Introductory Macroeconomics Class XII CBSE PDF

Introductory A.J@i uniq Macroeconomics T.R. Jain Dr. V.K. Ohri Former Principal Associate Professor(Retd.) S.A. Jain College Shyam Lal College Ambala City (Delhi University), Delhi...

Introductory A.J@i uniq Macroeconomics T.R. Jain Dr. V.K. Ohri Former Principal Associate Professor(Retd.) S.A. Jain College Shyam Lal College Ambala City (Delhi University), Delhi Class XII A S H U T O S H K U M A R J A I S W A L  Printing History: Edition: 2020-21 Syllabus Covered: Central Board of Secondary Education, Delhi Medium: ENGLISH (Hindi medium is also available) Price: Three Hundred Sixty Rupees ( 360/-) ISBN: 978-93-89452-93-8 © Copyright Reserved by the Publishers All rights reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without written permission from the publishers. Published By: VK Global Publications Pvt. Ltd. Regd. 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It is notified that neither the publishers nor the author or seller will be responsible for any damage or loss of action to anyone, of any kind, in any manner, therefrom. For binding mistakes, misprints or for missing pages, etc. the publisher's liability is limited to replacement within one month of purchase by similar edition. All expenses in this connection are to be borne by the purchaser. Contents Introductory Macroeconomics 1. Introduction..........................................3 2. Some Basic Concepts of Macroeconomics...............15 3. National Income and Related Aggregates................51 4. Methods of Calculating National Income................ 81 5. Money.............................................133 6. Banking............................................ 151 7. Aggregate Demand, Aggregate Supply and Related Concepts....................................177 8. Short Run Equilibrium Output........................ 213 9. Problem of Deficient Demand and Excess Demand.................................255 10. Government Budget and The Economy................291 11. Foreign Exchange Rate...............................333 12. Balance of Payments................................365 Solved Numericals Unsloved Numericals Project Work CBSE Sample Question Paper, 2020 (Solved)  Syllabus Central Board of Secondary Education, Delhi Economics Class-XII Paper One 3 Hours Theory: 80 Marks Project: 20 Marks Units Periods Marks Part-A: Introductory Macroeconomics 1. National Income and Related Aggregates 28 10 2. Money and Banking 15 06 3. Determination of Income and Employment 27 12 4. Government Budget and the Economy 15 06 5. Balance of Payments 15 06 100 40 Part-B: Indian Economic Development 6. Development Experience (1947-90) and Economic Reforms since 1991 28 12 7. Current Challenges facing Indian Economy 60 22 8. Development Experience of India­ A Comparison with Neighbours 12 06 100 40 Part-C: Project Work 20 20 PART-A: INTRODUCTORY MACROECONOMICS Unit-1: National Income and Related Aggregates (28 Periods) /' lj What is Macroeconomics? L, V(lncome Basic concepts in macroeconomics: consumption goods, capital goods, final goods, intermediate goods; stocks and flows; gross investment and depreciation. Circular flow of income (two sector model); Methods of calculating National Income-Value Added or Product method, Expenditure method, Income method. Aggregates related to National Income: Gross National Product (GNP), Net National Product (NNP), Gross and Net  Domestic Product (GDP and NDP)-at market price, at factor cost; Real and Nominal GDP. GDP and Welfare. Unit-2: Money and Banking (15 Periods) Money-meaning and supply of money-Currency held by the public and net demand deposits held by commercial banks. Money creation by the commercial banking system. Central bank and its functions (example of the Reserve Bank oflndia): Bank of issue, Government Bank, Banker's Bank, Control of Credit through Bank Rate, CRR, SLR, Repo Rate and Reverse Repo Rate, Open Market Operations, Margin requirement. Unit-3: Determination oflncome and Employment (27 Periods) Aggregate demand and its components. Propensity to consume and propensity to save (average and marginal). Short-run equilibrium output; investment multiplier and its mechanism. Meaning of full employment and involuntary unemployment. Problems of excess demand and deficient demand; measures to correct them-changes in government spending, taxes and money supply. Unit-4: Government Budget and the Economy (15 Periods) Government budget-meaning, objectives and components. Classification of receipts-revenue receipts and capital receipts; classification of expenditure-revenue expenditure and capital expenditure. Measures of government deficit-revenue deficit, fiscal deficit, primary deficit-their meaning. Unit-5: Balance of Payments ( 15 Periods) Balance of payments account-meaning and components; balance of payments deficit-meaning. Foreign exchange rate-meaning of fixed and flexible rates and managed floating. Determination of exchange rate in a free market.  PART-B: INDIAN ECONOMIC DEVELOPMENT Unit-6: Development Experience (1947-90) and Economic Reforms since 1991 (28 Periods) A brief introduction of the state oflndian economy on the eve of independence. Common goals of Five Year Plans. Main features, problems and policies of agriculture (institutional aspects and new agricultural strategy, etc.), industry (industrial licensing, etc.) and foreign trade. Economic Reforms since 199 1: Features and appraisals of liberalisation, globalisation and privatisation (LPG policy); Concepts of demonetization and GST. Unit-7: Current Challenges facing Indian Economy (60 Periods) Poverty-absolute and relative; Main programmes for poverty alleviation: A critical assessment. Rural Development: Key issues-credit and marketing-role of cooperatives; agricultural diversification; alternative farming-organic farming. Human Capital Formation: How people become resource; Role of human capital in economic development; Growth ofEducation Sector in India. Employment: Formal and informal growth; problems and policies. Infrastructure: Meaning and Types: Case Studies: Energy and Health: Problems and Policies-A critical assessment. Sustainable Economic Development: Meaning, Effects of Economic Development on Resources and Environment, including global warming. /' lj Unit-8: Development Experience oflndia­ A Comparison with Neighbours ( 12 Periods) L, V(lrxomeYGDP India and Pakistan India and China Issues: growth, population, sectoral development and other Human Development Indicators. Design of Question Paper Central Board of Secondary Education, Delhi Economics Class XII Theory: 80 Marks Duration: 3 Hours Project: 20 Marks s. No. Typology of Questions Objective Short Short Type/MCQ Answer I Answer II II Answer Long Marks I Mark 3 Marks 4 Marks 6 Marks 1. Remembering: Exhibit memory of previously learned material by recalling 5 1 2 1 22 facts, terms, basic concepts, and answers. 2. Understanding: Demonstrate understanding of facts and ideas by organizing, comparing, 5 1 2 1 22 translating, interpreting, giving descriptions, and stating main ideas. 3. Applying: Solve problems to new situations by applying acquired 5 1 1 1 18 knowledge, facts, techniques and rules in a different way. 4. Analysing and Evaluating: Examine and break information into parts by identifying motives or causes. Make inferences and find evidence to support generalizations. Present and defend opinions by making judgments about 5 1 1 1 18 information, validity of ideas, or quality of work based on a set of criteria. Creating: Compile information together in a different way by combining elements in a new pattern or proposing alternative solutions. Total 20xl=20 4 X 3 = 12 6 X 4= 24 4x 6= 24 80 (34) Note: There will be Internal Choices in questions of I mark, 3 marks, 4 marks and 6 marks in both sections (A & B). In all, total 8 internal choices.  INTRODUCTORY MACROECONOMICS ASHUTOSH KUMAR JAISWAL Jnvm  ASHUTOSH KUMAR JAISWAL Meaning of Macroeconomics How Macroeconomics Differs from Microeconomics? Scope and Significance of Macroeconomics ,, I. MEANING OF MACROECONOMICS The term Macro in English has its origin in the Greek term Makros which means Large. In the context of macroeconomics, 'large' means economy as a whole. Thus, macroeconomics is defined as that branch of economics which studies economic issues or economic problems at the level of an economy as a whole. It studies such economic questions that concern the welfare of all residents of a country. These questions are like of employment for the residents, growth of output in the economy, the problem of price rise (called inflation) or the problem of depression (lack of demand for goods and services across different sectors of the economy) and so on. Macroeconomics also studies how government can improve the state of economy of a country. I In the words of M.H. Spencer, "Macroeconomics is concerned with the economy as a whole or large segments of it. In macroeconomics, attention is focused on such problems as the level of unemployment, the rate of inflation, the nation's total output and other matters of economy-wide significance." 