MACROECONOMICS

MEASURING NATIONAL INCOME

Economics – A Course CompanionBlink & Dorton, 2007, p147-157

Introduction to Macroeconomics

Macroeconomics is concerned with the allocation of a nation’s resources and is concerned with five main variables:• Economic Growth• Employment• Price Stability• External Stability • Income Distribution

Macroeconomic Variables & Objectives

Variable Macroeconomic Objective

Economic Growth

A steady rate of increase of national output

Employment A low level of unemployment

Price Stability A low and stable rate of inflation

External Stability A favourable balance of payments position

Income Distribution

An equitable distribution of income

CIRCULAR FLOW OF INCOME MODELTwo Sector Model

• In this model there are two sectors – households and firms.

Households• People who buy the nation’s output of goods

and services and the owners all the economy’s factors of production.

• The supply these factors of production to the firms and in turn they receive payment for their factors.

CIRCULAR FLOW OF INCOME MODELTwo Sector Model

• The firms hire the factors of production from households and use these factors to produce the nation’s output of goods and services.

Factors of Production(provided by the households)

Payment to the factor(provided by firms)

Labour WagesLand RentCapital InterestEntrepreneurship Profits

Households provide the factors of production (1) and receive income (2). They buy the goods and services (3) produced by the firms by using the income received (4) and in this way the income circulates throughout the economy.

Limitations of the Two Sector Model

• The two sector model is very much a simplified model of the economy.

• Common sense, would suggest that households do not spend all their money they receive as income.

• Households can save some of their income.• By definition, saving means foregoing current

consumption to allow for consumption in the future. People deposit their money into banks and other financial institutions.

Leakages from the Circular Flow

Leakages• Incomes received but not used to finance

expenditure on goods and services.• Savings is a known leakage from the circular

flow.

Savings – Negative Impact on Circular Flow

• If households do not buy all the output that is produced by the firms, then firms will have unsold stocks of goods and as a result they will reduce their output.

• To reduce output, the firms will use fewer factors of production and thus pay less income.

• This shows how savings will cause the amount of income circulating in the economy to fall.

Savings-Positive Impact on the Circular Flow

• Firms will have access to savings of households by borrowing money from financial institutions such as banks or pension funds.

• They can use this money to increase their stock of capital and expand their output.

• This is know as investment and is an injection into the circular flow.

Injections into the Circular Flow

There are several injections into the circular flow:• Consumer Expenditure on goods & services• Investment Expenditure, • Government Expenditure• Export Revenue

The Foreign Sector

• If households buy goods and services from other countries, then some of their income flows out of the economy’s circular flow.

• Thus imports are also known as leakages, because they represent expenditure on income not returning to the firms.

• People in foreign countries buy the country’s exports of goods and services.

• Exports are an injection into the circular flow, because they represent a source of income not coming directly from households.

THE FOREIGN SECTOR

• There is no reason to assume that exports will be equal to imports.

• Countries usually have trade imbalances.

Government Sector

• Some of the income earned by households must be paid to the government in the form of taxes.

• Taxes are leakages from the circular flow.• Governments spend money in the economy on

a wide range of areas, such as schools, roads, hospitals etc.

• Government spending on goods and services represents an injection into the circular flow.

Government Sector

• There is no reason to assume that government spending will be equal to tax revenues.

• Governments are able to spend more than they earn in order to deliberately influence the level of leakages and injections in an economy, therefore affect the level of national income.

Transfer Payments are NOT an Injection

• The category of government spending known as transfer payments are NOT included as an injection in to the circular flow.

• Transfer payments are payments to individuals that are not a result of an increase in output.

• Examples of transfer payments are pensions, unemployment benefits, child allowance payments.

• Governments tax income of some households and transfers this income to others through the payments

• As it is a transfer of income, rather than income in exchange for output, this spending does not represent an injection.

THECOMPLETECIRCULARFLOW MODEL

Most government spending is an injection, BUT.. Transfer Payments (eg: Pensions) are not an injection.

Equilibrium in the Circular Flow Model

• The economy is equilibrium where leakages are equal to injections.

• If leakages rise, without a corresponding increase in injections, then national output will fall to a new equilibrium, as there will be less income circulating.

• If injections rise with no corresponding rise in leakages, then the economy will move to a new equilibrium.

HOW IS NATIONAL INCOME MEASURED?

• The most commonly used measure of a country’s national income is GDP (Gross Domestic Product).

• There are three different methods:1. The Output Method2. The Income Method3. The Expenditure Method

MEASURING NATIONAL INCOMEThe Output Method

• This measures the actual value of the goods and services produced.

