Business Economics Lecture Notes for BSA, BTTM & BLHM I March 2017

INTRODUCTION TO MACROECONOMICS

Macroeconomics is concerned with the behavior of the economy as a whole- with booms and
recessions, the economy’s aggregate output of goods and services and the growth of aggregate
output, the rates of inflation and unemployment, the balance of payments and exchange rates.
Macroeconomics mainly deals with long-run economic growth and with short-run fluctuations
that constitutes the business cycle.
Macroeconomics focuses on the economic behavior and policies that affect consumption and
investment, the determinants of changes in wages and prices, monetary and fiscal policies, the
money stock, the government budget, interest rates and the national debt.

ECONOMIC GROWTH
Economic growth is a major macroeconomic goal. Economic growth is attained by an economy
when it sustains persistent increases in aggregate output over long periods of time. In this regard,
we pay attention to an economy’s national income values to ascertain whether it is achieving
economic growth or not. In this topic, we shall focus on exploring national income as a measure
of economic growth, with emphasis on GDP.

Economic growth refers to the increase in an economy’s aggregate output that occurs over long
periods of time. Economic growth implies that an economy’s society is able to consume much
more in the current period- more food, clothing, medical care, entertainment- than was the case
100 years ago, for instance.
Economists monitor economic growth by tracking real gross domestic product (real GDP): the
total quantity of goods and services produced in a country over a year. When real GDP rises
faster than the population, output per person rises (real GDP per capita), and so does the average
standard of living.

The other macroeconomic goals of an economy are; Price stability and Low unemployment.

- High employment (or low unemployment)

High employment or low unemployment is considered as a major macroeconomic goal
because of two reasons.
First, unemployment affects the distribution of economic well-being among an
economy’s citizens. People who cannot find jobs suffer a loss of income. In addition, a
high unemployment rate implies that the economy is not achieving its full economic
potential: Many people who want to work and produce additional goods and services are
not able to do so. With the same number of people, but fewer goods and services to
distribute among that population, the average standard of living will be lower.

- Price stability (low inflation)

An economy aiming at price stability means that inflation should be kept as low as
possible while avoiding a deflation at the same time. Inflation is usually defined as a
persistent increase in the general price level. Inflation affects society’s standards of living
by eroding the value of money and purchasing power.

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Business Economics Lecture Notes for BSA, BTTM & BLHM I March 2017

DEFINING NATIONAL INCOME

National income refers to the total monetary value of goods and services produced by an
economy in a given period of time usually one year. National income may be redefined as
aggregate earnings by the different factors of production in form of rent, interests, salaries &
wages and profits in a given period of time usually one year

EXPRESSIONS OF NATIONAL INCOME

National income is generally expressed in two ways; as GDP and as GNP.

Gross Domestic Product (GDP);

The GDP measures the value of all final goods and services produced within a country’s national
boundaries over a given period. Economists and policymakers care about the GDP because
material living standards depend largely on what an economy produces in the way of final goods
and services. Residents of an economy that produces more food, more clothes, more shelter,
more machinery, etc., are likely to be better off (at least, in a material sense) than citizens
belonging to some other economy producing fewer of these objects.

Gross National Product (GNP); refers to the total monetary value of goods and services
produced by nationals during a given period of time. It considers nationals irrespective of where
they are located excluding output by foreign nationals in the domestic economy.

What to consider when measuring GDP

It is important to note what statisticians have to pay attention to when measuring GDP.

Final goods and Value added;

GDP only includes the value of final goods and services. This is simply aimed at avoiding
double counting. For instance when measuring the value of a car, the full of the car is what is
included in GDP computation. The components of the car, such as tires that were sold to the car
maker, are intermediate goods, and their value is not included in GDP.
In practice, double counting is also avoided by considering value added. At each stage of the
manufacture of a good, only the value added to goods at each stage of production is counted as
part of GDP. For instance, the value of maize corn produced by the farmer is part of GDP. Then
the value of the maize four sold by the miller minus the cost of maize corn is the miller’s value
added, as shown below.

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Business Economics Lecture Notes for BSA, BTTM & BLHM I March 2017

Stage Good Value of good Value added

I Maize corn 500/- 500/-
II Maize flour 1,500/- 1000/-
Total value added=
1500/-
If we follow this process along for all goods and services, it is seen that the sum of value added
for all goods and services will be equal to the value of the final goods and services, as shown
above.

Current output
GDP consists of the value of output produced in the current period. It thus excludes all
transactions in commodities produced in previous periods. For instance, the construction of new
houses is part of GDP, but not that of already existing houses. The brokerage fees for the sale of
the existing houses is considered as part of GDP. The agent provides realtor services in the
current period by linking the buyers and sellers, and that is considered as current output.