2. HOW MACROECONOMICS DIFFERS FROM MICROECONOMICS? You have already studied microeconomics at +1 level. Now that you have understood the meaning of macroeconomics, you can draw a distinction between micro and macro economics, as under: 3  (I) Basis of the Study Microeconomics studies problems of scarcity and choice at the level of an individual, a household, a firm or an industry. Macroeconomics studies problems of scarcity and choice at the level of an economy as a whole. Illustration Microeconomics studies how a consumer exercises his choice of goods and services so that he maximises his satisfaction with a given income. Macroeconomics studies how the national resources are used (for the production of defence goods or consumer goods) so that the welfare of all the residents is maximised. (2) Economic Variables Macroeconomic Microeconomics uses microeconomic variables such as consumer's Variables demand or producer's supply. Macroeconomic variables are those economic Macroeconomics, on the other hand, uses macroeconomic variables variables which are studied such as aggregate demand (referring to demand for all the goods and at the level of economy as a whole. These variables services in the economy) and aggregate supply (referring to supply of are important components all the goods and services in the economy). of the subject matter of macroeconomics. The important ones are: (3) Economic Agents Level of employment in the economy, Economic agents refer to the individuals and institutions who take National income, economic decisions. Individual economic agents include consumers Aggregate demand, and producers. They focus on the maximisation of personal gains. Aggregate supply, Institutional economic units include state or statutory bodies [like Consumption RBI (Reserve Bank of India), SEBI (Securities and Exchange Board of expenditure in the economy, and India) and TRAI (Telecom Regulatory Authority of India)]. They focus Investment expenditure on the maximisation of social welfare. At the micro level, economic in the economy. decisions are taken largely by the individual economic agents, while at the macro level institutional agents play a significant role. (4) Degree of Aggregation In microeconomics, there is a limited degree of aggregation of economic variables, compared to macroeconomics. Illustration Microeconomics studies equilibrium of an industry; it is an aggregation of all the firms producing a particular commodity. Macroeconomics studies equilibrium of the economy as a whole; it is an aggregation of all economic units in the economy. 4 Introductory Macroeconomics However, important it is to note that with a view to examine structural change in the economy, macroeconomics also studies the level of economic activity in agricultural sector, industrial sector and services sector, separately. (5) Different Set of Assumptions Microeconomics and macroeconomics are based on a different set of assumptions. Certain variables are assumed to be constant in microeconomics, whereas they are assumed to be changing in macro; similarly, certain variables that are assumed to be constant in macro are assumed to be changing in microeconomics. Illustration In microeconomics, total output and employment are taken as constant while these are important variables in macroeconomics. In macroeconomics, distribution of output/income is taken as constant, while it is an important variable in microeconomics. ( 6) Central Issue Allocation of resources is the central issue in microeconomics. Determination of the overall level of output (and employment) is the central issue in macroeconomics. (7) Method of Study Method of study in macroeconomics is often described as 'general equilibrium analysis'. On the other hand, method of study in microeconomics is often described as 'partial equilibrium analysis'. t>TS Q. Distinguish between partial equilibrium and general equilibrium. Ans. Partial equilibrium refers to equilibrium in one market (say, commodity market) on the assumption that there is no change in other markets (like labour market or capital market). General equilibrium refers to simultaneous equilibrium in all the markets in the economy. Partial equilibrium is the method of study in microeconomics. General equilibrium is the method of study in macroeconomics. (8) Micro-Macro Paradox What is logical at the micro level may not be logical at the macro level. Illustration - If an individual saves more, he adds to his future prosperity. Introduction 5  - If all the people in an economy save more (and spend less), demand for goods and services may decline. Consequently, investment may decline; production and employment level may fall. The economy will be driven towards future poverty rather than prosperity. t>TS Q. Is saving a virtue or a vice? Ans. From the viewpoint of an individual, saving is a virtue. He can deposit his savings in a bank and can earn a regular income. But, from the viewpoint of the economy as a whole, saving may prove to be a vice. When everybody saves more, expenditure tends to decline. It causes a decline in aggregate demand. A fall in aggregate demand causes a fall in investment. Implying a fall in production and a fall in the level of employment. The economy may be driven into the state of depression. 3. SCOPE AND SIGNIFICANCE OF MACROECONOMICS Scope Scope of macroeconomics refers to the field of study (or area of study) of macroeconomics. It includes the following leading issues (in accordance with the CBSE syllabus for the +2 graders): (1) Estimation of National income and Related Aggregates: Macroeconomics starts with the concept of national income. It deals with the definition and estimation of national income and its related aggregates like GDP (Gross Domestic Product) and NDP (Net Domestic Product). (2) Theory of Employment: Macroeconomics studies the theories related to employment (or unemployment) in the economy. Keynesian theory of employment is of notable significance in this context. It explains the causes of unemployment, and suggests the possible remedies to combat it. (3) Theory of Money: Creation of money (or creation of credit) by the commercial banks is an important component of macroeconomics. Linked to it, is the role of Central Bank of a country (RBI in India) in regulating the supply of money in the economy. (4) Theory of General Price Level-Inflationary and Deflationary Gaps: This is yet another significant component of macroeconomics. It reveals the trend path of the general price level leading to inflationary and deflationary gaps in the economy. (5) Role of the Government (or Government Budget): Macroeconomics studies how government budget impacts the level of economic activity in the economy. 6 Introductory Macroeconomics  (6) Exchange Rate and Balance of Payments: Determination of exchange rate and the way it is managed (in the international money market) is an important element of the scope of macroeconomics. Briefly, as a specialised branch of economics, macroeconomics focuses on such issues which explain (i) how an economy functions, and (ii) how can it be managed (or regulated), so that social welfare is maximised. Significance The following observations highlight the significance of macroeconomics: (1) Description of the Economy: Macroeconomics offers a deep description of the economy. Estimation of national income (across different sectors) reveals the nature and level of economic activity in the economy. Study of unemployment reveals the magnitude of the problem and the way it can be handled. Government budget reveals the way economy is regulated by the government. (2) Roadmap of Growth and Development: Macroeconomics offers a roadmap of growth and development. Programmes and policies of economic growth are drawn by assessing the needs and means of the economy. (3) Economic Stability: Study of macroeconomics helps achieve economic stability. This is achieved through appropriate monetary policy (pursued by the Central Bank of the country) and fiscal policy/budgetary policy (pursued by the government). (4) BoP (Balance of Payments) Status: BoP status of a country reveals performance of the economy in relation to rest of the world. Balance of trade (Export and Import) shows our capacity to export and compulsion to import. (5) Problems of Poverty and Environmental Pollution: Macroeconomics offers insights into the problems of poverty and environmental pollution. It is by using macro-models that these problems are addressed. (6) Poli cy Formulation: Information relating to macroeconomic variables (like aggregate demand, aggregate supply, total consumption and investment expenditure in the economy, output across different sectors of the economy and the like) is extremely useful in the formulation