Chapter 8 The level of overall economic activity
8.1 Economic activity
The circular flow of income model
The model in a closed economy with no government
Def: circular flow of income model illustrates a number of concepts and relationships
that will help us understand the macroeconomy.
1/ closed economy:
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no international trade
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no government
2/ markets:
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resource market: household sell, business buy.
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product market: household buy, business sell.
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rent=land
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wages=labor
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interest=capital
3/
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profit=entrepreneurship
4/ money flow:
In any given time period, the value of output produced in an economy is equal to the
total income generated in producing that output, which is equal to the expenditures
made to purchase that output.
Adding leakages and injections
1/ leakages:
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saving, taxes, imports
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money that leaves the circular flow
2/ injections:
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investment, government spending, exports
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money that enters the circular flow
3/ saving and investments:
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money saved in the financial market is used to invest firms
4/ Taxes and government spending:
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Households pay taxes to the government and the government uses the tax
funds to finance government expenditures
5/ Imports and exports:
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Imports represent household spending that leaks out as payments to the other
countries. Exports are spending by foreigners who buy goods and services
produced by the domestic firms.
6/ open economy= international trade
7/ size of circular flow:
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Leakage>injection: smaller size of CF:
Suppose saving (a leakage) is larger than investment (an injection). Fewer
goods and services are purchased, firms cut back on their output, they buy
fewer factors of production, unemployment increases (since firms buy a smaller
quantity of labour) and household income is reduced.
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Leakage< injection: bigger size of CF:
Suppose spending on exports is greater than spending on importsForeigners
demand more goods and services, firms begin to produce more by purchasing
more factors of production, unemployment falls (as firms buy a larger quantity
of labour), and household income increases.
8.2 Measures of economic activity
Understanding measures of economic activity
Introduction to measures of economic activity
national income and aggregate allows:
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assess an economy’s performance
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make comparisons with other economies
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establish a basis for making policies
(value= quantity x price)
How economic activity is measured
There are three ways to measure the value of aggregate output:
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the expenditure approach adds up all spending to buy final goods and
services produced within a country over a time period
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the income approach adds up all income earned by the factors of production
that produce all goods and services within a country over a time period
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the output approach calculates the value of all final goods and services
produced in a country over a time period.
1/The expenditure approach: we include only purchases of final goods and services.
Total spending:
• Consumption spending=C:
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purchases by households on final goods and services in a year
• Investment spending= I:
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spending by firms on capital goods (i.e. buildings, machinery, equipment, etc.)
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spending on new construction (housing and other buildings).
• Government spending= G:
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purchases by the government of factors of production, including labour
services
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includes investment by government, which is referred to as ‘public investment’
(usually on capital goods including roads, airports, power generators, building
schools and hospitals, etc.).
• Net exports =X− M:
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the value of all exports (abbreviated as X) minus the value of all imports
(abbreviated as M).
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Exports = aggregate output
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Imports = domestic spending on goods and services that have been produced
in other countries
GDP
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Gross domestic product : the market value of all final goods and services
produced in a country over a time period.
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C+I+G+(X− M) = GDP
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commonly used measures of the value of aggregate output.
• Some clarifications concerning investment: (can be undertaken by firms and
government & capital’ includes only spending on physical capital)
2/The income approach:
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adds up all income earned by the factors of production within a country over a
time period (wage rent interest profit)
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To calculate GDP using the income approach, it is necessary to make some
adjustments to national income.
3/The output approach:
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the value of each good and service produced in the economy over a particular
time period (usually a year) sums up
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the value of all final goods and services
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calculates the value of output by economic sector: opportunity to study the
performance of each individual sector.
Distinctions relating to measures of the value of output
GDP VS GNI/GNP
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GDP: output produced within the country
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is the total value of all final goods and services produced within a country over a time
period (usually a year), regardless of who owns the factors of production.
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What is produced in the country?
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GNI (gross national income): income of the country’s residents
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is the total income received by the residents of a country, equal to the value of all final
goods and services produced by the factors of production supplied by the country’s
residents regardless where the factors are located.
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What is received by the country’s residents
nominal values VS real values
¶
Nominal (GDP or GNI) measured with current prices:
which does not account for changes in prices.
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Real (GDP or GNI) measured with past price
eliminated the influence of changes in prices and focus on the change in
quantity.