GDP at market prices and GDP at factor cost

GDP at market prices values goods at their market prices. The market price is the price that is
paid by the final consumer of the goods and services. The market price includes the cost of
factors of production and indirect taxes, whose burden is passed on to the consumer by
producers.
GDP at factor cost values aggregate output at the net prices. The net price is computed as the
market price minus indirect taxes, which is the factor cost.

Real and Nominal GDP

Nominal GDP is the measure of the value of aggregate output in a given period expressed in
terms of the current prices prevailing during that period. Nominal GDP changes from year to
year for two reasons; i) the physical quantity of aggregate output changes. ii) inflation depicted
by the increase in the average price level. Suppose that an economy produced the same aggregate
output in 2 years between which the average price level has doubled. Nominal GDP in the 2 nd
year would be twice as much as that of the first year, even though the physical aggregate output
of the economy has not changed at all.

Real GDP is the measure of the value of aggregate output in a given period at the same constant
prices based on a certain base year. For instance, in the example shown below, real GDP is
measured in the prices of the base year 2009. This means that calculating real GDP for the years
2010-2012, the year’s aggregate output is multiplied by the average price level that prevailed in
2009. The growth in real GDP is brought about by growth in aggregate output, because it is
adjusted for inflation. For this reason, real GDP provides a better depiction of an economy’s
growth as compared to nominal GDP.

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Business Economics Lecture Notes for BSA, BTTM & BLHM I March 2017

The table below shows a simple example that illustrates the calculation of nominal and real
GDP.

Year Aggregate output Average price Nominal GDP Real GDP

(metric tones) level (Ushs) (Ushs) (Ushs)
2009 20 2 40 40
2010 25 4 100 50
2011 32 5 160 64
2012 45 8 360 90

DIY Exercise: Compute the growth rates of Nominal and real GDP for the years 2010-2012.
Analyse your results by comparing the growth rates of nominal and real GDP across the years.

Defining the components of GDP

GDP is the sum of consumption expenditure (C), investment spending (I), government purchases
(G) and net exports (X-M), expressed as GD P=C+ I +G+ X −M .

Consumption expenditure consists of the expenditure on final goods and services by the
household sector. It includes expenditures on goods such as food, clothing, cars, televisions, and
services such as haircuts and doctor visits.
Investment spending consists of expenditure on capital goods bought by the business sector for
future use. Investment throughout this course is defined as additions to the physical stock of
capital. Investment includes construction of factories and offices, purchase of machinery and
additions to a firm’s inventories of goods. It does not include buying of bonds or shares.
Government purchases consist of the expenditure on goods and services by the government
sector. This includes such items as national defense expenditures, road construction by local and
central governments, and salaries of government employees. It does not include transfer
payments to individuals such as social security benefits and unemployment benefits. Transfer
payments are payments that are made to people without them providing a current service in
exchange. Because transfer payments reallocate existing income and are not made in exchange
for goods and services, they are not part of GDP.
The sum of government purchases and transfer payments is known as government expenditure.
Net exports take into account trade with the rest of the world. Net exports refer to the total
export receipts minus the total import bill. Net exports represent the net expenditure from abroad
on a country’s domestic goods and services, which provide income to domestic producers.

GDP Vs GNP
The difference between GDP and GNP arises because some of the aggregate output is produced
by nationals who live abroad.
GNP is computed as; GNP=GDP+ factor payments from abroad- factor payments to foreigners.

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When GDP exceeds GNP, it implies that the nationals working abroad earn less that foreigners
earn in that country. When GNP exceeds GDP, it indicates that the foreigners in the country earn
less compared to that country’s nationals who work abroad.
GDP is a preferred measure of economic growth, over GNP, for 3 reasons;
i) To make international comparisons on economic performance easier because GDP is
what most countries use as a measure for economic growth.
ii) GDP is easier to measure since data on net foreign earnings is poor/ difficult to attain.
iii) GDP is a better measure for designing home policies especially in regard to the job-
creating potential of the economy.

Net Domestic Product (NDP) and Net National Product (NNP)

Economists make a distinction between the gross national product and the net national product
(NNP) also between gross domestic product and net domestic product. Capital wears out or
depreciates, while it is being used to produce output. The NNP essentially corrects the GNP by
subtracting off the value of the capital that depreciates in the process of production. Capital
depreciation is sometimes also referred to as capital consumption. The NDP is simply defined as
the GDP less capital depreciation. A case could be made that the NNP and NDP better reflects an
economy’s level of production since it takes into account the value of capital that is consumed in
the production process.

