Macroeconomic Analysis and Policy

Biswa Swarup Misra

Session 3

0
 Income and Expenditure
 Gross Domestic Product (GDP) measures
total income of everyone in the economy.
 GDP also measures total expenditure on the
economy’s output of g&s.

For the economy as a whole,

income equals expenditure, because
every rupee of expenditure by a buyer
is a rupee of income for the seller.

1
 The Circular-Flow Diagram
 is a simple depiction of the macro economy.
 illustrates GDP as spending, revenue,
factor payments, and income.
 First, some preliminaries:
• Factors of production are inputs like labor, land,
capital, and natural resources.
• Factor payments are payments to the factors of
production. (e.g., wages, rent)

2
FIGURE 1: The Circular-Flow Diagram

Households:
 own the factors of production,
sell/rent them to firms for income
 buy and consume g&s

Firms Households

3
FIGURE 1: The Circular-Flow Diagram

Firms Households

Firms:
 buy/hire factors of production,
use them to produce g&s
 sell g&s

4
FIGURE 1: The Circular-Flow Diagram

Revenue (=GDP) Spending (=GDP)

Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income (=GDP)
profit (=GDP)
5
 What This Diagram Omits
 The government
• collects taxes
• purchases g&s
 The financial system
• matches savers’ supply of funds with
borrowers’ demand for loans
 The foreign sector
• trades g&s, financial assets, and currencies
with the country’s residents

6
 Final
Bread produced Purchases
Wheat for
self consumption -Non-Market activity-
(Farmer does not pay himself
in Household to produce bread)
Wheat
produced
by Farmer
(INR 50)

Session 2-3 MEASURING A NATION’S INCOME B.S.Misra 7

 Final
Bread produced Purchases
Wheat for
self consumption -Non-Market activity-
(Farmer does not pay himself
in Household to produce bread)
Wheat Sale of
produced bread Consumption
Purchased by Wheat + Effort
by Farmer result in output (INR 100)
Baker (who puts
(INR 50) of bread
in effort to transform
it to another good)
Value of effort = INR
50

Session 2-3 MEASURING A NATION’S INCOME B.S.Misra 8

 Final
Purchases

Wheat Sale of
produced bread Consumption
Wheat + Effort
by Farmer Purchased by result in output (INR 100)
Baker (who puts
(INR 50) of bread
in effort to transform
it to another good)
Value of effort =
INR 50

If we ask farmer and baker to report their

output and simply add their outputs we would
falsely conclude that INR 150 of output has been
produced in the economy.

What causes the error in counting is that we

have counted wheat which is not a final good.

Session 2-3 MEASURING A NATION’S INCOME B.S.Misra 9

Intermediate Good

• An intermediate good is one that is used up in the

production of other goods during the same
period in which it was produced.
• Intermediate goods like wheat and oil should not
be double counted when output is computed.
• To avoid errors from inclusion of intermediate
goods agents should be asked to report their
sales of final goods to consumers.
• Baker reports sale of INR 100 of final good
• Farmer reports sale of INR 0 of final good.
• Total value of final goods = INR 100

10
 Final
Purchases

Wheat Sale of
produced bread Consumption
Wheat + Effort
by Farmer Purchased by result in output (INR 100)
(INR 50) Baker (who puts of bread
in effort to transform it to
another good) Value of
effort = INR 50

Alternatively agents should report the contribution each

makes to the total output
Value added is the market value of the product of an agent minus
the cost of intermediate inputs purchased. Value added is
arrived at by subtracting costs from the revenues.
Farmer’s value added = INR 50
(Assuming he did not pay for any costs)
Baker’s value added = INR 50
Total value added = INR 100
Session 2-3 MEASURING A NATION’S INCOME B.S.Misra 11
 Final
Purchases

Wheat Sale of
produced bread Consumption
Wheat + Effort
by Farmer Purchased by result in output
(INR 50) Baker (who puts of bread
in effort to transform Unsold bread
it to another good) on Shelves Investment
Value of effort = INR 50 in
Wheat not Inventory
used up

Suppose farmer does not sell all bread produced or

use up all the wheat purchased from the farmer?

A firm’s unused raw materials or unsold output is

its inventory.
The change in the stock of inventory in an account-
ing year is treated as an inventory investment and
is classified as a final good.
e10 12
 Now suppose baker wants to scale up business
and buys new baking racks and a new oven.