of policies for the growth and development of the country. lntrod{lction 7  Emerging challenges of the economy become evident only through macroeconomic data. In short, we can say that the knowledge of macroeconomic variables and macroeconomic models is extremely essential in understanding the performance of the economy, as well as in the formulation of policies and programmes for its growth and development. Power Points & Revision Window ------------ Macroeconomics is that branch of economics which studies economic problems (or economic issues) at the level of economy as a whole. j Microeconomics as different from Macroeconomics ! Microeconomics deals with the problem of choice and scarcity at the individual level, while macroeconomics does it at the level of economy as a whole. Microeconomics uses microeconomic variables (like consumer's demand and producer's supply}, while macroeconomics uses macroeconomic variables (like AD and AS}. Microeconomics involves lesser degree of aggregation than the macroeconomics. Microeconomics and macroeconomics are based on different set of assumptions. Allocation of resources is the central issue in microeconomics, while in macroeconomics the central issue is the determination of national income and employment. What is ideal at the micro level (like, saving by an individual) may not be ideal at the level of an economy as a whole. j Scope and Significance of Macroeconomics ! Scope: (i) Estimation of national income and related aggregates, (ii) Theory of employment, (iii) Theory of money, (iv) Theory of general price level: inflationary and deflationary gaps, (v) Role of the government (or government budget}, (vi) Exchange rate and balance of payments. Significance: (i) Description of the economy, (ii) Roadmap of growth and development, (iii) Economic stability, (iv) BoP (Balance of Payments) status, (v) Problems of poverty and environmental pollution, (vi) Policy formulation. rEXERCISEj 1. Objective Type Questions (Remembering & Understanding based Questions) A. Multiple Choice Questions Choose the correct option: 1. Macroeconomics is concerned with: (a) the level of output of goods and services in the economy (b) the general level of prices (c) GDP growth (d) all of these 8 Introductory Macroeconomics  2. Study of general price level is a subject matter of: (a) microeconomics (b) macroeconomics (c) both (a) and (b) (d) none of these 3. Aggregation is involved in: (a) microeconomics (b) macroeconomics (c) both (a) and (b) (d) none of these 4. Economic agents include: (a) government (b) consumers (c) producers (d) all of these 5. Which of the following statements is associated with general equilibrium analysis? (a) Equilibrium in the market of gold ornaments (b) Equilibrium across all markets in the economy (c) Equilibrium price of a good in the competitive market (d) None of these Answers 1. (d) 2. (b) 3. (c) 4. (d) 5. (b) B. Fill in the Blanks Choose appropriate word and fill in the blank: 1. Aggregate demand is not a variable. (micro/macro) 2. is related to the economy as a whole. (Microeconomics/Macroeconomics) 3. Study of price behaviour in India will come under the preview of (microeconomics/macroeconomics) 4. Monetary and fiscal policies of the government are a part of analysis. (microeconomic/macroeconomic) 5. From the viewpoint of economy, saving leads to in aggregate demand. (rise/fall) 6. Allocation of resources is the central issue in. (microeconomics/macroeconomics) 7. Determination of overall level of output is the central issue in (microeconomics/macroeconomics) Answers 1. micro 2. Macroeconomics 3. macroeconomics 4. macroeconomic 5. fall 6. microeconomics 7. macroeconomics C. True or False State whether the following statements are True or False: 1. Microeconomics studies the problem of scarcity and choice at the level of economy as a whole. (True/False) 2. General equilibrium relates to macroeconomics. (True/False) 3. Output of a firm is not a macro variable. (True/False) 4. Aggregation is involved only in macroeconomics. (True/False) Introduction 9  5. If an individual saves more, he adds to his future prosperity. However, if an economy saves more, it may be driven towards future poverty. (True/False) 6. What is logical at the macro level may not be true at the micro level. (True/False) 7. A profit-maximising firm is not an economic agent. (True/False) Answers 1. False 2. True 3. True 4. False 5. True 6. True 7. False D. Matching the Correct Statements I. From the set of statements given in Column I and Column II, choose the correct pair of statements: Column I Column II (a) General equilibrium (i) Microeconomics (b) Commodity market (ii) Partial equilibrium (c) Microeconomics (iii) Total output and employment are taken as constant (d) Problem of unemployment in India (iv) A microeconomic activity (e) Macroeconomics (v) Study of price behaviour of a firm Answer (c) Microeconomics -(iii) Total output and employment are taken as constant II. Identify the correct sequence of alternatives given in Column II by matching them with respective items in Column I. Column I Column II (a) Macro (i) Limited degree of aggregation of economic variables (b) National income (ii) Central issue of macroeconomics (c) Partial equilibrium (iii) Means large (d) Microeconomics (iv) Equilibrium in one market (e) Determination of overall level of output (v) A macroeconomic variable Answers (a)-(iii), (b)-(v), (c)-(iv), (d)-(i), (e)-(ii) E. 'Very Short Answer' Objective Type Questions 1. Define macroeconomics. Ans. Macroeconomics is the study of economic relationships, economic problems or economic issues at the level of economy as a whole, like the problem of inflation or of unemployment. 2. Define microeconomics. Ans. Microeconomics is the study of economic relationships, economic problems or economic issues at the level of an individual like a consumer, or a producer. 3. Give two examples of macroeconomic studies. Ans. (i) Study of price behaviour in India, and (ii) Study of unemployment in India. 10 Introductory Macroeconomics  4. Give two examples of microeconomic studies. Ans. (i) Study of consumer behaviour: consumer equilibrium & law of demand, and (ii) Study of price determination in the commodity market. 5. Give two examples of macroeconomic variables. Ans. (i) Aggregate supply, and (ii) Aggregate demand. 6. What is meant by economic agents? Ans. Economic agents are the individuals or institutions who take economic decisions. 2. Reason-based Questions (Com prehension of the Subject- matter) Read the following statements carefully. Write True or False with a reason. 1. Study of the problem of unemployment in India is considered a microeconomic study. Ans. False. Problem of unemployment in India is an economic issue at the level of economy as a whole, hence considered as macroeconomic study. 2. Aggregation is involved only in macroeconomics. Ans. False. The difference lies in the degree of aggregation. While in microeconomics, aggregation is done at the level of an individual household, an individual industry or an individual market, in macroeconomics, aggregation is done at the level of an economy as a whole. 3. Monetary and fiscal policies of the government are a part of macroeconomic analysis. Ans. True. Both these policies are related to issues of growth and development at the level of the economy as a whole. 4. Aggregate demand in macroeconomics is identical with market demand in microeconomics. Ans. False. Aggregate demand is the sum total of demand for all the goods and services in the economy whereas market demand refers to demand for a particular commodity in the market. 5. 'Save more' is always a virtue. Ans. False. Saving is a virtue at the micro level but not necessarily at the macro level. Because, greater saving implies lesser expenditure, lesser demand and therefore lower inducement to invest. 6. Problem of scarcity and choice ceases to exist at the macro level when resources of the entire nation are pooled together. Ans. False. Even if resources of the entire nation are pooled together, these continue to be scarce in relation to the aggregate demand of the economy. 3. H OTS & Applications 1. Macroeconomics is the study of aggregates while microeconomics is not. Comment. Ans. It is wrong to state that there is no aggregation in microeconomics. It is in microeconomics that we study concepts like market demand which is the aggregate of individual demand for a commodity. However, the difference lies in the degree of aggregation. While in microeconomics, aggregation is done at the level of an individual household, an individual industry or an individual market, in macroeconomics, aggregation is done at the level of an economy as a whole. 