HOW IS NATIONAL INCOME (GDP) MEASURED?

i) The Factor Income Method (Income Approach)

The production of a nation’s output generates income. Labour must be employed, land must be
rented, capital must be used and entrepreneurs must be involved in combining these factors of
production. The calculation of GDP under this approach involves adding up factor payments.
Therefore, GDP = Rent + Wages + Interest + Profits in respect of the four factors of production
of the economy. All transfer payments are excluded in national income measurement to avoid
double counting.

ii) The Expenditure Method

The GDP expenditure method is also known as the final product method. GDP in this case is
calculated by adding up all the expenditures made to purchase the final output produced in that
year. Total expenditures include all money spent on final goods and services at market prices.
These expenditures are included; aggregation of the household sector expenditure (consumption
expenditure), business firms’ expenditure (investment spending), government purchases
(provision of social services) including net exports (X-M) in respect of the four sectors of the
economy.

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Therefore, GDP = C + I + G + X – M. To avoid double counting, expenditure on factor inputs

and intermediate goods are excluded.

iii) The Value Added Approach/ the output method

Production occurs in stages. Some firms produce outputs that are used as inputs by other firms,
and these other firms in turn produce outputs that are used as inputs by yet other firms. This
approach measures each firm’s own contribution to total output, that is, the amount of market
value that is produced by that firm. This approach avoids the statistical problems of double
counting by distinguishing between two types of output; intermediate goods and final goods and
services. Intermediate goods and services are outputs of some firms that are in turn inputs for
other firms. Final goods and services are goods that are purchased to be used in the final form.

Under the value added approach, each firm’s value added is the value of its output minus the
value of the inputs that it purchases from other firms. For instance, a bakery’s value added is the
value of the bread and cakes it produces minus the value of the flour and other inputs that it buys
from other firms. Note that the value of final goods and services (bread and cakes) is equal to the
value added, as shown earlier.

Problem of measuring GDP

GDP data are, in practice, used not only as a measure of the value of aggregate output produced
but also as a measure of the welfare of the residents of that country. GDP, however, fails to
reflect the true value of aggregate output and welfare of the residents due to the following
problems of GDO measurement that may arise;

1. In practice, GDP is supposed to measure the value of output that is to some extent
marketable or exchangeable. Marketable output that is not exchanged in a market is not
included as GDP. For instance housework/ home chores. Assuming that home chores are
contracted out to a housemaid/houseboy, then what they are paid would be counted as
part of GDP, because there is an exchange taking place.
2. The majority of an economy is usually employed in the production of non-marketable
output- subsistence output- a consumption good that is produced and consumed by the
individual producing it. Non-marketable output is likely to be very large and has value,
but is not included as GDP.
3. GDP as a measure of economic performance says nothing about the distribution of output
in an economy. When computed as per capita GDP, GDP can only give us some idea
about the level of production accruing to an average individual in the economy.
4. The underground economy; by some estimates, as much as 30% of an economy’s GDP
may not be measured in the GDP accounts due to the presence of an underground
economy. The underground economy comprises of those who work at a second job for
cash, illegal gambling, working after entering the country illegally, working while

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collecting unemployment benefits, illegal drug dealing. People attempt to conceal

transactions that are illegal, not complying with tax or immigrant laws or other
government regulations. GDP accounts do not include the value of illegal activities as a
matter of principle, so part of the underground economy would not count even if it could
be measured.
The remaining activities in the underground economy occur mainly because people are
trying to avoid losing some government benefit or avoid paying taxes, and these activities
should be included in GDP. The existence of the underground economy implies that the
measured GDP is below the true aggregate output.
5. GDP accounts do not take environmental pollution and degradation into account, which
is particularly important in developing countries.
6. Some activities measured as adding to real GDP in fact represent the use of resources to
avoid or contain ‘bads’ such as crime or risks to national security.

Circular flow of income

Circular flow of income refers to the expression of the inter linkages among economic agents
of a macro economy. It shows the flow of income and expenditures across macroeconomic
sectors through interactions of agents in the macroeconomic markets.
Illustration of the circular flow of income

The arrows show the flows of income and expenditure among the economic agents through the
three macroeconomic markets. The boxes show the macroeconomic sectors and markets. Let’s
first define the macroeconomic sectors and the macroeconomic markets before we analyse the
interlinkages of all the agents in the macroeconomy.

Macroeconomic sectors of the economy

There are four sectors of the economy that form the foundation for macroeconomic analysis, as
discussed below.

