stock to begin with. During the year that follows it has produced very little. But it has met the demand in the market by selling from the stock it had at the beginning of the year. How shall we treat these stocks which a firm may intentionally or unintentionally carry with itself? Also, let us remember that a firm buys raw materials from other firms. The part of raw material which gets used up is categorised as an intermediate good. What happens to the part which does not get used up? 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 ≡ production of the firm during the year – sale of the firm during the year. The sign ‘≡’ stands for identity. Unlike equality (‘=’), an identity always holds irrespective of what variables we have on the left hand and right hand sides of it.

For example, we can write 2 + 2 ≡ 4, because this is always true. But we must write 2 × x = 4. This is because two times x equals to 4 for a particular value of x, (namely when x = 2) and not always. We cannot write 2 × x ≡ 4. Observe that since production of the firm ≡ 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.

For example, let us suppose that a firm had an unsold stock worth of Rs 100 at the beginning of a year. During the year it had produced Rs 1,000 worth of goods and managed to sell Rs 800 worth of goods. Therefore the Rs 200 is the difference between production and sales. This Rs 200 worth of goods is the change in inventories. This will add to the Rs 100 worth of inventories the firm started with. Hence the inventories at the end of the year is, Rs 100 + Rs 200 = Rs 300. Notice that change in inventories takes place over a period of time. Therefore it is a flow variable. 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. 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. The second category of investment is the fixed business investment, which is defined as the addition to the machinery, factory buildings, and equipments employed by the firms. The 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 decumulation of inventories. This can be illustrated with the help of the following example. Suppose a firm manufactures shirts. It starts the year with an inventory of 100 shirts. During the coming year it expects to sell 1,000 shirts. Hence it produces 1,000 shirts, expecting to keep an inventory of 100 at the end of the year. However, during the year, the sales of shirts turn out to be unexpectedly low. The firm is able to sell only 600 shirts. This means that the firm is left with 400 unsold shirts. The firm ends the year with 400 + 100 = 500 shirts. The unexpected rise of inventories by 400 will be an example of unplanned accumulation of inventories. If, on the other hand, the sales had been more than 1,000 we would have unplanned decumulation of inventories. For example, if the sales had been 1,050, then not only the production of 1,000 shirts will be sold, the firm will have to sell 50 shirts out of the inventory. This 50 unexpected reduction in inventories is an example of unexpected decumulation of inventories.

What can be the examples of planned accumulation or decumulation of inventories? Suppose the firm wants to raise the inventories from 100 shirts to 200 shirts during the year. Expecting sales of 1,000 shirts during the year (as before), the firm produces 1000 + 100 = 1,100 shirts. If the sales are actually 1,000 shirts, then the firm indeed ends up with a rise of inventories. The new stock of inventories is 200 shirts, which was indeed planned by the firm. This rise is an example of planned accumulation of inventories. On the other hand if the firm had wanted to reduce the inventories from 100 to 25 (say), then it would produce 1000 – 75 = 925 shirts. This is because it plans to sell 75 shirts out of the inventory of 100 shirts it started with (so that the inventory at the end of the year becomes 100 – 75 = 25 shirts, which the firm wants). If the sales indeed turn out to be 1000 as expected by the firm, the firm will be left with the planned, reduced inventory of 25 shirts. We shall have more to say on the distinction between unplanned and planned change in inventories in the chapters which follow.

It is worth noting that the sales by the firm includes sales not only to domestic buyers but also to buyers abroad (the latter is termed as exports). It is also to be noted that all the above mentioned variables are flow variables. Generally these are measured on an annual basis. Hence they measure value of the flows per year. Net value added of the firm i ≡ GVAi – Depreciation of the firm i (Di) 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 producedby 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. If there are N firms in the economy, each assigned with a serial number from 1 to N, then GDP ≡ Sum total of the gross value added of all the firms in the economy This implies that the gross domestic product of the economy is the sum total of the net value added and depreciation of all the firms of the economy. Summation of net value added of all firms is called Net Domestic Product (NDP).

The description of the economy in the previous section enables us to have a rough idea of how a simple economy – without a government, external trade or any savings – may function. The households receive their payments from the firms for productive activities they perform for the latter. As we have mentioned before, there may fundamentally be four kinds of contributions that can be made 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. In this simplified economy, there is only one way in which the households may dispose off 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.

