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.
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.
Macroeconomics, as a separate branch of economics, emerged after the British economist John Maynard Keynes published his celebrated book, The General Theory of Employment, Interest and Money in 1936. The dominant thinking in economics before Keynes was that all the labourers who are ready to work will find employment and all the factories will be working at their full capacity. This school of thought is known as the classical tradition. However, the Great Depression of 1929 and the subsequent years saw the output and employment levels in the countries of Europe and North America fall by huge amounts. It affected other countries of the world as well. Demand for goods in the market was low, many factories were lying idle, workers were thrown out of jobs. In USA, from 1929 to 1933, unemployment rate rose from 3 per cent to 25 per cent (unemployment rate may be defined as the number of people who are not working and are looking for jobs divided by the total number of people who are working or looking for jobs). Over the same period aggregate output in USA fell by about 33 per cent. These events made economists think about the functioning of the economy in a new way. The fact that the economy may have long lasting unemployment had to be theorised about and explained. Keynes’ book was an attempt in this direction. Unlike his predecessors, his approach was to examine the working of the economy in its entirety and examine the interdependence of the different sectors. The subject of macroeconomics was born.
We must remember that the subject under study has a particular historical context. We shall examine the working of the economy of a capitalist country in this book. In a capitalist country production activities are mainly carried out by capitalist enterprises. A typical capitalist enterprise has one or several entrepreneurs (people who exercise control over major decisions and bear a large part of the risk associated with the firm/enterprise). They may themselves supply the capital needed to run the enterprise, or they may borrow the capital. To carry out production they also need natural resources – a part consumed in the process of production (e.g. raw materials) and a part fixed (e.g. plots of land). And they need the most important element of human labour to carry out production. This we shall refer to as labour. After producing output with the help of these three factors of production, namely capital, land and labour, the entrepreneur sells the product in the market. The money that is earned is called revenue. Part of the revenue is paid out as rent for the service rendered by land, part of it is paid to capital as interest and part of it goes to labour as wages. The rest of the revenue is the earning of the entrepreneurs and it is called profit. Profits are often used by the producers in the next period to buy new machinery or to build new factories, so that production can be expanded. These expenses which raise productive capacity are examples of investment expenditure. In short, a capitalist economy can be defined as an economy in which most of the economic activities have the following characteristics,
- (a) there is private ownership of means of production
- (b) production takes place for selling the output in the market
- (c) there is sale and purchase of labour services at a price which is called the wage rate (the labour which is sold and purchased against wages is referred to as wage labour).
If we apply the above mentioned three criteria to the countries of the world we would find that capitalist countries have come into being only during the last three to four hundred years. Moreover, strictly speaking, even at present, a handful of countries in North America, Europe and Asia will qualify as capitalist countries. In many underdeveloped countries production (in agriculture especially) is carried out by peasant families. Wage labour is seldom used and most of the labour is performed by the family members themselves. Production is not solely for the market; a great part of it is consumed by the family. Neither do many peasant farms experience significant rise in capital stock over time. In many tribal societies the ownership of land does not exist; the land may belong to the whole tribe. In such societies the analysis that we shall present in this book will not be applicable. It is, however, true that many developing countries have a significant presence of production units which are organised according to capitalist principles. The production units will be called firms in this blog. In a firm the entrepreneur (or entrepreneurs) is at the helm of affairs. She hires wage labour from the market, she employs the services of capital and land as well. After hiring these inputs she undertakes the task of production. Her motive for producing goods and services (referred to as output) is to sell them in the market and earn profits. In the process she undertakes risks and uncertainties. For example, she may not get a high enough price for the goods she is producing; this may lead to fall in the profits that she earns. It is to be noted that in a capitalist country the factors of production earn their incomes through the process of production and sale of the resultant output in the market. In both the developed and developing countries, apart from the private capitalist sector, there is the institution of State. The role of the state include framing laws, enforcing them and delivering justice. The state, in many instances, undertakes production – apart from imposing taxes and spending money on building public infrastructure, running schools, colleges, providing health services etc. These economic functions of the state have to be taken into account when we want to describe the economy of the country. For convenience we shall use the term government to denote state.
Apart from the firms and the government, there is another major sector in an economy which is called the household sector. By a household we mean a single individual who takes decisions relating to her own consumption, or a group of individuals for whom decisions relating to consumption are jointly determined.
Households also save and pay taxes. How do they get the money for these activities? We must remember that the households consist of people. These people work in firms as workers and earn wages. They are the ones who work in the government departments and earn salaries, or they are the owners of firms and earn profits. Indeed the market in which the firms sell their products could not have been functioning without the demand coming from the households. So far we have described the major players in the domestic economy. But all the countries of the world are also engaged in external trade. The external sector is the fourth important sector in our study. Trade with the external sector can be of two kinds,
- The domestic country may sell goods to the rest of the world. These are called exports.
