2.1. The level of overall economic activity

Economic Activity Macroeconomics is the study of the economy as a whole. Its goal is to explain the economic changes that affect many households, firms, and markets at once.

The circular flow of income model National income, output, and expenditure are generated by the activities of the two most vital parts of an economy, its households and firms, as they engage in mutually beneficial exchange.

HouseholdsThe primary economic function of households is to supply domestic firms with needed factors of production - land, human capital, real capital and enterprise. The factors are supplied by factor owners in return for a reward:

Land is supplied by landowners,  Human capital by labour,  Real capital by capital owners (capitalists) and Enterprise is provided by entrepreneurs.

Entrepreneurs combine the other three factors, and bear the risks associated with production.

FirmsThe function of firms is to supply private goods and services to domestic households and firms, and to households and firms abroad. To do this they use factors and pay for their services.  

Factor incomesFactors of production earn an income, which contributes to national income. Land receives rent, human capital receives a wage, real capital receives a rate of return, and enterprise receives a profit.

Members of households pay for goods and services they consume with the income they receive from selling their factor in the relevant market.

Production functionThe simple production function states that output (Q) is a function (f) of:  (is determined by) the factor inputs, land (L), labour (La), and capital (K), i.e.Q = f (L, La, K)

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The Circular flow of incomeIncome (Y) in an economy flows from one part to another whenever a transaction takes place. New spending (C) generates new income (Y), which generates further new spending (C), and further new income (Y), and so on. Spending and income continue to circulate around the macro economy in what is referred to as the circular flow of income.

In another respect, for an economy as a whole, income must equal expenditure because:

Every transaction has a buyer and a seller. Every dollar of spending by some buyer is a dollar of income for some

seller.

The equality of income and expenditure can be illustrated with the circular-flow diagram.

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Injections and withdrawals

The circular flow will adjust following new injections into it or new withdrawals from it. An injection of new spending will increase the flow. A net injection relates to the overall effect of injections in relation to withdrawals following a change in an economic variable.  

Savings and investment

The simple circular flow is, therefore, adjusted to take into account withdrawals and injections. Households may choose to save (S) some of their income (Y) rather than spend it (C), and this reduces the circular flow of income. Marginal decisions to save reduce the flow of income in the economy because saving is a withdrawal out of the circular flow. However, firms also purchase capital goods, such as machinery, from other firms, and this spending is an injection into the circular flow. This process, called investment (I), occurs because existing machinery wears out and because firms may wish to increase their capacity to produce.

The public sector

In a mixed economy with a government, the simple model must be adjusted to include the public sector. Therefore, as well as save, households are also likely to pay taxes (T) to the government (G), and further income is withdrawn out of the circular flow of income.

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Government injects income back into the economy by spending (G) on public and merit goods like defence and policing, education, and healthcare, and also on support for the poor and those unable to work.

Including international trade

Finally, the model must be adjusted to include international trade. Countries that trade are called ‘open’ economies, the households of an open economy will spend some of their income on goods from abroad, called imports (M), and this is withdrawn from the circular flow.

Foreign consumers and firms will, however, also wish to buy domestic products, called exports (X), and this is an injection into the circular flow.

Source: http://www.economicsonline.co.uk/Managing_the_economy/The_circular_flow_of_income.html

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Summary of Injections & Leakages

Leakages (withdrawals) from the circular flowNot all income will flow from households to businesses directly. The circular flow shows that some part of household income will be:

1.Put aside for future spending, i.e. savings (S) in banks accounts and other types of deposit

2.Paid to the government in taxation (T) e.g. income tax and national insurance

3.Spent on foreign-made goods and services, i.e. imports (M) which flow into the economy

Withdrawals are increases in savings, taxes or imports so reducing the circular flow of income and leading to a multiplied contraction of production (output)

Injections into the circular flow are additions to investment, government spending or exports so boosting the circular flow of income leading to a multiplied expansion of output.

1. Capital spending by firms, i.e. investment expenditure (I) e.g. on new technology

2. The government, i.e. government expenditure (G) e.g. on the NHS or defense

3. Overseas consumers buying UK goods and service, i.e. UK export expenditure (X)

4.An economy is in equilibrium when the rate of injections = the rate of withdrawals from the circular flow.