These objects are not used up during the

accou-nting period and are not intermediate
goods. Neither are they sold as final goods by
baker.
Objects are called capital goods and economic
entity who purchases them is considered
to be final user of the capital good.

A capital good is a long-lived good that is used in

the production of other goods and services.

Session 2-3 MEASURING A NATION’S INCOME B.S.Misra 13

 Capital goods and intermediate goods are similar in
that they are both used to produce other
goods.

They are dissimilar in that capital goods are not

used up right away like intermediate goods.

Session 2-3 MEASURING A NATION’S INCOME B.S.Misra 14

 Capital goods and intermediate goods are similar in
that they are both used to produce other
goods.
They are dissimilar in that capital goods are not
used up right away like intermediate
goods.
The total quantity of a country’s capital goods
is called its capital stock.

Change in the capital stock from the beginning

of the year to end of the year is denoted
as investment for that year.

If the baker began the year with stock of INR 500 of

ovens and ended the year with stock of INR 800 of
ovens he is considered to have invested INR
300 during the year.
Session 2-3 MEASURING A NATION’S INCOME B.S.Misra 15
 A capital good is not used up right away but it
dimin-ishes in its material respect and is
used up eventually - it undergoes depreciation.

If in a given year INR 500 of new capital is created and

INR 150 of old capital wears out, then the
capital stock would have increased by INR 350

Gross Investment = INR 500

Depreciation = INR 150
Net Investment = INR 350

Session 2-3 MEASURING A NATION’S INCOME B.S.Misra 16

 Figure 1.1: Production Processes and the National Income
Final
Bread produced Purchases
Wheat for
self consumption -Non-Market activity-
(Farmer does not pay himself
in Household to produce bread)
Wheat Sale of
produced bread Consumption
Wheat + Effort
by Farmer Purchased by result in output
(INR 50) Baker (who puts of bread
in effort to transform Unsold bread
it to another good) on Shelves Investment
Value of effort = INR 50 in
Wheat not Inventory
used up

Not used Not sold

New Oven, Purchased up during to others
New Baking Racks by Baker so course of as Final
(Capital Stock) as to scale year Good
up production
(Gross Investment) Net Addition
Net
to
Capital Investment
Deterioration of Stock
Capital Good
(Depreciation)

Session 2-3 MEASURING A NATION’S INCOME B.S.Misra 17

Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

Goods are valued at their market prices, so:

• GDP measures all goods using the same units
(e.g., dollars in the U.S.), rather than “adding
apples to oranges.”
• Things that don’t have a market value are
excluded, e.g., housework you do for yourself.
18
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

Final goods are intended for the end user.

Intermediate goods are used as components
or ingredients in the production of other goods.
GDP only includes final goods, as they already
embody the value of the intermediate goods
used in their production.
19
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

GDP includes tangible goods

(like DVDs, mountain bikes, soaps)
and intangible services
(dry cleaning, concerts, cell phone service).

20
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

GDP includes currently produced goods,

not goods produced in the past.

21
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

GDP measures the value of production that occurs

within a country’s borders, whether done by its own
citizens or by foreigners located there.

22
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

usually a year or a quarter (3 months).

23
 National Income Accounting
 National income accounts: an accounting
framework used in measuring current economic
activity
 Three alternative approaches give the same
measurements
• Product approach: the amount of output
produced
• Income approach: the incomes generated by
production
• Expenditure approach: the amount of spending
by purchasers

24
 National Income Accounting
 The Bakery example shows that all three
approaches are equal
• Important concept in product approach:
value added = value of output minus value of
inputs purchased from other producers

25
 National Income Accounting
 Why are the three approaches equivalent?
• They must be, by definition
• Any output produced (product approach) is
purchased by someone (expenditure approach)
and results in income to someone (income
approach)
• The fundamental identity of national income
accounting:
total production = total income = total expenditure

26
 Equivalence of Three Approaches
 Imagine an economy with only two businesses, called
OrangeInc and JuiceInc.
 OrangeInc owns and operates orange groves. It sells
some of its oranges directly to the public. It sells the rest
of its oranges to JuiceInc, which produces and sells
orange juice. The following table shows the transactions
of each business during a year.

