Macroeconomic

Theory and Policy

Biswa Swarup Misra

Session-3

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 Circular Flow of Income

MEASURING A NATION’S INCOME B.S.Misra 23

 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.

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Active Learning 1: Income Equals Expenditure

▪ Nalah pays James $50 to mow her lawn.

A.What happens with total expenditure?
B.What happens with total income?

▪ James is a seller of a service and Nalah is a

buyer: James earns $50, and Nalah spends $50.
A.Total expenditure rises by $50.
B.Total income rises by $50.
The transaction contributes equally to the economy’s
income and to its expenditure. GDP, whether measured as
total income or total expenditure, rises by $50.
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 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)

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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

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FIGURE 1: The Circular-Flow Diagram

Firms Households

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

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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)
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 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

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The Circular Flow and the Measurement of GDP
In a very simple model of the
economy, we could start with
households and firms.
To measure overall
economic activity, we could
measure the amount of
money that households
spend on goods and
services.
Or we could measure
income to households.

▪ Figure-1
▪The circular flow and the
measurement of GDP
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 Adding Government to the Circular Flow
Let’s add in some more
layers. We’ll start with
government.
How does the government
affect economic activity?
• It takes in taxes from
households and firms.
• It uses those taxes to
buy goods and services,
and to make transfer
payments-payments to
households for which the
government does not
receive a good or ▪ Figure-2
service in return. ▪The circular flow and the
measurement of GDP
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Adding the Rest of the World to the Circular Flow
Some economic activity
takes place between
households, firms, and the
rest of the world.
• Households buy goods
and services from firms
in other countries; these
are known as imports.
• Firms sell goods and
services to households
in other countries; these
are known as exports.

▪ Figure-3
▪The circular flow and the
measurement of GDP
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Adding the Financial System to the Circular Flow
Finally, there are firms that
deal specifically in flows of
money; we label these
firms the financial system.
• Households elect not to
spend some of their
income, and instead
save it with financial
system firms like banks.
• These financial system
firms lend money to
other firms and the
government.
▪ Figure 4
▪The circular flow and the
measurement of GDP
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 GDP

MEASURING A NATION’S INCOME B.S.Misra 35

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.

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Active Learning 2: What is included in GDP?

Nalah pays James $50 to mow her lawn.

A. What happens with GDP?
B. Will your answer to the previous question
change if Nalah and James get married?

A. When Nalah pays James $50 to mow her

lawn, that transaction is part of GDP.
B. If James and Nalah get married, and James
continues to mow Nalah’s lawn, the value of
the mowing is now left out of GDP because
James’ service is no longer sold in a market.

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 Excluded Transactions from GDP
▪ Transactions occurring in the so-called
“underground economy” are also omitted from
the official measure of GDP.
▪ Some products are excluded from GDP because
they are hard to measure:
• Most items produced and sold illicitly, such as illegal
drugs
• Most items that are produced and consumed at
home (never enter the marketplace). GDP includes
vegetables you buy at the grocery store but not
vegetables you grow in your garden.

MEASURING A NATION’S INCOME B.S.Misra 38

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.
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 Intermediate versus Final Goods

▪ Intermediate goods are sold to firms and then

bundled or processed with other goods or services for
sale at a later stage.
▪ Finished goods and services are sold to final users
and then consumed or held in personal inventories.
▪ To avoid double counting, only finished goods are
included in GDP.
▪ However, machinery and equipment used to produce
other goods are included in GDP.

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 Intermediate versus Final Goods

Which of the following is a finished good?

a. A book in Amazon’s inventory.
b. Tires purchased by a Toyota plant.
c. Tires purchased by you for your car.

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 Intermediate versus Final Goods

Which of the following is a finished good?

a. A book in Amazon’s inventory.
b. Tires purchased by a Toyota plant.
c. Tires purchased by you for your car.
Answer: c. Tires purchased by you are a finished good
because they are for your own use (consumption), not for
resale.

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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).

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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.

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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.

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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).

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 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 47

 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 48

 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 49

 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

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 Value Added
Final
Purchases

Wheat Sale of
produced bread Consumption
Wheat + Effort
by Farmer Purchased by (INR 100)
result in output
(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 51
 Inventory
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 52
 Capital Good

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 53

 Intermediate versus Capital Good
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 54

 Investment
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 55
 Depreciation
A capital good is not used up right away but it
diminishes 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 56

 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
Investment
Capital
Deterioration of Stock
Capital Good
(Depreciation)

Session 2-3 MEASURING A NATION’S INCOME B.S.Misra 57

 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

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 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

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 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

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 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.

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 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? 62
 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. 63
 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.
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 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.
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 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.

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 Equivalence of Three 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.
▪ 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.

MEASURING A NATION’S INCOME B.S.Misra 67

 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

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