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).

1
 - 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:

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.

2
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.

3
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.

4
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:

5
 - 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:

- 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.

6
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.

7
 - 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.

8
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:

9
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.

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:

10
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:
- 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.

11
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.

12
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.

13
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.

14
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.

15
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.

16
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.

17