LECTURE 1 OVERVIEW OF NATIONAL INCOME

Lecture Outline
1.1. Introduction
1.2. Objectives
1.3. Defining Economics
1.4. National Income Accounting
1.5. Measuring the cost of living
1.6. Summary
1.7. Exercise
1.8. Further Reading
1.1 Introduction
Welcome to lecture 1. This lecture aims at assisting you in recalling some important concepts
learnt in National Income Accounting covered in CEC 101. It will be important for you to read
through it carefully as this will form the basis for our discussions in the subsequent lectures.

In this lecture we shall begin by defining economics and more specifically macro economics.
We shall then consider the circular flow of income for a two sector economy and how Gross
Domestic Product (GDP) is measured. Finally, we shall look at weaknesses of GDP as a
measure of standards of living.

1.2 Objectives

At the end of this lecture you should be able to:

a) Define Economics
b) Explain how macro economics is summarized in three models
c) Identify macro economic data
d) Describe the circular flow of income
e) Distinguish between GDP deflator and CPI

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1.3.0 Defining Economics
Economics is the study of how human beings coordinate their wants and desires, given the
institutional structures of the society. By “institutional structures” we mean decision-making
mechanisms, social customs, and political realities of that society.
An economic system is the system by which the economy is organized. An economy is the
institutional structure through which individuals in a society coordinate their diverse wants and
desires. Economics can also be viewed as the social science concerned with the problem of
using scarce resources to attain the maximum fulfillment of society’s unlimited wants.

Recall that, economics is divided into two: Microeconomics and Macroeconomics.

Microeconomics is concerned with the study of specific economic units e.g. individual
households, as well as firms or industries. Macroeconomics is the study of the economy as a
whole or its basic subdivisions or aggregates such as the government, household and business
sectors. An aggregate is a collection of specific economic units treated as if they were one
unit. Macroeconomists attempt to explain economic events and to devise polices to improve
economic performance.

1.3.1 Economic Model

To understand the economy, economists use models which are theories that simplify reality in
order to reveal how independent variables influence dependent valuables. The art in the
science of economics is in judging whether a model usefully captures the important economic
relationships for the matter at hand. Because no single model can answer all questions, macro-
economists use different models to look at different issues.

A key feature of a macroeconomic model is whether it assumes that prices are flexible or fixed.
According to most macroeconomists, models with flexible prices describe the economy in the
long run (a period where all factors of production can be varied), whereas models with fixed
prices offer a better description of the economy in the short run (a period within which most
of the factors of production cannot be varied).

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1.3.2 Macro economics summarized in three models
The study of macroeconomics is organized around three models that describe the world as
follows:
i) The very long run: concerned with the long run behavior of the economy. It is the domain
of growth theory, which focuses on the growth of productive capacity i.e. the factors of
production and the technology that firms use to produce goods and services.
ii) The long run: here the product capacity is treated as given. The level of productive
capacity determines output, and fluctuations in demand relative to this level of supply
determine prices and inflation.
iii) The short run: where fluctuations in demand determine how much of the available
capacity is used and thus the level of output and unemployment.

1.3.3 Macro economic Data

The most obvious source of information about the economy is casual observation. When you
go shopping, you, see how fast prices are rising. However, economic statistics are a more
systematic and objective source of information. The government regularly collects data on
economic agents and then various statistics are computed that summarize the state of the
economy. These statistics are used by economists to study the economy and by policy makers
to monitor economic developments and formulate appropriate policies. Three important
economic statistics used most often are:
i) Gross Domestic Product: which is defined as the total market value of all final goods
and services produced within a nation’s borders in a given time period.
ii) Consumer Price Index: An index used to measure the level of prices. It turns the
prices of many goods and services into a single index measuring the overall level of
prices.
iii) Unemployment rate: This is a statistic that measures the percentage of those
people wanting to work who do not have jobs.

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 Activity 1: What is the value GDP, CPI and Unemployment rate in Kenya?
You can look for these values in the Economic Surveys, Central Bank Bulletin, or
in Newspapers.

1.4.0 National Income Accounting

National Income Accounting refers to the measurement of aggregate economic activities,
particularly national income and its components. GDP is often considered the best
measure of how well the economy is performing. The goal of GDP is to summarize in a
single number the monetary (shillings) value of economic activity in a given period of
time. The value of final output produced in a given period, measured in the current prices is
referred to as Nominal GDP.

There are two ways to view this statistic. One way to view GDP is the total income of everyone
in the economy. Another way to view GDP is as the total expenditure of the economy’s output
of goods and services. Consider the following two sector economy.

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 Figure 1-1
Income

Labour

Households Firms

Goods

Expenditure

Imagine an economy that produces a single good, bread, from a single input labour. Figure 1-1
illustrates all the economic transactions that occur between households and firms in this economy.

The inner loop represents the flow of bread and labour. The households sell their labour to the
firms and the firms use the labour to produce goods and services, which in turn they sell to the

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households. The outer loop represents the corresponding flow of shillings. The households buy
bread from the firms. The firms use some of the revenue generated from the sale of bread to pay
workers and the remainder is the profit which belongs to the owners of the firms.

The two loops combined in the above figure gives us what is referred to the Circular flow of
income. GDP measures the flow of income in this economy. i.e. It is the total income from the
product of bread which equals the sum of wages and profit – the top half of the circular flow of
income. It is also the total expenditure on purchase of bread the bottom half of the circular flow of
income. GDP can also be interpreted as the total value added in the economy i.e.
Value added = value of final – value of intermediate
goods/services goods/services

GDP per capita relates the total value of annual output to the number of people who share that
output; it therefore refers to the average GDP per person. It is commonly used as a measure of a
country’s standard of living. It does not, however, tell us what portion of
output every citizen is getting.