2. What is true at the micro level may be a paradox at the macro level? Explain with an example. Ans. What is true at the micro level may not be true at the macro level. This is the meaning of paradox. Example: Saving is a virtue for an individual. If he saves more, he accumulates more wealth and therefore enhances his ability to earn more. But at the macro level, if everyone starts saving more, demand for goods and services may decline to the extent that there is no inducement to invest. Consequently, income and production level may reduce. Introduction 11  3. Do you think that the general price level is of any relevance at the micro level? Ans. General price level is a macro issue. But it is of great significance at the micro level. An individual producer would always monitor the trend path of the general price level. If prices are rising, business expectations are high. It induces investment. If, on the other hand, prices are falling, business expectations turn to be sluggish. Inducement to invest is hurt. Accordingly, investment is reduced. 4. Analysis & Evaluation 1. What may happen if savings are encouraged in an economy? Ans. Increased savings are not good for the economy because (in absence of increased investment) they cause a fall in the level of AD (aggregate demand), because of which the level of employment or output may fall. However, if increased savings are mobilised and converted into capital formation they become instrumental in the growth of economy by boosting the level of employment or output or income. 2. What do you think is the significance of macroeconomic agents in the economy? Support your answer with example. Ans. Macroeconomic agents refer to the institutions as decision-makers in the economy. RBI (Reserve Bank of India) is an example of macroeconomic agent in India. The R B I plays a significant role in monitoring the supply of money in the economy. Excess supply of money may lead to inflation while deficient supply may lead to deflation. By regulating the supply of money, the RBI combats the situations of inflationary and deflationary gaps in the economy. 5. N CERT Questions (With H ints to Answers) 1. What is the difference between microeconomics and macroeconomics? [ Hint: (i) Microeconomics studies economic issues or economic problems at the level of an individual- an individual firm, an individual household or an individual consumer. On the other hand, macroeconomics studies economic issues or economic problems at the level of an economy as a whole. (ii) Allocation of resources to different uses is the central issue in microeconomics. On the other hand, determination of the level of output and employment is the central issue in macroeconomics. (iii) There is a smaller degree of aggregation in microeconomics. Example: We study output behaviour of an industry which is aggregate of all the firms producing a particular commodity. On the other hand, there is a larger degree of aggregation in macroeconomics. Example: We study national output which is aggregate of output of all the producing units in the economy.] 2. Describe the Great Depression of 1929. [ Hint: It was precisely in 1929 that great depression affected developed economies of the capitalistic world. Its impact continued almost for the entire decade of 30's. During that worldwide depression, there was a persistent fall in the level of employment and output. In USA, unemployment shot up from 3% to 25% between the period 1929-33. Fall in employment was accompanied with a fall in GDP. Between the period 1929-33, GDP in USA fell by about 33%.) 6. M iscellaneous Questions and Reference to the Text for Answers A. Questions of 3 & 4 marks each 1. What do you mean by macroeconomics? [Page 3) 2. State the scope of macroeconomics. [Page 6, 7) 12 Introductory Macroeconomics  3. State any four differences between microeconomics and macroeconomics. [Page 3-6] 4. What is the difference between partial equilibrium and general equilibrium? [Page 5] B. Questions of 6 m a rks each 1. What is meant by macroeconomics? Discuss its scope. [Page 3, 6, 7] 2. Explain the differences between microeconomics and macroeconomics. Give suitable examples. [Page 3-6] 3. What is the significance of macroeconomics? [Page 7, 8] DOs and DON'Ts 1. Do n ot ever conclude that there is n o aggregation of economic u n its i n microeconomics (or that, there is aggregation of economic units only i n macroeconomics). There is aggregation of economic u n its i n m icroeconomics a s well, thou gh to a lim ited extent. Thus, when w e study eq u ilibri u m of the i n d u stry (or m arket eq u ilibri um), we a re foc u s i n g o n aggregation of the firms. 2. Do not ever consider a situation a s good or bad both at the micro and macro levels. What is g ood at the micro level may not be good at the macro level. Thus, a n ind ividual prod ucer may find prod uction of liq uor as more profitable busi ness than the prod uction of clean domestic fuel. B ut at the level of the economy a s a whole, the government may d iscourage the prod uction of liquor through heavy taxation, and encourage the prod uction of clean domestic fuel through s u bsidy....,........ Emergence of M acroeconom ics as a Separate Branch of Economics G reat Depression of 1 930's i s a l a n d mark event that led to the emergence of macroeconom ics as a separate branch of economics. It does n ot mean that the concept of macroeconomics d id not exi st prior to this event. But macroeconom ics (prior to the G reat Depressi on) was considered more l i ke an extension of microeconom ics: it did not exist a s a sepa rate (or specia l i sed) branch of economics. Of course, there was a reason to it: It was bel ieved by the (classical) economists that the princi ples of microeconom i cs were enough to expl a i n the behaviour of the economy as a whole. The a rg u ment runs l i ke th is: M i croeconomics teaches us that (i n pursuit of self-i nterest) every i ndivi d u a l (i n a ma rket economy or a free economy) maximi ses his sati sfaction with h i s g iven income. Maxim isation of i n d ivi d u a l sati sfaction (or welfare) i m p l ies the maxi misation of welfare of all the i n d ividuals i n the economy. It i m p l ies maxi m i sation of soc i a l welfare. I f social welfare is maxi mised, the scarce resou rces i n the economy must have been opt i ma l ly uti l ised. M i croeconom ics fu rther teaches us that i n a free economy (or u nder perfect com petition), all ma rkets tend to be in a state of eq u i l i bri u m. Thus, i n the l a bou r ma rket S L = D L (su pply of labour = demand for l a bour). It i s a situation of fu l l employment. Introduction 13  There cou l d be unemployment when S L > D L. But, i n such a situation wage rate wou l d fa l l , lea d i n g to a fa l l i n S L and rise i n D L. Eventu a l ly, the situation of fu l l emp loyment wou l d a utomatica l ly be restored. T h u s, fu l l employment i s a norm a l featu re of a ma rket economy. Briefly, the pri ncip les of microeconom i cs expla i n that i n a free econ omy: (i) social welfare is maxi m i sed, (ii) resou rces a re opti m a l ly uti l i sed, a n d (ii i) fu l l employment is a norma l situ ation. Accord i n g ly, the classical econom i sts conclu ded that the pri nciples of microeconom i cs were enou gh to exp l a i n the behaviour of the economic activity at the macro leve l. There was no need to consider macroeconomics as a sepa rate bra n ch of economics. G reat Depression of 1 930's contradicted the Classical Thought During the depression of 30's, economic events u nfol d ed i n such a manner that the c l assica l thought was tota lly contradicted. Fo l lowi n g poi nts a re of notable s i g n ifica nce in this reg ard: (i) The depression of 30's led to huge unemp loyment i n the developed cou ntries of the worl d (North America and Europe). (i i) I n USA, unemployment shot up from 3 % to 25% between the period 1 929-33. (i i i) Fa l l in employment was accompan ied with a fa l l in GDP, Between the period 1 929-33, G D P in USA fel l by about 33%. (iv) Fa l l in G D P led to a fa l l i n AD (agg regate dema nd). Accord i n g ly, there were d rastic cuts i n output a s planned by the producers across a l l sectors of the economy. (v) Cut i n p l a n ned output i m p l ied a fu rther fa l l i n employment a n d G D P i n the economy. Th us, during the depression of 30's, the western econom ies were d riven i nto the vicious circle of low demand and low G D P. Th i s circle operated as under: Low AD Low p l a n ned output Low level of employment Low G D P Low AD This is ca l led 'Low Level Equ i l ibri u m Tra p'. The classical econom ists fa i l ed to fi nd any a n swer to this low level eq u i l i bri u m tra p. Ma rket forces o f s u p p l y a n d d e m a n d fa i l ed t o brea k i t. It is i n s u c h a situation that macroeconomics emerged as a sepa rate branch of econom ics. Prof. Keynes was the pioneer i n the field of mod ern macroeconomics. He invented severa l macroeconomic vari a b l es (l i ke AD a n d AS) a n d form u lated a macroeconom i c model to b reak the vicious c i rcle of 'low level eq u i librium tra p'. He diagnosed lack