Introduction and Structure of Macroeconomics

1. Macroeconomics is the part of economic theory that studies the economy, such as
national income, aggregate employment, general price level, aggregate consumption,
aggregate investment, etc. Its main instruments are aggregate demand and aggregate
supply. It is also called the ‘Income Theory’ or ‘Employment Theory’.
2. Structure of macro economy: As we know, Macroeconomics is concerned with
economic problems at the level of an economy as a whole. Structure of
Macroeconomics implies study of different sectors of the economy.
An economy may be divided into different sectors depending on the nature of study.
(a) Producer sector engaged in the production of goods and services.
(b) Household sector engaged in the consumption of goods and services.
Note: Households are taken as the owners of factors of production.
(c) The government sector engaged in activities like taxation and subsidies
(d) Rest of the world sector engaged in exports and imports.
(e) Financial sector (or financial system) engaged in the activity of borrowing and
lending.
3. Circular flow of income.
It refers to flow of money, income or the flow of goods and services across different
sectors of the economy in a circular form.
There are two types of Circular flow:
(a) Real/Product/Physical Flow
(b) Money/Monetary/Nominal Flow
(a) Real flow
(i) Real flow of income implies the flow of factor services from the household sector to
the producing sector and corresponding flow of goods and services from the producing
sector to the household sector.
(ii) Let us consider a simple economy consisting only of 2 sectors:
• Producer Sector.
• Household Sector.
 (iii) These two sectors are dependent on each other in the following ways:
• Producers supply goods and services to the households.
• Household (as the owners of factors of production) supplies factors of production (or
factor services) to the producers.
This interdependence can be explained with the help of the diagram given here.
(b) Money Flow
(i) Money flow refers to the flow of factor income, as rent, interest, profit and wages from
the producing sector to the household sector as monetary rewards for their factor
services as shown in the flowchart.

(ii) The households spend their incomes on the goods and services produced by the
producing sector. Accordingly, money flows back to the producing sector as household
expenditure as shown in the flowchart.

Circular Flow Of Income In Two Sector Model:

The following assumptions with regard to a simple economy with only two sector
of economics activity are:
(i) There are only two sectors in the economy; that is, household and firms.
(ii) Household supply factor services to firms.
(iii) Firms hire factor services from Households.

(iv) Households spend their entire income on consumption.

(v) Firms sell all that is produced to the households.
(vi) There is no government or foreign trade.
Such an economy described above has two types of markets.
(i) Market for goods and services, that is product market.
(ii) Market for factors of production, factor market.
As a result we can derive the following, in the case of our simple economy:
(i) Total production of goods and services by firms = Total consumption of goods and
services by Household Sector.
(ii) Factor Payments by Firms = Factor Incomes of Household Sector.
(iii) Consumption expenditure of Household sector = Income of Firm.
(iv) Hence, Real flows of production and consumption of Firms and households =
Money flows of income and expenditure of Firms and Households.

Phases Of Circular Flow:

There are three types of phases of Circular flow.

(i) Production Phase:
• It deals with the production of goods and services by the producer sector.
• If we study it in term of the quantity of goods and services produced, it is a Real Flow.
But, it is a Money flow, if we study it in terms of the market value of the goods produced.
(ii) Distribution Phase: It means the flow of income in the form of rent, interest, profit
and wages, paid by producer sector to the household sector. It is a Money Flow.
(iii) Disposition Phase:
• Disposition means expenditure made. This phase deals with expenditure on the
purchase of goods and services by households and other sectors.
• This is a Money Flow from other sectors to the producer sector. These phases are
illustrated in the figure given here.

