Lesson II: Macro-economic Framework

An Introduction to System of National Accounts - Basic Concepts

Sixth e-Learning Course on the 2008 System of National Accounts September 2014 – November 2014

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Content

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SNA – Introduction Circular Flow in an Exchange Economy Factors of Production

Lesson Objectives

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The objective of the lesson is to Introduce the linkage of the SNA 2008 to the general

macroeconomic structure of a country; Expose participants to the process of how goods and

services are produced, and used through the circular flow of income concept

Introduce factors of production

National Accounts (NA) and Macro-economics

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NA have a long tradition. The term ‘national accounts’ has been around for quite a while.

Adam Smith came close to the idea in his “The Wealth of Nations”. He recognized the economic flows and their linkages.

The core idea: Balanced ‘circular flow of money’ leads to the fundamental macroeconomic relationship:

Value of production (Y) ≡ Consumption (C) + Investment (I) ≡ final demand aggregate. NAs is essentially founded on this.

SNA - Introduction

SNA framework

The SNA is founded on the macro-economic framework that gives a set of identities – relationships between different flow and stock variables.

These identities form the basis of the SNA sequence of accounts consisting of measures of economic flows and stocks in monetary values.

A set of standard procedures of valuation is recommended for attributing monetary values to flows and stocks.

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SNA - Introduction

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Macro-economic Framework

The macro-economic framework is based on the premises that all goods and services produced in the

domestic economy are put to “use” of one kind or other; circular flows income and expenditure of the residents and

the non-residents participating in transactions of the domestic economy.

The framework establishes the equivalence of supply and use of goods & services produced the value of production of goods and services, income

generated in production and expenditure on products and non-produced assets.

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SNA - Introduction

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Circular Flow in an Exchange Economy

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Macro-economic Framework

The macro-economic framework is based on the premises that all goods and services produced in the

domestic economy are put to “use” of one kind or other; circular flows income and expenditure of the residents and

the non-residents participating in transactions of the domestic economy.

The framework establishes the equivalence of supply and use of goods & services produced the value of production of goods and services, income

generated in production and expenditure on products and non-produced assets.

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Circular flow

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Balanced circular flow

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Goods and services are produced in production process

Income is generated from and is equal to value of goods and services produced

Income, thus generated, is spent for purchase of goods and services produced

either for final consumption

or for use in further production.

National Accounts provide a quantitative description of all these processes and their inter-linkages.

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Circular flow

Flows in Exchange Economic – An Illustration

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In an island country called Monojima there was only one enterprise that carried out production in 2005. It was a closed economy and had no government.

In 2005, the enterprise was a partnership of three different households – A, B & C; sold all goods and services produced during the year; hired land from other households and paid them rent borrowed money from other households and paid them

interest engaged workers from households and paid wages and

salaries (w&s).

Circular Flow

An Illustration (contd.)

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In 2005, receipts and payments of the enterprise were as follows:

Value of goods and services sold: 15,000 cowries

Rent paid: 1,200 cowries Interest paid: 900 cowries Wages and salaries paid: 8,900

cowries What was the value of production? What was the income of the owners of the enterprise? What was the total income of its residents? What was the total expenditure on purchase of goods &

services of its residents?

Circular Flow

An Illustration (contd.)

The value of production (Y) was clearly 15,000 cowries – the

value of goods & services produced and sold by the enterprise

The partners earned a profit of 4,000 cowries [= 15,000 – 1,200 –

900 – 8,900].

The income of the other households was 11,000 cowries

[the sum of rent (1,200), interest (900) and wages & salaries (8,900)].

Again, the total expenditure of the households was also 15,000 cowries.

Thus,

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Circular Flow

Production ≡ Income ≡ Expenditure

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Basic Circular Flow in an Exchange Economy

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Two-Sector Model:

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Households Enterprises

Labour & other factor services

Goods & services

Expenditure on goods & services

Wages & salaries and OS

Households Enterprises Households Enterprises

Circular Flow

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Basic Circular flow (Contd.)

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The interactions involve flows going in two directions: Flows of goods and services, called real flows Flows of payments for these goods and services, called

money flows

Households are defined as the owners of all factors of production – land, labour, capital and entrepreneurship.

Households provide factor services and in return gets paid by the enterprises – wages & salaries (w&s) and operating surplus (OS).

This constitutes the income of the economy.

Circular Flow

Basic Circular flow (Contd.)

Households spend their income on purchase of all goods and services produced by enterprises – the expenditure of the economy

Economy’s expenditure in turn has to be equal to the value of goods & services produced and sold in the economy.

This establishes the equivalence of the value of production of goods and services, income generated in production and expenditure on products and non-produced assets.

Thus,

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Circular Flow

Production ≡ Income ≡ Expenditure

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Use of Produced Goods and Services

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The circular flow presented above is oversimplified, as it ignores a very basic notion in economics: the use of intermediate products in the production process.

An enterprise uses output (goods and services) of other enterprises or of itself in its production process. Like Intermediate Products: raw materials, semi-processed

materials and services; or Machinery, equipments, building & construction and capital

services (financed by investments made by households).

This leads to a modified representation of circular flow.

