Income

Households Firms
Consumption

Saving Taxes Taxes

Investment
Government
Transfer Govt.
payments spending

Foreign Trade
Imports Exports

The Circular Flow of Income and Spending

Thursday, December 1, 1
2022
According to the circular flow
diagram of income and spending,
all final goods produced in the
Kenyan or [American] economy
are purchased either by the three
domestic sectors - households,
businesses, and government - or
by foreign consumers.

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2022
 SECTORS OF THE ECONOMY
(i) Consumer or Household Sector (C)
The role of the sector include the supply
of labour services to other factors of
production and also the payment of taxes
to the government for the provision of
services. The excess income (Disposable)
is spent on consumer goods. It is a basic
decision making unit in the economy.

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2022
(ii ) Business Sector (I)
Includes all production units
and aims at profit
maximization. The role of the
business sector include the
provision of goods and
services and payment of taxes
to the government.
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2022
(iii) Government Sector (G)
In economics, government is treated as an economic
agent and its role include taxation and transfer
payments otherwise known as its distribution
function. Provision of goods and services especially
those that cannot be provided by the private sector
such as national defence, schools, police,
infrastructure which is known as an allocation
function.
The government tries to influence the level of
economic activities by making use of fiscal and
monetary policies as a stabilization function. In this
function government stabilizes prices, exchange
rates and employment
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2022
(iv) External or Foreign Sector, (X - M)
Rather than treat Kenyan exports and
imports separately, our national income
accountants take the difference between
the two. Thus, net exports of goods and
services or, more simply, net exports, is the
amount by which foreign spending on
Kenyan goods and services exceeds Kenyan
spending on foreign goods and services.

C + Ig + G + Xn = GNP

Thursday, December 1, 6
2022
These four categories of expenditures -
personal consumption expenditures (C),
gross private domestic investment (Ig),
government purchases (G) and net
exports (Xn) - are comprehensive. They
include all possible types of spending.
Added together, they measure the market
value of the year’s output or, in other
words, the GDP

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2022
MEASURING THE PRICE LEVEL
It is significant for two reasons:
1. It is meaningful to know how
much the price level has changed, if
at all, from one period too another.
That is we must be aware of whether
and to what extent inflation (a rising
price level) or deflation (a falling
price level) has occurred.
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2022
2. Because GDP is the market value, or
total money value, of all final goods
and services produced in a year, money
values are used as the common
measure when summing a
heterogeneous output into a
meaningful total. The value of different
years output (GDPs) can be
meaningful compared only if the value
of money itself does not change.

Thursday, December 1, 9
2022
Price Indexes
The price level is stated as an index
number. A price index measures the
combined price of a particular collection
of goods and services, called a “market
basket” in a given period relative to the
combined price of an identical or similar
group of goods and services in a
reference period. The point of reference
or bench-mark is called the ‘base-year’
more formally.
Thursday, December 1, 10
2022
Price index = price of market basket in a given year x 100
in a given year price of the same market basket in the base year
Different Types of Price Indices
1. Consumer price index (CPI) - It measures the
index of those living in urban areas. It is talking
about what the urban dwellers consume in a year or
month. The economists go to different households
and ask people, for instance, how much maize, milk,
etc is consumed by a family in a month, or week and
collect this information. This information is used to
find the average price of consumer index.

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2022
2. Retail price index (RPI) - It is using the retail
prices as a basis to determine the market basket,
e.g cost of milk, bread at retail prices.
3. Whole price index (WPI) - It deals with things
being sold at wholesale prices. It is concerned
with a small portion of the earning.
4. Producer price index (PPI) - This is a price for
producers. It measures the prices of thousands of
commodities at the point of their first commercial
sale.
5. GDP price index - to calculate the changes in
GDP, GDP price index is used if you are to inflate
or deflate the GDP price index
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2022
6. Export price index provides a measure of price
changes for all products sold by a country to
foreign buyers.
7. Import price index measures price changes of
commodities purchased from other countries.
The GDP price index for the GDP deflator is more
useful than the CPI for measuring the overall price
level. The GDP deflator is broader than the CPI in
that the GDP deflator includes not only the prices
of consumer goods and services but also the prices
of investment goods, goods and services purchased
by government and goods and services which enter
into the world trade.

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2022
For this reason, the GDP deflator is the price
index associated with adjusting money or
nominal GDP for price changes. Nominal GDP
is output valued in terms of the prices existing at
the time the output is produced.
GDP price index compares the price of each
year’s output to the price of that same output in
the base year or reference year. The base year is
taken to be 100 in our calculations for
convenience. An increase in the GDP price
index from one year to the next constitutes
inflation. A decrease in the price index constitutes
deflation
Thursday, December 1, 14
2022
NOMINAL AND RETAIL GDP
National income accountants deflate GDP for
rising prices and inflate it when prices are
falling. These adjustments give us a picture of
GDP for various years as if prices and the
value of the dollar were constant. A GDP
figure which reflects current prices, that is,
which is not adjusted for changes in the price
level, is alternatively called unadjusted,
current dollar, money or nominal GDP.

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2022
The simplest and most direct method of
deflating or inflating a year’s nominal
GDP is to express that year’s index
number in decimal form and divide it
into the nominal GDP. In equation form:
Nominal GDP = real GDP
price index (in hundredths)

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2022
 Item Year Year
1990 1994
Nominal GDP$600m $880m
Price index (base year 1975 = 100) 120 140
Population 10m 10.5m

Real GDP for 1990 = Nominal GDP 1990 X Base year

1990 GDP Deflator
= $ 600m X 100 = $500m
120
Real GDP for 1994 = $880m X 100 = $607.14
140
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2022
GDP’S SOCIAL WELFARE
GDP is a reasonably accurate and extremely useful
measure of domestic economic performance. It is
not and was never intended to be an index of social
welfare. The following are some reasons why it
might understate or overstate real output and why
more output will not necessarily make society
better off.
1) None market transactions
2) Leisure
3) Improved product quality
4) Composition and distribution of output
5) Per capita output
6) Environment
Thursday, December 1, 18
2022