 Household Sector; This sector includes all consumers who spend a proportion of their
income on purchase of consumer goods and services. In addition, they are considered to
be the owners of factor of production.

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Business Economics Lecture Notes for BSA, BTTM & BLHM I March 2017

 Business Sector; This sector contains all firms that combine factors of production to
produce goods and services and sell their output to the household and government
sectors.
 Government Sector; This sector includes all government departments, institutions and
ministries that undertake resource allocation decisions to maximize social economic
welfare. The government sector has the roles of allocation, regulation and stabilization to
achieve its ultimate goal of maximizing social welfare.
 Foreign Sector; This sector is comprised of individuals and firms that are engaged
exporting and importing goods and services.

Economic agents within the prior-mentioned sectors interact through the macroeconomic
markets, that is, the product, resource and resource markets.

 Product market; the product market, also known as goods or output market refers to a
market where final goods and services are sold and purchased. The seller of these goods
and services is primarily the business sector, while the buyers are mainly the household
and government sectors.
 Resource markets; the resource market, also known as the factor market is a market
where units of the four factors of production are sold and purchased or hired. The
business sector acquires factors of production through this market and pays to the
household sector, the owners of these factors of production.
 Financial markets; refer to those markets where funds flow from surplus spending units
to deficit spending units. These are markets in which funds are transferred from people
who have an excess of available funds to people who have a shortage. Financial markets
such as money, securities and foreign exchange markets are crucial to promoting greater
economic efficiency by channeling funds from people who do not have a productive use
for them to those who do. Indeed, well-functioning financial markets are a key factor in
producing high economic growth, and poorly performing financial markets are one
reason that many countries in the world remain desperately poor.

Let’s now analyze the flow of income and expenditure from the viewpoints of these economic
actors. Households receive income as factor payments from the sale of factors of production to
the business sector and use the income to pay taxes to the government, to consume goods and
services, and to save through the financial markets.
Firms receive revenue from the sale of goods and services to the government and household
sectors and use it to pay for the factors of production. Firms borrow in financial markets to buy
investment goods, such as machinery and factories.
The government receives revenue from taxes and uses it to pay for government purchase. Any
excess of tax revenue over government spending is called public saving, which can be either
positive (a budget surplus) or negative (a budget deficit).
For simplicity, the foreign sector has been excluded.

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Business Economics Lecture Notes for BSA, BTTM & BLHM I March 2017

PER-CAPITA INCOME AS A MEASURE OF WELFARE

Per-capita GDP refers to the value of all goods and services produced per person and is
computed as;

GDP
Per-capita GDP=
Total population of a country
As earlier mentioned, economists and policymakers care about the GDP and the per capita GDP
in particular because material living standards depend largely on what an economy produces in
the way of final goods and services. As we shall see later on, the link between an economy’s per
capita GDP and individual welfare is not always exact. But it does seem sensible to suppose that
by and large, higher levels of production (per capita) in most circumstances translate into higher
material living standards.

It is assumed that the higher the per-capita GDP, the higher the standards of living (welfare).
This implies that if per capita income is twice higher in 2011 compared to 2008, the standard of
living is assumed twice higher in 2011. However, higher per-capita GDP does not necessarily
imply higher welfare due the following reasons.

Limitations of Using Per-Capita Income as a Measure of Standards of Living

i) Doesn’t take into account the type of goods produced. Some goods such as alcohol,
cigarettes, do not directly improve on human welfare but increase national income and
hence per capita income.
ii) Per-capita GDP does not take into account the efforts applied in producing output.
Employees could be over worked for example, working twice the normal 8 hrs of work.
Per-capita GDP may be high while welfare may not necessarily be high.
iii) Similarly, the impact of economic activity on the environment is not directly taken into
account in calculating GDP for instance oil drilling may have negative impact on the
environment.
iv) Per-capita GDP does not take into account many factors that may be important to quality of
life, such as the quality of water, sanitation and security from crime which distortions the
measure of welfare.
v) The per-capita GDP statistics do not consider income distribution.
vi) Nominal GDP per capita does not account for inflation which is an important determinant
of welfare.
vii) Inflationary tendencies make comparison in welfare over time very difficult.

We have explored how national income is measured, with emphasis on GDP. We further
explored the problems of GDP and GDP per capita measurement as a reflection of economic
growth and welfare. We finally used the circular flow of income to explain the inter linkages of
economic agents within a macro economy. For the next two macroeconomics topics, we shall
explore the financial markets with emphasis on the central bank and commercial banks and
international trade- to understand how an open economy yields gains from trade.