of AD as the root cause of the problem, and suggested large scale expend itu re by the govern ment as a remedy. Ill 14 Introductory Macroeconomics  Classification of Goods: (i) Final Goods and Intermediate Goods (ii) Consumption Goods and Capital Goods Concept and Components of Consumption Expenditure ,, Concept and Components of Investment Stocks and Flows Four Sectors of the Economy lntersectora/ Flows-Rea/ Flows and Money Flows Circular Flow of Income I. CLASSIFICATION OF GOODS Countless number of goods are produced and consumed in the economy. These are like shoes and shirts for the school children, machines and tools for the farms and firms, guns and ammunition for the defence forces, ships and airplanes for tourists, and so on. Different goods show different characteristics. Broadly, goods are classified in two ways: (i) Final Goods and Intermediate Goods, and (ii) Consumption Goods and Capital Goods. Classification of Goods Consumption Goods 0 Final Goods or Consumer Goods & & Intermediate Goods Capital Goods 15  Following is a brief description of these categories: Final Goods These are those goods which have crossed the boundary line of production and are ready for use by their final users. Who are the final users? These are (i) consumers, and (ii) producers. Accordingly, final goods are often classified as: (i) final consumer goods, and (ii) final producer goods. Final consumer goods are finally purchased by the consumers for the satisfaction of their wants. Final producer goods are finally purchased by the producers and are generally used as fixed assets in the process of production. F®CUS Final consumer goods are the goods which are ready for use by their final users, and consumers are their final users. Example: Bread and butter, as used by the consumers. ZONE Final producer goods are the goods which are ready for use by their final users, and producers are their final users. Example: Tractors and harvesters, as used by the farmers. Expenditure on final consumer goods by the households is called consumption expenditure. Expenditure on final producer goods by the producers is called investment expenditure. Accordingly, Expenditure on Final Goods = Consumption expenditure+ Investment expenditure. I Expenditure on Final Goods = Consumption expenditure + Investment expenditure What do we mean when we say that final goods have crossed the boundary line of production? We mean that these goods are out of the process of production or the process of value addition. Example: A shirt in a retail showroom is all set for sale to its final user. No value is to be added to the shirt by way of stitching, ironing, packaging, etc. The only value addition left now is when it is actually sold to the consumer, who is its final user. If the retailer purchases this shirt for 900 from the wholesaler and sells for 1,000 to the consumer, there is value addition of 100 (= 1,000 - 900). This is the final stage of value addition to the shirt. Once it is sold to the consumer (the final user) the shirt will be treated as out of the boundary line of production, and shirt worth 1,000 counted as a final good. You may note that only final goods are included in the estimation of national product or national income. Intermediate Goods Intermediate goods are those goods (i) which have yet not crossed the boundary line of production, (ii) value is still to be added to 16 Introductory Macroeconomics these goods, and (iii) which are yet not ready for use by their final users. In other words, intermediate goods are those goods which are purchased by one firm from the other firm: (i) as raw material, or (ii) as goods for resale. Example: Shirts purchased by firm X from firm Y for resale are intermediate goods. Because, value is to be added to the shirts through resale. Likewise, wood purchased by a carpenter (from a timber merchant) for making chairs is an intermediate good. Because, wood is used as a raw material for making chairs. Value is to be added to wood by converting it into chairs. Intermediate goods are those goods which are within the boundary line of production, value is yet to be added to these goods, and these goods are yet not ready for use by their final users. Or Intermediate goods are those goods which are purchased by one firm from the other either for resale or for use as a raw material. Value of intermediate goods ultimately becomes a part of the value of final goods. Example: When a carpenter buys wood worth 10,000 and converts it into chairs worth 20,000, then the value of chairs (final goods) includes the value of wood (intermediate good). Accordingly, intermediate goods are not included in the estimation of national product or national income. Otherwise, there would be duplication in the estimation of national product, called 'Double Counting' (counting the value of a good more than once). Expenditure on intermediate goods by the producers during an accounting year is called intermediate consumption or intermediate cost. If intermediate consumption is F@CUS deducted from the value of output, we get 'gross value addition' (also called Gross Value ZONE Added, or Gross Product of the producer). Thus, Value of Output (say chairs) - Intermediate consumption (cost of wood and other material used in the production of chairs) = Gross value addition or gross product of the producer. The Same Good May be Final or Intermediate It is not possible to name one set of goods as final goods and another set as intermediate goods. The same good may be final or intermediate good. The distinction depends on the end-use of the goods. To illustrate, sugar used as a raw material in the production of biscuits is an intermediate good. But, sugar used by the households in milk or tea is a final good. Likewise, paper purchased by a student is a final good. But when purchased by a publisher (for making books), it is an intermediate good. Some Basic Concepts of Macroeconomics 17  What Matters is the End-use of Goods Note While classifying goods as final or intermediate, what matters is the End-use of the goods end-use of goods. You are to check what end-use a good is put to. is the principal basis of classifying the goods as If it is used by the producers as a raw material, it is to be treated intermediate goods and as an intermediate good. Also, if it is purchased and resold by the final goods. producers, it is to be treated as an intermediate good. But if it is used by the producer as a fixed asset (like a tractor used by the farmer), it is to be treated as a final good. And, of course, goods purchased by the households for final consumption, are to be treated as final goods. Thus, a good as such is not to be named as final or intermediary. Milk as such is not to be taken as final or intermediary. It is to be treated as final or intermediary depending on its end-use. It may also be noted that a good may be used partly as an intermediary and partly as final. Thus, the entire milk sold by the dairy farmers in a village may not be a final good. Only that part of it is to be treated as final good which is sold to the consumer households. The other part which is sold to the producers for making sweets (and which is used as a raw material) is to be treated as an intermediate good. Intermediate and Final Goods-The Difference f@C US 1------- n _t _e _rm_e_d _ia _ t_ e_G_o_o_d_s___-+--____F_ ni _a_l_G_ o_o_d_s____----1 z Q NE {i} These goods remain within the boundary line of production, and {i) These goods are outside the boundary line of production, and are not ready for use by their final are ready for use by their final users. users. {ii) These goods may be used as raw {ii} These goods are not used as raw material for the production of material for the production of other goods during the accounting other goods during the accounting year. year. (iii) These goods may be resold by {iii) These goods are not resold by the firms for profit during the the firms for profit during the accounting year. accounting year. (iv) Value is yet to be added to these (iv) Value is not to be added to these goods. goods. (v) Expenditure on these goods is (v) Expenditure on these goods is called intermediate consumption called final expenditure(= C + l}. or intermediate cost. (vi) These goods are not included in (vi) These goods are included in the the estimation of national product estimation of national product or or national income. national income. [Note: Accounting year is the year during which production of goods and services is estimated in the domestic economy. Or, it is the year during which national product/national income is estimated for the country.] 