• This is most common way GDP is measured.• This is calculated by summing all of the value added

by all the firms in the economy. • We say valued added, it means that at each stage of

the production process, it is necessary to deduct the costs of inputs, so as not to “double count” the inputs. We are concerned with the value of `final` goods and services

MEASURING NATIONAL INCOMEThe Output Method

• The data is usually grouped according to different production sectors in the economy.

Primary Sector• Agriculture and MiningSecondary Sector• ManufacturingTertiary Sector• Services.

• The output methods measures the value of the arrow marked (3) in figure 14.1

MEASURING NATIONAL INCOMEThe Income Method

• This measures the value of the incomes earned in the economy.

MEASURING NATIONAL INCOMEThe Expenditure Method

• This measures the value of all spending on goods and services in the economy.

• This is calculated by summing up the spending by all the different sectors in the economy.

These include:• Spending by households, known as Consumption (C)• Spending by firms, known as Investment (I)• Spending by Governments (G)• Spending by foreigners on exports minus spending on

imports. (X-M)

MEASURING NATIONAL INCOMEA Comparison of the Methods

• Each approach measures the value of a nation’s output differently by looking at different sets of data.

Definitions of GDP

Gross Domestic Product – Output Method• The total value of all final goods and services

produced in an economy in a year or a specified period of time.

Gross Domestic Product – Expenditure Method• GDP is the total value of all spending in the

economy, algebraically expressed as:GDP = C + I + G + (X-M).

MEASURING NATIONAL INCOMEA Comparison of the Methods

• Theoretically all three methods should lead to the same figure.

• In practice, however, the data that is collected to calculate each of three values comes from many different and varied sources, and inevitably there will be inaccuracies in the data, leading to imbalances among the final values.

• Some of these inaccuracies are the result of timing of the data gathering; often figures have to be revised at later data when full information is collection.

MEASURING NATIONAL INCOMEDefinition Summary

National Output = National Income =National Expenditure

GROSS DOMESTIC PRODUCT (GDP) &GROSS NATIONAL PRODUCT (GNP)

• An additional definition for GDP can be useful when making comparisons with GNP.

Gross Domestic Product• GDP may be defined as the total of all economic

activity in a country, regardless of who owns the productive assets.

Eg: If an Indian Multinational company (MNC) is operating in Canada earning profits, this income is included in Canadian GDP and not the Indian GDP.

GROSS NATIONAL PRODUCT

• Gross National Product (GNP) is the total income that is earned by a country’s factors of production regardless of where the assets are located.

• Eg: The profits earned by the Indian MNC would be included in Canada’s GDP, but not Canada’s GNP, because Canada does not own the assets.

• Similarly, Canada’s GDP would not include profits earned by a Canadian MNC operating in Brazil, but its GNP would include such profits.

GROSS NATIONAL PRODUCTPractical Definition

• GNP is equal to GDP plus income earned from assets abroad minus income paid to foreign assets operating domestically.

• The income earned by assets held in foreign countries is known as property income from abroad.

• The difference between income earned from assets abroad minus income paid to foreign assets operating domestically is known as net property income from abroad.

GROSS NATIONAL PRODUCTSummary - Definition

GNP =

GDP + net property income from abroad

GROSS NATIONAL PRODUCT (GNP) and NET NATIONAL PRODUCT (NNP)

• Throughout the course of a year, a country’s capital stock will lose some of its value.

• This is known as depreciation of capital or capital consumption.

This is due to several factors:• It may simply be due to wear and tear as machinery is

used; there may be damage to capital equipment or technology might make machinery obsolete.

• In effect capital gets “used up” and the GDP does not take into account this depreciation of capital

NET NATIONAL PRODUCT (NNP)

• Net national product (NNP), is GDP minus depreciation (capital consumption)

• While NNP gives a more realistic view of real economic activity of a country, in practice is it very difficult to account for depreciation.

• Thus gross figures are the more widely used measures.

NET NATIONAL PRODUCTSummary – Definition

NNP =GDP - Depreciation

NOMINAL GDP & REAL GDP

• If we are comparing the GDP of a country from one year to another, it is necessary to take into account that fact that prices in the economy are likely to have risen.

• If prices of goods and services rise (inflation), then this will overstate the value of GDP.

• GDP may rise even if there hasn’t actually been an increase in economic activity.

REAL GDP

• In order to obtain a true picture of the change in economic activity, we take the nominal GDP, which is the value at current prices and adjust it for inflation to get GDP at constant prices.

