Lecture Three - National Income

Macroeconomic Theory
• Macroeconomic analysis explains past patterns in aggregate

economic activity and tries to predict future changes. It is the
study of the economy as an interrelated system
• Examples of interest to macroeconomics
• Macroeconomists are interested in the differences in income across

countries and the adoption of policies that would enable countries to
sustainably increase their level of economic output.
Lecture Three NI BM Chitah ECN 1215 Intro to

1
• National Income (NI) Section
• This section addresses the main issues that define and introduce the
key concepts of macroeconomic theory: The objective of the section
is to ensure that:
• We obtain an understanding of macroeconomics as the study of the whole

economy
• Revisit elements of the scope of macroeconomic analysis within this context
• Show how the national accounts measure macroeconomic variables

2
• Explain the circular flow between households and firms
• Understand why leakages always equal injections
• Make an analysis of comprehensive measures of national income and output
• discuss whether national output contributes to national happiness*

3
• Questions and Issues in Macroeconomics - the study of year-to-year, or
“short-run,” fluctuations in economic activity (and long run)
• Why does economic growth sometimes stall, or even temporarily turn negative?
• We call an economic downturn lasting at least two quarters a recession (a quarter

is one-fourth of a year) – what causes it?
• During recessions the unemployment rate, one of the most important

macroeconomic variables is affected – how does this occur? Why?

4
Questions, questions, questions
• What determines the total output of a country, which we call its [real] GDP?
• Are there inevitably business cycles, recessions in other words, or can output grow
smoothly over time?
• Why do some countries grow faster than others over sustained periods? Will growth go
on forever? After centuries of being asleep, why did the Chinese and Indian economic
giants finally awaken?

5
• What about market - why did unemployment rise in the 1970s but fall substantially
thereafter?
• How much unemployment was caused by the financial crisis? Do workers price
themselves out of jobs by greedy wage claims?
• Does technical progress destroy jobs? Can the government create more jobs?

6
• Lets assume the starting point is to consider issues surrounding output,
our focus will include consideration of:
[1] Output as a function of

• firms, by
• households, by
• the government and by
• foreigners (exports)
[2] Interest rates and bank lending as they affect the demand for output
and how/effects of the financial sector interacts with the real
economy.

7
• 3]Price and wage adjustments – which help restore output to full capacity
• 4]Monetary policy and fiscal policy - all affect inflation and

unemployment and in addition how foreign trade and foreign capital affect
the economy
• 5]The balance of payments records - transactions with foreigners. The

dynamics of the national economy also depend on the exchange rate
policy pursued.
• This leads us towards explain business cycles around full capacity and
long-run growth at full capacity output.
8
• Later as a systematic and logical follow up extend analysis to
• develop a basic model of output determination in the short run.
• describe money, banking and how interest rates are set.
• Examine monetary and fiscal policy including basics of aggregate supply and price
adjustment.
• Inflation and unemployment.
• Exchange rates, the balance of payments and macroeconomics within open

economies
9
Macroeconomy
• Real gross domestic product (GDP) measures the output of goods

and services produced by an economy.
• The business cycle refers to swings in GDP around an economy’s trend

rate of output growth.
• Economic growth is a (change) rise/fall in real GDP.

10
• The labour force is the number of people at work or looking for work
• The unemployment rate is the fraction of the labour force without a

job.
• The inflation rate is the percentage annual increase in the average price
of goods and services.

11
The Circular Flow of Income
• The circular flow shows how both real resources and financial
payments flow between firms and households.
• The economy comprises numerous individual economic units:

households, firms as well as central and local government.
• Individual decisions of all the economic agents determine the economy’s

total spending, income and output.
• At this stage we ignore the government and other countries, leaving just firms and
households.
12
• Table shows transactions between these two sectors.
• Households own the factors of production (inputs to production).

Households rent labour to firms in exchange for wages.
• Households are ultimate owners of firms and get their profits.
• Capital and land, even if held by firms, are ultimately owned by

households

13
Households Firms
1] Supply inputs to firms Use inputs to make output
2] Receive incomes from firms Rent inputs from households
3] Buy output of firms Sell output to households

14
• First row - households supply inputs to firms, which use these to make
output.
• Second row of Table shows the corresponding payments. Households

earn incomes (wages, rents, profits), which are payments by firms for
using these inputs.
• Third row shows that households spend their incomes buying the output
of firms, giving firms the money to pay for renting production inputs.