18 Introductory Macroeconomics  t>TS Q. 1. How would you find out whether a particular expenditure is an expenditure on intermediate goods or on final goods? Ans. Expenditure on final goods must lead to: (i) final consumption expenditure (C), or (ii) investment expenditure (I). The expenditure which does not lead to C and I (like the expenditure on raw material) is to be treated as an expenditure on intermediate goods. Expenditure on intermediate goods leads to intermediate consumption or intermediate cost. Q. 2. Purchase of a car always means the purchase of a final good. Do you agree? Ans. No. It depends on the end-use of the car. If it is purchased by a household, it is a final good. It is like a consumer durable. If it is purchased by taxi-operators, then again it is a final good, as it is to be finally used by the producer as a fixed asset. However, if the car is purchased by a retail dealer from the factory for the purpose of resale, it is to be treated as intermediate good. Consumption Goods or Consumer Goods Consumption goods (or consumer goods) are those goods which are directly used for the satisfaction of human wants. Example: Ice cream and milk as used by the households. These goods are consumed by the households when purchased. Consumption goods are broadly classified into four categories, as under: Consumption Goods/Consumer Goods Durable Semi-durable Non-durable Non-material Goods Goods or Goods Goods Services (1) Durable Consumption Goods: Durable consumption goods are those goods which can be used for several years and are of relatively high value. These goods are repeatedly used before being discarded as useless. TV, radio, car, scooter, washing machine are some examples of durable consumption goods. (2) Semi-durable Consumption Goods: Semi-durable consumption goods are those goods which can be used for a period of one year or slightly more. These goods are not of very high value. Clothes, furniture, crockery, electric goods, etc., are the examples of semi-durable consumption goods. (3) Non-durable or Single-use Consumption Goods: Non-durable or single-use consumption goods are those goods which are used-up Some Basic Concepts of Macroeconomics 19  in a single act of consumption. For example, the bread that you eat is used-up in a single act of consumption. The same bread cannot be used again. Also these goods are of relatively low value. Ink, domestic LPG, milk and petrol are some other examples of non-durable or single-use consumption goods. (4) Services: Services are those non-material goods which directly satisfy human wants. A few examples of services are the services of a doctor, lawyer, domestic servant, etc. Capital Goods Capital goods are fixed assets of the producers. Plant and machinery are the examples of capital goods. These goods are used by the producers either for (i) the replacement of the capital stock, or for (ii) addition to the capital stock. As fixed assets, capital goods are repeatedly used in the process of production for several years and are of high value. Even nuts and bolts (or nails and screws) are used for All Machines are not several years, but these are not capital goods. Because these are of Capital Goods low value. Thus, only those fixed assets of the producers are taken It must be borne in as capital goods which are used in the process of production for mind that all machines are not capital goods. several years and which are of high value. Also, capital goods involve A sewing machine in a depreciation. It refers to loss of value of fixed assets (in use) owing to tailoring shop is a fixed asset of the tailor; it is their wear and tear. F®CUS a capital good. But the same machine with a Capital goods are fixed assets of the producers. These consumer household goods are used in the process of production for several is not a capital good. It is simply a durable­ ZONE years and are of high value. Use of these goods leads to use consumer good. depreciation (loss of value of fixed assets when these are Likewise, a car with repeatedly used). Example: Plant and machinery. a tourist company is a capital good. But the same car with a All Capital Goods are Producer Goods, consumer household is a durable-use consumer But all Producer Goods are not Capital Goods good. Thus, while Producer goods are those goods which are used in the production identifying goods as capital goods, we must of other goods. These goods include: (i) goods used as raw material make sure about their by the producers, like wood used to make furniture, and (ii) goods end-user. If the end-user of a durable good is a used as fixed assets by the producers, like plant and machinery. household consumer, it Unlike fixed assets of the producers, goods used as raw material is durable-use consumer good. On the other are not durable-use goods. These are single-use producer goods: hand, if the end-user these cannot be repeatedly used in the process of production. Thus, of a durable good is a producer, it is a capital the same wood cannot be repeatedly used to make furniture. Fixed good. Capital goods assets (or capital goods), on the other hand, are repeatedly used in are only those durable the process of production. These are durable-use producer goods. goods which are used as producer goods, not Thus, while all capital goods are producer goods, all producer goods as consumer goods. are not capital goods. 20 Introductory Macroeconomics  Consumption Goods and Capital Goods-The Difference 1-----C _o n_ __su _m_p_i o_n_G t_ _o__ds o_ _a_p ________c ta _i__l_G _o_o _d_s____ f@CUS (i) Consumption goods lead to direct- satisfaction of human wants. (i) Capita/ goods do not lead to direct- satisfaction ofhuman wants. ZONE (ii) These goods are consumed by the (ii) These goods are not consumed by households when purchased. the households. Instead, these are used by the producers for further production. (iii) Expenditure on consumption (iii) Expenditure on capital goods is goods is called consumption called in vestment expenditure. expenditure. (i vJ Higher production of consumption (i v) Higher production of capital goods leads to higher le vel of goods leads to higher production welfare of the people. It raises capacity in the economy. It is the their quality of life. backbone of GDP growth. [Note: Both consumption goods and capital goods have one common characteristic: that are final goods, and therefore, included in the estimation of national income.] t>TS Q. All producer goods are not capital goods. Why? Ans. Producer goods include: (i) goods used as raw material, like wood used to make furniture, and (ii) goods used as fixed assets, like plant and machinery. Capital goods include only fixed assets of the producers. These are dura ble-use producer goods. On the other hand, goods used as raw materia l a re single-use producer goods. These are not repeated ly used in the process of production. Accordingly, all producer goods a re not capital goods. 2. CONCEPT AN D COM PO N E NTS OF CONSU M PTIO N EXPE N D ITURE In macroeconomics, consumption expenditure refers to aggregate consumption expenditure in the economy. Who are the consumers in an economy? These are broadly classified as: (i) households, (ii) the government, and (iii) non-profit private institutions (like NGO, temples, mosques, gurudwaras, and others). Households buy consumer goods for the satisfaction of their wants. The government buys consumer goods for distribution among defence forces, for mid­ day meals in the government schools, and such other purposes. Non­ profit private institutions buy consumer goods for charity. If we add up expenditure on the purchase of consumer goods by the households, government and non-profit private institutions, we get an estimate of total consumption expenditure in the economy. Thus: Some Basic Concepts of Macroeconomics 21  F®CUS Aggregate Consumption Expenditure = Consumption expenditure by the households + Consumption expenditure by the ZONE government + Consumption expenditure by the non-profit private institutions (NGO, temples, mosques, gurudwaras, and others) 3. C O N C EPT AN D CO M PO N E NTS O F I NVESTM ENT What is I nvestm e nt? Investment refers to increase in the stock of capital. Thus: I = Investment K = Capital stock LlK = Change in capital stock during the year. Change in the stock of capital is called 'capital formation'. Accordingly, investment is also defined as capital formation. From the viewpoint of the economy as a whole, investment refers to total production of capital goods during an accounting year. As noted earlier, these goods may be used either for the replacement of existing capital stock or for adding to the existing capital stock. I Investment refers to capital formation, or a process that increases the stock of capital. Fixed I nvestm ent a n d I nvento ry I nvestment Investment has two components: (i) Fixed investment, and (ii) Inventory investment. Following are the details: Fixed Investment Fixed investment refers to increase in the stock of fixed assets (like plant and machinery) of the producers during an accounting year. Example: If at the beginning of the year 2019, a producer has stock of 8 machines and at the end of 2019, he has a stock of 10 machines, then the stock of his fixed