Lesson II: Macro-economic Framework An Introduction to System of National Accounts - Basic Concepts Fifth e-learning Course on the 2008 System of National Accounts May 2014 July 2014 1
Content 2 SNA Introduction Circular Flow in an Exchange Economy Factors of Production
Lesson Objectives 3 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
SNA - Introduction 4 National Accounts (NA) and Macroeconomics 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. 5 5
SNA - Introduction 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. 6 6
7 Circular Flow in an Exchange Economy
Circular flow 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. 8 8
Circular flow 9 Balanced circular flow 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. 9
Circular Flow 10 Flows in Exchange Economic An Illustration 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 11 An Illustration (contd.) 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, Production Income Expenditure 12 12
13 Circular Flow Basic Circular Flow in an Exchange Economy Two-Sector Model: Goods & services Expenditure on goods & services Households Enterprises Wages & salaries and OS Labour & other factor services 13
Circular Flow 14 Basic Circular flow (Contd.) 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, Production Income Expenditure 15 15
Circular Flow 16 Use of Produced Goods and Services 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 Goods & services for final consumption Households Households Final Consumption Expenditure (HFCE) Goods & services for Capital Formation GCF Goods & services for Intermediate consumption (IC) Purchase of IC Enterprises Wages & salaries and OS Labour & other factor services (including financial investments) 17 17
Circular Flow 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, semiprocessed materials and services and Capital goods & services. 18 18
Circular Flow 19 Relook at Monojima - An Illustration 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 20 Relook at Monojima (Contd.) 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 21 Relook at Monojima (Contd.) 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: value of production (Y) Consumption (C) + Investment (I g ) final demand aggregate. 22 22
Circular Flow 23 Basic Macroeconomic Relationship 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 Y C + S Y C + I g This leads to another basic macro-economic relationship: (gross) Investment (I g ) Savings (S )
Circular Flow 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. 24 24
Circular Flow 25 Monojima with a change - An Illustration 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 26 Monojima with a change (contd.) 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 Production Income Expenditure (gross) Investment (I g ) Savings (S ) would still hold.
27 Factors of Production
Factors of Production Factors of Production 28 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. 29 29
Factors of Production 30 Factors of Compensation 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 Labour Land & natural resources Capital entrepreneurship Factor payment / compensation Compensation of employees Rent Interest profit
Factors of Production 31 Use of Produced Goods and Services 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.
32 Circular Flow Modified Circular flow with Government and external transactions Circular Flow of Money an Exchange Economy Income from enterprises to households Households Enterprises: Businesses & govt. services Primary Income from RoW (net) RoW Flow of taxes (less subsidies) Private savings Consumption expenditure RoW Government Government surplus Financial market Net capital inflow & transfers government expenditure Investment expenditure Net exports RoW 32
Lesson Summary 33 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
34 End of Lesson II