Unit 8

Created @December 9, 2023 11:39 PM

Class Economics

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Unit 8 - Level of overall economic activity

8.1 - Economic activity
Model in a closed economy with no government

Unit 8 1
 💡 Households → Resource Markets
Land, Labour, Capital, and Entrepreneurship

💡 Resource Markets → Households

Household Income (Rent, Wages, Interest, and Profit)

💡 Resource Markets → Firms

Land, Labour, Capital, and Entrepreneurship

💡 Firms → Resource Markets

Costs of Production

💡 Product Markets → Firms

Revenues

💡 Firms → Product Markets

Goods and Services

💡 Households → Product Markets

Household Expenditure

💡 Product Markets → Households

Goods and Services

This is how the circular flow of income works with no leakages and injections.

Unit 8 2
 In the circular flow of income, the income flow from firms to households is equal to
the expenditure flow from houses to firms and the opposite is true as well

The two flows are also equal to the value of the output flow (value of goods and
services)

The circular flow diagram shows that in any span of time, an

economy’s value of output produced is equal to the total income
generated through the production of that output, which is also equal
to the expenditures from the purchasing that output.

With leakages and injections

Similar to a closed circular flow of income, however, money can flow into or out of the
economy. Money flowing into the economy is injections and money flowing out is
withdrawals.

💡 Households → Financial Markets

Saving (leakage)

💡 Financial markets → Firms (businesses)

Investment (injection)

Savings are consumer income that is not spent, therefore it is considered a leakage

Investment is when firms spend money to finance the production of capital goods

Households place savings in financial markets and financial markets lend it out to
firms

💡 Households → Government
Taxes (leakage)

Unit 8 3
 💡 Government → Firms (businesses)
Government spending (injection)

Taxes are leakages because money flows out to the government instead of to the
purchasing of goods and services

Comes back as injections because governments spend money on goods/services

💡 Households → Other countries

Spending on imports (leakage)

💡 Other countries → Firms (businesses)

Spending on exports (injection)

Imports are leakages because money leaks out to other countries

Exports are the opposite because foreigners are sending money back into the flow
when they purchase domestically produced goods/services

8.2 - Measures of economic activity

Little notes
The measurement of economic activity consists of measuring an economy’s value
of output or national income, also referred to as national income accounting

National income accounting is the measurement of an economy’s

national income and their value of output. Also involves other
measures of economic performance done by specialized statistical
services in every nation.

Unit 8 4
 National output is the total output of an economy, also known as
aggregate output. This is often measured by real GDP (RGDP).

National income is the total income of an economy which includes

factor payments or sum of wages, interest, rent + profit. This is
often used interchangeably with the aggregate output value,
especially in macroeconomic models.

Gross domestic product (GDP) is the market value of all final

goods/services produced in a country over a time period (typically a
year)

Gross national income (GNI) is the total income received by

residents of a country regardless of where the factors of production
which generate the income are located
Equal to the value of all final goods/services produced by a
country’s residents’ factors of production

Knowing a country’s income and output is useful because it allows economists to:

Evaluate an economy’s performance over time

Compare income and output of the economy to the economies of other nations

Understand what policies can help the economy meet certain objectives/goals

In macroeconomics, output is always in terms of value (its quantity * price)

The measurement of economic activity

There are three ways to measure the value of national/aggregate output

Expenditure approach which sums up all the spending on the purchase of final
goods/services produced in a country over a time period (calculation of the
value of what is produced over the year: spending)

Unit 8 5
 Income approach which sums up all income earned through factors of
production that produce the goods/services in a country over a time period
(measure of the value of income generated by production: income earned)

Output approach which sums up the value of all final goods and services that
are produced over a time period

Expenditure approach
Calculation of GDP as market value of final output by summing up expenditures
made on final goods/services

“Final” refers to goods/services ready for final use

When measuring aggregate output, only purchases of final goods and services are
included

Intermediate goods are not included because if they are, then it would involve
double counting, therefore exaggerating the value of aggregate output

Total spending is separated into four components

Consumption spending (C) which includes all purchases by households on final

goods/services over a time period

Investment spending (I) which includes spending by firms on capital goods such
as buildings, equipment, and machinery, and spending on new construction
such as housing or other buildings

Government spending (G) which includes a government’s spending in a country

(national, regional, local). Includes purchases of factors of production, and also
includes government investment (also referred to as public investment), which
often involves airports, power plants, buildings, and roads.

Net exports (X - M) which is the value of all exports minus the value of all
imports

Formula for a measure of aggregate output (GDP) is C + I + G + (X - M)

Unit 8 6
 💡 Investment refers to spending by firms or a government on capital goods and
construction. In measuring aggregate output, investment in capital involves
only physical capital, not human, natural, or financial capital.

Income approach
The sum of all income earned by factors of production in a country over a period of
time

Includes wages earned by labour, rent earned from land, interest earned by
capital, and profits from entrepreneurship

When the factors are added up, we get national income

Not the same as GDP

To calculate GDP using income approach, adjustments must be made

This approach is useful in helping economists see relative income shares of factors
of production and compare specific factors to those of other countries

Output approach
Measures value of each good/service produced in the economy over a time period

Adds them up to get total value of output produced

Involves value of final goods/services to avoid double counting

Calculates value of output by economic sector (i.e agriculture, manufacturing,

transport, etc)

Value of output for each sector is added together to obtain total value of output

Allows economists to see performance of each sector and compare them to that of
other nations

GDP and GNI

Sometimes, an economy’s output is produced by factors of production which belong
to foreigners

Unit 8 7
 To deal with this, the concepts “domestic” and “national” are used to differentiate
between measures of aggregate output and income

