Unit 6: The National Economy

Session 6 (Source: Sloman, J. 2006, Economics, FT

Pearson, Harlow) Chapter 13
Learning Objectives
At the end of the lesson, students will be able to:
1. Distinguish between microeconomic and
macroeconomic issues and problems.
2. Explain the circular flow of income.
3. Describe the various phases of the business
cycle.
4. Explain the three ways of estimating GDP,
namely the product, income and expenditure
methods.
5. Understand the limitations of GDP as a measure
of the standard of living and the ways to correct it.
 THE SCOPE OF
MACROECONOMICS
• Microeconomics and macroeconomics
– Microeconomics concentrates on individual
units – the household, the firm, markets and the
industry.
– Macroeconomics examines the economic
behaviour of aggregates:
• economic growth
• unemployment
• inflation
• balance of payments and exchange rates
The National Economy
The Circular Flow of Income
 Macroeconomics
• The study of the performance of national
economies, and of the policies that
governments use to try to improve that
performance
 The circular flow of income

Firms

Consumption of INNER FLOW

Factor domestically
payments produced goods
and services (Cd)

Households
fig
THE CIRCULAR FLOW OF INCOME
• Withdrawals (W)
– net saving from households (S)
– net taxes to government from households & firms
(T)
– import expenditure of households & firms (M)
– W=S+T +M
• Injections (J)
– investment expenditure through intermediaries such
as banks (I)
– government expenditure on infrastructure (G)
– export expenditure by foreigners on domestic goods
(X)
– J=I+G+X
 The circular flow of income

INJECTIONS

Export
expenditure (X
(X)
Investment (I
(I )
Government
Consumption of expenditure (G
(G )

Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M
(M )
Net taxes (T
(T )
saving (S)

WITHDRAWALS
fig
The National Economy
Short--term Growth and the Business
Short
Cycle
 SHORT-TERM GROWTH & THE
SHORT-
BUSINESS CYCLE
• Actual and potential national income
– actual economic growth: the percentage annual
increase in national output actually produced.
– potential economic growth: speed in which an
economy can grow and its potentialities for
expansion in resources and efficiency.
 Growth and the production possibility curve

Growth in
actual output
Good X

b
a

O
Good Y
 Growth and the production possibility curve

Growth in
potential output
Good X

I II
O
Good Y
 Growth and the production possibility curve

Growth in
actual and
potential output
Good X

I II
O
Good Y
SHORT--TERM GROWTH & THE BUSINESS
SHORT
CYCLE
• Economic growth & the business cycle
– Actual growth in terms of GDP would fluctuate with the
business cycle.

– The business cycle is the periodic fluctuations of national

output around its long term trend (potential output).

– The phases of the business cycle

• Upturn: rise in employment, income & consumer spending.
• Expansion: economy expands rapidly.
• Peaking out: Growth slows down & diseconomies seep into the
economy.
• Slowdown or recession: Little or no growth; low demand; low
production; low employment.
 The business cycle
Potential output
National output

3
4
2 Actual
3
output
4
2 1

O
Time
fig
The National Economy
Measuring National Income
 Definition of GDP
Market value of all final goods and services produced
within the geographical boundary of the country,
during a particular time period.
Market Value
The GDP figure can only capture goods and services
that are marketed
Final Good and Services
These are the goods and services sold to the final user
Geographical Boundary
Within the country borders.
During a particular time period
Usually one calendar year but quarterly data also
compiled
 Definition of GNP
Market value of all final goods and services produced
by resources owned by the nation during a particular
time period
Resources owned by the nation
Only output produced by resources or factors of
production owned by the nation are reflected in that
country’s GNP. This includes output produced by the
nation’s resources abroad.
GNP = GDP + factor income from abroad – factor
income to abroad.
 Market Value
• Market Value
– Calculating GDP for Econland
• Total production = 4 sweaters, 10 bushels
of wheat and 3 mp3 players
• Price of sweaters = $10, Price of 1 bushel
of wheat = $5, Price of 1 mp3 player =
$100
– Calculating GDP for Econland
• GDP= (4 x $10) + (10 x $5) + (3 x $100) =
$390
19
 Double--Counting
Double
Intermediate goods are not included in GDP as
the final price of the product already reflects the
value of all its components (including
intermediate goods)
To avoid double-counting, count only the value
added to a product as it moves through each
stage of its production process.
The gross value added during each stage of
production is the difference between the value of
the product (its selling price) and the cost of
materials needed to make it.
 Computation of Value Added
Stage of Sale Cost of Intermediate Gross Value
Production Value Goods Added
(1) (2) (3)

