Section 1 Macroeconomics
2.1a The circular flow
• In the resource (or factor) market, businesses are
buyers who compete for the factors of production to
produce their goods and services.
• This generates demand for labor, capital, land and
entrepreneurial ability.
• For these resources, they will pay wages, interest,
rent and profits (WiRP).
• Each payment correlates to a factor of
production:
Factor of
production
Labor
Capital
Land
Entrepreneurial
ability
Payment
Wages
Interest
Rent
Profits
• Sellers of resources (households) will try to maximize
their income by selling their factors to the highest
bidder.
• For example, a worker with scarce skills will be able
to sell their labor for a higher wage than a less
qualified competitor.
• With their incomes, the sellers of resources will turn
to the product market to spend their earnings on
goods and services.
The circular flow
• Circular Flow Diagrams are the simplest models for
understanding how a macro-economy works. This
relatively simple example shows how aggregate
income levels are exchanged for resources—
including labor—that are bought from households.
• Income, in turn, gets spent on goods and services,
repaying firms for the money spent on resources.
• Sophisticated circular flow models include leakages
and injections into the macroeconomy. The relative
size of each leakage or injection can have a large
impact upon the economy’s final output.
• Leakages and injections must equal each other and
therefore can be presented as follows:
Leakages
Injections
Taxes
Imports
Government
spending
Exports
Savings
Investment
• One implication of the model is that the
values of each flow are equal.
• Since resource expenditure is funded by
consumer spending, they must be equal, and
the total value of production must be the
same as well.
2.1b Measuring national income
• There are two distinct methods of measuring
the total output of an economy.
• Gross Domestic Product (GDP)
• Gross National Product (GNP)
• GDP is the total money value of all goods and
services produced in an economy over a
certain time, usually one year. GDP includes
the output of foreign firms in a country, but
does not include the output of domestic firms
overseas. This figure is based on geographic
boundaries.
• GNP is the total money value of all goods and
services produced by the citizens or firms of a
particular country, no matter where they are
based, but does not include the production of
foreign firms within the country. This figure is
based on nationality/citizenship of the owner
of the property or labor.
• Net Domestic Product (NDP) is Gross Domestic
Product less depreciation, and depreciation is the
value of capital that is used-up in production and
must be replaced.
• GDP = NDP + depreciation
• Another important distinction is that of
Nominal GDP vs. REAL GDP.
• Nominal GDP can exaggerate the true value of
production because it measures output at
current prices. If there is significant inflation,
any change in GDP will be greater than the
real change in output.
• REAL GDP measures output with a single
year’s prices, what is called a base year.
• GDP is useful in discerning a broad picture of
the relative size of economies and making
general comparisons between countries.
• Another valuable measure is called Per Capita
GDP, which is a better measure of, on average,
how wealthy people are in different countries.
• Per Capita GDP = GDP ÷ population
• GDP as a measurement has several
shortcomings, one of which was just noted
(income distribution).
A. GDP also does not take into account
qualitative changes in the output of goods and
services. We know that electronics that have
been developed recently have many more
features than those just 5 years old. GDP does
not take into consideration this advance in
technology.
B. GDP does not take into account informal or
black market activities. Consequently, the
babysitting that you provided to your
neighbor last weekend is not counted in the
GDP. Nor are illegal activities such as selling
stolen goods counted.
C. Do it yourself activities are not counted in the
GDP. The work of stay at home parents around
their house nor is the shed built by your dad
last summer included in GDP.
D. Used or second hand goods are not counted
as they were already calculated in the GDP the
year they were originally manufactured.
E. Purely financial transactions such as stock
market transactions or transfer payments
between the government and citizens or
family gifting of cash (such as at holiday or
graduation time).
F. In developing countries, most citizens are
engaged in informal subsistence economic
activities, which are not in the formal
economy and therefore not counted in the
GDP figures.
• Finally, GDP does not take into account
negative externalities that are produced as a
result of economic activity.
• The green GDP, which has been attempted by
several countries, is meant to measure the
output of goods and services while
subtracting the “bads” of environmental
destruction.
• There are two primary methods of calculating
GDP:
Income method = adding up all of the money
incomes generated by the owners of the
factors of production (or WiRP) of a given
economy for a given accounting period.
Expenditure method = compiling all of the
expenditures on final goods and services
within an economy for a given accounting
period.
• The income approach to GDP accounting is
demonstrated from the data for the U.S.
economy in the first quarter of 2012 shown
below:
Category
Compensation of employees
(wages)
Rents
Interest
Gross value
(billions USD)
8,451.5
445.5
709.6
Proprietor’s profits
1,130.8
Corporate profits
1,604.5
Taxes on production and
imports
Adjustments to misc.
income
National Income
Consumption of Fixed
Capital
GDP
1,113
52.6
13,507.5
2,004.1
15,511.6
Note several interesting elements of the
methodology:
• Taxes on Production and Imports: This is
basically an adjustment to take into account
indirect taxes (i.e. business property, sales and
excise taxes) that find their way into
transactions but are not really counted in the
WiRP figure.
• Consumption of Fixed Capital: Essentially this
is value of depreciated capital that has been
replaced as a cost of production, which is not
counted as income. As the money is not
available for other uses, it does not show up in
anybody’s income. This category is an
accounting method to balance the GDP in the
income method with the expenditure method.
• The most common method of GDP accounting
though is the expenditure method. It is
broken down as follows:
• Consumption (C): Personal household
expenditures on goods and services. This
includes everything from food to utilities to
rent to clothing to cars to school supplies.
Services are things like hair styling, doctors,
auto repair and banking.
Investment (I): Gross private investment in
physical plant, machinery, construction and
inventories. This includes replacement
investment of worn out machinery or
buildings. This figure does not include paper
assets (stocks and bonds) as these are mere
changes in ownership rather than the creation
of new productive capacity.
Government expenditures (G): Government
purchases includes expenditures on goods and
services used in providing public services as
well as spending on schools and highways
which might not be used up in a year.
• Net exports (X-M): Exports are goods and
services, which are developed within an
economy and sold abroad to consumer from
other countries. In the expenditure method
these are an injection, yet imports (our
country’s purchases of foreign made goods
and services) are a leakage. Therefore, we take
the net effect of these transactions and
include that figure in the final GDP figure.
• All of this can be put together as a simple
equation:
C + I + G +(X – M) = GDP
• This equation also happens to be the equation
for Aggregate Demand (AD) which will
become a useful tool for you in future sections
when discussing how different policies impact
economic output.
• Here is an example from the first quarter of
2012 in the U.S. economy.
Category
Value (billions USD)
Personal Consumption (C)
11,009.5
Gross private investment (I)
2,046.5
Government expenditures (G)
3,108.2
Net exports (X-M)
- 620.1
GDP
15,454.0