Source: http://www.tutor2u.net/economics/reference/circular-flow-of-income-and-spending

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Measures of Economic activity

Gross Domestic Product (GDP)

Gross domestic product (GDP) is a measure of the income and expenditures of an economy.

‘It is the total market value of all final goods and services produced within a country in a given period of time’.

“GDP is the Market Value . . .” Output is valued at market prices.

“. . . Of All Final . . .” It records only the value of final goods, not intermediate goods (the value is

counted only once).

“. . . Goods and Services . . “ It includes both tangible goods (food, clothing, cars) and intangible services

(haircuts, housecleaning, doctor visits).

“. . . Produced . . .” It includes goods and services currently produced, not transactions

involving goods produced in the past.

“ . . . Within a Country . . .” It measures the value of production within the geographic confines of a

country.

“. . . In a Given Period of Time.” It measures the value of production that takes place within a specific

interval of time, usually a year or a quarter (three months).

Legal vs illegalGDP includes all items produced in the economy and sold legally in markets. GDP excludes most items that are produced and consumed at home and that never enter the marketplace. It excludes items produced and sold illicitly, such as illegal drugs.

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Gross National Product (GNP)

GNP and GDP both reflect the national output and income of an economy. The main difference is that GNP (Gross National Product) takes into account net income receipts from abroad.

GDP (Gross Domestic Product) is a measure of national income / national output and national expenditure produce in a particular country.

GNP = GDP + Net property income from abroad. This net income from abroad includes, dividends, interest and profit.GNP includes the value of all goods and services produced by nationals whether in the country or not.

Example of GNPIf a Japanese multinational produces cars in the UK; this production will be counted towards UK GDP. However, if the Japanese firm sends £50m in profits back to shareholders in Japan. Then this outflow of profit is subtracted from GNP. UK nationals don’t benefit from this profit.

If a UK firms makes profit from insurance companies located abroad, then if this profit is sent back to UK nationals, then this net income from oversees assets will be added to GNP.

Note if a Japanese firm invests in the UK, it will still lead to higher GNP, as some national workers will see higher wages. However, the increase in GNP will not be as great as GDP.

If a county has similar inflows and outflows of income from assets, then GNP and GDP will be very similar.

However, if a country has many multinationals that repatriate income from local production, then GNP will be lower than GDP.

For example, Luxembourg has a GDP of $87,400 but a GNP of only $45,360.

A country like Ireland has received significant foreign investment. Therefore for Ireland, there is a net outflow of income from the profits of these multinationals. Therefore, Irish GNP is lower than GDP.

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Gross National Income (GNI)GNI (Gross national Income) is based on a similar principle to GNP. The World Bank define GNI as‘The sum of value added by all resident producers plus any product taxes (minus subsidies) not included in the valuation of output plus net receipts of primary income (compensation of employees and property income) from abroad’

The World Bank now uses GNI rather than GNP.UK GNI

This shows a small net income from abroad so the GNI  £715,028m is greater than GDP (£713,980)

Source: http://www.economicshelp.org/blog/3491/economics/difference-between-gnp-gdp-and-gni/

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Nominal and real GDP/GNP/GNI

Taking GDP as an exemplar

• Nominal GDP values the production of goods and services at current prices.• Real GDP values the production of goods and services at constant prices.

An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator.

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GDP Deflator

The GDP deflator is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. It tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced.

Formula

G D P defla to r = N o m in a l G D PR ea l G D P

1 0 0

Distinguish between total GDP/GNP/GNI and per capita GDP/GNP/GNI

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Per capita GDP is a measure of the total output of a country that takes the gross domestic product (GDP) and divides it by the number of people in the country. The per capita GDP is especially useful when comparing one country to another because it shows the relative performance of the countries. A rise in per capita GDP signals growth in the economy and tends to translate as an increase in productivity.

The gross domestic product (GDP) is one of the primary indicators of a country's economic performance. It is calculated by either adding up everyone's income during the period or by adding the value of all final goods and services produced in the country during the year. Per capita GDP is sometimes used as an indicator of standard of living as well, with higher per capita GDP being interpreted as having a higher standard of living.