Activity 2: Describe the weakness of GDP per capita as a measure of the standards of living.

1.4.1 The components of Gross Domestic Product:

The National income accounts divide GDP into four broad categories of spending.
1. Consumption: Consists of the goods services bought by households. It is divided into
three subcategories: non-durable goods, durable goods and services.
2. Investment: Consists of goods bought for future use. Investment is also divided into
three sub categories: business fixed purchase of new plant and equipment by firms,

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 residential new houses fixed investment and inventory investment and in firms,
investment of goods.
3. Government Purchases: are the goods and services bought by the state, cables and
local governments. This includes such items as military equipment, highways, and the
service that government workers provide.
4. Net exports: Takes into account trade which other countries. Net exports are the value
of goods and services exported to other countries minus the value of goods and services
that foreigners provide us. Net exports represent the net expenditure from aboard on
our goods and services, which provide income for domestic producers. In other words
it exports (X) minus imports (M).

A closed economy has three uses of goods and services it produces. These three components
are expressed in an equation as follows.
Y = C+ I+ G
This equation is an identity. It must hold because of the way the variables are defined. It is
called a national income accounts identity.

1.4.2 Real GDP vs. Nominal GDP

You will recall that Nominal GDP has been defined as the value of goods measured at current
prices. Real GDP is the value of goods and services measured using a constant set of prices.
The general formula for computing real GDP is:
Real GDP in year t = Nominal GDP in year t x Price level in base year
Price level in year t
The GDP deflator: - also called the implicit price deflation for GDP is the ratio of nominal
GDP to real GDP:
GDP deflator = Nominal GDP
Real GDP
The GDP deflator reflects what’s happening to the overall level of prices in the economy.

1.5.0 Measuring the standard of living

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A shilling today doesn’t buy as much as it did twenty years ago. The cost of everything has gone
up. This increase in overall prices is called inflation and it is one of the primary concerns of
economists and policy makers. The most commonly used measure of the level of prices is the CPI.
It is the price of a given basket of goods and services relative to the price of the same basket in
some base year.

What do we use in Kenya to measure inflation?

1.5.1 CPI vs GDP Deflator:

There are three key differences between the two measures:
1. GDP deflator measures the prices of all goods and services produced, whereas the CPI
measures the prices of only the goods and services bought by consumers. Thus, an
increase in the price of goods bought by firms or the government will show up in the
GDP deflator but not in the CPI.
2. GDP deflator includes only those goods produced domestically. Imported goods are
not part of GDP and do not show up in the GDP deflator. Hence an increase in the
price of a Toyota made in Japan and sold in this country affects the CPI, because the
Toyota is bought by consumers, but if does not affect the GDP deflator.

3. The CPI assigns fixed weights to the prices of different goods, whereas the GDP
deflator assigns changing weights. In other words, the CPI is computed using a fixed
basket of goods, where as the GDP deflator allows the basket of goods to change over
time as the composition of GDP changes.

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1.6 Summary
This lecture has reminded you about a few things worth remembering.
1. Economics is the study of how human beings coordinate their wants and desires, given the
institutional structures of the society. By “institutional structures” we mean decision-
making mechanisms, social customs, and political realities of that society.
2. Macroeconomics is the study of the economy as a whole or its basic subdivisions or
aggregates such as the government, household and business sectors.
3. Economists use models which are theories that simplify reality in order to reveal how
independent variables influence dependent valuables.
4. The study of macroeconomics is organized around three models that describe the world as
follows: The short run, long run and the very long run.
5. Three important economic statistics used most often are: Gross Domestic Product,
Consumer Price Index and Unemployment rate.
6. National Income Accounting refers to the measurement of aggregate economic activities,
particularly national income and its components. GDP is often considered the best measure
of how well the economy is performing.
7. The National income accounts divide GDP into four broad categories of spending
Consumption, Investment, Government Purchases and Net exports.
8. The three key differences between CPI vs GDP Deflator are: GDP deflator measures the
prices of all goods and services produced, whereas the CPI measures the prices of only the
goods and services bought by consumers. GDP deflator includes only those goods produced
domestically. The CPI assigns fixed weights to the prices of different goods, whereas the
GDP deflator assigns changing weights.

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1.7 Exercise
Attempt the following Questions
1. a) Define macroeconomics
b) How has macroeconomics been summarized in three models
2. State the importance of macro-economic data
3. Discuss the circular flow diagram
4. What are the components of the national income identity?
5. What are differences between the GDP deflator and the CPI?

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1.8 Further Readings:
The following books are available for further readings. It would be important for you to read
some if not all so that you can broaden your understanding on the topic. Where later editions
exist, the information may not be found in the exact chapters.

Branson, Williams H, (1989), Macroeconomic theory and policy, 3rd Edition, Chapter 1 and 2
Dernburg, Thomas Fredrick,(1985), Macroeconomics: concepts, theories and policies, 7th
Edition, Mc Graw-Hill, Chapter 1 and 2.
Donbusch, Rudiger et al, (2001), Macroeconomics, 8th Edition, Tata Mc Graw-Hill, Chapter 1
and 2.
Mankiw, N. Gregory, (1999), Macroeconomics, 4th Edition, Worth Publishers, Chapter1,2 and
3.

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