Logger $20 -
$20
Cutter $50 $20
$30
Manufacturer $120 $50 $70
Retailer $200 $120 $80

$200
 Stages of Production
$20

$50

$200

$120
 Some Qualifications
• Old output
- already counted back at the time it was
produced.
• Re-sale goods
- no new production has taken place.
• Sales of Stock and Bonds
- exchanges of paper assets and do not
constitute current production.
 GDP

Plus
Minus Factor Income
Factor Income from abroad
to abroad
GNP
MEASURING NATIONAL INCOME

• The three ways of measuring GDP

–the product method
–the income method
–the expenditure method
The circular flow of national income and expenditure
(1) Production

(2) Incomes (3) Expenditure

fig
 MEASURING NATIONAL INCOME
• The product method
– the problem of double counting
– the measuring of value added
– gross value added (GVA)
– some qualifications
• Stocks
• Old output
• Resale goods
 UK GVA (product-based measure): 2004
Agriculture, forestry and fishing £9,381 m
Mining, energy and water supply £46,171 m
Primary sector

Manufacturing
£154,636 m Secondary
sector
Construction £67,619 m

Wholesale and retail trade; repairs £128,382 m

Hotels and restaurants £33,757 m
Transport and communication £78,279 m

Banking, finance, insurance, etc. £20,794 m

Letting of property £254,669 m Tertiary sector

Public administration and defence £53,483 m

Education, health and social work £131,918 m

Other services £54,236 m

fig

Total GVA £1,033,324 m

UK GVA (product-based measure): 2004
Agriculture, forestry and fishing £9,381 m 0.9
Mining, energy and water supply £46,171 m 4.5

Manufacturing
£154,636 m 15.0

Construction £67,619 m 6.5

Wholesale and retail trade; repairs £128,382 m 12.4

Percentage of GVA
Hotels and restaurants £33,757 m 3.3
Transport and communication £78,279 m 7.6

Banking, finance, insurance, etc. £20,794 m 2.0

Letting of property £254,669 m 24.6

Public administration and defence £53,483 m 5.2

Education, health and social work £131,918 m 12.8

Other services £54,236 m 5.2

fig

Total GVA £1,033,324 m 100.0

MEASURING NATIONAL INCOME
• The income method
– adding factor earnings (w + r + i + p)
– some qualifications
• transfer payments: social security benefits, pensions &
gifts are excluded because no goods and services are
exchanged.
• direct taxes are excluded as gross income are counted
• Indirect taxes and subsidies on products: add taxes
and subtract subsidies to get market price valuation.
 UK GVA by category of income: 2004
Compensation of employees
(wages and salaries)
£684,734 m
Operating surplus
(gross profit, rent and interest of firms, government and
other institutions)
£293,494 m
Mixed incomes
£73,116 m
Tax less subsidies on production
(other than those on products) plus
statistical discrepancy £17,980 m
Total GVA £1,033,324 m
fig
 UK GVA by category of income: 2004
Compensation of employees 62.8
(wages and salaries)
£684,734 m
Operating surplus 28.4
(gross profit, rent and interest of firms, government and
other institutions)
£293,494 m
Mixed incomes 7.1
£73,116 m
Tax less subsidies on production 1.7
(other than those on products) plus
statistical discrepancy £17,980 m
Total GVA £1,033,324 m 100
fig
UK GVA by category of income: 2004
Compensation of employees
(wages and salaries) 62.8
£684,734 m

Percentage of GVA
Operating surplus
(gross profit, rent and interest of firms
government and other institutions) 28.4
£293,494 m

Mixed incomes 7.1

£73,116 m
Tax less subsidies on production
(other than those on products) plus 1.7
statistical discrepancy £17,980 m