Circular Flow

Circular Flow in Exchange Economy – a Modified Version

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Households Enterprises

Labour & other factor services (including financial investments)

Goods & services for final consumption

Households’ Final Consumption Expenditure (HFCE)

Wages & salaries and OS

Households Enterprises Households Enterprises

Goods & services for Intermediate consumption (IC)

Goods & services for Capital Formation

GCF

Purchase of IC

Circular Flow

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Modified Circular flow (Contd.)

This representation of circular flow redefines the production in the economy.

Of the goods and services produced by the enterprises, a part flows back to enterprises, in form of Intermediate Consumption (IC) - raw materials, semi-

processed materials and services and Capital goods & services.

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Circular Flow

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Relook at Monojima - An Illustration

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A relook reveals that there were in fact three enterprises. In 2005, receipts and payments of the enterprises from sale of products for household consumption & capital goods were as before: Value of goods and services sold: 15,000 cowries Rent paid: 1,200 cowries Interest paid: 900 cowries Wages and salaries paid: 8,900 cowries

Circular Flow

Relook at Monojima (Contd.)

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It was also revealed that the total sales (15,000 cowries) consisted of: products for household consumption: 14,000 cowries and capital goods (say tractor): 1,000 cowries

The capital goods produced by one enterprise was purchased by other enterprises.

Circular Flow

Relook at Monojima (Contd.)

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With the knowledge of this detail,

What was the value of production?

What was the total income of its residents?

What was households’ consumption expenditure?

What was enterprises investment expenditure on capital goods?

What was the total expenditure on purchase of goods & services of its residents?

Circular Flow

Modified Circular flow (Contd.) The way “production” of an economy is defined, the

intermediate consumption gets eliminated and what remains are: Goods & services for final consumption and Capital goods & services for investment

In our illustration, production = 15,000 household consumption = 14,000

(gross) Investment = 1,000 This leads to the basic macro-economic relationship:

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Circular Flow

value of production (Y) ≡ Consumption (C) + Investment (Ig) ≡ final demand aggregate.

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Basic Macroeconomic Relationship

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Thus, from the production side, The value of production, 15,000 cowries, is also the income of the households. But, households spent only 14,000 cowries for consumption. Thus, savings (S) of the households, Y - C, was 1,000 cowries, since This leads to another basic macro-economic relationship:

Circular Flow

Y ≡ C + Ig

Y ≡ C + S

(gross) Investment (Ig) ≡ Savings (S )

A consequent questions What if goods and services that are produced but not sold in

the marketplace? Will the value of production still be equal to expenditure?”. Note that the unsold goods goes into inventory.

The change in inventories (CII) of finished products is included in the value of production and

since, the unsold goods are treated as economic assets, the CII is considered a part of investment.

Thus, the basic relations would still hold good.

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Circular Flow

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Monojima with a change - An Illustration

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Consider the following change: As before, Value of goods and services produced: 15,000 cowries of which, consumption products: 14,000 cowries and capital goods (say tractor): 1,000 cowries

But the households now spend only 13,500 cowries and put 500 cowries in their piggy banks

Circular Flow

Monojima with a change (contd.)

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Households spent only 13,500 cowries for consumption. Thus, savings (S) of the households, would be 1,500 cowries (gross) investment will now be 1,000 cowries for purchase of capital goods plus 500 cowries for the CII.

Thus both the identities would still hold.

Circular Flow

Production ≡ Income ≡ Expenditure

(gross) Investment (Ig) ≡ Savings (S )

Factors of Production

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Factors of Production

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Factors of production are the resources employed in production processes that facilitate production

but do not become part of the product or

become significantly transformed by the production process.

Factors of Production

Factors of Production (contd.) In macro-economics,

land (and other natural resources), labour, capital (human-made tools and equipment) and entrepreneurship are treated as factors of production, which are directly or

indirectly owned by the households.

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Factors of Production

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Factors of Compensation

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Services provided by these factors in production process are called factor services. The payments made for use of factor services by the enterprises are called factor payment or factor compensations. Factor of production Factor payment / compensation

Labour Compensation of employees

Land & natural resources Rent

Capital Interest

entrepreneurship profit

Factors of Production

Use of Produced Goods and Services

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But the presentation is oversimplified, as it ignores a very basic notion in economics: the use of intermediate products in the production process.

An enterprise uses output (goods and services) of other enterprises or of itself in its production process. Like Intermediate Products: raw materials, semi-processed

materials and services; or Machinery, equipments, building & construction and capital

services (financed by investments made by households). Thus, all goods and services produced by the enterprises do

not flow to the households. This leads to a modified representation of circular flow.

Factors of Production

Modified Circular flow with Government and external transactions

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Circular Flow

Circular Flow of Money an Exchange Economy

Households Enterprises:Businesses & govt. services

Income from enterprises to households

Net exports

Consumption expenditure

Government

Financial market

government expenditure

Private savings

Investment expenditure

Flow of taxes (less subsidies)

Prim

ary I

ncom

e fro

m R

oW(n

et)

RoWRoW RoW

Government surplus

Net capital inflow & transfers

Lesson Summary

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In this lesson you have learnt The process through that National Accounts are founded

on the process of production Process of production, generation of incomes and

expenditures on goods and non-produced assets Various uses to which goods & services are put to ie

consumption, raw materials etc Sectors that produce and use goods i.e households,

private businesses, government

End of Lesson II

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