27
 Equivalence of Three Approaches
 OrangeInc pays $15,000 per year in wages to workers to pick oranges,
and it sells these oranges for $35,000 ($10,000 worth of oranges to
households and $25,000 worth of oranges to JuiceInc).
 Thus OrangeInc’s profit before taxes is $35,000 - $15,000 = $20,000.
Because OrangeInc pays taxes of $5000, its after-taxprofit is $15,000.
 JuiceInc buys $25,000 of oranges from OrangeInc and pays wages of
$10,000 to workers to process the oranges into orange juice. It sells the
orange juice for $40,000, so its profit before taxes is $5000 ($40,000 -
$25,000 - $10,000). After paying taxes of $2000, its after-tax profit is
$3000.
 What is the total value, measured in dollars, of the economic activity
generated by these two businesses? The product approach, income
approach, and expenditure approach are three different ways of arriving
at the answer to this question; all yield the same answer.

28
 Equivalence of Three Approaches
 The product approach measures economic activity by adding the
market values of goods and services produced, excluding any goods
and services used up in intermediate stages of production. This
approach makes use of the value added concept.
 The value added of any producer is the value of its output minus the
value of the inputs it purchases from other producers.
 The product approach computes economic activity by summing the
value added by all producers. In our example, OrangeInc produces
output worth $35,000 and JuiceInc produces output worth $40,000.
However, measuring overall economic activity by simply adding $35,000
and $40,000 would “double count” the $25,000 of oranges that JuiceInc
purchased from OrangeInc and processed into juice.
 To avoid this double counting, we sum value added rather than output:
Because JuiceInc processed oranges worth $25,000 into a product
worth $40,000, JuiceInc’s value added is $15,000 ($40,000 - $25,000).
OrangeInc doesn’t use any inputs purchased from other businesses, so
its value added equals its revenue of $35,000. Thus total value added in
the economy is $35,000 + $15,000 = $50,000. 29
 Equivalence of Three Approaches
 The income approach measures economic activity by adding all
income received by producers of output, including wages received by
workers and profits received by owners of firms.
 As you have seen, the (before-tax) profits of OrangeInc equal its
revenues of $35,000 minus its wage costs of $15,000, or $20,000.
 The profits of JuiceInc equal its revenues of $40,000 minus the
$25,000 the company paid to buy oranges and the $10,000 in wages
paid to its employees or $5000.
 Adding the $20,000 profit of OrangeInc, the $5000 profit of JuiceInc,
and the $25,000 in wage income received by the employees of the two
companies, we get a total of $50,000, the same amount determined by
the product approach.

30
 Equivalence of Three Approaches
 In this calculation we added the before-tax incomes of workers and
firm owners.
 Equivalently, we could have added the after-tax incomes of
producers of output and the taxes received by the government.
 Recall that, when taxes are subtracted, OrangeInc’s after-tax profits
are $15,000 and JuiceInc’s after-tax profits are $3000.
 Adding the two firms’ after-tax profits of $18,000, total wage income
of $25,000 (we assumed that workers pay no taxes), and the $7000
in taxes received by the government, we again obtain $50,000 as
the measure of economic activity.

31
 Equivalence of Three Approaches
 Finally, the expenditure approach measures activity by adding the
amount spent by all ultimate users of output.
 In this example, households are ultimate users of oranges. JuiceInc is
not an ultimate user of oranges because it sells the oranges (in
processed, liquid form) to households.
 Thus, ultimate users purchase $10,000 of oranges from OrangeInc and
$40,000 of orange juice from JuiceInc for a total of $50,000, the same
amount computed in both the product and the income approaches.
 Our explanation implicitly assumes that everything produced is sold.
What if a firm produces some goods that it can’t sell?
 National income accounting treats unsold goods as though they were
purchased by the firm from itself; that is, accumulation of unsold goods in
inventory is treated as part of expenditure. Thus expenditure and
production remain equal even if some goods remain unsold.

