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  1. 1. Macro Economic Phenomenon
  2. 2. Circular Flow of Economic Activities and Income The simple model of the circular flow assumes two players Firms • Produce and supply the goods and services. • Require various factors of production to produce these goods and services. Households • Take joint decision about the consumption of goods and services. • Provide services in terms of factor inputs to the firms • Get paid for these services by firms which households spend on consumption. • Money flows from firms to households as factor payments and from households to firms as expenditure on goods and services. • It is a circular flow of money or income
  3. 3. Circular Flow of Income (Two Sector Economy) (Wages, Rent, Interest and Profits) Factor Payments (Y) Factor Inputs Households Savings (S) Financial Market Investment (I) Firms Goods and Services (O) Consumption expenditure (C) In the equilibrium Y=C+S=C+I=E=O
  4. 4. Circular Flow of Economic Activities and Income • • • • • • • • Value of output produced (Y) = value of output sold (O) Value of output sold = Sum of consumption expenditure (C) and investment expenditure (I). Y=O=C+I=E……(1) Income is either consumed or saved (S). Y=C+S………….(2) C+I=Y=C+S………(3) Therefore: I = S…………(4) Savings are withdrawal of money from the circular flow Investment is injection of money into the circular flow For equilibrium savings should be equal to investments Hence Y=O=E
  5. 5. Circular Flow of Income (Four Sector Economy) The third sector is Government (G) • Government Spending – – – • On provision of public utility goods and services. Provides salaries to the households Pays to firms for purchases of goods and services Government Revenue – – Households and firms pay various taxes and other payments and provide factor inputs to the government. Government borrows from the financial market to fill revenue gap. The fourth sector is the external sector • • Imports (M): Outflow of income occurs when the domestic firms buy goods and services from foreign ones. Exports (X): Inflow of income takes place when foreign firms buy goods and services from domestic ones
  6. 6. Circular Flow of Income (Four Sector Economy) Government (G) Taxes Taxes Factor Payments Remittances for purchases Factor Inputs Salaries Households Savings (S) Imports (M) Financial Market Investment (I) Imports (M) Goods (O) Consumption Expenditure Exports (X) Foreign Nations (X-M) Firms Exports (X) National Income=C+I+G+(X-M)
  7. 7. Circular Flow of Income (Four Sector Economy) • National income includes expenditures on consumption investment, government and net of exports (X-M) National Income=C+I+G+(X-M) • Since national income can either be consumed, or saved, or paid as tax to the government: C+I+G+(X-M)=C+S+T I+G+(X-M) =S+T • Sum of private investment and expenditure on net exports is equal to the sum of savings and tax revenue. Thus: I+G+X =S+T+M • Therefore, W=J • At equilibrium, total injections are equal to total withdrawals.
  8. 8. Aggregate Demand • Sum of demand for all goods and services by all consumers for a given period of time may be termed as aggregate demand • It is the total demand in terms of goods and assets at a given price by all the people in an economy. • Thus it can be said that aggregate demand refers to aggregate expenditure made by the society as a whole.
  9. 9. Aggregate Demand • Aggregate demand consists of two components, – aggregate demand (AD) for consumer goods i.e. consumption demand (C) – aggregate demand for capital goods i.e. Investment demand (I). Thus AD = C+I
  10. 10. Aggregate Supply • Aggregate supply is the total national output produced and supplied by all the factors of production in an economy. • It refers to the supply of all goods and services in the economy for a given period of time. • Aggregate supply (AS) consists of – Aggregate supply of consumer goods (C) and – Aggregate Supply capital goods (where capital comes from savings) (S), Hence AS=C+S
  11. 11. Equilibrium in Economy Expenditure AS=C+S AD=C+I E E C I O Y Income AD=AS=C+S=C+I=Y=O=E
  12. 12. Stock and Flow • The distinction between stock and flow usually lies in the dimension of time. • Stock may be defined as any economic variable which has been accumulated at a specific point of time – like money, assets and wealth. • Flow includes the variables which increase (inflows) and decrease (outflows) the stock, over a period of time. – like income, consumption, saving and investment
  13. 13. Stock and Flow Stock Inflow Outflow Inventory Incoming goods Outgoing goods Bank balance Deposits Withdrawals Population Births + immigration Deaths + emigration Money Supply Income Consumption + investment Mathematically a stock can be seen as an accumulation or integration of flows over time, with outflows subtracted from the stock. Stock=Inflows-Outflows
  14. 14. Intermediate and Final Goods • Intermediate goods (and services) are items purchased by firms for using them in production of some other good of utility. • Also known as producer goods because they are used as inputs in the production of other goods. – partly finished goods or raw material.
  15. 15. Intermediate and Final Goods • Final goods are demanded by the final consumer for using these goods as they are. • Also known as consumer goods, as no value addition is made beyond this stage. – Durable, non durable, perishable goods • The distinction is made for calculation of national income where only final goods are considered.
