Section 1 Macroeconomics2.1a 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

Payment

Labor WagesCapital InterestLand Rent

Entrepreneurial ability

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 Government spending

Imports 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 Gross value (billions USD)

Compensation of employees (wages)

8,451.5

Rents 445.5

Interest 709.6

Proprietor’s profits 1,130.8

Corporate profits 1,604.5

Taxes on production and imports

1,113

Adjustments to misc. income

52.6

National Income 13,507.5

Consumption of Fixed Capital

2,004.1

GDP 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