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. Observe that the aggregate spending of the economy must be equal to the aggregate income earned by the factors of production (the flows are equal at A and C). Now let us suppose that at a particular period of time the households decide to spend more on the goods and services produced by the firms. For the time being let us ignore the question where they would find the money to finance that extra spending since they are already spending all of their income (they may have borrowed the money to finance the additional spending). Now if they spend more on the goods and services, the firms will produce more goods and services to meet this extra demand. Since they will produce more, the firms must also pay the factors of production extra remunerations. How much extra amount of money will the firms pay? The additional factor payments must be equal to the value of the additional goods and services that are being produced. Thus the households will eventually get the extra earnings required to support the initial additional spending that they had undertaken. In other words, the households can decide to spend more – spend beyond their means. And in the end their income will rise exactly by the amount which is necessary to carry out the extra spending. Putting it differently, an economy may decide to spend more than the present level of income. But by doing so, its income will eventually rise to a level consistent with the higher spending level. This may seem a little paradoxical at first. But since income is moving in a circular fashion, it is not difficult to figure out that a rise in the flow at one point must eventually lead to a rise in the flow at all levels. This is one more example of how the functioning of a single economic agent (say, a household) may differ from the functioning of the economy as a whole. In the former the spending gets restricted by the individual income of a household. It can never happen that a single worker decides to spend more and this leads to an equivalent rise in her income. We shall spend more time on how higher aggregate spending leads to change in aggregate income in a later chapter.

Such a story which describes the functioning of an imaginary economy is called a macroeconomic model. It is clear that a model does not describe an actual economy in detail. For example, our model assumes that households do not save, there is no government, no trade with other countries. However models do not want to capture an economy in its every minute detail – their purpose is to highlight some essential features of the functioning of an economic system. But one has to be cautious not to simplify the matters in such a way that misrepresents the essential nature of the economy. The subject of economics is full of models, many of which will be presented in this book. One task of an economist is to figure out which model is applicable to which real life situation. If we change our simple model described above and introduce savings, will it change the principal conclusion that the aggregate estimate of the income of the economy will remain the same whether we decide to calculate it at A, B or C? It turns out that this conclusion does not change in a fundamental way. No matter how complicated an economic system may be, the annual production of goods and services estimated through each of the three methods is the same.

We have seen that the aggregate value of goods and services produced in an economy can be calculated by three methods. We now discuss the detailed steps of these calculations.


One of the pioneers of the subject we call economics today, Adam Smith, named his most influential work – An Enquiry into the Nature and Cause of the Wealth of Nations. What generates the economic wealth of a nation? What makes countries rich or poor? These are some of the central questions of economics. It is not that countries which are endowed with a bounty of natural wealth – minerals or forests or the most fertile lands – are naturally the richest countries. In fact the resource rich Africa and Latin America have some of the poorest countries in the world, whereas many prosperous countries have scarcely any natural wealth. There was a time when possession of natural resources was the most important consideration but even then the resource had to be transformed through a production process. 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. Let us now dwell upon this flow of production. How does this flow of production arise? People combine their energies with natural and manmade environment within a certain social and technological structure to generate a flow of production. In our modern economic setting this flow of production arises out of production of commodities – goods and services by millions of enterprises large and small. These enterprises range from giant corporations employing a large number of people to single entrepreneur enterprises. But what happens to these commodities after being produced? Each producer of commodities intends to sell her output. So from the smallest items like pins or buttons to the largest ones like aeroplanes, 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. Thus a farmer producing cotton sells it to a spinning mill where the raw cotton undergoes transformation to yarn; the yarn is, in turn, sold to a textile mill where, through the productive process, it is transformed into cloth; the cloth is, in turn, transformed through another productive process into an article of clothing which is then ready to be sold finally 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 transformations is called a final good.