assets increases by 2 machines during the year 2019. Fixed investment of the producer during the year 2019 = 2 machines. F®CUS Fixed Investment = Stock of fixed assets with the producers at the end of the accounting year ZONE - Stock of fixed assets with the producers at the beginning of the accounting year = Increase in the stock of fixed assets with the producers during an accounting year 22 Introductory Macroeconomics Fixed investment is also called fixed capital formation. This implies increase in the stock of capital in terms of fixed assets (or capital goods) which are repeatedly used in the process of production for several years. Significance of Fixed Investment Following observations bring out the significance of fixed investment: (i) Fixed investment raises production capacity of the producers. (ii) By raising production capacity of the producers, fixed investment leads to higher level of output in the economy. (iii) Higher level of output (because of fixed investment) leads to higher rate of economic growth, popularly known as GDP growth. Inventory Investment At a point of time, producers hold the stock of (i) finished goods (unsold goods), (ii) semi-finished goods (goods which are in the process of production), and (iii) raw material. This is called ' inventory stock'. Change in inventory stock during the year is called inventory investment of the producers. Inventory Investment = Inventory stock at the end of the accounting year F®C U S - Inventory stock at the beginning of the accounting year ZONE = Change in inventory stock during an accounting year Significance of Inventory Investment Inventory investment primarily consists of investment in terms of the stock of (i) raw material, and (ii) finished goods. The stock of raw material is significant because: (i) It ensures uninterrupted supply of inputs to the producers. (ii) With enough stock of raw material, the producers can avoid day­ to-day purchases from the market. Accordingly, uncertainties of the market (relating to price and availability of the raw material) are avoided. The stock of finished goods is significant because it enables the producers to meet the potential (future) demand for their product. Here, it may be noted that the actual inventory stock at a time may not be the desired inventory stock. A part of it may be undesired. A producer may have expected to sell 1,000 units of washing machines. But, actually he could sell 500 units owing to the lack of demand. In such a case, 500 units of washing machines (unsold stock) are an undesired inventory stock. Such a stock leads to losses. Some Basic Concepts of Macroeconomics 23  Desired inventory stock refers to planned inventory stock. This is maintained by the producers to meet the future demand. Undesired inventory stock, on the other hand, refers to unplanned inventory stock. It arises because demand for the product turns out to be lower than expected. Unplanned inventory stock leads to losses. G ross I nvestm ent, N et I nvestment and The Concept of Depreciati o n Gross investment refers to total production of capital goods during the year. This includes (i) capital goods used for the replacement of existing capital stock (which is worn-out), and (ii) capital goods used as a net addition to the existing capital stock. Capital goods used for the replacement of existing capital stock refers to 'depreciation'. Capital goods used as net addition to the existing capital stock is called 'net investment'. Gross Investment = Net investment + Depreciation (also called replacement investment) Net Investment Gross investment - Depreciation (also called = replacement investment) I Gross Investment = Net investmen t + Depreciation (expenditure on the replacement of worn -out fixed assets or replacement investment) Net Investment = Gross investment - Depreciation Significance of Net Investment Following observations highlight the significance of net investment: Only net investment leads to addition to (i) It raises the stock of capital in the economy. Higher stock of the stock of capital capital increases the availability of capital per unit of labour. Depreciation (a part of gross investment) only Accordingly, efficiency of labour rises. replaces the worn-out (ii) It helps generate opportunities of employment. Because, fixed assets. It helps to maintain the existing unemployment in India is largely due to the lack of capital. stock of cap ital (iii) Net investment is a net rise in production capacity of the economy. Accordingly, GDP growth is accelerated. Briefly, net investment enhances production capacity, generates opportunities of employment, promotes efficiency of labour and accelerates GDP growth. 24 Introductory Macroeconomics  Gross Investment and Net Investment-The Difference G ross I nvest me nt Net I nvest me nt F@CUS (i) It includes expenditure by the producers on the purchase of new (i) It includes expenditure by the producers on the purchase of new ZONE assets as well as expenditure on assets only. More specifically, it the replacement of existing assets does not include expenditure by during an accounting year. the producers on the replacement of existing assets. (ii) It includes replacement investment (ii) It does not include replacement (= depreciation offixed assets). investment. (iii) It does not show net addition to (iii) It shows net addition to the the existing capital stock. existing capital stock. [ N ote: Both gross investment as wel l as net investment include: ( i ) fixed investment, and ( i i ) inventory investment. ] f>TS Q. How does higher rate of net capital formation lead to higher level of productivity/efficiency of labour? Ans. Higher rate of net capital formation implies greater availabil ity of capital (in terms of machines) per unit of labour. Aided by machines, efficiency of labour definitely increases. This precisely is the reason why labour in developed countries (like USA) is more efficient than in less developed countries like India. Concept of Depreciation While fixed assets (like plant and machinery) are in use, they go down in value owing to (i) normal wear and tear, and (ii) accidental damages (beyond their routine repairs and maintenance). They go down in value also when they become obsolete (or outdated) due to change in technology or change in demand. This is called 'expected obsolescence' (which the producers normally expect to happen). Depreciation is the loss of value of fixed assets in use on account of: (i) normal wear and tear, (ii) accidental damages, and (iii) expected obsolescence. Depreciation is also called consumption of fixed capital. Because of depreciation, fixed assets need to be replaced from time to time. Replacement of fixed assets requires funds. Provision for the funds is made on annual basis. To illustrate, if a machine is purchased for 10,00,000 and its expected lifetime of use is 10 years, then the annual provision for funds (to replace the machine after Some Basic Concepts of Macroeconomics 25  10, 00, 000 10 years) = = 1,00,000. This is called Depreciation 10 Reserve Fund. I Depreciation reserve fund refers to that fund which the producers keep for replacement investment. Significance of Depreciation Reserve Fund Depreciation reserve fund is a fund to replace the worn-out fixed assets. It fulfills the need for replacement investment. Lack of depreciation reserve fund implies the lack of replacement investment. Accordingly, overall investment (gross investment) in the economy tends to fall. This leads to a fall in the level of output. The level of income and employment will also fall. The economy will slip into a state of 'economic slowdown'. It might be caught into a low level equilibrium trap: a situation when low income causes low demand, and low demand causes low output; and once again low income. Expected and Unexpected Obsolescence It is essential to know the difference between 'expected (or foreseen) obsolescence' and 'unexpected (or unforeseen) obsolescence'. Expected obsolescence has two components: (i) Loss of value of fixed assets when these become obsolete/ outdated owing to change in technology. Example: A plant producing black and white TVs becomes obsolete when technology is discovered to produce colour TVs. (ii) Loss of value of fixed assets when these become obsolete/ outdated owing to change in demand. Example: A plant producing rubber shoes becomes obsolete when demand shifts from rubber shoes to leather shoes. Expected obsolescence is estimated by the producers on the basis of their knowledge and experience of the market conditions. Unexpected obsolescence occurs owing to (i) natural calamities (like earthquake, floods or fire), and (ii) fall in market value of the assets when there is economic recession. Loss of value of fixed assets owing to unexpected obsolescence is called 'capital loss'. These losses are not a part of depreciation or depreciation reserve fund. Only expected obsolescence is considered for the estimation of depreciation, not the unexpected obsolescence. 