<h5 id="21-some-basic-concepts-of-macroeconomics">2.1 Some Basic Concepts of Macroeconomics</h5> <ul> <li>Economic wealth of a nation is not solely dependent on the possession of natural resources, but on how these resources are used in generating a flow of production and income.</li> <li>The flow of production in a modern economic setting arises from the production of commodities (goods and services) by millions of enterprises, which are sold to consumers for final use or for use in further production.</li> <li>Final goods are items meant for final use and will not undergo any further transformation at the hands of any producer. They can be categorized into consumption goods (like food and clothing) and capital goods (used in the production process).</li> <li>Intermediate goods are mostly used as raw material or inputs for production of other commodities and are not final goods.</li> <li>The total final goods and services produced in an economy in a given period of time are either in the form of consumption goods (both durable and non-durable) or capital goods.</li> <li>Depreciation is an annual allowance for wear and tear of a capital good, which is the cost of the good divided by the number of years of its useful life. It is a concept used to accommodate regular wear and tear of capital.</li> </ul> <p>======</p> <h5 id="22-circular-flow-of-income-and-methods-of-calculating-national-income">2.2 Circular Flow of Income and Methods of Calculating National Income</h5> <ul> <li>The economy can be visualized as a circular flow of income between firms and households.</li> <li>Households receive payments from firms for their contributions to production: labor (wages), capital (interest), entrepreneurship (profit), and natural resources (rent).</li> <li>In this simple economy, households spend their entire income on domestically produced goods and services, resulting in no leakage from the system.</li> <li>The aggregate income of the economy can be measured through the expenditure method (measuring aggregate spending on final goods and services), the product method (measuring aggregate value of final goods and services produced), or the income method (summing total factor payments).</li> <li>When households decide to spend more on goods and services, firms produce more and pay extra remunerations to factors of production. This results in an eventual rise in income, consistent with the higher spending level.</li> <li>The simple macroeconomic model presented here is a simplified version of an economy, and serves to highlight essential features of economic systems. The model’s conclusion about aggregate income calculation remains consistent even when savings are introduced.</li> </ul> <p>======</p> <h5 id="221-the-product-or-value-added-method">2.2.1 The Product or Value Added Method</h5> <ul> <li>The text introduces the concept of value added, which is the difference between a firm’s total production and the value of intermediate goods used.</li> <li>Depreciation, or consumption of fixed capital, is also discussed. When included in value added, it results in Gross Value Added, and when deducted from Gross Value Added, it results in Net Value Added.</li> <li>The text also discusses the treatment of unsold stock or inventory, which is the stock of unsold finished goods, semi-finished goods, or raw materials carried from one year to the next.</li> <li>The change in inventories during a year is equal to the firm’s production during the year minus the sale of the firm during the year.</li> <li>The gross value added of a firm can be represented as G gross value of the output produced by the firm - value of intermediate goods used by the firm + value of change in inventories - value of depreciation of the firm.</li> </ul> <p>======</p> <h5 id="222-expenditure-method">2.2.2 Expenditure Method</h5> <ul> <li>The Expenditure Method is an alternative way to calculate GDP by looking at the demand side of products.</li> <li>The final expenditure is the part of expenditure which is undertaken not for intermediate purposes and it is calculated by adding final consumption expenditure, final investment expenditure, government expenditure, and export revenues.</li> <li>The sum total of the revenues that the firm i earns is given by R Vi ≡ Sum total of final consumption, investment, government and exports expenditures received by the firm i.</li> <li>The sum total of the final expenditures received by all the firms in the economy is equivalent to C+I+G+X-M, where C is the aggregate final consumption expenditure, I is the aggregate final investment expenditure, G is the aggregate expenditure of the government, X is the aggregate expenditure by the foreigners on the exports of the economy, and M is the aggregate imports expenditure incurred by the economy.