Source: http://www.investopedia.com/terms/p/per-capita-gdp.asp

Relevant Statistics

GDP per capita (current prices US$) - http://data.worldbank.org/indicator/NY.GDP.PCAP.CD

GDP per capita (constant 2005 prices) - http://data.worldbank.org/indicator/NY.GDP.PCAP.KD

GNI per capita (constant 2005 prices) - http://data.worldbank.org/indicator/NY.GNP.PCAP.KD

Methods of measuring output

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Some government statistics agencies use the Income Approach by collecting data from sources (including tax agency) on the incomes that firms pay households for the services of factors of production they hire – wages for labour, interest for the use of capital, rent for the use of land and profit for entrepreneurship – and summing those incomes. This approach is like attaching a meter to the circular flow of income diagram on all the flows of factor incomes from firms to households and measuring the magnitude of those flows.

The National Income Account divide incomes into five categories:

Compensation of employees Net interest Rental income of persons Corporate profits Proprietors’ income

Explanation of income categories

1. Compensation of employees – is the payment for labour services. It includes net wages and salaries plus fringe benefits paid by employers such as health care, insurance, social security payments and pension fund contributions

2. Net Interest – is the interest households receive on loans they make minus the interest housholds pay on their borrowing.

3. Rental income of persons – is the payment for the use of land and other rented inputs. It includes payments for rented housing and imputed rent for owner-occupied housing (Imputed rent is an estimate of what homeowners would pay to rent the housing they own and use themselves)

4. Corporate profits – is a combination of interest on capital and profits for entreprenurship

5. Proprietors’ Income – people who run their own business. Their income is a mixture of the previous four items.

GDP: The Income Approach

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The sum of all incomes equals net domestic product at factor cost. GDP equals net domestic product at factor cost plus indirect taxes less subsidies plus capital consumption (depreciation).

US GDP 2000 Income ApproachItem Amount in billions

of dollarsPercentage of GDP

Compensation of employees

5639

Net Interest 564Rental income 140Corporate profits 957Proprietors’ income 711Net domestic product at factor cost

8011

Indirect taxes less subsidies

698

Capital Consumption 1257GDP 9966 100.0

From Factor Cost to Market Price

The expenditure approach values goods and services at market process and the income approach values them at factor cost – the cost of the factors of production used to produce them. Indirect taxes and subsidies make these two values differ. Sales taxes make market price exceed factor cost, and subsidies make factor cost exceed market prices. To convert the value at factor cost to the value at market prices, we must add indirect taxes and subtract subsidies.

From Gross to Net

The expenditure approach measures gross product and the income approach measures net product. The difference is deprecation, the decrease in the value of capital that results from its use and from obsolescence – also called capital consumption.

Expenditure includes investment which is the purchase of new capital. Because some new capital is purchased to replace depreciated capital, the expenditure approach gives a gross measure. So to get gross domestic product from the income approach we must add depreciation to total income.Green GDP

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The Green Gross Domestic Product is an economic growth index that quantifies and calculates the environmental consequences of that growth.

What is it?China's the only major nation that's used Green Gross Domestic Product to measure its economic viability. Chinese premier Wen Jiabao announced in 2004 that the Green GDP would replace the traditional GDP as a financial productivity measure. Published back in 2006, the Chinese Green GDP showed that the financial loss caused by pollution in China was 511.8 billion yuan ($66.3 billion), which was 3.05 percent of the nation's economy.

What does it measure?Green GDP monetizes the effects of the loss of biodiversity and the costs of climate change.

How do they get there?Like other alternative indicators, such as the Sustainable Development Index or the Genuine Progress Indicator, the Green GDP quantifies the costs of pollution, climate change, waste and other factors likely to cause costly damages in the future.

What can it tell us (really)?This is just another way to try to quantify and measure the monetary impact of the environmental damage caused by a country's economic growth. The idea is that, while the economy might look like it's growing now, the damages caused by that growth will inevitably drag it downward in the future. The preciseness of the Green GDP's measurement methods is debatable; after all, since the future costs are not actually known, those calculations are based on speculation - well-informed speculation, but still. What it really gives us is another way of looking at economic growth, putting it in perspective alongside its potential future economic consequences.

But nobody's perfectNow that you've read all this, we'll let you know that no one uses Green GDP as an economic indicator anymore. Chinese officials put a stop to that back in 2007, after it was found that the Green GDP caused their economic growth rate to drop to unattractively low levels, nearly zero in some provinces. The government thereby withdrew its support for the index and went back to the old school Gross Domestic Product.Source: http://www.marketplace.org/topics/business/economy-40/alternative-indicator-green-gdp

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The Business Cycle

Parkin and Bade's textEconomics gives the following definition of the business cycle: 

"The business cycle is the periodic but irregular up-and-down movements in economic activity, measured by fluctuations in real GDP and other macroeconomic variables."