15
• From this, have three equivalent ways in which to measure the total
economic activity in an economy:
• (a) the value of all goods and services produced,
• (b) the total value of earnings arising from the factor services supplied,
• (c) the total value of spending on goods and services.
• All payments are the counterparts of real resources.

16
• Assume all payments are spent buying real resources. We get the same
estimate of total economic activity whether we use the
• value of production,
• the level of factor incomes or
• total expenditure on goods and services.

17
• Household income = household spending if all income is spent.
• The value of output = total spending on goods and services if all goods
are sold.
• The value of output also = the value of household incomes.
• Profits are residually defined – the value of sales minus the rental of
inputs – and since profits accrue to the households that own firms,
household incomes (from renting out inputs or from profits) equal the
value of output.

18
• Assume a Simple Model
• What happens if firms do not sell all their output?
• What happens if firms sell output not to households but to other firms?
• What happens if households do not spend all their incomes?

19
• Our conclusion will be unchanged: the level of economic activity can be
measured by valuing total spending, total output or total earnings.
All three methods give the same answer.
• Our framework still omits key features of the real world: savings,
investment, government spending and taxes, transactions between firms and with the
rest of the world.
• These are all easily remedied, to create a comprehensive system of

national accounts.

20
National Income Accounting
• Measuring National Income and National Output
• Gross national product (GNP), also called gross national income (GNI), is the total income
of a country.
• GNP, or GNI, measures the value of the income that its citizens earn, from whatever
countries this income is derived.
• Gross domestic product (GDP) measures the value of output produced in a country, no
matter whose citizens contribute to this production.

21
• A Zambian working in a bank in Harare contributes to Zimbabwean GDP -
that is location where inputs supplied and output produced.
• If Zambian then sends some of her income back to relatives in Zambia - adds
to Zambian (but not to Zimbabwean) GNP.
• Similarly, Tswana foreign investments in Zambia add to Zambian output and

GDP, but the income derived will ultimately add to Botswana GNP rather than
Zambian GNP.
• So, GNP measures the total worldwide income of citizens of a country;

• GDP measures the output produced within a country, no matter which citizens produce it.
22
• Process of addition to output; output may be created through:
• Value added is the increase in the value of goods as a result of the

production process.
• Final goods are purchased by the ultimate user, either households buying
consumer goods or firms buying capital goods such as machinery.
• Intermediate goods are partly finished goods that form inputs to a

subsequent production process that then uses them up.
23
…circular flow concept
• Assume: Closed economy i.e. an economy which does not transaction

nor interact with outside world – i.e. there is no external sector/
economy
• Output and income are the same.
• First, extend the simple circular flow between firms and households
shown in earlier Table

24
• Transactions do not take place exclusively between a single firm and a
single household only,
• Firms hire labour services from households and also buy raw materials
and machinery from other firms.
• To avoid double counting, we use value added.

25
• Value added =>
Gross output
Less [-] Value of input
goods used
= Value added
• Closely related is the distinction between final goods and intermediate

goods.

26
• Ice cream is a final good consumed by its ultimate user.
• Steel is an intermediate good, made by one firm but then used as an input
by another firm.
• Capital goods are final goods because they are not used up in subsequent
production.
• They do not fully depreciate during the production period under study.

27
Illustration: Calculation of GDP for a Simple Economy
• Assume,
• A four-firm economy:
• a steel maker,
• a producer of capital goods (machines) for the car industry,
• a tyre maker and,
• a car producer who sells to the final user, households

28
1] Good 2] Seller 3] Buyer 4] Transaction 5] Valued 6] Spending 7] Household
value added on final earnings
goods
Steel Steel maker Machine 1,000 1,000 1,000

maker
Steel Steel maker Car maker 3,000 3,000 3,000
Machine Machine Car maker 2,000 1,000 2,000 1,000

maker
Cars Car maker Households 5,000 2,000 5,000 2,000
Total 11,000
transactions
GDP 7,000 7,000 7,000

29
Computations……
• Steel firm makes £4000 worth of steel [= value added of steel output]
• 25% output sold to machine maker
• 75% of output sold to car maker
• All £4000 is value added or net output of the steel firm, but,
• £4000 - paid out as household income [(wages, rents, (residual=profits)].
• Therefore, the first two rows of the last column also add up to £4000.

