Macroeconomics

Session 2
 Why is national income accounting
important?
• Measuring the level and rate of growth of national income is
important to economists when they are considering:

– Economic growth and where a country is in the business cycle

– Changes to average living standards of the population

– Looking at the distribution of national income

• Output typically measured as GDP = value of all final goods and services produced
within a country over a particular period of time.
 The Circular Flow Of Income

Households

Spending

Factor Incomes Products Factor Services

Firms

Factor Incomes Factor Services

Wages/Salaries Labour
Interest Capital
Profit Entrepreneur
Rent Land
 Leakages
• Not all FACTOR INCOME is spent on domestic goods. There are leakages
from income:

• Taxation - taken from wages/salaries and off the price of goods

(GST) etc

• Savings – households may not spend all their income

• Imports – households and firms may spend on imports.

ALL OF THE ABOVE ARE LEAKAGES FROM DOMESTIC INCOME

 The Circular Flow Of Income

Tax
Savings
Imports

Households

Spending

Factor Incomes Products Factor Services

Firms
These LEAKAGES reduce the circular flow of income. WHY ?

 Savings are put into bank accounts.

 Taxation goes to government.

 Import spending goes abroad.

 Injections
In contrast, there are 3 forms of spending that are injected into the flow.
Injection: Additions of extra spending into the circular flow of income

These are ;
• Government Spending - money spent by the government on salaries,
defence, benefits, education etc.
• Investment - money spent by firms on capital goods.

• Exports - goods sold by domestic firms abroad

Injections come from outside of the circular flow. They increase the circular
flow of income.
 The Circular Flow Of Income
Savings
Imports
Tax

Households

Spending

Factor Incomes Products Factor Services

Firms
Investment
Exports
Government
Spending
 Injections, Leakages and Income
If Injections > Leakages then…. ?
Income Rises

If Leakages > Injections then…. ?

Income Falls

If Injections = Leakages then…. ?

Income Stays the Same

• Gross Domestic Product (GDP): the market value of all final
goods and services produced in a country during a year.

 GDP excludes financial transactions and income transfers – these do not

reflect production.
 Measuring Gross Domestic Product

• Only count final goods and services  NO DOUBLE COUNTING

• Ex. Would not include the full price of a car AND the tires bought by the
manufacturer for the car  tires = intermediate goods

• Only count goods and services currently (in the time period being considered)
produced & excludes transactions involving used goods
• Ex. Include the construction of new homes in current GDP, but not the sale of
existing homes

• Only count goods and services produced within a country, regardless of the
ownership/nationality of the producing firm
• Ex. Include the sale of a car produced by a Japanese car manufacturer located
in the U.S. in U.S. GDP
 Problems of GDP Measurement
• There are three major criticisms of the GDP measure:

1. Omits non-market goods and services

• Ex. Work of stay-at-home mothers and fathers not included in GDP

2. No accounting for “bads” such as crime and pollution

• Ex. Crime is a detriment to society, but there is no subtraction from GDP to account for it

3. No correction for quality improvements

• Ex. Technological improvements are beneficial to the economy, but nothing is added to
GDP to account for them

 Despite these drawbacks, GDP is still considered one of the best economic indicators
for estimating growth in an economy
 National Income and Product Accounting

• Domestic vs. National

• GDP (at MP) refers to the value of all final goods and
services produced within a country’s borders

• GNP (at MP) refers to the value of all final goods and
services produced by the nationals of a country
regardless of where they produce it.
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GNP = GDP + Net Factor Income From Abroad
 National Income and Product Accounting
• Gross vs. Net
• Net of what???
• Net of depreciation
• Gross Private Domestic Investment (I) includes all
equipment, structures, and net additions to inventory
produced in a year
• But some capital stock depreciates in the process of producing
this year’s output
• Net National Product (at MP) = GNP (at MP) - Depreciation
• NNP reflects net investment
 National Income and Product Accounting

• NNP (at FC) = NNP at MP - Indirect Business Taxes +

Subsidies
• Sales taxes are included in what we pay for things but go to the
government.
• They’re not part of anyone’s income

• NNP at FC = National Income

NI includes the wages, interest, rents, and profits earned from
producing the year’s Net National Product.
 From GDP to National
Income
• Use the terms output and income interchangeably in macroeconomics,
but are they really equivalent?