Some Basic Concepts Of MacroEconomics

1. Factor Income
(a) Income earned by factor of production by rendering their productive services in the
production process is known as Factor Income.
(b) It is a bilateral [Two-Sided] Concept.
(c) It is included in National Income as it contribute something in the flow of goods and
services.
Examples: Rent, interest, wages and profit.
2. Transfer Income
(a) Income received without rendering any productive services is known as transfer
income.
(b) It is a unilateral [one-sided] concept.
(c) It is not included in National Income as it does not contribute anything in the flow of
goods and services.
Examples: Old Age Pension, Scholarship, Unemployment allowance.
There are two types of transfers:
(i) Current transfers (ii) Capital transfers
(i) Current Transfers
• Transfers made from the income of the payer and added to the income of the recipient
(who receive) for consumption expenditure are called current transfers.
• It is recurring or regular in nature.
For example, scholarships, gifts, old age pension, etc.
(ii) Capital Transfers
• Capital transfers are defined as transfers in cash and in kind for the purpose of
investment to recipients, made out of the wealth or saving of the donor.
• It is non recurring or irregular in nature.
For example, investment grant, capital gains tax, war damages, etc.
3. Stock
(a) Any economic variable which is calculated at a particular point of time is known as
stock.
(b) It is static in nature, i.e., it do not change.
(c) There is no time dimension in stock variables.
For example, Distance, Amount of Money, Money Supply, Water in Tank, etc.
4. Flow
(a) Any economic variable which is calculated during a period of time is known as flow.
(b) It is dynamic in nature, i.e., it can be changed.
(c) There is time dimension in flow variables.
For example, Speed, Spending of Money, Water in River, Exports, Imports, etc.
5. Economic territory or Domestic Territory:
(a) According to the United Nations, economic territory is the geographical territory
administered by a government within which persons, goods and capital circulate freely.
(b) The above definition is based on the criterion “freedom of circulation of persons,
goods and capital”. Clearly, those parts of the political frontiers (or boundaries) of a
country where the government of that country does not enjoy the above “freedom” are
not to be included in economic territory of that country.
(i) One example is embassies. Government of India does not enjoy the above freedom
in the foreign embassies located within India. So, these are not treated as a part of
economic territory of India. They are treated as part of the economic territories of their
respective countries. For example the U.S. embassy in India is a part of economic
territory of the U.S.A. Similarly, the Indian embassy in Washington is a part of economic
territory of India.
(ii) International organizations like UNO, WHO, etc. located within the geographical
boundaries of a country.
(iii) In layman terms, the domestic territory of a nation is understood to be the territory
lying within the political frontiers (or boundaries) of a country. But in national income
accounting, the term domestic territory is used in a wider sense. Based on ‘freedom’
criterion, the scope of economic territory is defined to cover:
• Ships and aircrafts owned and operated by normal residents between two or more
countries. For example, Indian Ships moving between china and India
i regularly are part of domestic territory of India. Similarly, planes operated by Air India
between Russia and Japan are part of the domestic territory of India. Similarly, planes
operated by Malaysian Airlines between India and Japan are a part of the domestic
territory of Malaysia.
• Fishing vessels, oil and natural gas rigs and floating platforms operated by the
residents of a country in the international waters where they have exclusive
rights of operation. For example, Fishing boats operated by Indian fishermen in
international waters of Indian Ocean will be considered a part of domestic territory of
India.
• Embassies, consulates and military establishments of a country located abroad. For
example, Indian Embassy in Russia is a part of the domestic territory of India.
‘Consulate’ is an office or building used by consul (an officer commissioned by the
government to reside in a foreign country to promote the interest of the countiy to which
he belongs).
6. Citizenship/Nationalship
(a) Citizenship is basically a legal concept based on the place of birth of the person or
some legal provisions allowing a person to become a citizen.
(b) It means, Indian citizenship can arise in two ways:
(i) When a person is born in India, he acquires automatic citizenship of India.
(ii) A person born outside India applies for citizenship and Indian Law allows him to
become Indian Citizen.
7. Normal Resident/Resident
(a) A Normal residenf, whether a person or an institution, is one whose centre of
economic interest lies in the economic territory of the country in which he lives.
(b) The centre of economic interest implies in two things:
(i) The resident lives or is located within the economic territory for more than one year
and
(ii) The resident carries out the basic economic activities of earnings, spending and
accumulation from that location
(c) There is a difference between the terms normal resident (resident) and citizen (or
national).
(i) A person becomes a national of a countiy because he was born in the country or on
the basis of some other legal criterion.
(ii) A person is treated resident of a country on the basis of economic criterion.
(iii) It is not necessary that a resident must also be the national of that country. Even
foreigners can be the residents if they pass the above stated economic criterion.
For example, a large number of Indian nationals have settled in U.S.A., England,
Australia, etc. as residents (and not as nationals) of these countries. For India, they
are Non-resident Indians (NRI) but continue to remain Indian nationals.
Following are not included under the category of Normal residents:
(i) Foreign visitors in the country for such purposes as recreation, holidays, medical
treatment, study tours, conferences, sports events, business etc. (they are supposed to
stay in the host country for less than one year. In case they continue to stay for one
year or more in the host country, they will be treated as normal residents of the host
countiy).
(ii) Crew members of foreign vessels, commercial travelers and seasonal workers in ,
the country (Foreign workers who work part of the year in the country in response to the
varying seasonal demand for labour and return to their households and border workers
who regularly cross the frontier each day or somewhat less regularly, (i.e. each week) to
work in the neighbouring country are the normal residents of their own countries.
Example: Nepal.
(iii) Officials, diplomats and members of the armed forces of a foreign country.
(iv) International bodies like World Bank, World Health Organisation or International
Monetary Fund are not considered residents of the country in which these organisations
operate but are treated as residents of international territory. However, the staffs of
these bodies are treated as normal residents of the country in which the international
body operates. For example, international body like World Health Organisation located
in India is not normal resident of India but Americans working in its office for more than
a year will be treated as normal residents of India.
(v) Foreigners who are the employees of non-resident enterprises and who have come
to the country for purposes of installing machinery or equipment purchased from their
employers. (They are supposed to stay for less than one year. In case they continue to