“Domestic” in GDP means the output was produced by factors of production within
the country (domestically) regardless of who owns them

“National” in GNI (Gross National Income) refers to income of the country’s

residents, regardless of where the income comes from

Nominal and real values

Nominal value is money value

Measured in terms of prices which prevail at the time of the measurement

However, since prices change over time, we need to account for that in order to
determine how much the quantity of goods/services has changed

To get rid of the influence of changing prices on the value of output, real values are
used

Real values are measured while accounting for changes in prices over time

Total and per capita values

Per capita is a latin expression which means per person

Takes the total value and divides it by the population

For instance, GDP per capita is the GDP divided by the country’s population

Important to distinguish between total and per capita

Different populations across countries makes it that it is unfair to compare total

GDP because oftentimes, the country with a higher population has a higher
GDP. Thus, GDP per capita is used to account for differences in population
sizes

Population growth can inflate GDP, so GDP per capita can more accurately
show the changes of GDP for individuals and show the standard of living in a
country

Total values gives a summary of the overall size and performance of an economy
whereas per capita values give a summary of the standard of living in a country

Unit 8 8
 Real GDP/GNI per capita and purchasing power parity (PPP)
Since different countries have different price levels, it is important to have a way to
account for different price levels to compare purchasing power across countries

Purchasing power parities (PPP) is a special exchange rate

between currencies that make the buying power equal to that of 1
USD, making them equal to each other
Eliminates influence of price level differences when comparing
purchasing power between countries

Purchasing power parity means “buying power equivalence”

8.3 - Calculations based on national income accounting

Little notes
Calculating nominal GDP using expenditure approach:

GDP = C + I + G + (X - M)

It is not required to learn how to calculate GDP using income and output
approaches

Calculating GNI

GNI = GDP + income from abroad - income sent abroad

Calculating real GDP and real GNI using price deflators

To find real GDP, find value of quantities using the same prices of a single year AKA
the base year

Real GDP measures value of current output using constant (base year) prices

Price deflators are price indices used to convert nominal values into
real values

Unit 8 9
 Price indices are measures of average prices in one period relative
to the average prices of a base year

GDP deflator = (nominal GDP/real GDP) x 100

Real GDP = (nominal GDP/price deflator) x 100

8.4 - The business cycle

Little notes
Real output in majority of nations grows over long periods of time, but the growth is
usually uneven and irregular with output in some years growing rapidly, in some
growing slowly, and in some even falling

Business cycles consist of short-term fluctuations in growth of real

output which consists of alternating periods of expansion and
contraction

Business cycles are irregular and unpredictable

Phases of the business cycle

Expansion

Occurs when there is positive growth in real GDP

Employment of resources increase and the general price level usually also
begin to rise more rapidly

Peak

Represents the cycle’s max real GDP and is the end of the expansionary phase

When an economy reaches the peak, unemployment of resources has fallen a

lot and general price levels can be rising rapidly

Economy is likely experiencing inflation

Contraction

Unit 8 10
 After the peak, the economy begins experiencing a fall in real GDP

If the contractionary phase lasts six months (two quarters) or more, it is called a
recession

Falling real GDP and a growing unemployment of resources

Increases in price levels could slow down substantially and it is possible for
prices in some sectors to fall

Trough

The cycle’s minimum level of GDP

The end of the contractionary phase

May be widespread unemployment

Followed by a new period of expansion (known as a recovery), indicating the

start of a new cycle

The long-term growth trend is the average growth over long periods of time

Shows how output over time grows when the fluctuations are ironed out

Unit 8 11
 Output represented by this trend is the potential output

Potential output is the level of output produced when there is full

employment
- When unemployment equals the natural rate of unemployment

Full employment in the production possibilities model means when

the max amount of resources in an economy are being used to
produce the max quantity of goods/services, implying no
unemployment
In the AD- AS model however, it is the natural rate of unemployment
or the unemployment when the economy is producing potential
output

When economies produce at full employment, unemployment still exists, it’s just
that the economy is at the natural rate of unemployment

There will always be at any time people who are in between jobs or out of work
due to various factors

Thus a certain degree of unemployment can be considered “natural”

💡 When actual GDP is above or below potential GDP, there is a GDP/output

gap
Output gap is the actual GDP - potential GDP

Why study the business cycle

To find ways to reduce the intensity of expansions and contractions

Increase steepness of the long-term growth trend

8.5 - National income stats and alternative measures

Little notes

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 National income stats such as GDP and GNI do not accurately measure the true
value of output

Do not include non-marketed output

Output of some goods/services are not sold in the market and do not
generate income

Includes stuff like repairing one’s home

In developing countries, output often never reaches the market and are
instead used for a household’s own consumption

Does not include output sold in underground (parallel) markets

When transactions are unrecorded, they are not included in GDP/GNI

Does not account for improvements in quality of goods/services

Does not account for the value of negative externalities

Different domestic price levels can affect the perception of GDP

Can be health with when converting values into a single common currency
using purchasing power parities

Does not accurately measure economic well-being

Does not distinguish between good or bad consumption of output

Does not matter if they are demerit or merit goods, they are included in
GDP/GNI all the same

Does not reflect achievements in levels of education, health, and life

expectancy

Improvements in these are not necessarily included in GDP/GNI

Does not provide info on wealth inequalities

Does not incorporate leisure

Does not consider the time citizens have to enjoy themselves/time off work

Does not account for quality of life factors

Ex. crime rate, peace, stress levels, insecurities/uncertainties, political

freedom

Unit 8 13
 Some examples of alternatives measures of well-being include:

OECD Better Life Index

Happiness Index

Happy Planet Index

Green GDP

Unit 8 14