• Gross Domestic Product @ current market prices

± Net Factor Income from abroad
= Gross National Product @ current market prices
Less indirect taxes
Plus subsidies
= Gross National Product @ factor cost
Less Depreciation
= Net National Product at factor cost (National Income)
 Methods of measuring NI

• Output or value added approach

• Expenditure approach

• Income approach
 Output or value added approach

• The total value of all final goods and services (i.e. output) can
be found out by adding up the total value of output produced
at different stages of production. This method is to avoid the
double-counting.
Value Added at Various Stages of Production

Stages of Production Value of Value Added

Transactions
1. Farmer grows wheat, sells it
$0.12 $0.12
to miller
2. Miller converts wheat to
0.28 0.16
flour, sells it to baker
3. Baker bakes bagel, sells it to
0.60 0.32
bagel store
4. Bagel store sells bagel to
0.75 0.15
consumer
Total $1.75 $0.75
 Expenditure approach

Amount of Expenditure refers to all spending on currently-

produced final goods and services in an economy.
• The value of GDP can be computed by adding up
expenditures of market participants:
GDP = C + I + G + (X – IM)
Where:
C = Consumption expenditure X = exports
I = investment expenditure IM = imports
G = government expenditure
 Consumption

• Goods and services used by households are called consumption

goods.
 Investment
• Investment goods are the plant, machinery, and equipment that we
produce.

• Also includes net inventory changes and new residential

construction.
 Government Spending

• Resources purchased by the government sector are unavailable for

consumption or investment purposes.
 Net Exports

• Exports are goods and services sold to foreign buyers.

• Imports are goods and services purchased from foreign sources.

Income approach

• National Income = Wages+ Interest Income + Rental Income + Profit

 Nominal vs. Real GDP
• NGDP is the value of output in a given period measured in current dollars

• NGDP in 2007 is the sum of the value of all outputs measured in 2007 dollars:
N
NGDP2007   Pi 2007 * Qi2007
i 1

• Changes in NGDP could be purely due to changes in prices  if GDP is to be used as a measure of
output, need to control for prices

• RGDP is the value of output in constant dollars  scaled by a based year price, so
that any change in GDP is due to change in production, not prices
N
• If PB is the price in the base year for good i, RGDPB in 2007
2007 is:
RGDP2007   Pi * Qi
i 1
 Inflation and Prices
• Inflation, , is the rate of change of prices:  t  Pt  Pt 1
Pt 1

where Pt is today’s price and Pt-1 is last period’s price

• If  > 0, prices are increasing over time  inflation

• If  < 0, prices are decreasing over time  deflation

• How do we measure prices?

• For the macroeconomy, need a measure of overall prices = price index
• There are several price indexes, but most common are CPI, PPI, and the GDP
deflator
 Price Indexes: GDP Deflator

• GDP deflator is the ratio of NGDP in a given year to RGDP of that year

• Since GDP deflator is based on a calculation involving all goods produced in

the economy, it is a widely based price index that is frequently used to
measure inflation

• Measures the change in prices between the base year and the current year

• Ex. If NGDP in 2006 is $6.25 and RGDP in 2006 is $3.50, then the GDP
deflator for 2006 is $6.25/$3.50 = 1.79  prices have increased by
79% since the base year
 Price Indexes: CPI
• CPI measures the cost of buying a fixed basket of goods and services
representative of the purchases of consumers
• Measure of the cost of living for the average household

• Differs from GDP deflator in three ways:

1. CPI measures prices of a more limited basket of goods and services (only household goods
and services)

2. The bundle of goods in the consumer basket is fixed, while that of the deflator is allowed to
vary

3. CPI includes prices of imports, while GDP deflator only considers those goods produced
within the domestic economy
 Price Indexes: PPI
• PPI measures the cost of buying a fixed basket of goods and services
representative of a firm
• Captures the cost of production for a typical firm
• Market basket includes raw materials and semi-finished goods