stay for one year or more, they will be treated as normal residents of the host country).
8. Final Goods
(a) These are the goods that are used for:
(i) Personal Consumption (like bread purchased by consumer household), or (if)
Investment Or Capital Formation (like building, machinery purchased by a firm)
(b) In other words, final goods are those, which require no further processing and are
available in an economy for consumption purpose or investment. These give direct
satisfaction to a consumer.
(c) According to production boundary, if a good crosses the imaginary line around the
production unit and reaches to final consumer or investment made by a producer within
the imaginary line of production unit is known as the final good.
9. Intermediate Goods
(a) These are the goods that are used for:
(i) Further processing (like sugar used for making sweets); or
(ii) Resale in the same year (If car purchased by car dealer for resale).
(b) In other words, intermediate goods are the ones, which require further processing
and are not available in an economy for the purpose of consumption. These goods give
indirect satisfaction to a consumer.
(c) According to the production boundary, if a good does not cross the imaginary line
around the production unit and reaches to other firm within the production boundary, is
known as intermediate good.
10. Point to Remember for Final Goods and Intermediate Goods
(a) Basis of Classification: If a good is used for:
(i) Personal consumption; or (ii) Investment
Then it is a final good, whereas, if a good is used for:
(i) Further processing; or
(ii) Resale in the same year, then it is known as intermediate good.
Thus, the basis of classification between these two goods is not the commodity itself,
but the use made of it.
For example, bread used by a consumer household is a final goods, but the same used
by a bakery for making a sandwich is a intermediate goods.
(b) Production Boundary
(i) Production boundary plays a vital role to differentiate between intermediate and final
goods. The production boundary is the imaginary line around the production unit.
(ii) According to the production boundary, if a good crosses the imaginary line around
the production unit and reaches to final consumer or investment made by a producer
within the imaginary line of production unit, it is known as final good.
As against it, if a good does not cross the imaginary line around the production unit and
reaches to other firm within the production boundary, it is known as intermediate good.
In the given diagram, there are 3 production units. The thick border drawn around these
three units is the Production Boundary.
Within this limit, wheat and flour are intermediate goods.
Bread is final good as it lies outside the purview of production boundary.
11. Important Points about
Intermediate Goods: As far as intermediate consumption of general government is
concerned, it’s purchased goods ranges from ordinary writing paper, pencils and pens
to sophisticated fighter aircrafts. The goods and services purchased include both
durable goods and non-durable goods and services. The intermediate consumption of
the general government includes the following items:
(a) Value of all Non-durable Goods and Services such as petrol, electricity, lubricants,
stationery, soaps, towels etc. including repair and maintenance of capital stock: Non-
durable goods and services are those which have an expected life time of use of less
than one year. Repair and maintenance of capital stock mean expenditure incurred for
maintaining fixed assets and keep them in good working order. This includes the
expenditure on new parts of the fixed assets. The life of the new parts may be around
one year or slightly more and the value should be relatively small. For example,
replacement of the tyres of a truck is an intermediate consumption, but not the
replacement of its engine.
(b) Expenditure on Military Equipment missiles, rockets, bombs, warships, submarines,
military aircrafts, tanks, missile carriers and rocket-launchers etc. whose function is to
release weapons. Military vehicles and light weapons.
(c) Value of goods received from foreign governments in form of gifts or as transfers.
Examples of these transfers in kind are food, clothing, medicines, vegetable oils, butter,
toys sent by the government of one country to the other in times of natural calamities or
as a token of goodwill and friendship between two countries.
However, the goods received for distribution to consumer households without
renovation or alternation should not be included in intermediate consumption as these
goods go into the final consumption of consumer households.
(d) As we know, intermediate goods are purchased by one production unit from another
production unit within the production boundary.
However, it’s not necessary that all purchases by one production unit from other
production units are intermediate purchases. For example, purchases of building,
machinery, etc. are not intermediate purchases (if they are not meant for resale in the
same year). Rather, these purchases are meant for investment and are termed as final
product.
(e) Research and development
• Commodities consumed. In research and exploratory activities (like oil exploration in
different parts of India by the Oil and Natural Gas Commission) or improving the
technology of a particular production process.
• Commodities used in basic scientific research.
• Advertisements, market research and public relationship meant for improving the
goodwill of the business enterprises.
• Business expenses of the employees on tours and entertainment.
12. Final goods can be classified into two groups: Consumption Goods and Capital
Goods.
(a) Consumption Goods:
(i) Meaning: Consumption goods are those which satisfy the wants of the consumers
directly. For example, cars, television sets, bread, furniture, air-conditioners, etc.
(u) Categories of Consumption Goods:
• Durable goods: These goods have an expected life time of several years and of
relatively high value. They are motor cars, refrigerators, television sets, washing
machines, air-conditioners, kitchen equipments, computers, communication equipments
etc.
• Semi-durable goods: These goods have an expected life time of use of one year or
slightly more. They are not of relatively great value. Examples are clothing, furniture,
electrical appliances like fans, electric irons, hot plates and crockery.
• Non-durable goods: Goods which can not be used again and again, i.e., they lose their
identity in a single act of consumption are known as non-durable goods. These are
foodgrains, milk and milk products, edible oils, beverages, vegetables, tobacco and
other food articles.
• Services: Services are non-material goods which satisfy the human wants directly.
They cannot be seen or touched, i.e., they are intangible in nature. These are medical
care, transport and communications, education, domestic services rendered by hired
servants, etc.
(b) Capital Goods:
(i) Capital goods are defined as all goods produced for use in future productive
processes.
For example, all the durable goods like cars, trucks, refrigerators, buildings, aircrafts,
air-fields and submarines used to produce goods and are ready for sale in the market
are a part of capital goods.
(ii) Stocks of raw materials, semi-finished and finished goods lying with the producers at
the end of an accounting year are also a part of capital goods.
(iii) Some more examples of capital goods are machinery, equipment, roads and
bridges.
(iv) These goods require repair or replacement over time as their value depreciate over
a period of time.
13. Differentiate between final goods and intermediate goods on the basis of end
used classification of goods and services with example.