Total GVA £1,033,324 m 100.0

fig
 UK GDP: 2004

GVA (gross value added at basic prices) £1,033,324m

plus Taxes on products £138,639m

less Subsidies on products £7,524m

GDP (at market prices) £1,164,439m

 MEASURING NATIONAL INCOME

• The expenditure method

–C+G+I+X–M

• Gross national income (GNY)

• Net national income (NNY)

 Expenditure Approach
Consumption
• Personal consumption expenditure
• Consists of purchases of final goods and
services by households during the year.
• Three main types of consumer
expenditures
– durable goods
– non-durable goods
– services
 Expenditure Approach
Investment
• Gross private domestic investment
• Consists of spending on new capital
goods
• Investment consists of spending on
current production that is not used for
current consumption
– new physical capital
– new residential construction
– additions to inventories
 Expenditure Approach
Government Expenditure
• Government consumption and investment
• Spending by all levels of government for final
goods and services
• Do not include transfer payments
 Expenditure Approach
Net Exports
• Difference between export earnings and
import payments (X – M) resulting from
the interaction between that country and
the rest of the world
• Includes merchandise trade and
services
 Expenditure Approach
Aggregate Expenditure (AE)

= Consumption + Investment +
Government Purchases + Net Exports

= C + I + G + (X - M)

= GDP
UK GDP by category of expenditure, GNY and NNY:
2004
£ million
Consumption expenditure of households and NPISH (C) 760 678
Government final consumption (G) 246 810
Gross capital formation (I) 194 798
Exports of goods and services (X) 289 959
less Imports of goods and services (M) –328 384
Statistical discrepancy 578

Gross domestic product (GDP) (at market prices) 1 164 439

.
fig
 UK GDP by category of expenditure, GNY and NNY:
2004
£ million
Consumption expenditure of households and NPISH (C) 760 678
Government final consumption (G) 246 810
Gross capital formation (I) 194 798
Exports of goods and services (X) 289 959
less Imports of goods and services (M) –328 384
Statistical discrepancy 578

Gross domestic product (GDP) (at market prices) 1 164 439

plus Net income from abroad 25 184

Gross national income (GNY) 1 189 623

fig
 UK GDP by category of expenditure, GNY and NNY:
2004 £ million
Consumption expenditure of households and NPISH (C) 760 678
Government final consumption (G) 246 810
Gross capital formation (I) 194 798
Exports of goods and services (X) 289 959
less Imports of goods and services (M) –328 384
Statistical discrepancy 578

Gross domestic product (GDP) (at market prices) 1 164 439

plus Net income from abroad 25 184

Gross national income (GNY) 1 189 623

less Capital consumption (depreciation) –121 577

Net national income (NNY) fig

1 068 046
MEASURING NATIONAL INCOME

• Households' disposable income

• Taking account of:

–inflation

–population
 Accounting for Inflation
Nominal GDP
• measures the value of output in current dollars
i.e. GDP valued at their current market prices
• since the economy’s average price level
changes over time, current dollar comparisons
across years can be misleading
Real GDP
• eliminates price changes
• measures the value of output in constant dollars
i.e. GDP valued at the prices prevailing in a
selected year (base year)
 GDP Price Deflator
GDP Price Deflator = Nominal GDP X 100
Real GDP
• Quantity-weighted average of the prices of all the
final goods and services produced in the economy
• Used to measure price changes over the years
• Differs from the other price indexes because it
does not use fixed weights
• Broadest-based index
Computing GDP
2007 (base yr) 2008
P Q P Q
Good A $30 100 $35 120
Good B $50 20 $55 22

Use the above data to solve these problems:

A. Compute nominal GDP in 2007.
B. Compute real GDP in 2008.
C. Compute the GDP deflator in 2008.
Computing GDP
2007 (base yr) 2008
P Q P Q
Good A $30 100 $35 120
Good B $50 20 $55 22
Use the above data to solve these problems:
A. Compute nominal GDP in 2007.
$30 x 100 + $50 x 20 = $4,000
B. Compute real GDP in 2008.
$30 x 120 + $50 x 22 = $4,700
Computing GDP
2007 (base yr) 2008
P Q P Q
Good A $30 100 $35 120
Good B $50 20 $55 22
Use the above data to solve these problems:
C. Compute the GDP deflator in 2008.
Nom GDP = $35 × 120 + $55 × 22 = $5,410
GDP deflator = 100 x (Nom GDP)/(Real GDP)
= 100 x ($5,410)/($4,700) =
115.1
 Tracking Economic Performance
• A simple and quick gauge to determine whether
an economy is doing well or is growing is to check
whether it has managed to produce a larger
output of goods and services when compared to
the previous year
• An economy is declared to be growing if the real
GDP for that year is larger than the real GDP for
the previous year.
• An economy is declared to be in recession if the
real GDP for that year is less than that for the
previous year
 Tracking Economic Performance

Real GDP current year - Real GDP previous year X 100%

Real GDP previous year

• A year with economic growth would have a

positive economic growth rate and a year of
recession would have a negative economic
growth rate
 Accounting for Population

• GDP per capita is simply a country’s GDP

divided by its population

• often used to rank nations from the richest to

the poorest

• used to indicate the nation’s standard of living

GDP per head as a percentage of the EU15 average: 2004

GDP per head GDP (PPS) per head

Luxembourg 220.5 196.9
Denmark 142.7 112.0
Ireland 141.7 127.1
USA 127.3 142.5
Sweden 122.5 106.7
Japan 116.0 107.1
UK 112.6 109.1
Netherlands 112.0 108.1
Germany 104.1 98.5
France 103.6 104.4
Italy 92.0 97.5
Spain 76.0 87.4
Greece 58.6 74.4
Portugal 50.3 67.7
Czech Republic 33.2 64.6
Poland 20.0 44.6
 MEASURING NATIONAL INCOME
• National income statistics: suitable measures of
living standards?
– items that are excluded
• non-marketed items
• the underground economy
– production: poor indicator of welfare?
• production does not equal consumption
• human costs of production
• externalities
• Higher crime, stress related illness
• distribution of income
 Measuring National Income
• Non-marketed items
– non-market activity, such as the child care
a parent provides his or her child at home
• Underground economy
– Illegal transactions such as drugs, guns and
prostitution
– Undeclared part time income to avoid paying taxes
• Production does not equal consumption
– If GDP rises due to investment, this may not lead to
increase in current consumption
 Measuring National Income
• Human costs of production
– Rise in GDP due to less leisure time
• Externalities
– Polluted air, ozone depletion
• Higher crime, stress related illness
– Higher crime leads to greater spending on GDP
– Increased stress leads to more spending on health care
• Distribution of income
– Some people grow very rich while others are left behind
 Tutorial question 1
• The table below shows some data of a small country,
Tunisia
Year Price of oil Quantity Price of Quantity
(per of oil textiles of textiles
barrel) (per ton)

2008 $100 1,000 $50 1,200

(base barrels
year)
2009 $120 1,100 $52 1,300
barrels
 Tutorial question 1(ct’d)

(a) Calculate the nominal GDP, real GDP and GDP deflator
for 2009.
(b) What is the percentage change in real GDP between
2008 and 2009
 Tutorial question 2

• What components of the current year GDP of U.S. (if

any) would each of the following transactions affect
under the expenditure method?
(a)A family buys a refrigerator produced Japan
(b)Honda expands its car factory in Ohio
(c)A family buys a second hand car
(d)A car company sells a car from its inventory
 Tutorial question 3
One bag of locally produced flour is sold for $1.00 to a
bakery, which uses the flour to bake bread that is sold
for $3.00 to consumers. A second bag of imported flour
that costs $1.50 is sold to a consumer in a grocery store
for $2.00. Taking these three transactions into account,
what is the effect on GDP?
 Tutorial question 4
The table below shows data for a country, Xanadu in the
year 2007.
 Tutorial question 4 (ct’d)
Calculate Xanadu’s GDP in 2007.
 Tutorial question 5

Why do economists use market values when calculating

GDP? What is the economic rationale for giving high
value items more weight in GDP than low value items.
End of Unit 6