To put it simply, the business cycle is defined as the real fluctuations in economic activity and gross domestic product (GDP) over a period of time.

The fact that the economy experiences these ups-and-downs in activity should be no surprise. In fact, all modern industrial economies like that of the United States endure considerable swings in economic activity over time.

The ups may be marked by indicators like high growth and low unemployment while the downs are generally defined by low or stagnant growth and high unemployment. Given its relationship to the phases of the business cycle, unemployment is but one of the various economic indicators used to measure economic activity. For most detailed information about how various economic indicators and their relationship to the business cycle, check out A Beginner's Guide to Economic Indicators.

Parkin and Bade go on to explain that despite the name, the business cycle is not a regular, predictable, or repeating cycle. Though its phases can be defined, its timing is random and, to a large degree, unpredictable.

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The Phases of the Business CycleWhile no two business cycles are exactly the same, they can be identified as a sequence of four phases that were classified and studied in their most modern sense by American economists Arthur Burns and Wesley Mitchell in their text Measuring Business Cycles. 

The four primary phases of the business cycle include:1. Expansion: A speedup in the pace of economic activity defined by high

growth, low unemployment, and increasing prices. The period marked from trough to peak.

2. Peak: The upper turning point of a business cycle and the point at which expansion turns into contraction.

3. Contraction: A slowdown in the pace of economic activity defined by low or stagnant growth, high unemployment, and declining prices. It is the period from peak to trough.

4. Trough: The lowest turning point of a business cycle in which a contraction turns into an expansion. This turning point is also called Recovery. 

These four phases also make up what is known as the "boom-and-bust" cycles, which are characterized as business cycles in which the periods of expansion are swift and the subsequent contraction is steep and severe.

Source: http://economics.about.com/cs/studentresources/f/business_cycle.htmShort term fluctuations and long term trend – phases of the cycle

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There should be no difficulties for you in finding your way through figure 3.3.12. The long run trend (potential real GDP) is upward sloping and in keeping with empirical evidence, which suggests a long run trend of around 1.5 to 3.5% yearly growth. (Yet note that the cycles are highly stylized.) The cycle is discernible as reoccurring expansions and contractions. Economic activity – measured by real GDP – at its lowest point is called a ‘ trough’, followed by ‘ recovery’, ‘ boom’ and ‘ peak’. When economic activity slows and then falls over a period of time, one speaks of ‘recession’. When the bottom of the cycle is reached once more a cycle has been completed – which is also measured as the time periods from peak to peak.

The cycle in figure 3.3.12 also shows the difference between potential and actual output in the output gaps. The output gap is defined as actual real GDP minus potential GDP, and one therefore speaks of negative output gaps when de facto real GDP is lower than potential and positive output gaps when real GDP is higher than long run potential. Over the cycle, the components of aggregate demand and variables within the main macro objectives will be affected in many ways.

Decrease in GDP growth (slowdown) and decrease in GDP

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One common mistake seen in many an exam paper is when students fail to distinguish clearly between a decrease in GDP (e.g. negative growth) and a decrease in the rate of growth. In figure 3.3.12, the period just before the “peak” is characterized by a slower rate of growth – the slope of the business cycle curve falls. The period from t1 to t2 shows a slower rate of growth while t2 to t3 shows a decrease in growth.

During the period 2006 to 2007, the US growth rate (in GDP terms) fell from 2.7% to 1.9% - a fall in the rate of growth. During the economic crisis of 2008 and 2009, US growth went from 0% in 2008 to a low of-3.5% in 2009 – e.g. the US economy contracted by 3.5% during 2009. Thus in the latter period, the US economy experienced an absolute fall in GDP; this is because the economy experienced negative GDP growth i.e. a contraction.

US real GDP by quarter 2000 – 2009

Measuring changes in real GDP: Yearly % change

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Questions

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1: Classify each of the following items as a final good or service or an intermediate good or

service:

(a) Banking services bought by a student.

(b) New cars bought by Hertz, the car rental firm.

(c) Newsprint bought by USA Today from International Paper.

(d) Ice cream bought by a diner and used to produce sundaes.