Words that Matter

1. Circular flow of income: It refers to flow of money income or the flow of goods and
services across different sectors of the economy in a circular form.
2. Money flow (nominal flow): Money flow refers to the flow of factor income, as rent,
interest, profit and wages from the producing sector to the household sector as
monetary rewards for their factor services.
3. Real flow or physical flow: Real flow of income implies the flow of factor services
from the household sector to the producing sector and corresponding flow of goods and
services from the producing sector to the household sector.
4. Factor income: Income earned by factor of production by rendering their productive
services in the production process is known as Factor Income.
5. Transfer income: Income received without rendering any productive services is
known as Transfer Income.
6. Current transfers: Transfers made from the current income of the payer and added
to the current income of the recipient (who receive) for consumption expenditure are
called current transfers.
7. Capital transfers: Capital transfers are defined as transfers in cash and in kind for
the purpose of investment to recipient made out of the wealth or saving of a donor.
8. Final goods: These are those which are used for:
(a) Personal consumption (like bread purchased by consumer household), or
(b) Investment or capital formation (like building, machinery purchased by a firm)
9. Intermediate goods: These are those, which are used for:
(a) Further processing (like sugar used for making sweets), or
(b) Resale in the same year (If car purchased by a car dealer for resale).
10. Consumption goods: Consumption goods are those goods which satisfy the wants
of consumers directly.
11. Capital goods: Capital goods are defined as all goods produced for use in future
productive processes.