30
• Firms have spent £4000 buying this steel output, but it is not
expenditure on final goods.
• Steel is also an intermediate good, used up in later stages of the production

process
• The machine maker buys £1000 of steel input, converting it into a

machine sold to the car maker for £2000.
• The value added by the machine maker is £2000 minus £1000 spent on
steel input.

31
• Net revenue of £1000 accrues directly to households as income or
profit.
• Since the car firm intends to keep the machine in the future, the full
value of £2000 is shown under ‘final expenditure’ during the period.
• The car producer spends £3000 on steel, used up during the period in
which cars are made.

32
• Subtract £3000 from the car output of £5000 to get the value added of
the car maker.
• Value added and household income are £2000.
• Finally, the car producer sells the car for £5000 to the final consumer –
households.
• Only then does the car become a final good. Its full price of £5000 is
final expenditure.

33
• The car producer spends £3000 on steel, used up during the period in which
cars are made.
• We subtract £3000 from the car output of £5000 to get the value added of
the car maker. Value added and household income are £2000.
• Finally, the car producer sells the car for £5000 to the final consumer –
households.
• Only then does the car become a final good. Its full price of £5000 is final
• Expenditure
34
• Gross value of all the transactions = £11 000; overstating the value of
the goods the economy has actually produced.
• The £3000 that the steel producer earned by selling steel to the car
producer is already included in the final value of car output. National
output cannot count this twice.
• Column (5) shows the value added at each stage in the production
process; £7000 is the true net output of the economy.

35
• Since each firm pays the corresponding net revenue to households either
as direct factor payments or indirectly as profits, household earnings are
£7000 in the last column of the table.
• If we add up payments made to households as income and profits, we get

the same measure of GDP.
• Same answer obtains if we measure spending on final goods and services.
• In this case, final users are households buying cars and the car producer
buying the (everlasting) machinery used to make cars.

36
Investment and Saving
• Investment is the purchase of new capital goods by firms
• Saving is the part of income not spent buying goods and services
• If total output and household incomes are each £7000, but households
spend only £5000 on cars, where does rest incomes go?
• Further who is responsible for the additional or difference in spending?

37
• To resolve these issues, we introduce the concepts of Investment and
Saving
• Households spend £5000 on cars. Their income is £7000, so they save

£2000.
• The car maker spends £2000 on investment, buying new machinery.
• Figure shows what happens to the circular flow.

38
• The bottom half of the figure shows that incomes and factor services are
each £7000.
• But £2000 leaks out from the circular flow when households save.
• Only £5000 finds its way back to firms as household spending on cars

39
Investment, saving and the circular flow
• The inner loop continues to show flows of real resources between firms and households.
• Firms use factor services supplied by households to make consumer goods and services
for households
• Firms also use new capital goods from/for other firms.

40
• Firms also earn revenue from expenditure on new capital goods by other firms.
• Saving is a leakage from the circular flow of payments, investment is an

injection into the circular flow.
• The outer loop continues to show payment flows.
• Factor incomes are either saved by households or spent on consumer goods.

41
Figure 1 Circular Flow

42
Comparative Figure 1 -
Circular flow

43
• consumption: the expenditure by households on goods and services.
• product market: the market for consumer goods and services.
• factor market: the market for the factors of production/factor inputs
• income: the earnings of factors of production expressed as an amount per period of
time
• Households sell factor services to the business sector and earn income. With this income,
they pay for the goods and services received from the business sector.

44
• leakage: income received within the circular flow that does not flow
directly back.
• saving: the portion of income that is not spent on consumption.
• injection: any spending flow that is not dependent on the current level
of income.
• investment: (postponed consumption) spending on new capital goods.
• The Saving Leakage and Investment Injection

• The financial intermediaries match the lending (savings) of the households with the
borrowing (investment) of the business sector.

45
• A leakage from the circular flow is money not recycled from households to
firms.
• An injection is money that flows to firms without being recycled through

households.
• On the inner loop, firms make an output worth £5000 for consumption by
households and an output of £2000 of capital goods for investment by firms.
• On the outer loop, which relates to money payments, saving is a leakage of

£2000 from the circular flow and investment spending is an injection of
£2000 to the circular flow

46
47
• Inner loop, firms make an output of £5000 for consumption by
households and
• output of £2000 of capital goods for investment by firms.
• On the outer loop, which relates to money payments, saving is a leakage

of £2000 from the circular flow and
• investment spending is an injection of £2000 to the circular flow

48
• Questions..
• Coincidental that household savings of £2000 exactly equal investment?
• If not, how is the money saved by households, transferred to firms to

allow them to pay for investment spending?

