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3.1 Measuring National Income The Circular Flow of Income Macroeconomics is defined as the study of the overall aspects and workings of a national economy. As such, national income is a very important concept to consider in macroeconomics. National income refers to the amount of money that the nation earns through investment, etc. Thus, economists would have to know how to measure national income, and the basis of this knowledge is the circular flow of income, which is shown in Figure 1. Product Market $ $ G/S G/S Households Firms LLC* LLC $ $ Factor Market *LLC=Land, labor, capital This circular diagram shows how the economy works with the households spending money on goods, which goes to the product market, which then goes to the firms. The firms spend this money for more factors of production in the factors market, which then gives money to the households as wages, which is used again to buy products, starting the cycle again. A similar cycle occurs with households acting as labor as a part of the factor market, who are used by the firms to create goods and services. These goods and services go to the product market and are bought by the households. Measurement Methods Now that we know what the national income and the circular flow of income are, the methods of measuring the national income are the next step. There are three different methods: output method, expenditure method, and output method, described below. The Output Method- total amount of final goods and services produced in a year GDP at market price= Output value –intermediate consumption For example, a car’s parts may have come from different parts of the world and bought at a different price. To avoid double-counting, only the value of the final product, the car, is counted. The metal for the design of the car cost $100, the Hemi engine cost $50, and other parts were $200. The final product of the car is priced at $450. The GDP would be $450-$350=$100. The Expenditure Method-total domestic spending by consumers, firms, govt, and foreigners GDP=Consumption + Investment + Government Spending + Net exports The equation is self-explanatory. Just add each component of GDP to get GDP. (Net exports=exports-imports) The Income Method: total incomes earned by factors of production involved in the production of goods/services in a year Natl income = wages + nominal company profit +income of self employee +Net Factor Income from abroad Just add each part to arrive to national income. Vocabulary Time! 1. Gross vs net- Net is the number after costs are deducted while gross is the “raw” number without the cost deductions. (ie gross profit and net profit) 2. National vs domestic-Domestic implies the masses as separate individuals while national implies the nation as a whole, as one (ie American people and the USA/ GDP and GNP) 3. nominal vs real- nominal DOES NOT include inflation while real DOES (ie real and nominal interest rates) 4. total vs per capita- total is the sum; per capita is per person (ie total output and resources per capita) 3.2 Introduction to Development Economic growth is the increase in output of goods and services within an economy. In general, economists use GDP as a measurement of the economy. The increase in percent of real GDP is the measure of economic growth. The “real” before GDP means the GDP has been adjusted for inflation and is thus a more accurate measurement (so that Price Levels do not affect the measurement of economic growth). Economic development is the increase in wealth or welfare of the people of the economy. Generally it involves creating sustainable jobs and incomes as well as (for less developed countries) creating a substantial tax base. While this may appear similar to economic growth, the two have a large distinction. Economic growth is the size of the economy overall. If one person makes more money or produces more, the economy grows. Economic development is per capita, meaning one person will not affect the economic development measurement that much. If one person makes all the money in the economy, economic growth will remain high, but economic development will be very low. Essentially: Economic Growth = Economic Development Number of People GDP is the market value of all final goods and services produced within a country in a given period of time. This means: 1) Goods are measured by the amount people are willing to pay. If one good costs twice as much as another, its production contributes twice as much. This is why it’s “market value” 2) “Final goods and services” means just that: the last good. If Bob makes lumber into wooden 2X4s that are sold at Home Depot, and then Sue buys those 2X4s and uses them to build a house and sells the house on the market, the only thing that counts in the GDP is the sale of the house since it is the final product of the goods. It can also go for services. 3) “Produced within a country” means that the goods have to be made currently. Resale of Sue’s house will not count in the GDP because nothing was produced. If Bob moves out of the country and chops some lumber and sells it to another person in the other country, that sale does not count towards the GDP because it was not done within the country. 4) The GDP is only measured “in a given time period” usually means “this year” or “this quarter (three months)” The difference between GDP and GNP is simple. Gross National Product is the market value of all final goods and services produced within a country plus the value of all final goods and services earned by nationals in other countries minus the value of all final goods and services earned by foreigners in the country in a given time period. In this case, Bob’s sale of wood in the other country counts towards his countries GNP but not his countries GDP. If another person entered the country and sold something to Sue, the sale would count towards her countries GDP but not GNP. Essentially: GDP + Citizen Sales Abroad – Foreign Sales Domestically = GNP GDP Foreign Sales Within Borders GNP Domestic Sales Citizen Sales Abroad GDP itself is not always a good measure in comparing welfare between countries for the same reason that economic growth is different from economic development. All the GDP of Country A could be found in one person, but the GDP could be as high as Country B who has its GDP spread out over a large number of people. Country A has a lower quality of life, and less welfare overall, but the same outputs as Country B. This means GDP per capita is a much better measurement to compare the welfare of two countries. But this still has a few flaws. For example, GDP does not measure the quality of life exactly. Just because output is high does not mean people are living well. GDP per capita does not take into account the quality of the environment, the amount of leisure time people have within the country, the non-market activities (for example: if Sue asks Bob to mow her lawn and pays him $20, that money is not a part of the GDP, nor is any black market trade.) Just GDP does not (as stated) measure a distribution of income. GDP also does not measure the quality of the goods, externalities, what exactly is being produced, and sustainability. Overall though, a country with more GDP can afford to increase the welfare of the society, so it is a decent measure. The purchasing power allowance for GDP is important because not all currencies of less developed countries do well. Essentially it measures the amount that the consumers can buy within two countries and compares them. If the purchasing power of one economy is higher than another, it is less developed. This cuts out the exchange rates that make some economies appear weaker than they are. Alternatives include: 1) HDI (Human Development Index) which is GDP with life expectance and education factored in. 2) GNP 3) GDP per capita 4) PCRI (Per Capita Real Income) 5) Anything that factors in current capital and environmental wealth that is not measured by GDP. The problem with measuring economic development is the number of things hat go into the measurement. GDP does not take into account the distribution of wealth, does not take into account the environment, negative externalities, changes in population over time, and illegal markets. But trying to take these into account is extremely difficult. HDI attempts to input education and life expectancy, but creating a number for these in order to use with GDP and then compare with other countries is difficult and often times crude in its construction. The actual government is almost always excluded. Throughout history, the welfare of a communist government has been less than a free market government, but the actual government and its laws and effects are not inputted into development and measuring any real comparison between two countries. MINI-IA http://www.reuters.com/article/domesticNews/idUSTRE5212TH20090302 This article speaks of the effects of the global economic crisis on the US. From a macroeconomic standpoint, the US has increased its national income for January due to certain measures taken to stimulate the US economy. Oddly enough, this boost of income corresponded to the increase of consumer spending despite the recession. Nevertheless, this increase of national income is predicted to be temporary as the crisis worsens. According to the expenditure method of measuring national income, the gross domestic product (GDP) of the USA would have increased in January due to the increase of consumption. As consumption increases, GDP increases due to the fact that consumption is a component of GDP, the value of all final goods and services produced in a specific country. Using the other methods of output and income would not have worked in this situation, since these methods do not take into account consumer consumption in its coinciding equation. Generally, an increase of GDP means an improvement of the standard of living Some limitations of using GDP to measure the standard of living is that it does not take into account an equal distribution of wealth, leisure time, quality of the environment, and non-market activity. Thus, it is a bit skewed in its calculations. Nevertheless, the relationship between GDP and the standard of living is existent to some extent, for a large GDP enables a country to provide better schools, health care, etc.