Why do 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. Similarly most of the items that enter our kitchen are transformed through the process of cooking. But 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 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. Of the final goods, we can distinguish between consumption goods and capital goods. 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.) Then there are other 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. The stock of capital that an economy possesses is thus preserved, maintained and renewed partially or wholly over time and this is of some importance in the discussion that will follow.
We may note here that 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. Thus if we consider all the final goods and services produced in an economy in a given period of time they are either in the form of consumption goods (both durable and non-durable) or capital goods. As final goods they do not undergo any further transformation in the economic process. 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. Now, to have a comprehensive idea of the total flow of production in the economy, we need to have a quantitative measure of the aggregate level of final goods produced in the economy. However, in order to get a quantitative assessment – a measure of the total final goods and services produced in the economy – it is obvious that we need a common measuring rod. We cannot add metres of cloth produced to tonnes of rice or number of automobiles or machines. Our common measuring rod is money. Since each of these commodities is produced for sale, the sum total of the monetary value of these diverse commodities gives us a measure of final output. But why are we to measure final goods only? Surely intermediate goods are crucial inputs to any production process and a significant part of our manpower and capital stock are engaged in production of these goods. However, since we are dealing with value of output, we should realise 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. At this stage it is important to introduce the concepts of stocks and flows.Often we hear statements like the average salary of someone is Rs 10,000 or the output of the steel industry is so many tonnes or so many rupees in value. But these are incomplete statements because it is not clear whether the income which is being referred to is yearly or monthly or daily income and surely that makes a huge difference. Sometimes, when the context is familiar, we assume that the time period is known and therefore do not mention it. But inherent in all such statements is a definite period of time. Otherwise such statements are meaningless. Thus 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.Flows are defined over a period of time.

In contrast, 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. To further understand the difference between stock variables and flow variables, let us take the following example. 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. To come back to our discussion on the measure of final output, that part of our final output that comprises of capital goods constitutes gross investment of an economy1. These may be machines, tools and implements; buildings, office spaces, storehouses or infrastructure like roads, bridges, airports or jetties. But all the capital goods produced in a year do not constitute an addition to the capital stock already existing. A significant part of current output of capital goods goes in maintaining or replacing part of the existing stock of capital goods. This is because the already existing capital stock suffers wear and tear and needs maintenance and replacement. A part of the capital goods produced this year goes for replacement of existing capital goods and is not an addition to the stock of capital goods already existing and its value needs to be subtracted from gross investment for arriving at the measure for net investment. This deletion, which is made from the value of gross investment in order to accommodate regular wear and tear of capital, is called depreciation. So 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