49
• Suppose
• Y denotes GDP, which also equals the value of household incomes,
• C denotes household spending on consumption and
• S denotes saving.

50
• By definition, saving is unspent income, so,
• Y ≡ C + S, where the symbol ≡ means ‘is identically equal to, as a matter

of definition’.
• Since one definition of GDP is that it is = the sum of final expenditure,
• Y ≡ C + I. Putting these two definitions together,
• S≡I
• since both are identical to (Y − C).

51
• Therefore, it is no accident that saving and investment are each £2000 in
our example.
• Saving and investment are always equal, in the absence of government

and foreign sectors
• Note:
• an identity sign means always equal, no matter what the values of the other variables
while equals sign means that some particular values of the variables (output,
consumption, and so on) are needed in order to ensure the equality of the two sides of
the equation.
52
• Back again to outer loop - All household spending in the top half of the
figure returns to households as income in the bottom half of the figure.
• Investment spending by firms is matched by an income flow to

households in excess of their consumer spending.
• Since saving is defined as the excess of income over consumption,

investment and savings must always be equal.
• These accounting identities follow from our definitions of investment,

saving and income.

53
• Actual saving must equal actual investment.
• This need not mean desired saving equals desired investment.
• To study that, we need models of desired saving and desired investment, a task
for later
• In market economy, financial institutions and financial markets channel

household saving to the firms that wish to borrow to invest in new capital
goods – this analysis is premised on the following assumptions

54
• Inventories or stocks are goods currently held by a firm for future
production or sale.
• This creates a gap between the output and expenditure measures of

GDP?
• Producers add to their inventories or stocks of finished goods awaiting

sale to consumers in the next period.
• Stocks are sometimes called working capital.

55
Domestic Government, Foreign Economies (External sector)
• Governments raise revenue both through direct taxes on income

(wages, rents, interest and profits) and
• Indirect taxes or expenditures taxes (VAT, petrol duties and cigarette

taxes).
• Taxes finance two kinds of expenditure:

• Government spending on goods and services, G, is purchases by the
government of physical goods and services. It includes the wages of civil
servants and public sector in general….

56
• Transfer payments: On the other hand, government incurs transfer
payments = monetary payments that require no goods or services in
return (pensions, unemployment benefits, subsidies).
• Transfer payments do not affect national income or national output.
• They are not included in GDP. There is no corresponding net physical

output. Taxes and transfer payments merely redistribute existing income
and spending power away from people being taxed and towards people
being subsidized.
57
• In contrast, spending G on goods and services produces net output, and
gives rise to factor earnings in the firms supplying this output and also
to additional spending power of the households receiving this income.
• Hence government spending G is part of GDP. It is final expenditure

since government is now an additional end user of the output.
• GDP at market prices measures domestic output inclusive of

indirect taxes on goods and services.

58
Open Economy
• We now examine an open economy that deals with other countries.
• Households, firms and the government may buy imports Z that are not
part of domestic output and do not give rise to domestic factor incomes.
• Such goods are not in the output measure of GDP, the value added by
domestic producers.
• However, imports show up in final expenditure. There are two solutions

to this problem.
59
• We could subtract the import component separately from C, I, G and X
and measure only final expenditure on the domestically made bit of
consumption, investment, government spending and exports.
• But it is easier to continue to measure total final expenditure on C, I, G

and exports (X) and then to subtract from this total expenditure on
imports (Z).

60
• Assume
• Y ≡ GDP at basic prices,
• the economy’s value added or net output is goods and services for domestic consumption,
investment, government spending and net exports minus indirect taxes becomes:
• Y ≡ GDP at basic prices ≡ C + I + G + NX − Te

61
• Household incomes at basic prices are supplemented by welfare benefits B less direct
taxes Td. This gives us personal disposable income
• (Y +B − Td) ≡ C + S
• available for households to spend. Suppose for the moment that saving is
done only by households, in which case, then---
• Disposable income must be spent on consumption or saving:

62
• Y + B − Td ≡ C + S

63
64
65
• Figure extends the circular flow between households and firms to include
• government and
• foreign sectors.
• Firms make factor payments Y to households.
• Disposable income
• Y + B − Td
• includes transfer payments B less direct taxes Td. Disposable income goes on saving S
or consumption C.