- The economy may also buy goods from the rest of the world. These are called imports.
Besides exports and imports, the rest of the world affects the domestic economy in other ways as well. Capital from foreign countries may flow into the domestic country, or the domestic country may be exporting capital to foreign countries.
Macroeconomics deals with the aggregate economic variables of an economy. It also takes into account various interlinkages which may exist between the different sectors of an economy. This is what distinguishes it from microeconomics; which mostly examines the functioning of the particular sectors of the economy, assuming that the rest of the economy remains the same. Macroeconomics emerged as a separate subject in the 1930s due to Keynes. The Great Depression, which dealt a blow to the economies of developed countries, had provided Keynes with the inspiration for his writings. In this book we shall mostly deal with the working of a capitalist economy. Hence it may not be entirely able to capture the functioning of a developing country. Macroeconomics sees an economy as a combination of four sectors, namely households, firms, government and external sector.
By economic units or economic agents, we mean those individuals or institutions which take economic decisions. They can be consumers who decide what and how much to consume. They may be producers of goods and services who decide what and how much to produce. They may be entities like the government, corporation, banks which also take different economic decisions like how much to spend, what interest rate to charge on the credits, how much to tax, etc. Macroeconomics tries to address situations facing the economy as a whole.
Adam Smith, the founding father of modern economics, had suggested that if the buyers and sellers in each market take their decisions following only their own self-interest, economists will not need to think of the wealth and welfare of the country as a whole separately. But economists gradually discovered that they had to look further. Economists found that first, in some cases, the markets did not or could not exist. Secondly, in some other cases, the markets existed but failed to produce equilibrium of demand and supply. Thirdly, and most importantly, in a large number of situations society (or the State, or the people as a whole) had decided to pursue certain important social goals unselfishly (in areas like employment, administration, defence, education and health) for which some of the aggregate effects of the microeconomic decisions made by the individual economic agents needed to be modified. For these purposes macroeconomists had to study the effects in the markets of taxation and other budgetary policies, and policies for bringing about changes in money supply, the rate of interest, wages, employment, and output. Macroeconomics has, therefore, deep roots in microeconomics because it has to study the aggregate effects of the forces of demand and supply in the markets. However, in addition, it has to deal with policies aimed at also modifying these forces, if necessary, to follow choices made by society outside the markets. In a developing country like India such choices have to be made to remove or reduce unemployment, to improve access to education and primary health care for all, to provide for good administration, to provide sufficiently for the defence of the country and so on. Macroeconomics shows two simple characteristics that are evident in dealing with the situations we have just listed. These are briefly mentioned below.
First, who are the macroeconomic decision makers (or ‘players’)? Macroeconomic policies are pursued by the State itself or statutory bodies like the Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI) and similar institutions. Typically, each such body will have one or more public goals to pursue as defined by law or the Constitution of India itself. These goals are not those of individual economic agents maximising their private profit or welfare. Thus the macroeconomic agents are basically different from the
individual decision-makers. Secondly, what do the macroeconomic decision-makers try to do? Obviously they often have to go beyond economic objectives and try to direct the deployment of economic resources for such public needs as we have listed above. Such activities are not aimed at serving individual self-interests. They are pursued for the welfare of the country and its people as a whole.
If we observe the economy of a country as a whole it will appear that the output levels of all the goods and services in the economy have a tendency to move together. For example, if output of food grain is experiencing a growth, it is generally accompanied by a rise in the output level of industrial goods. Within the category of industrial goods also output of different kinds of goods tend to rise or fall simultaneously. Similarly, prices of different goods and services generally have a tendency to rise or fall simultaneously.
We can also observe that the employment level in different production units also goes up or down together.
If aggregate output level, price level, or employment level, in the different production units of an economy, bear close relationship to each other then the task of analysing the entire economy becomes relatively easy. Instead of dealing with the above mentioned variables at individual (disaggregated) levels,
we can think of a single good as the representative of all the goods and services produced within the economy. This representative good will have a level of production which will correspond to the average production level of all the goods and services. Similarly, the price or employment level of this representative good will reflect the general price and employment level of the economy. In macroeconomics we usually simplify the analysis of how the country’s total production and the level of employment are related to attributes (called ‘variables’) like prices, rate of interest, wage rates, profits and so on, by focusing on a single imaginary commodity and what happens to it. We are able to afford this simplification and thus usefully abstain from studying what happens to the many real commodities that actually are bought and sold in the market because we generally see that what happens to the prices, interests, wages and profits etc. for one commodity more or less also happens for the others. Particularly, when these attributes start changing fast, like when prices are going up (in what is called an inflation), or employment and production levels are going down (heading for a depression), the general directions of the movements of these variables for all the individual commodities are usually of the same kind as are seen for the aggregates for the economy as a whole. We will see below why, sometimes, we also depart from this useful simplification when we realise that the country’s economy as a whole may best be seen as composed of distinct sectors. For certain purposes the interdependence of (or even rivalry between) two sectors of the economy (agriculture and industry, for example) or the relationships between sectors (like the household sector, the business sector and government in a democratic setup) help us understand some things happening to the country’s economy much better, than by only looking at the economy as a whole.
