Download 3.1 Measuring National Income The Circular Flow of Income

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.