Let us examine this concept called depreciation a little more in detail. Let us consider a new machine that a firm invests in. This machine may be in service for the next twenty years after which it falls into disrepair and needs to be replaced. We can now imagine as if the machine is being gradually used up in each year’s production process and each year one twentieth of its original value is getting depreciated. So, instead of considering a bulk investment for replacement after twenty years, we consider an annual depreciation cost every year. This is the usual sense in which the term depreciation is used and inherent in its conception is the expected life of a particular capital good, like twenty years in our example of the machine. Depreciation is thus an annual allowance for wear and tear of a capital good.2 In other words it is the cost of the good divided by number of years of its useful life. Notice here that depreciation is an accounting concept. No real expenditure may have actually been incurred each year yet depreciation is annually accounted for. In an economy with thousands of enterprises with widely varying periods of life of their equipment, in any particular year, some enterprises are actually making the bulk replacement spending. Thus, we can realistically assume that there will be a steady flow of actual replacement spending which will more or less match the amount of annual depreciation being accounted for in that economy. Now if we go back to our discussion of total final output produced in an economy, we see that there is output of consumer goods and services and output of capital goods. The consumer goods sustain the consumption of the entire population of the economy. Purchase of consumer goods depends on the capacity of the people to spend on these goods which, in turn, depends on their income. The other part of the final goods, the capital goods, are purchased by business enterprises either for maintenance or addition to their capital stock so that they can continue to maintain or expand the flow of their production. In a specific time period, say in a year, the total production of final goods can thus be either in the form of consumption or investment and there is thus a trade-off. If an economy, out of its current production of final goods, produces more of consumer goods, it is producing less of investment goods and vice-versa. We will soon see, however, that this simple additive relation is more complex in more than one way. The relation, in fact, is that of a basic circularity expressing the self-feeding nature of the production process. Consumption goods sustain the basic objective of any economy – the need to consume. Consumption may range from basic life sustenance to luxurious lifestyles. Human beings must consume to survive and work and it is consumption of the basic necessities of life – food, clothing, shelter that make us function. But as human societies advance and progress, their consumption needs become much more wide ranging and complex. Not only are newer consumption needs perceived and correspondingly new consumer goods and services produced, but also the meaning of basic necessities may now include not only food and clothing but such essentials like basic education and health care. If consumption is the ultimate objective, these consumables – goods and services – are to be both produced and purchased. Whereas it is possible, in different social or economic arrangements, for goods to be produced and distributed to members of the society without being purchased or sold, we are not considering an economy like that. In the economy under consideration all goods and services are produced by the entrepreneur for sale and the enterprise intends to make a profit through the act of selling. So the act of production makes this consumption feasible in two ways – by producing these consumption goods and simultaneously generating the income for those who are involved in the production process. The entrepreneur buys machines and employs people to make this production feasible. The objective of the entrepreneur is to sell the commodities produced and earn profits. The act of employment, in turn, generates income for those who are employed. The income that the employed earn and the profit that the entrepreneur earns become the basis for purchase of consumption goods that are being produced for sale. But the production of consumption goods would not be feasible without capital goods. Human labour is combined or applied on the stock of capital goods to produce the consumables and the capital goods. More sophisticated the capital goods are, more will be the productivity of labour. The traditional weaver would take months to weave a sari but with modern machinery thousands of pieces of clothing are produced in a day. Decades were taken to construct the great historical monuments like the Pyramids or the Taj Mahal but with modern construction machinery one can build a skyscraper in a few years. One of the signs of progress in our modern society is both the qualitative and quantitative enhancement that has happened to capital stock. The larger and more sophisticated the capital stock, the more numerous and more varied will be the output of commodities and, consequently, more numerous and varied will be the production of consumption goods. But aren’t we contradicting ourselves? Earlier we have seen how, of the total output of final goods in an economy, if a larger share goes for production of capital goods, a smaller share is available for production of consumer goods. Here we have to bring in the relevance of the time period in our discussion. Given a stock of capital goods with which production commences in a year, of the total output produced at the end of the year, if more of capital goods are produced then less of consumption goods are produced. But the more the capital goods produced now, more will be the productive capacity of the system in the future. Hence a larger volume of consumption goods can be produced in the future. If, at present, the economy sets aside a greater fraction of its output for investment purpose, its capacity to produce more output in the future rises. This phenomenon becomes possible because capital goods, unlike non-durable consumer goods, do not get immediately exhausted with their use – they add to the stock of capital in quantitative terms. The new stock may also be qualitatively superior to the existing stock (just as a modern textile mill is more productive than the old handlooms). In both cases the capacity of the economy to produce more output in the future rises. Now if we concentrate on production in a given time period, say a year, we can observe the basic circularity. Total output of final goods and services produced in an economy in a year has two different parts – the consumer goods and services, and the capital goods. The consumer goods and services sustain the consumption of the total population of the economy. From the population of the economy is derived its workforce, people who contribute to production either by providing their labour and skill or by supplying their capital or entrepreneurship. Such human effort is combined with existing stock of capital goods – tools, machines, infrastructure etc. to form the basis for production of output. Of this a part of the final output comprises of this year’s capital goods production, which replaces or adds to the existing capital stock, and the resultant capital stock, in interaction with human labour and entrepreneurship, will be the basis for production of output in the next cycle of production i.e. next year. Thus the economic cycle rolls on, making a continuous process of consumption and production possible. We can also observe here that unless the current production of capital goods is entirely used up for replacement of old capital stock, which in most instances is rather unlikely, i.e. if there is a net addition to capital stock at the end of this year’s production cycle, next year’s production commences with a larger stock of capital. This can thus become the basis for larger production of output. Thus the economic cycle not only rolls on, it also has a strong tendency to expand. We can also locate another view of the circular flow inherent in the discussion we have made had so far. Since we are dealing with all goods and services that are produced for the market, i.e. to be sold, the crucial factor enabling such sale is demand for such products backed by purchasing power. One must have the necessary ability to purchase commodities. Otherwise one’s need for commodities does not get recognised by the market. We have already discussed above that one’s ability to buy commodities comes from the income one earns as labourer (earning wages), or as entrepreneur (earning profits), or as landlord (earning rents), or as owner of capital (earning interests). In short, the incomes that people earn as owners of factors of production are used by them to meet their demand for goods and services. So we can see a circular flow here which is facilitated through the market. Simply put, the firms’ demand for factors of production to run the production process creates payments to the public. In turn, the public’s demand for goods and services creates payments to the firms and enables the sale of the products they produce. So the social act of consumption and production are intricately linked and, in fact, there is a circular causation here. The process of production in an economy generates factor payments for those involved in production and generates goods and services as the outcome of the production process. The incomes so generated create the capacity to purchase the final consumption goods and thus enable their sale by the business enterprises, the basic object of their production. The capital goods which are also generated in the production process also enable their producers to earn income – wages, profits etc. in a similar manner. The capital goods add to, or maintain, the capital stock of an economy and thus make production of other commodities possible.

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