DEPARTMENT OF ECONOMICS

ECO 112 BASIC MACROECONOMICS

TUTORIAL QUESTIONS

Measuring Domestic output and national income

1. By using the circular flow model (for closed economy with no government
participation/spending; and for the economy with government participation and foreign
sector), explain why we can use both the income and the expenditure approach to
measure national output of a country.

Closed Economy with No Government Participation:

Income Approach:
- In this closed economy, households supply factors of production (labor and capital) to
businesses in the resource market.
- Businesses pay incomes (wages, profits, rents, interest) to households for these factors of
production.
- The total of these factor incomes represents the national income.
- National Income = Wages + Profits + Rents + Interest

Expenditure Approach:
- Businesses use the factors of production to produce goods and services, which are then sold to
households in the product market.
- Households, in turn, spend their incomes on these goods and services.
- The total expenditures made by households represent the national output.
- National Output = Consumption + Investment

Economy with Government Participation and Foreign Sector:

Income Approach:
- Similar to the closed economy, households supply factors of production, and businesses pay
incomes.
- In this case, the government also plays a role by taxing and providing transfer payments.
- The total of all factor incomes, including those received from the government, represents the
national income.
- National Income = Wages + Profits + Rents + Interest + Taxes - Transfer Payments

Expenditure Approach:
- Businesses produce goods and services, and households purchase them.
- The government participates by spending on goods and services (government spending) and
collecting taxes.
- Additionally, there are foreign transactions (exports and imports).
- The total expenditures made by households, businesses, government, and the foreign sector
represent the national output.
- National Output = Consumption + Investment + Government Spending + (Exports - Imports)

Key Reasons for Using Both Approaches:

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Circular Flow Concept:
- The circular flow of income and expenditures illustrates that every dollar spent is someone's
income.
- The income generated in the production process is spent on goods and services, creating a
continuous cycle.

National Income Identity:

- Both approaches are interconnected through the national income identity, where national
income is equal to national output.
- The equality is based on the principle that all production is ultimately sold, and all income
generated is spent.

Measurement Consistency:
- The consistency of measurement ensures that the total income earned in an economy equals
the total expenditures made.

Different Perspectives:
- The income approach focuses on production rewards and factor incomes.
- The expenditure approach emphasizes final demand and the total spending on goods and
services.

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2. An economy is made up of three firms.
Firm A produces milk; it sells P3000 worth of milk to firm and P4000 worth to firm
C and it pays P1000 to its workers (it has no other sales or costs). Firm B makes
cheese and sells P6000 worth of it, paying its workers P2000. Firm C makes butter,
selling P10,000 worth and pay its workers P4000. There are no transactions between
firms B and C. What is the value of the country’s GDP?

To calculate the Gross Domestic Product (GDP), we can use the income approach, which
sums up all the factor incomes (wages, profits, rents, interest) earned by the factors of
production (labor and capital) in the economy. In this scenario, we'll consider the total
wages paid by the three firms.

Given information:

- Firm A sells milk: P3000 to Firm B and P4000 to Firm C, and pays its workers P1000.
- Firm B sells cheese: P6000 and pays its workers P2000.
- Firm C sells butter: P10,000 and pays its workers P4000.

Wages Paid:
- Firm A: P1000
- Firm B: P2000
- Firm C: P4000

Now, we can calculate the Gross Domestic Product (GDP) by summing up the total
wages paid by the three firms:

GDP = Wages paid by Firm A + Wages paid by Firm B + Wages paid by Firm C

GDP = P1000 + P2000 + P4000 = P7000

Therefore, the value of the country's GDP is P7000.

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3. What is GDP? Why do we take into account the market value of all final goods and
services produced in the country while computing GDP of a country?

Gross Domestic Product (GDP):

Gross Domestic Product (GDP) is a key economic indicator that measures the total
market value of all final goods and services produced within the borders of a country in a
specific time period. It provides a comprehensive snapshot of a nation's economic
activity, reflecting the total output generated by the economy.