• This is achieved through the use of a GDP deflator and the value is known as real GDP.• To compare GDP data over time, it is necessary

to use the real value, so that price changes cannot distort the information.

The adjective “real” in front of an economic variable.

• Whenever you see the adjective `real` in front an economic variable, it means that the variable has been adjusted for inflation.

• This makes it possible to compare data over time.

REAL GDP Summary - Definition

Real GDP =

Nominal GDP adjusted for inflation

GDP per capita

• GDP per capita is the total GDP divided by the size of the population.

• While the total economic activity of a country is appropriately measured using the GDP figure, if one is to make any judgement about a the progress of a country in comparison with other countries in terms of raising living standards, then the GDP per capita figure is much more appropriate.

GDP per capita

Example• China has total GDP which exceeds Canada,

but on per capita basis China is well behind Canada.

• This is simply because China has over 1.3 billon people and Canada about 30 million.

Why collects national income statistic?

• Collecting national income data is complicated and expensive.

• Every country has organization that is responsible for calculating and reporting on the country’s national accounts.

• The United Nations provides guidelines for such work in the System of National Accounts (SNA)

How are national income statistics used?

Report Card for a Country• Economic objective is a stated objective of

governments. • People use statistics to judge whether or not a

government has been successful in achieving its macroeconomic objective of increased growth.

How are national income statistics used?

Develop Policies

Develop Models & Forecasts about the Future

Business Forecasts about the Future Demand

Evaluating the Standard of Living in a Country

Limitations of Data

Inaccuracies• Figures tend to become more accurate after a

time lag as they are revised when additional data are included.

• The United Nations SNA works with all countries to improve the methods of gathering data.

• This improves the validity of comparisons.

Unrecorded or Under-Recorded Economic Activity – Informal Markets

• It is important to note that national income accounts can only record economic activity that has been officially recorded.

• They therefore do not include any do-it-yourself work or other work done at home.

• If you paint your own home, your work will not be included in the country’s GDP, but if you pay a house painting company do so, the activity is recorded and GDP will rise. BUT.. If you a pay a trades person cash for the job and he does not declare the income, then there is no record of this economic activity.

Unrecorded or Under-Recorded Economic Activity – Informal Markets

Developing Countries• This is major problem in developing countries

where much of the output does not make it to any recorded market.

• Much of the food consumed in developing countries may be produced by subsistence farmers, who grow their own food.

• Although estimates of the value of this are made, it is likely that GDP figures are undervalued and inaccurate.

The Hidden EconomyBlack Markets

• This includes activity that is unrecorded because the actual work is illegal.

• Eg: drug trafficking.• It is also includes unrecorded activity that is

legal, but people are doing it illegally.• Eg: If foreign workers do not have the

appropriate work permits to do work such as cleaning, building or working in restaurants, their work will go unrecorded.

The Hidden EconomyBlack Markets

• Work may not be recorded because people want to avoid paying taxes.

• When governments impose high taxes on cigarettes, this provides smokers with additional incentive to buy cigarettes illegally to avoid paying taxes.

• High costs associated with government health and safety regulations may provide another incentive to hire worker unofficially.

The Hidden EconomyBlack Markets

Country Hidden Economy - % of GDP (2002-2003)

Greece 28.2%Italy 25.7%Norway 18.4%Canada 15.2%USA 8.4%

Higher Tax Burden=Greater Black Markets

• It is argued that for the most part, the countries with higher tax burdens, have a higher amount of hidden economic activity

Limitations of Data- External Costs

• GDP figures do not take into account the costs of resource depletion

• Cutting down trees leads to an increase in GDP, but there is no measure to account for the loss of these trees.

• GDP figures do not make deductions for the negative consequences of air and water pollution and traffic congestion. All these external costs will compromise the quality of life, even as GDP increases.

Limitations of Data- Other Quality of Life Concerns

• GDP may grow because people are working longer hours or taking fewer holidays.

• People may have higher incomes, but not necessarily higher standards of living.

• GDP does not include free activities such as volunteer work or people caring for the elderly and children at home.

Limitations of Data- Composition of Output

• It is possible that large part of a country’s output is in goods that do not benefit consumers such as defence.

• If this is the case, then it would be hard to argue that a higher GDP will raise living standards.

EXAMINATION QUESTIONSShort Response Questions

1. Using a diagram of the circular flow of income model, explain three ways that income can be measured.

(10 marks)

2. Distinguish between GDP, GNP and NNP. (10 marks)

EXAMINATION QUESTIONS Essay Question

1a. Explain three uses of national income statistics. (10 marks)

1b. Evaluate the use of GDP figures as means of comparing countries. (15 marks)