66
• This spending is augmented by injections of government spending G on goods
and services,
• Investment spending I and
• Exports X, but
• is reduced by the additional leakage Z into imports.
• From C + I + G + NX
• or GDP at market prices, we must subtract the leakage of indirect taxes Te to

get GDP at basic prices Y which firms pay out to households.
67
Round the top loop of the figure……………
• consumption C at market prices is supplemented by injections of
• investment spending I,
• net exports NX and
• government spending G.
• From this GDP at market prices, we subtract indirect taxes Te to get GDP at basic
prices.

68
• S + NT + Z ≡ I + G + X
• Where
• Net taxes NT are direct and indirect taxes minus welfare benefits.
• Investment, government spending and exports are all injections to the

circular flow that do not originate from households.

69
• Conversely, household spending leaks out, directly or indirectly, through:
• saving,
• taxes (net of benefits) and
• imports:
• only the remaining spending flows back to domestic firms and round again as
household incomes.
• If there is no government or foreign sector, this becomes
• S ≡ I, as we had before. Generally,
• (S − I) + (NT + G) ≡ (X − Z)

70
71
72

Lecture Three - National Income

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Lecture Three - National Income

Uploaded by

Copyright:

Available Formats

Macroeconomic Theory

• Macroeconomic analysis explains past patterns in aggregate

• Examples of interest to macroeconomics

• Macroeconomists are interested in the differences in income across

Lecture Three NI BM Chitah ECN 1215 Intro to

• We obtain an understanding of macroeconomics as the study of the whole

• Revisit elements of the scope of macroeconomic analysis within this context

• Show how the national accounts measure macroeconomic variables

Lecture Three NI BM Chitah ECN 1215 Intro to

• Understand why leakages always equal injections

• Make an analysis of comprehensive measures of national income and output

• discuss whether national output contributes to national happiness*

Lecture Three NI BM Chitah ECN 1215 Intro to

• We call an economic downturn lasting at least two quarters a recession (a quarter

• During recessions the unemployment rate, one of the most important

Lecture Three NI BM Chitah ECN 1215 Intro to

Lecture Three NI BM Chitah ECN 1215 Intro to

Lecture Three NI BM Chitah ECN 1215 Intro to

[1] Output as a function of

Lecture Three NI BM Chitah ECN 1215 Intro to

• 4]Monetary policy and fiscal policy - all affect inflation and

• 5]The balance of payments records - transactions with foreigners. The

• develop a basic model of output determination in the short run.

• describe money, banking and how interest rates are set.

• Inflation and unemployment.

• Exchange rates, the balance of payments and macroeconomics within open

• Real gross domestic product (GDP) measures the output of goods

• The business cycle refers to swings in GDP around an economy’s trend

• Economic growth is a (change) rise/fall in real GDP.

Lecture Three NI BM Chitah ECN 1215 Intro to

• The unemployment rate is the fraction of the labour force without a

Lecture Three NI BM Chitah ECN 1215 Intro to

• The economy comprises numerous individual economic units:

• Individual decisions of all the economic agents determine the economy’s

• Households own the factors of production (inputs to production).

• Households are ultimate owners of firms and get their profits.

• Capital and land, even if held by firms, are ultimately owned by

Lecture Three NI BM Chitah ECN 1215 Intro to

1] Supply inputs to firms Use inputs to make output

2] Receive incomes from firms Rent inputs from households

3] Buy output of firms Sell output to households

Lecture Three NI BM Chitah ECN 1215 Intro to

• Second row of Table shows the corresponding payments. Households

Lecture Three NI BM Chitah ECN 1215 Intro to

• (a) the value of all goods and services produced,

• (c) the total value of spending on goods and services.

• All payments are the counterparts of real resources.

Lecture Three NI BM Chitah ECN 1215 Intro to

• the level of factor incomes or

• total expenditure on goods and services.

Lecture Three NI BM Chitah ECN 1215 Intro to

• The value of output also = the value of household incomes.

Lecture Three NI BM Chitah ECN 1215 Intro to

• What happens if firms do not sell all their output?

• What happens if households do not spend all their incomes?

Lecture Three NI BM Chitah ECN 1215 Intro to

• These are all easily remedied, to create a comprehensive system of

Lecture Three NI BM Chitah ECN 1215 Intro to

• Measuring National Income and National Output

Lecture Three NI BM Chitah ECN 1215 Intro to

• Similarly, Tswana foreign investments in Zambia add to Zambian output and

• So, GNP measures the total worldwide income of citizens of a country;