Importance of Market Value in Computing GDP:

Final Goods and Services:

- GDP accounts for the market value of final goods and services, which are those goods
and services that are consumed by end-users. Intermediate goods, used in the production
process, are excluded to avoid double-counting. This ensures that the value added at each
stage of production is captured only once.

Avoiding Double-Counting:
- Taking into account the market value of final goods and services helps prevent the
double-counting of production. If the value of intermediate goods were included, the
GDP would overstate the economic output by counting the same value multiple times.

Capturing Value Added:

- GDP measures the total value added at each stage of production. Value added is the
difference between the value of a firm's output and the value of its intermediate inputs.
By focusing on the market value of final goods, GDP captures the contribution of each
stage of production to the overall economic output.

Comparability:
- Expressing GDP in terms of market value allows for comparability over time and
across different countries. It provides a standardized metric that facilitates meaningful
comparisons of economic performance.

Economic Efficiency:
- Market values in GDP represent the economic efficiency of resource allocation. Prices
in markets signal the relative scarcity and demand for goods and services, guiding the
allocation of resources to where they are most valued by consumers.

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4. Give examples of purely financial transactions and explain why those transactions are
excluded from the calculation of GDP

Purely financial transactions involve the exchange of financial assets and liabilities
without the production of goods or services. These transactions are excluded from the
calculation of Gross Domestic Product (GDP) because GDP measures the value of final
goods and services produced in an economy, and financial transactions do not contribute
to the real output of goods and services. Here are examples of purely financial
transactions:

Stock Market Transactions:

- Buying and selling stocks in the stock market do not directly contribute to the
production of goods and services. These transactions involve the transfer of ownership of
financial assets (stocks) and are excluded from GDP calculations.

Bond Transactions:
- Buying and selling bonds in financial markets represents transactions involving debt
instruments. These financial transactions do not involve the production of goods and
services and are therefore excluded from GDP.

Real Estate Transactions:

- Purely financial transactions related to real estate, such as buying or selling existing
homes or commercial properties, involve the transfer of property rights without the
production of new goods and services. These transactions are not included in GDP.

Bank Loan Transactions:

- When a bank provides a loan to a borrower, it involves a financial transaction that
does not contribute to the production of goods and services. Similarly, when loans are
repaid, it represents a financial transaction but does not directly contribute to GDP.

Currency Exchange:
- Transactions in the foreign exchange market, where currencies are bought and sold,
are purely financial and do not involve the production of goods and services. Changes in
currency values are excluded from GDP calculations.

Transfer Payments:
- Transfer payments, such as social security benefits, unemployment benefits, and
pensions, involve the redistribution of income from one group to another. These
payments are excluded from GDP because they do not represent the production of new
goods or services.

Insurance Premiums and Claims:

- Transactions related to insurance, such as paying insurance premiums or receiving
insurance claims, are financial transactions. While insurance services contribute to GDP,
the financial aspects of insurance transactions are excluded.

Gifts and Inheritances:

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 - The transfer of wealth through gifts and inheritances involves financial transactions
but does not contribute to the production of goods and services. Therefore, these
transactions are excluded from GDP.

The exclusion of purely financial transactions from GDP calculations ensures that the
GDP measure reflects the value of actual economic output and production. Including
financial transactions could lead to double-counting and distort the true economic
performance of a country. GDP aims to capture the value of final goods and services
produced in an economy to provide an accurate picture of its economic activity.

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5. What does double counting mean? Explain, by giving example, how double counting is
avoided in national income accounting.

Double counting refers to the incorrectly/wrongly counting of the same economic

transaction or value multiple times in the calculation of a country's Gross Domestic
Product (GDP). In national income accounting, it's crucial to avoid double counting to
provide an accurate representation of the total economic output.

Example of Double Counting:

Consider a scenario where a farmer sells wheat to a flour mill, and then the mill sells the
flour to a bakery. If we were to count the value of both the wheat and the flour in GDP, it
would result in double counting. The wheat's value is already included when it is sold to
the mill, and counting the flour again when sold to the bakery would inflate the GDP.