</li> <li>Investment expenditure, I, is the most unstable out of the five variables on the right hand side of the equation.</li> </ul> <p>======</p> <h5 id="223-income-method">2.2.3 Income Method</h5> <ul> <li>GDP by income method is equal to the sum total of factor incomes.</li> <li>Factor incomes include total wages and total profits.</li> <li>Total wages received by workers of A and B is 20 + 60 = 80.</li> <li>Total profits earned by A and B is 30 + 90 = 120.</li> <li>Therefore, GDP by income method is 80 (wages) + 120 (profits) = 200.</li> </ul> <p>======</p> <h5 id="224-factor-cost-basic-prices-and-market-prices">2.2.4 Factor Cost, Basic Prices and Market Prices</h5> <ul> <li>The GDP at factor cost has been the most highlighted measure of national income in India.</li> <li>The CSO reports GDP at factor cost and at market prices. It has replaced GDP at factor cost with GVA at basic prices, and GDP at market prices is now the most highlighted measure.</li> <li>Factor cost includes payment to factors of production, but does not include any tax. Market prices are arrived at by adding total indirect taxes less total subsidies to the factor cost.</li> <li>Basic prices include production taxes (less production subsidies), but not product taxes (less product subsidies). To arrive at market prices, product taxes (less product subsidies) are added to the basic prices.</li> <li>The CSO now releases GVA at basic prices, which includes net production taxes but not net product taxes. To arrive at GDP (at market prices), net product taxes are added to GVA at basic prices.</li> </ul> <p>======</p> <h5 id="23-some-macroeconomic-identities">2.3 Some Macroeconomic Identities</h5> <ul> <li>GDP at Market Prices (GDPMP): Market value of all final goods and services produced within a domestic territory of a country in a year. Equation: GDPMP = C + I + G + X - M</li> <li>GDP at Factor Cost (GDPFC): GDPMP minus net product taxes. Measures money value of output produced by firms within a country in a year. Equation: GDPFC = GDPMP - NIT</li> <li>Net Domestic Product at Market Prices (NDPMP): GDPMP minus depreciation. Allows policy-makers to estimate how much the country has to spend to maintain their current GDP.</li> <li>NDP at Factor Cost (NDFC): Income earned by the factors in the form of wages, profits, rent, interest, etc., within the domestic territory of a country. Equation: NDFC = NDPMP - Net Product Taxes</li> <li>GNP at Market Prices (GNPMP): Value of all the final goods and services that are produced by the normal residents of a country, measured at market prices. Equation: GNPMP = GDPMP + NFIA</li> <li>NNP at Factor Cost (NNPFC) or National Income (NI): Sum of income earned by all factors in the production in the form of wages, profits, rent and interest, etc., belonging to a country during a year. Equation: NI = NDPMP - Net Product Taxes = NDFC + NFIA</li> </ul> <p>======</p> <h5 id="24-nominal-and-real-gdp">2.4 Nominal and Real GDP</h5> <ul> <li>Real GDP is calculated using a constant set of prices, or constant prices, to evaluate goods and services, ensuring that any changes reflect actual changes in production volume.</li> <li>Nominal GDP is the value of GDP at current prevailing prices, which may change due to price fluctuations and not necessarily reflect changes in production volume.</li> <li>The ratio of nominal GDP to real GDP provides an idea of price movement from the base year to the current year, with the GDP deflator measuring this change as the ratio of nominal to real GDP.</li> <li>The Consumer Price Index (CPI) is an alternative measure of price change in an economy, focusing on a given basket of commodities bought by a representative consumer, expressed in percentage terms.</li> <li>CPI may differ from the GDP deflator due to differences in the goods and services considered, inclusion of imported goods prices, and varying weights according to production levels.</li> </ul> <p>======</p> <h5 id="25-gdp-and-welfare">2.5 GDP and Welfare</h5> <ul> <li>GDP, as the sum of goods and services, can be distributed unequally, leading to improved GDP not necessarily meaning improved welfare for all.</li> <li>Many non-monetary exchanges are not accounted for in GDP, such as domestic work or barter exchanges, leading to underestimation of economic activity and well-being.</li> <li>Externalities, both positive and negative, are not reflected in GDP. This can result in overestimation or underestimation of the economy’s welfare.</li> <li>Negative externalities, such as pollution, can harm individuals and communities without compensation, while positive externalities can enhance welfare without being accounted for in GDP.</li> <li>GDP’s focus on market transactions may not accurately represent the overall well-being of a country’s population, making it an imperfect indicator of welfare.</li> </ul> <p>======</p>