32
 Exercise:

• A farmer grows a kilo of wheat

and sells it to a miller for Rs10.00.
• The miller turns the wheat into flour
and sells it to a baker for Rs.30.00.
• The baker uses the flour to make a loaf of
bread and sells it to an engineer for Rs.60.00.
• The engineer eats the bread.
Compute & compare
value added at each stage of production
and GDP

33
 The Components of GDP
 Recall: GDP is total spending.
 Four components:
• Consumption (C)
• Investment (I)
• Government Purchases (G)
• Net Exports (NX)
 These components add up to GDP (denoted Y):

Y = C + I + G + NX

34
 Consumption (C)
 is total spending by households on g&s.
 Note on housing costs:
• For renters, consumption includes rent
payments.
• For homeowners, consumption includes
the imputed rental value of the house,
but not the purchase price or mortgage
payments.

35
 Investment (I)
 is total spending on goods that will be used in the
future to produce more goods.
 includes spending on
• capital equipment (e.g., machines, tools)
• structures (factories, office buildings, houses)
• inventories (goods produced but not yet sold)
Note: “Investment” does not
mean the purchase of financial
assets like stocks and bonds.

36
 Investment vs. Capital

Note: Investment is spending on new capital.

Example (assumes no depreciation):
• 1/1/2007:
economy has $500b worth of capital
• during 2007:
investment = $60b
• 1/1/2008:
economy will have $560b worth of capital

37
 Stocks vs. Flows
Flow Stock
A stock is a
quantity measured
at a point in time.
E.g.,
“The U.S. capital stock
was $26 trillion on
January 1, 2006.”
A flow is a quantity measured per unit of time.
E.g., “U.S. investment was $2.5 trillion during 2006.”

38
Stocks vs. Flows - examples

stock flow

a person’s
a person’s wealth
annual saving

# of people with # of new college

college degrees graduates this year

the govt debt the govt budget deficit

39
 Now you try:
Stock or flow?
 the balance on your credit card statement
 how much you study economics outside of class
 the size of your compact disc collection
 the inflation rate
 the unemployment rate

40
 Government Purchases (G)
 is all spending on the g&s purchased by govt
at the federal, state, and local levels.
 G excludes transfer payments, such as
Social Security or unemployment insurance
benefits.
These payments represent transfers of income,
not purchases of g&s.

41
 Net Exports (NX)
 NX = exports – imports
 Exports represent foreign spending on the
economy’s g&s.
 Imports are the portions of C, I, and G
that are spent on g&s produced abroad.
 Adding up all the components of GDP gives:

Y = C + I + G + NX

42
Share of different components in India’s GDP
in 2011-12 at 2004-05 base (%)

C 59
G 11
I 38
NX -9

43
 U.S. GDP and Its Components, 2005

billions % of GDP per capita

Y $12,480 100.0 $ 42,035

C 8,746 70.1 29,460

I 2,100 16.8 7,072

G 2,360 18.9 7,950

NX –726 –5.8 –2,444

44
U.S. GDP and Its Components, 2013

GDP % of GDP
Y 16768.1
C 11484 68
I 2648 16
G 3144 19
NX -508 -3

45
Exercise 1:
GDP and its components
In each of the following cases, determine how much GDP and each of
its components is affected (if at all).
A. Abhinav spends Rs.200 to buy his friend dinner
at Mayfair, the finest restaurant in Bhubaneswar.
B. Aditi spends Rs.1800 on a new laptop to use in his business. The
laptop was built in China.
C. Ispsita spends Rs.1200 on a computer to use in her business. She
got last year’s model on sale for a great price from a local
manufacturer.
D. Tata Motors builds Rs.500 million worth of cars,
but consumers only buy Rs.470 million worth of them.

46
Exercise 1:
Answers
A. Abhinav spends Rs. 200 to buy his friend dinner
at Mayfair.
Consumption and GDP rise by Rs. 200.

B. Aditi spends Rs.1800 on a new laptop to use in his

business. The laptop was built in China.
Investment rises by Rs.1800, net exports fall
by Rs.1800, GDP is unchanged.

47
Exercise 1:
Answers
C. Ipsita spends Rs.1200 on a computer to use in her
business. She got last year’s model on sale for a great
price from a local manufacturer.
Current GDP and investment do not change, because the
computer was built last year.

D. Tata Motors builds Rs.500 million worth of cars, but

consumers only buy Rs.470 million of them.
Consumption rises by Rs.470 million,
inventory investment rises by Rs.30 million,
and GDP rises by Rs.500 million.

48