Avoiding Double Counting:

National income accounting uses the concept of "value added" at each stage of
production to prevent double counting. Value added is the difference between the value
of a firm's output and the value of its intermediate inputs. This approach ensures that only
the additional value created at each stage is included in the GDP. Here's how it works:

Intermediate Goods Exclusion:

- Intermediate goods, which are used in the production process and are not the final
goods sold to consumers, are excluded from GDP. Including them would result in double
counting.

- Example: In the wheat-to-flour-to-bread example, the value of wheat is excluded once

it becomes part of the flour. Only the value added by the flour mill is counted, not the
entire value of the wheat.

Focus on Final Goods and Services:

- GDP accounts for the market value of final goods and services, which are those
consumed by end-users. This excludes the value of intermediate goods that are used in
the production chain.

- Example: If the flour is sold to the bakery and then used to make bread, only the final
value of the bread is included in GDP, not the value of the flour.

Value Added Approach:

- The value added by each firm in the production process is included in GDP. It
represents the contribution of that firm to the final value of the product.

- Example: If the flour mill adds value by processing the wheat into flour, only the
value added by the mill is included in GDP, not the entire value of the flour.

By focusing on the value added at each stage of production and excluding intermediate
goods, national income accounting ensures that the final market value of goods and
services is accurately reflected in GDP without double counting. This approach provides
a more accurate measure of a country's economic output and avoids overestimating the
value of production.

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6. Make out the distinction between the following:

a) GDP and GNP

b) GDP and NDP
c) National income, Personal Income and Disposable Income
d) Gross Private Domestic Investment and Net Private Domestic Investment
e) Net foreign factor income earned
f) Consumption of fixed capital/depreciation costs/ replacement cost

a) GDP and GNP:

Gross Domestic Product (GDP):

- Measures the total market value of all final goods and services produced
within the geographical boundaries of a country, regardless of the ownership
of the productive assets.
- It includes both domestic and foreign entities operating within the
country.

Gross National Product (GNP):

- Measures the total market value of all final goods and services produced
by the residents of a country, regardless of where they are located.
- It includes the production of domestic residents both within the country
and abroad.

b) GDP and NDP:

Gross Domestic Product (GDP):

- Measures the total market value of all final goods and services produced
within a country's borders, including depreciation.
- GDP includes the depreciation of capital, also known as "consumption of
fixed capital."

Net Domestic Product (NDP):

- Measures the total market value of all final goods and services produced
within a country's borders, excluding depreciation.
- NDP is obtained by subtracting the depreciation (or consumption of fixed
capital) from GDP.

c) National Income, Personal Income, and Disposable Income:

National Income:
- Represents the total income earned by the factors of production (labor and
capital) within a country, including wages, profits, rents, and taxes (minus
subsidies).
- National Income excludes depreciation and indirect taxes.

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Personal Income:
- Represents the total income received by individuals, including wages,
profits, rents, and transfer payments (e.g., social security benefits).
- Personal Income excludes corporate profits taxes and retained earnings.

Disposable Income:
- Represents the income available to individuals after personal taxes have
been paid.
- Disposable Income is obtained by subtracting personal taxes from
personal income.

d) Gross Private Domestic Investment and Net Private Domestic

Investment:

Gross Private Domestic Investment:

- Represents the total value of all new, fixed capital goods (such as
machinery, buildings, and infrastructure) produced within a country during a
specific time period.
- It includes both replacement investment and additions to the capital stock.

Net Private Domestic Investment:

- Represents the net change in the capital stock after accounting for
depreciation.
- Net Private Domestic Investment is obtained by subtracting the
depreciation (or consumption of fixed capital) from Gross Private Domestic
Investment.

e) Net Foreign Factor Income Earned:

- Represents the difference between the income earned by a country's
residents from abroad and the income earned by foreign residents within the
country.
- It includes wages, profits, rents, and taxes (minus subsidies) related to
foreign assets.

f) Consumption of Fixed Capital/Depreciation Costs/Replacement Cost:

Consumption of Fixed Capital:

- Represents the estimated value of the capital stock that is used up or worn
out in the process of production.
- It is also known as depreciation and is subtracted from Gross Domestic
Product to obtain Net Domestic Product.