2: GDP does not include the value of used goods that are resold. Why would including such

transactions make GDP a less informative measure of economic well-being?

3: Below are some data from the land of milk and honey

Year Price of Milk Quantity Price of Honey Quantity

2013 €1 100 €2 50

2014 €1 200 €2 100

2015 €2 200 €4 100

(a) Compute nominal GDP, Real GDP and the GDP deflator for each year using 2013 as the base

year

(b) Compute the percentage change in nominal GDP, Real GDP and the GDP deflator in 2014 &

2015

(c) Did economic well-being rise more in 2014 or 2015?

4: An island economy produces only bananas and coconuts. Table 1 gives the quantities produced and prices in 2014 and 2015. The base year is 2001.

2014 2015

Item Quantity Price Item Quantity Price

Bananas 100 $10 a bunch Bananas 110 $15 a bunch

Coconuts 50 $12 a bag Coconuts 60 $10 a bag

Calculate:

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(a) Nominal GDP in 2014(b) Nominal GDP in 2015(c) The value of 2015 production in 2014 prices(d) Percentage increase in production when valued at 2014 prices(e) The value of 2014 production in 2015 prices(f) Percentage increase in production when valued at 2015 prices(g) Real GDP in 2014 and 2015.(h) The GDP deflator in 2015.

5: Consider the following data on US GDP

Year Nominal GDP GDP Deflator

1996 7,662 billion 110

1997 8,111 billion 112

(a) What was the growth rate of nominal GDP between 1996 & 1997?

(b) What was the growth rate of the GDP deflator between 1996 and 1997?

(c) What was real GDP in 1996 measured in 1992 prices?

(d) What was real GDP in 1997 measured in 1992 prices?

(e) What was the growth rate of real GDP between 1996 & 1997?

(f) Was the growth rate of nominal GDP higher or lower than the growth rate of real GDP?

Explain

6: Table 1 gives some of the items in the US National Income and Product Accounts in 1998.

Item Amount (trillions of dollars)Compensation of employees 5.0Consumption expenditure 5.9Indirect taxes less subsidies 0.7Net interest 0.5Corporate profits 0.8Capital Consumption 1.1Rental income 0.1Investment 1.6Net exports -0.2Proprietors’ income 0.6

(a) Calculate US GDP in 1998(b) Did you use the expenditure approach or the income approach to make this calculation?(c) How much did the US government spend on goods and services in 1998?(d) By how much did capital in the United States depreciate in 1998?

7: Table 1 shows real GDP in Canada from the first quarter of 1989 to the fourth quarter of 1993.

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Billions of 1996 DollarsYear Quarter

1 2 3 41989 700 703 705 7061990 711 709 705 6981991 689 691 694 6961992 696 697 699 7021993 708 712 716 722

(a) In which quarter was Canada at a business-cycle peak?(b) In which quarter was Canada at a business-cycle trough?(c) Did Canada experience a recession during these years?(d) In what period did Canada experience an expansion?

8: Table 2 shows real GDP in Mexico from the first quarter of 1994 to the last quarter of 1996.

Trillions of 1993 PesosYear Quarter

1 2 3 41994 1.25 1.19 1.29 1.271995 1.21 1.16 1.28 1.271996 1.27 1.29 1.25 1.27

(a) In which quarter was Mexico at a business-cycle peak?(b) In which quarter was Mexico at a business-cycle trough?(c) Did Mexico experience a recession during these years?(d) In what years did Mexico experience an expansion?

8: Taking the information in the tables below:

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(a) Calculate the % change in real GDP for both Canada and Mexico. Highlight quarters of

negative economic growth (b) Using a spread-sheet application graph real GDP versus time

Business Cycle – Calculations of economic growth rates

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Canadian economic growth (billions CS$)Year Real GDP % change1989 1 700 ----1989 2 7031989 3 7051989 4 7061990 1 7111990 2 7091990 3 7051990 4 6981991 1 6891991 2 6911991 3 6941991 4 6961992 1 6961992 2 6971992 3 6991992 4 7021993 1 7081993 2 7121993 3 7161994 4 722

Mexican economic growth (trillions Pesos)Year Real GDP % change1994 1 1.25 ----1994 2 1.191994 3 1.291994 4 1.271995 1 1.211995 2 1.161995 3 1.281995 4 1.271996 1 1.271996 2 1.291996 3 1.251996 4 1.27

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