**When a variable is being compared over time, it is important to use real values.
Distinction between total and per capita
per capita = per person
Significance:
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Differing population sizes across countriesdifferent GDP per capita
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Population growth: relation between growth of GDP and the growth of
population
Gross VS net
NDP = GDP-depreciation
Evaluating national income statistics
Q: can GDP per capita and GNI per capita evaluate the standards of living.
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No
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National income statistics X true
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Other factors unaccounted in GDP and GNI
Why national income statistics (GDP/GNI) do not accurately measure the ‘true’ value
of output？
1/ GDP and GNI do not include non-marketed output：
Def: some output of goods and services is not sold in the market and does not
generate any income.
e.g. improve my home myself/ self-sufficient economy
greater in developing countries
2/GDP and GNI do not include output sold in underground (parallel) markets:
they go unrecorded
e.g.
legal goods
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reselling a good at a higher price than price ceiling
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plumber does not record income to avoid tax
illegal goods
3/GDP and GNI do not take into account quality improvements in goods and services:
technologylower price
4/GDP and GNI do not account for negative externalities:
environmental degradation overall welfare
5/GDP and GNI do not take into account the depletion of natural resources:
overall wellbeing
6/GDP and GNI and differing domestic price levels:
e.g. one place a good is sell for 100$ but other place 200$  l00$ country greater
purchasing power  quantity of goods and services that can be bought with
moneygreater living standard
solving: special exchange rates
Why measures of the value of output (GDP/GNI) cannot accurately measure
standards of living
1/GDP and GNI make no distinctions about the composition of output
2/GDP and GNI cannot reflect achievements in levels of education, health and life
expectancy
solve: Human Development Index
Human Development Index.
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Health care: as indicated by life expectancy.
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Education :as measured by the adult literacy rate and school enrolment ratios
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GDP per head: measured in US dollars, at purchasing power parity exchange rates.
3/GDP and GNI provide no information on the distribution of income and output:
only provide an indication of average output or average income per person
4/GDP and GNI do not take into account increased leisure
5/GDP and GNI do not account for quality of life factorsnon-economic factors: e.g
crime, relationship with other countries, security, mental health, freedom
Why it can accurately measure the Standard of living
1/ Real GDP per capita has high correlations with living standard.
2/ Also, real GDP per capita has considered the population size, allowing a more
accurate measurement.
3/ GDP data is widely available, is measured frequently, and is consistent
National income measures and standard of living comparisons over time and
between countries
1/ Comparisons over time
2/ Comparisons between countries
Green GDP: GDP that accounts for the value of resource and environmental
destruction
GDP :
1/They neglect to account for the loss of environmental resources and losses in
environmental quality
2/They include expenditures cleaning up pollution: e.g. getting rid of oil spill counts
health care expenditures
calculate:
Green GDP = GDP − the value of environmental degradation
Green GDP = GDP − the value of environmental degradation − P 6
8.4 The business cycle
Introduction to economic growth
Def: a percentage change in real GDP/GDP per capita (or real GNI/GNI per capita)
over a specified period of time
Distinguishing between a decrease in GDP and a decrease in GDP growth
A decrease quantity or decrease in the rate of change
Understanding the business cycle
The cyclical pattern and phases of the business cycle
Def: business cycle are fluctuations in the growth of real output, consisting of
alternating periods of expansion (increasing real output) and contraction (decreasing
real output)
Expansion
slope upward +GDP
1/employment of
growth
resources increases
2/inflation
Peak
maximum real GDP
1/ unemployment of
resources has fallen
substantially
2/ inflation
Contraction
falling real GDP+
1/ growing unemployment
Lasts more six months
downward-sloping
of resources
recession
Trough
2/ deflation or disinflation
cycle’s minimum level of
1/ widespread
GDP
unemployment
 short-term economic fluctuations
Short-term fluctuations and the long-term growth trend
long-term growth trendline
Def: potential output or potential GDP is the output represented by the long-term
growth trend
How unemployment relates to actual and potential output
potential output is the level of output produced when there is ‘full
employment’(natural rate of unemployment)
below line: above the natural rate of unemployment
Cyclical fluctuations, potential output and output gaps
1/ a, b and c, actual GDP is equal to potential GDP full employment
2/ d, there is an output gap+ unemployment falls to less than the natural rate
3/ e, there is an output gap+ unemployment is greater than the natural rate
Why we study the business cycle
understand macroeconomic objectives:
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Reducing the intensity of expansions and contractions
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Increasing the steepness of the line representing potential output