Depreciation Costs:
- Represents the reduction in the value of capital goods over time due to
wear and tear, obsolescence, or aging.
- Depreciation costs are a component of the consumption of fixed capital.

Replacement Cost:

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 - Represents the cost of replacing worn-out or obsolete capital goods with
new ones.
- It is related to the concept of maintaining the capital stock at a level that
sustains the productive capacity of the economy.

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7. If we assume that in the year 2016, the GDP of Botswana was P 125 billion and the NDP
was P105 billion. What accounts for this difference?

The difference between Gross Domestic Product (GDP) and Net Domestic Product
(NDP) is primarily due to the consumption of fixed capital, also known as depreciation.
Net Domestic Product accounts for the depreciation of capital goods during the
production process.

The relationship between GDP and NDP can be expressed by the following formula:

NDP = GDP - Depreciation

Where:
- NDP is Net Domestic Product,
- GDP is Gross Domestic Product,
- Depreciation is the consumption of fixed capital.

The formula indicates that NDP is GDP adjusted for the depreciation of capital during the
production of goods and services.

In the given scenario:

- GDP of Botswana in 2016 is P 125 billion.
- NDP of Botswana in 2016 is P 105 billion.

Therefore, the difference of P 20 billion between GDP and NDP is likely due to the
depreciation of capital during the production process.
This depreciation represents the wear and tear on the country's capital goods, such as
machinery, buildings, and infrastructure, used in the production of goods and services.
The P 105 billion NDP reflects the net output after accounting for this consumption of
fixed capital.

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8. When we say that national income is the income earned and personal income is the
income received, how does this make the difference?

The distinction between national income and personal income lies in the scope of income
coverage and the types of deductions made in the calculation. The concepts of national
income and personal income are related, but they represent different stages in the income
distribution process. Here's an explanation of the difference:

- Income Earned vs. Income Received:

- National income focuses on the income earned during the production of goods and
services.
- Personal income reflects the income received by individuals, which may be a portion
of the national income after certain deductions.

- Scope of Coverage:
- National income includes all incomes generated in the production process, whether
retained by businesses or received by individuals.
- Personal income narrows the focus to the income received by individuals, excluding
certain business-related components.

- Deductions:
- National income typically does not deduct personal taxes paid by individuals;
instead, it accounts for business taxes.
- Personal income deducts personal taxes to arrive at the amount available to
individuals for spending and saving.

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9. Briefly discuss the problems in the preparation of national income accounts of a country

Data Accuracy and Reliability:

- Gathering accurate and reliable data is a significant challenge. Data collection
methods, especially for small and informal sectors, may be less structured, leading to
potential inaccuracies.

Underground Economy:
- The presence of an underground or informal economy, where transactions occur off
the record, poses a challenge. Such activities may go unreported, leading to an
underestimation of the actual economic output.

Non-Market Transactions:
- Non-market transactions, such as unpaid household work and volunteer activities, are
challenging to quantify and include in national income accounts. These activities
contribute to the well-being of society but are often not accounted for in traditional
economic measures.

Quality of Data Sources:

- National income accounts rely on various data sources, including surveys,
administrative records, and statistical models. The quality and consistency of these
sources can vary, impacting the reliability of the overall accounts.

Inflation Adjustments:
- Adjusting for inflation is a critical aspect of measuring real GDP accurately. Choosing
appropriate price indices and dealing with the changing composition and quality of goods
and services over time pose challenges in inflation adjustments.

Technological Changes:
- Rapid technological advancements and changes in the structure of the economy can
make it challenging to update and adapt national income accounting methods to reflect
current economic realities.

Environmental Considerations:
- Traditional national income accounts may not fully capture the environmental costs
and sustainability challenges associated with economic activities. Integrating
environmental considerations into economic measures poses a growing concern.