From this discussion here, and your earlier reading of microeconomics, you may have already begun to understand in what way macroeconomics differs from microeconomics. To recapitulate briefly, in microeconomics, you came across individual ‘economic agents’ and the nature of the motivations that drive them. They were ‘micro’ (meaning ‘small’) agents – consumers choosing their respective optimum combinations of goods to buy, given their tastes and incomes; and producers trying to make maximum profit out of producing their goods keeping their costs as low as possible and selling at a price as high as they could get in the markets. In other words, microeconomics was a study of individual markets of demand and supply and the ‘players’, or the decisionmakers were also individuals (buyers or sellers, even companies) who were seen as trying to maximise their profits (as producers or sellers) and their personal satisfaction or welfare levels (as consumers). Even a large company was ‘micro’ in the sense that it had to act in the interest of its own shareholders which was not necessarily the interest of the country as a whole. For microeconomics the ‘macro’ (meaning ‘large’) phenomena affecting the economy as a whole, like inflation or unemployment, were either not mentioned or were taken as given. These were not variables that individual buyers or sellers could change. The nearest that microeconomics got to macroeconomics was when it looked at General Equilibrium, meaning the equilibrium of supply and demand in each market in the economy.
India has been regarded as a single entity since earliest times. The theologians and political philosophers have always regarded Bharatavarsha as a single country and talked of the thousand yojans of land that stretched from Himalayas to the sea as the proper domain of a single universal emperor. The Vishnupuran also emphasised the fundamental unity of the country when it observed that the country that lies north of the ocean and south of the snowy mountains is called Bharata. The seperation of India from other countries through Himalayas in the north and ocean in the other three sides of the country has also greatly contributed to the sense of unity of the country. The location of various religious places in different parts of the country and insistence on visit to these places as a sacred religious duty also emphasises the geographical unity of the country.
In the political sphere, the sense of unity of India has been a dominant feature since the Mauryan period. Though the country was divided into several political units, it has always been a cherished ambition of most of the rulers to carve out an all-India empire or become a Chakravarthi. According to Kautilya's Arthashastra, the domain of a Chakravarthi ruler extends from Himalayas to the seas. In other words a king could claim to be a Chakravarthi only if he was able to establish his rule over the whole of the country. Generally, the king desirous of assuming the title of Chakravarthi performed Asvamedha Yajna (Horse Sacrifice). The Mauryas as well as the Guptas during the ancient times carved out all-India empires. In the medieval times, Alauddin Khilji, Mohd. Tughlaq, Akbar, Shah Jahan also tried to establish all-India empires. These rulers also tried to provide an identical system of administration in different parts of the empire.
In the religious sphere also people of India have enjoyed considerable amount of unity despite the prevelance of different religions. The same Hindu gods and goddesses are worshipped throughout the country, even though they are known by different names in different regions. Like wise the Hindu religious works like Ramayana and Mahabharata are held in great esteem throughout the country and read with great devotion. The Vedas, the Puranas and other religious scriptures are looked with utmost respect all over the country. Religious places of Hindus are located in the four corners of the country and devout Hindus are expected to go on pilgrimage to these places. Rameshwaram is located in far south, Kailash in extreme north, Jagannadh Puri in extreme east and Somnath in the west.
Despite the presence of people of different races in the country, a sense of unity exists among the people. In the course of time they have become a part of the Indian or Hindu society which has assimilated the features of almost all races. Similarly, despite the presence of large number of languages, the country has enjoyed linguistic unity. Different languages weere developed for common use. In the 3rd Century B.C., Prakrit served as common language and was used for the communication of message of Royal missionaries to all the people in the kingdom. Thereafter, Sanskrit emerged as a common language of the people. Many region languages in use today have been derived from Sanskrit. With the advent of the Muslims in the northern India, Sanskrit suffered a setback but continued to thrive in Southern India. After the advent of the Britishers, English became popular and is widely spoken at present.
Some of the basic features of Indian culture such as Varna, Ashrama, Dharma, etc. are accepted and practised all over the country. Most of the festivals like Diwali and Holi are celebrated nation wide irrespective of religions. The sanctity of family life has also been accepted throughout the country and the various social ceremonies closely resemble one another. The essential fundamental unity rests upon the fact that diverse people of India have developed a peculiar type of culture and civilization utterly different from any type in the world.
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