• PPI is constructed from prices at an earlier stage of the distribution

process than the CPI

• PPI signals changes to come in the CPI and is thus closely watched by
policymakers
Identify which people are helped and which are
hurt by unanticipated inflation?
1. A man who lent out $500 to his friend in 1960 and is still waiting
to be paid back.
2. A tenant who is charged $850 rent each year.
3. An elderly couple living off fixed retirement payments of $2000
a month
4. A man that borrowed $1,000 in 1995 and paid it back in 2006
5. A women who saved a paycheck from 1950 by putting it under
her mattress
 Unemployment

• The unemployment rate measures the fraction of the workforce that is out of work
and looking for a job or expecting a recall from a layoff

• Important indicator of well-being of an economy as being without a job suggests a reduction in

income and purchases
 Types of Unemployment

• Voluntary Unemployment
• people who are unwilling to work at the prevailing wage rate

• Frictional Unemployment – short term

• occurs when workers leave their old jobs but haven't yet found new ones.
• when students are looking for that first job or when mothers are returning to the
workforce
• when workers are fired or, in some cases, laid off due to business-specific
reasons, such as a plant closure
 Types of Unemployment

• Structural Unemployment
• when shifts occur in the economy that creates a mismatch between the skills
workers have and the skills needed by employers.

• Cyclical unemployment
• caused by the contraction phase of the business cycle

• Seasonal Unemployment
• results from regular changes in the season. Workers affected by seasonal
unemployment include sugar and rice mill workers, ice cream vendors, etc.
 The Natural Rate an Full Employment
• Two of the of the three types of unemployment are
unavoidable:
• Frictional unemployment
• Structural unemployment

• Together they make up the natural rate of unemployment

(NRU). We are at full employment if we have only the natural
rate of unemployment.

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 Interest Rates and Real Interest Rates
• Interest rate = rate of payment on a loan or other investment over and
above the principle repayment in terms of an annual percentage

• Cost of borrowing money OR benefit of lending money

• Nominal interest rate = return on an investment in current dollars

• Real interest rate = return on an investment, adjusted for inflation

• If R is the nominal rate,

R  r and
 r is the real rate, then we can define the
nominal rate as:
 Some Identities: A Simple Economy
• Assume national income equals GDP, and thus use terms income and
output interchangeably

• Begin with a simple economy: closed economy with no public sector

 output expressed as Y  C  I …(1)
• Only two things can be done with income: consume and save 
national income expressed as Y  C  S (2), where S is private savings

C
  I  Y  C
  S
• Combine (1) and (2): demand income
(3)

• Rearrange (3) s.t. I  Y  C  S (4), or investment = savings

 Some Identities: Adding G and NX
• When add the government and the foreign sector, the fundamental
identity becomes Y  C  I  G  NX (5)
• Disposable (after-tax) income, YD, is what consumers split between C
and S when have a public sector, or
YD  Y  TR  TA (6), where TR = transfer payments and TA = taxes
 YD  C  S
(7)
• If rearrange (6) and substitute (5) for Y, then
YD  TR  TA  C  I (8)
 G  NX
• Substituting (7) into (8): C  S  TR  TA  C  I  G  NX(9)
• Rearranging: S  I  (G  TR  TA)  NX (10)
 S, I, Government Budget, and Trade
• S  I  (G  TR  TA )   NX where G + TR is total
      TradeSurplus
BudgetDeficit

government expenditures and TA is government income  difference

between expenditures and income is the government budget deficit

• Excess of savings over investment (S > I) in the private sector is equal to the
government budget deficit plus the trade surplus

• Any sector that spends more than it receives in income has to borrow to pay for the
excess spending
• Private sector can dispose of savings in three ways:
1. Make loans to the government
2. Private sector can lend to foreigners
3. Private sector can lend to firms who use the funds for I