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10. Discuss the problems of using GDP as a measure of nation’s welfare.

Excludes Non-Market Activities:

- GDP primarily focuses on market transactions, excluding non-market activities such
as unpaid household work and volunteer services. As a result, it may not fully capture the
overall contribution to well-being.

Ignores Income Distribution:

- GDP does not account for the distribution of income among the population. A country
with a high GDP may still have significant income inequality, impacting the well-being
of different socioeconomic groups.

Doesn't Reflect Income Disparities:

- GDP per capita does not consider how the economic output is distributed among the
population. A high per capita GDP may mask significant disparities in income levels.

Ignores Environmental Costs:

- GDP does not account for environmental costs and natural resource depletion.
Economic activities that lead to environmental degradation or resource depletion
contribute positively to GDP, but they may negatively impact overall welfare.

Quality of Life Factors:

- GDP does not measure various factors contributing to the quality of life, such as
access to healthcare, education, leisure time, and overall life satisfaction. These factors
are crucial for assessing well-being but are not captured by GDP.

Ignores Informal Economy:

- GDP tends to overlook the informal or underground economy, leading to an
underestimation of economic activities that contribute to welfare but are not officially
recorded.

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11. Define net exports.

Net Exports is a macroeconomic term that represents the difference between a

country's total exports of goods and services and its total imports of goods and
services over a specific period, usually a year. It is a component of the broader
measure of a country's balance of trade.

The formula for calculating Net Exports (NX) is:

Net Exports (NX) = Exports - Imports

Where:
- Exports: The total value of goods and services produced domestically and sold
to foreign buyers.
- Imports: The total value of goods and services purchased from foreign sources
and consumed domestically.

The resulting Net Exports can be positive or negative:

- A positive value indicates that a country exports more than it imports, leading to
a trade surplus.
- A negative value indicates that a country imports more than it exports, resulting
in a trade deficit.

Net Exports, along with other components such as consumption, investment, and
government spending, contributes to the calculation of Gross Domestic Product
(GDP).
The net exports component reflects the impact of international trade on the
overall economic output of a country.

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12. Describe the difference between real GDP and nominal GDP. Which concept is more
useful for measuring change in the economy over time? Why?

Nominal GDP:
- Definition: Nominal GDP measures the total value of all final goods and services
produced within a country's borders during a specific time period, using current market
prices.
- Inclusion of Inflation: Nominal GDP includes the effect of price changes, including
inflation or deflation, on the overall value of goods and services. As a result, it reflects
both changes in quantities produced and changes in prices.
- Formula: Nominal GDP = Sum of the Value of Goods and Services Produced X
Current Market Prices

Real GDP:
- Definition: Real GDP also measures the total value of all final goods and services
produced within a country, but it adjusts for inflation or deflation. It provides a measure
of economic output by holding constant the prices of goods and services, allowing for a
comparison of quantities produced over time.
- Exclusion of Inflation: Real GDP eliminates the effect of price changes by using
constant base-year prices, providing a more accurate measure of changes in the physical
volume of production.
- Formula: Real GDP = Sum of the Quantity of Goods and Services Produced X Base-
Year Prices

Which Concept is More Useful for Measuring Change in the Economy Over Time?
Why:

- Real GDP is More Useful:

- Real GDP is generally considered more useful for measuring changes in the economy
over time because it provides a clearer picture of the actual changes in output, abstracting
from the impact of inflation. It allows for a more accurate assessment of whether the
economy is growing or contracting in terms of physical production.
- By using constant prices, real GDP provides a more meaningful comparison of
economic performance across different time periods, facilitating the identification of
genuine economic growth or decline.
- Nominal GDP, on the other hand, can be influenced by changes in prices, making it
challenging to isolate the true changes in the quantity of goods and services produced.

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 13. Below is a list of hypothetical figures relating to domestic output and income of a
country for the year 2015. All figures are in millions of Pula.

