Some Basic Concepts of Macroeconomics

2.1 Some Basic Concepts of Macroeconomics

The Central Question: What Makes a Nation Wealthy?

Adam Smith, one of the founders of modern economics, titled his most famous work An Enquiry into the Nature and Cause of the Wealth of Nations. That title captures the deepest puzzle of the subject: what generates a country's economic wealth? What makes some nations rich and others poor?

The answer is not simply natural resources. Many countries in Africa and Latin America are richly endowed with minerals, forests, and fertile land, yet they include some of the poorest nations in the world. Meanwhile, several prosperous countries have scarcely any natural wealth. Even in earlier times when resource possession mattered most, those resources still had to be transformed through a production process. Economic wealth does not depend on mere possession of resources — it depends on how those resources are used to generate a flow of production, and how income and wealth arise from that process.

The Flow of Production

How does this flow of production come about? People combine their energies with the natural and man-made environment, within a particular social and technological structure, to generate a flow of production. In a modern economy, this flow consists of commodities — goods and services — produced by millions of enterprises. These range from giant corporations employing thousands of people down to single-entrepreneur operations.

Every producer intends to sell her output. From the smallest items like pins or buttons to the largest like aeroplanes, automobiles, giant machinery, or any saleable service (doctor, lawyer, financial consultant) — all goods and services produced are meant to be sold to consumers. The consumer may be an individual or another enterprise, and the purchased item may be for final use or for use in further production.

When a good is used in further production, it often loses its identity as that specific good and is transformed into something else. A farmer sells cotton to a spinning mill, where raw cotton becomes yarn. The yarn is sold to a textile mill, where it is transformed into cloth. The cloth is then transformed into an article of clothing, ready to be sold to consumers for final use.

Final Goods

An item that is meant for final use and will not pass through any more stages of production or transformation is called a final good. Once sold, it passes out of the active economic flow — it will not undergo any further transformation at the hands of any producer.

Thus it is not the nature of the good but the economic nature of its use that determines whether a good is final.

Consumption Goods and Capital Goods

Final goods are divided into two categories:

Consumption goods (or consumer goods) are goods like food and clothing, and services like recreation, that are consumed when purchased by their ultimate consumers. (Services are included here for convenience, though we often refer to them collectively as consumer goods.)

Capital goods are durable goods used in the production process — tools, implements, machines. They make the production of other commodities feasible but themselves do not get transformed in the production process. They are final goods, yet they are not consumed. They form part of capital, one of the crucial factors of production, and they enable production to continue for many cycles. Capital goods gradually undergo wear and tear, requiring repair or eventual replacement. The stock of capital an economy possesses is thus preserved, maintained, and renewed over time.

So all final goods and services produced in an economy in a given period are either consumption goods (durable or non-durable) or capital goods.

Intermediate Goods

Of the total production taking place in an economy, a large number of products do not end up in final consumption and are not capital goods either. Such goods are used by other producers as material inputs. Examples: steel sheets used for making automobiles, copper used for making utensils. These are intermediate goods — mostly used as raw material or inputs for production of other commodities. They are not final goods.

The Need for a Common Measuring Rod: Money

To get a quantitative measure of the total final goods and services produced in an economy, we need a common measuring rod. We cannot add metres of cloth to tonnes of rice or to the number of automobiles or machines. Money serves as that common measuring rod. Since each commodity is produced for sale, the sum total of the monetary value of these diverse commodities gives us a measure of final output.

Why Measure Only Final Goods?

Intermediate goods are crucial inputs, and a significant part of manpower and capital stock is engaged in producing them. However, the value of final goods already includes the value of the intermediate goods that entered into their production as inputs. Counting them separately would lead to the error of double counting. While considering intermediate goods may give a fuller description of total economic activity, counting them would highly exaggerate the final value of economic activity.

Stocks and Flows

We often hear statements like "the average salary of someone is Rs 10,000" or "the output of the steel industry is so many tonnes." These statements are incomplete because it is not clear whether the income is yearly, monthly, or daily — and that makes a huge difference. When the context is familiar, we assume the time period is known, but inherent in all such statements is a definite period of time. Otherwise they are meaningless.

Flows are concepts that make sense only when a time period is specified — income, output, profits. They occur over a period of time. Since much accounting is done annually, many flows are expressed annually (annual profits, annual production).

Stocks are defined at a particular point in time. Capital goods or consumer durables, once produced, do not wear out or get consumed in a delineated time period. Buildings or machines in a factory exist irrespective of the specific time period. There can be additions to or deductions from stock (a new machine added, a machine falling into disuse and not replaced).

Changes in stock over a specific period are themselves flows — for example, how many machines were added this year. A particular machine can be part of the capital stock for many years, but it is part of the flow of new machines added to the capital stock only for the single year when it was initially installed.

Gross Investment, Depreciation, and Net Investment

That part of final output comprising capital goods constitutes gross investment of an economy. These may be machines, tools, implements; buildings, office spaces, storehouses; or infrastructure like roads, bridges, airports, or jetties.

Not all capital goods produced in a year constitute an addition to the existing capital stock. A significant part of current output of capital goods goes toward maintaining or replacing part of the existing stock, which suffers wear and tear. The value of this replacement must be subtracted from gross investment to arrive at net investment.

This deduction for regular wear and tear of capital is called depreciation.

Understanding Depreciation

Consider a new machine that a firm invests in. It may be in service for twenty years, after which it needs replacement. We can imagine the machine being gradually used up in each year's production process — each year, one-twentieth of its original value gets depreciated. Instead of considering a bulk investment for replacement after twenty years, we consider an annual depreciation cost every year.

Depreciation is thus an annual allowance for wear and tear of a capital good. In other words, it is the cost of the good divided by the number of years of its useful life.

Depreciation is an accounting concept. No real expenditure may actually be incurred each year, yet depreciation is annually accounted for. In an economy with thousands of enterprises having widely varying equipment lifetimes, in any particular year some enterprises are actually making bulk replacement spending. So we can realistically assume a steady flow of actual replacement spending that more or less matches the amount of annual depreciation being accounted for in that economy.

The Trade-off Between Consumption and Investment

Total final output in an economy consists of consumer goods and services and capital goods. Consumer goods sustain the consumption of the entire population. Purchase of consumer goods depends on people's capacity to spend, which depends on their income. Capital goods are purchased by business enterprises, either for maintenance of the capital stock (replacing wear and tear) or for addition to the capital stock.

In a given year, the total production of final goods can thus be either in the form of consumption or investment. This implies a trade-off: if an economy produces more consumer goods, it produces fewer capital goods, and vice versa.

More sophisticated and heavy capital goods raise the ability of a labourer to produce goods. A traditional weaver takes months to weave a sari; with modern machinery, thousands of pieces of clothing are produced in a day. Decades were taken to construct the Pyramids or the Taj Mahal; with modern construction machinery, a skyscraper can be built in a few years. More production of newer varieties of capital goods helps in greater production of consumer goods. …