26 Introductory Macroeconomics  Expected Obsolescence and Unexpected Obsolescence-The Difference Exp ec t ed Obs o l esc enc e (i) It refers to a Jail in the value of Un ex p ec ted Obs o l esc en c e (i) It refers to a fall in the value F®CUS fixed assets due to change in of fixed assets due to natural ZONE technology or change in demand. calamities or economic recession. (ii) It is a part of depreciation. (ii) It is not a part of depreciation. Instead, it points to capital loss. (iii) Expected obsolescence is managed (iii) Unexpected obsolescence is through depreciation reser ve managed through insurance of Jund. the fixed assets. Consumption of Fixed Capital and Capital Loss-The Difference C o n su m p t oi n o f F x i ed Capi ta l (i) It refers to loss of value of fixed Cap i ta l L o ss (i) It refers to loss of value of fixed F®CUS assets (capital goods) while these assets while these are not in use. ZONE are being continuously used in the process of production. (ii) ltisalossdueto(a) normalwearand (ii) It is a loss due to (a) natural tear, (b) accidental damages, and calamities (earthquake, floods, (c) expected obsolescence. fire, etc.), and(b) Jail in the market value of the assets during periods of economic recession. (iii) It is managed through depreciation (iii) It is managed through insurance reser ve Jund. of the fixed assets. t>TS Q. 1. Distinguish between depreciation and depreciation reserve fund. Ans. Depreciation is the loss of fixed assets in use on account of: (i) normal wea r and tear, (ii) accidental da mages, and (iii) expected or foreseen obsolescence. On the other hand, depreciation reserve fund is a provision of funds to cope with depreciation losses. These funds are used for the replacement of fixed assets when these are worn-out or when these become obsolete/outdated. Q. 2. What is current replacement cost? Ans. It refers to the esti mated value of depreciation for all the producing units in the economy, during the period of an accounting year. 4. STOCKS AN D FLOWS M ean i ng of Stock A stock is a quantity measured at a particular point of time. On January 1, 2020 there may be 20,000 in your bank account. On Some Basic Concepts of Macroeconomics 27  January 1 0, 2020, there may be 2 5 , 000 i n you r ban k accou nt. All such val ues are stock val ues, as these are measured at a specific point of time. Capital and q uantity of money are notable exam p les of stock variables. M ean i ng of Flow A flow i s a q uantity measu red over a specified period of time. You may be getti ng 1 , 500 per month as pocket al l owance, you m ay be Certa i n concepts i n spend i ng 50 eve ryday in the canteen , you may be getting 8 per cent econom ics a re stud ied only as flow va riables, not ann ual i nterest on you r bank deposits. All these val ues/q uantities are as stock va riables. 'flows' as these are m easu red per u n it of time period (an h o u r, a day, a Example: Exports and I m ports. month , an year, etc. ). I ncom e , expend iture, prod uction , consu m ption and i nterest are n otable exam ples of flow variables. Here are some more exam ples of Stocks and Flows: Stock Flow 1. Wea lth 1. I ncome 2. La bour Force 2. Expenditure of Mo ney 3. Capital 3. Cap ita l Formation 4. Qua ntity/Supply of M o ney i n a 4. Cha nge in the Supply of Money in a Cou ntry Country 5. Ba n k Deposits 5. I nte rest on Ca pita l 6. Water i n the overhead ta n k 6. Lea kage of water from t h e overhead ta n k 7. Distance between Del hi a n d 7. Speed o f a ca r g o i n g from D e l h i to M u m ba i M u m bai 8. Rice stored i n a godown 8. Sales of rice 9. Po pu lation of a cou ntry 9. N u mber of births Stock and Flow-The Difference F®CUS S to ck F lo w ZONE (i) Stock refers to the value of a variable at a point of time. (i) Flow refers to the value of a variable during a period of time. (ii) Stock is not time dimensional. It (ii) Flow is time dimensional. It is is measured at a specific point of measured per hour, per month or time. per year. (iii) Stock impacts the flow. Greater (iii) Flow impacts the stock. Greater the stock of capital, greater is the the flow of income, greater is the flow ofgoods and services. stock ofwealth with the people. 28 Introductory Macroeconomics M utual Dependence between Stock and Flow Fig. 1 shows deposits of 20, 000 in your saving bank account on January 1, 2020. This is a stock of your savings. The withdrawals from this account ( 1,000 per month) is a flow concept. Likewise, deposits of 2,000 per month is a flow concept. F LOW STOCK FLOW I BAN K , l HD 0 - u u u · r Saving Bank Ne 1 ,000 t 20,000/- 1 -1 -2020 - Per Month I I A point to be noted is that your stock of savings depends upon your flow of deposits into your saving account. Likewise, your flow of withdrawals depends upon your stock of savings. Thus, there is a mutual dependence between stocks and flows. Q. f>TS Are the following Stocks or Flows? (i) Investment, (ii) Monetary Expenditu re, (iii) A H undred Rupee Note, (iv) A Family's Consumption of Sugar, (v) Services of a Tutor, (vi) Production of Cement, (vii) Machinery of a Sugar M ill. Ans. (i) Investment: It is a fl ow concept because it is related to a period of time. (ii) Monetary Expenditure: It is a flow concept because it is related to a period of time. (iii) A Hundred Rupee N ote: It is a stock concept because it is a component of supply of money. (iv) A Family's Consumption of Sugar: It is a flow concept because consumption relates to a period of time. (v) Services of a Tutor: It is a fl ow concept because it is related to a period of time. (vi) Production of Cement: It is a flow concept because it is related to a period of time. (vii) Machinery of a Sugar M i l l : It is a stock concept because it relates to a point of time. 5. FOU R SECTO RS OF TH E ECONOMY From the macro point of view, economy is often divided into four sectors, viz. , (1) Household Sector: It includes consumers of goods and services. Households are also the owners of the factors of production. Some Basic Concepts of Macroeconomics 29  {2) Producer Sector: It includes all producing units (firms) in the economy. For the production of goods and services, the firms hire/purchase factors of production (land, labour, capital and entrepreneurial skill) from the households. {3) Government Sector: It includes: (i) Government as a welfare agency, and (ii) Government as a producer. Government as a welfare agency performs such welfare functions as of law & order and defence. {4) The External Sector {also called Rest of the World Sector): It includes all such activities which are related to export and import of goods, and the flow of capital between the domestic economy and rest of the world. 6. I NTERSECTORAL FLOWS Each sector of the economy depends on the other in one way or the other. This is called intersectoral interdependence. Following observations highlight the intersectoral interdependence: The household sector depends on the producer sector for the supply of goods and services, needed for consumption. The producer sector depends on the household sector for the supply of factors of production (also called factor services). These are needed for the production of goods and services. The government sector depends on the producer and household sectors for its tax and non-tax revenue. Producers and households depend on the government for administrative services, besides law & order and defence. lntersectoral interdependence leads to intersectoral flows, either in the form of goods and services or in the form of money. lntersectoral flow in the form of money is called 'Money Flow', and intersectoral flow in the form of goods and services is called 'Real Flow'. Following is a brief description of money flows and real flows. Real Flows Real flows refer to the flow of goods and services among different sectors of the economy. Flow of factor services from household sector to the producer sector or the flow of goods and services from the producer sector to the household sector are examples of real flows. Fig. 2 illustrates real flows in case of a simple 2-sector economy, including (i) household sector, and (ii) producer sector. 30 Introductory Macroeconomics  Real Flows in a 2-sector Economy Goods Prod uced a n d Sold by the Firms HOU SEHOLD PRODUCER t SECTOR SECTOR or FI RMS [ Facto r Se rvices (La nd, La bo u r, Ca pita l a n d Entrepreneu rshi p) re ndered by the Households Fig. 2 shows real flows in terms of (i) flow of goods sold by the firms to the households, and (ii) flow of factor services rendered by the households to the producers. Both these flows are real as these involve the movement of goods and services from one sector to the other. Money does not come into the picture. Money Flows Money flows refer to the flow of money across different sectors of the economy. Flow of factor payments by the producer sector to