Calculate the following:

a. GDP by expenditure and income approach
b. NDP,
c. National income,
d. Personal income and
e. Disposable income.

Activity Amount
Personal consumption 245
Government consumption 72
Net Private Domestic Investment 33
Exports 32
Imports 21
Consumption of fixed capital/ 27
Depreciation of capital/
Capital replacement cost
Indirect Business Taxes/Taxes 18
on production and imports
Net Foreign Factor Income earned 16
Transfer payments 12
Rent 14
Social Security contributions 20
Interest 13
Proprietors’ income 33
Dividends 16
Compensation of employees –Wages 223
Undistributed corporate profits 21
Personal taxes 26
Corporate income taxes 19
Corporate profits (dividends+ corporate 56
income taxes+ undistributed corporate
profits)
Statistical discrepancy 20

14. Assume that a painter produces 20 paintings this year and 20 paintings next year.
What is the annual change in nominal GDP if the price of paintings rises from
P1,000 this year to P1,500 next year? Can you conclude that the economy grew
from this year to next year based on your answer? Why?

15. When will the Real GDP be higher than Nominal GDP?

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 16. The following table shows nominal GDP and an appropriate price index for a
group of selected years. Compute real GDP. Indicate in each calculation whether
you are inflating or deflating the nominal GDP data.

Nominal GDP, Price index Real GDP,

Year Billions (2000 = 100) Billions

1974 P663.6 22.13 P ______

1984 1500.0 34.73 P ______
1994 3933.2 67.66 P ______
2004 7072.2 90.26 P ______
2014 11734.3 109.10 P ______

Basic Macroeconomic Relationships and the Aggregate Expenditure Model

1. What is Consumption and Saving? What is their relationship with the income of an
individual?

2. Define the average propensity to consume (APC) and the average propensity to save
(APS); marginal propensity to consume (MPC) and marginal propensity to save (MPS);
and complete the following table.

Level of output and Consumption Savings APC APS MPC MPS

Income
GDP=DI
P 240 P P -4
260 0
280 4
300 8
320 12
340 16

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 360 20
380 24
400 28

a. Show the consumption and saving schedules graphically

b. Find the break-even level of income. Explain why it is possible for households to
dissave at very low-income level.

3. Discuss the non-income determinants of consumption and saving.

a. Why is investment expenditure inversely related to interest rates?

b. Apart from the rate of interest and expected rate of net profit, what other major
factors determine investment and bring changes in investment?

4. Distinguish between change in investment and change in the size of investment.

5. Explain the components of aggregate demand/expenditure in:

a. a closed private economy and
b. an open economy with the involvement of government and external sector?
c. How do changes in aggregate expenditure influence equilibrium GDP?

6. Complete the table by using the following information and answer the questions:

There are four components of expenditure in the economy. Assume that government
expenditure is fixed at P50 billion; Investment expenditure is also fixed at P50 billion.
Exports are exogenously fixed at P100 billion and Imports are exogenously fixed at P50
billion, and government levies a lump sum tax fixed at P100 billion.

National Disposable Consumpti Investment Government Exports Imports Agg. Agg.

income Income on Expenditure Expenditure Exp. I Exp. II
Expenditur
e
100 0 50
200 100 130
300 200 210
400 300 290
500 400 370
600 500 450
700 600 530
800 700 610
900 800 690
1000 900 770
1100 1000 850

Fill in all the other blanks, and using the expenditure-income method, determine the
equilibrium level of income and graph it. Also explain why all other income levels are
not equilibrium incomes.

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 7. What is meant by investment multiplier? What is its significance in an economy?
8. Assume that investment spending increases by P40 billion from the P50 billion in
question 7.
a. What will be the new equilibrium income?
b. Determine the size of the investment multiplier from the above change.

9. Assume the consumption schedule for an open economy is:

C=85+ 0.75Y
Assume further that planned investment ( I g) net exports ( X n) and government (G ) spending are
independent of national income and constant at: I g=30 ; X n=15 ; G=100 . Calculate the
equilibrium level of income and consumption.

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