  16. 16. Capital Formation • Capital formation is the enlargement of capital stock. • The process of savings being converted into investment is known as capital formation • Investment: individual • Capital formation: nation • Gross private investment is business spending on equipment, residential structures, and inventories; it is net investment plus depreciation (or capital consumption allowance). • Gross Capital Formation refers to the aggregate of additions to fixed assets (Fixed Capital Formation) and increase in stocks of inventories during a period of time.
  17. 17. Capital Formation • Rate of capital formation is the measure of growth of an economy, because it determines the volume of investment in future. • The higher the rate of capital formation, higher is the increase in production of goods and services and hence higher is the economic growth of the economy. Capital Formation in India (at 1999-2000 Prices) 2004-05 Gross Fixed Capital Formation Change in Stocks Rs. Crore 2005-06 2006-07 6,57,317 7,57,806 8,68,618 46,633 78,821 86,840
  18. 18. Government Revenue and Expenditure • Government Revenue: income received by government in various forms, including Direct and Indirect Taxes and non- tax revenue. • A direct tax is one paid directly to the government by the persons on whom it is imposed • An indirect tax is one where incidence is on one person and impact is on someone else. • Non tax revenue includes profits from investment, interest earned on securities, etc.
  19. 19. Government Expenditure • Government Expenditure – Government Expenditure is which is made from public exchequer. – Includes transfer payments, which refers to payments made to certain sections of the society as a social welfare measure. – It is an exchange of purchasing power from one group of people to another. – These include unemployment compensation, retirement benefits, pensions, etc.
  20. 20. Employment • An important macro variable that affects the national economy. • A person who is willing and capable to work in a productive activity and is engaged for certain number of hours per week, whether working for self or someone else, is employed • The population of any country is divided into working population (age group of 16 to 65 ) and dependents. • Every country tries to achieve full employment so that maximum economic growth with maximum social welfare can be achieved.
  21. 21. Types of Unemployment • • • • • Involuntary unemployment : where people are capable to work and willing to work at the prevailing wage rate but fail to get an opportunity. Voluntary unemployment : where a person is out of job because he is either not willing to work on the prevalent or prescribed wages or does not want to work at all. Frictional Unemployment occurs when an individual is out of his current job and looking for another job. This is purely temporary phenomenon. Structural Unemployment: occurs when there is a mismatch of skilled workers in the labour market. Classical Unemployment: occurs when trade unions and labor organization bargain for higher wages, which leads to fall in the demand for labour.
  22. 22. Types of Unemployment • Cyclical unemployment is the result of the trade cycle. It is also referred as Keynesian unemployment, or as deficient-demand unemployment. • Sudden unemployment occurs due to changes in the work place conditions; this may be due to closure of the firm, dispute between partners, etc. • Seasonal unemployment occurs when certain industries and traders engage workers for a particular season such as Sugar industry, tourism and event management. • Disguised unemployment is one where people appear to be employed but when you remove some of them the total produce remains same. Marginal productivity of labour is zero in such case.
  23. 23. Consumption Function • The aggregate consumption in any economy is the summation of consumption expenditure by all the individuals • Marginal propensity to consume (mpc) is defined as the ratio of consumption changes to income changes – mpc tells how much will be the change in consumption due a change in income. mpc = dC/dY mps=dS/dY mpc+mps=1 • Average propensity to consume (apc) refers to the percentage of income that is spent on goods and services rather than on savings. apc= C/Y
  24. 24. Consumption Function • Consumption function will normally be like: • C = a+bY Where: C = Consumer spending a = Autonomous consumption, or the level of consumption that would still exist even if income was zero, b = Marginal propensity to consume, Y = Real disposable income
  25. 25. Consumption Function Y Consumption (C) M C= f(Y) N L 450 O Income (Y) X Keynesian Consumption Function •The curve LNM shows the marginal propensity to consume. •Keynes proposed that mpc declines as income rises. Mathematically: 1>dC/dY>0
  26. 26. Investment Function • • • • • • • In the condition of equilibrium savings are equal to investment; implying whatever is not spent on consumption, is spent on investment. Gross investment is total value of productive assets created during a given period i.e. one year. Net investment in any given year = Gross investment minus an estimate for replacement investment. Private Investment: Investments made by individuals and corporate Public Investment: made by Government Autonomous Investment is income inelastic. Some amount of investment which is normally done by the Government. Induced Investment takes place due to various factors such as higher expected rate of return, increase in demand for capital goods, etc.
  27. 27. Investment Function • • • • • In Keynesian theory inducement to invest depends upon two factors: (i) marginal efficiency of capital and (ii) the rate of interest. Marginal efficiency of capital (mec) represents the demand function of the capital goods (new investments). Keynes defines marginal efficiency of capital as “being equal to that rate of discount which would make the present value of series of annuities given by the returns expected from the capital asset during its life just equal to its supply price”. Cost of capital is the supply price. Marginal efficiency of capital of an asset depends upon the prospective yield and supply price of that asset.