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Contents

Economics - Unit 2 ....................................................................................................................................... 3


TOPIC 1: National Income Accounting ........................................................................................................ 3
1. Circular Flow of Income ................................................................................................................... 3
1) Basic model/Closed private economy ........................................................................................... 4
2) Closed Economy model/Three Sector model ................................................................................ 5
Open Economy Model .......................................................................................................................... 7
2. National Income Accounting ................................................................................................................ 8
GNP....................................................................................................................................................... 8
Net Domestic Product ........................................................................................................................... 8
Net National Product ............................................................................................................................. 8
Avoidance of Multiple Counting .............................................................................................................. 8
Value Added ......................................................................................................................................... 9
Exclusion of Non-Production Transactions .......................................................................................... 9
3. Measuring GDP .............................................................................................................................. 10
The Expenditure Approach ................................................................................................................. 10
Components ........................................................................................................................................ 10
The Income Approach ............................................................................................................................. 12
Components ........................................................................................................................................ 12
Adjustments of National Income ........................................................................................................ 13
Other Types of Income ........................................................................................................................... 14
Personal Income .................................................................................................................................. 14
Disposable Income .............................................................................................................................. 14
4. Interpreting National Income statistics ........................................................................................... 15
5. Uses Of National Income Accounts ................................................................................................ 16
6. Nominal & Real GDP ..................................................................................................................... 17
Definition ............................................................................................................................................ 17
The Adjustment Process Between Nominal and Real GDP .................................................................... 18
Price Index .............................................................................................................................................. 18
GDP Deflator .......................................................................................................................................... 18

7. Limitations of GDP ......................................................................................................................... 20



Economics - Unit 2
TOPIC 1: National Income Accounting

This second unit of the CAPE Economics Syllabus focuses on macroeconomics.
Specific Objectives
1. Explain the circular flow of income
2. Explain the concept of national income accounting
3. Explain the different ways of deriving national income accounts
4. Interpret national income accounts
5. Use national income accounts to analyse the performance of the economy as a whole
6. Derive real GDP from nominal GDP
7. Explain the limitations of GDP

Macroeconomics is the branch of economics that studies economic aggregates
1
/grand totals. An example
of an aggregate would be the level of unemployment in the country, or the inflation rate.
1. Circular Flow of Income

It is a model of economy that shows the circular flow of expenditures and incomes that result from
decision makers' choices and the way those choices interact to determine what, how, and for whom goods
and services are produced (Bade & Parkin 2009).
There circular flow consists of certain economic units or economic agents. These are:
Households
Firms
Government
International sector
Financial institutions
The circular flow therefore shows the interaction between the economic agents. These flows can be real
of monetary in nature.



1
An aggregate is a collection of individual economic units which are lumped together and treated as if they are a
single unit.


1) Basic model/Closed private economy

For our analysis we will start with a simplified model. It shows a purely private economy which has two
sectors:
1. The household sector which:
supplies the four resources
purchases goods and services produced by firms

2. The business sector consists of firms which:
hire the factors of production
produce goods and services
The model has two markets:
1. The resource/factor market in which resources or the services of resource suppliers are bought
and sold (McConnell & Bruce 2007). Households exchange their factors with businesses that pay
for their use with money or factor payments.

2. The product market in which businesses provided final goods and services to households which
pay for them with money.




Figure 1.1: Two Sector Circular Flow of Income Model

The inner arrows represent real flows of goods and services. The outer arrows represent money
flows.
2) Closed Economy model/Three Sector model

The model can be extended to three sectors where the government is fully integrated into the real and
monetary flows that make up the economy. Government has to purchase from both:
1. the product market where it will purchase computers and equipment (for example to patch roads)


2. the resource market where it will hire military service personnel, police and teachers

Figure 1.2: Three Sector Circular Flow/Closed Economy Model
The Government provides public goods and services to both households and businesses (for example
roads, bridges and schools). These public goods and services can only be provided if government has
funds and these are raised via taxes paid by both households and businesses
NB - * acknowledges that government provides transfer payments to households in the form of
social security payments, and provides subsidies to businesses and concessions. Hence for:
households: Net Taxes = Taxes welfare and/or social security payments
businesses: Net Taxes = Taxes (corporate and sales) subsidies and/or tax concessions
Analysis of the Circular Flow

1. The three sector model indicates how government can alter the way income is distributed since it
reallocates resources and changes up the level of economic activity. The distribution of income is
more equal because higher tax revenues are drawn from affluent households and transferred to
low income households through transfer payments.


2. The allocation of resources is different when compared with a purely private economy.
Government will purchase labour resources and goods which may differ from those purchased
from households. Government reallocates resources to allow for the provision of public goods
such as health, defence, and roads.
3. Government can choose to increase expenditure and boost the production of goods and services.
It can also increase or decrease taxes or increase transfer payments to raise the level of income in
the economy and cause consumer spending to rise. Government flows suggest ways that
government may attempt to stabalise the economy.
Government spending adds flows of income (an injection) whilst tax payments are a withdrawal (or
leakage) of potential spending from the flow of income.
Open Economy Model

The circular flow can be extended to include the rest of the world. We will remove the real flows to make
the model less complicated. This model will include the financial market and the rest of the world.
Example 1
Draw a circular flow of income diagram of an open economy.
Solution

Figure 1.3: Open Economy Circular Flow of Income

The blue arrows represent the inner flow. The red arrows represent the withdrawals from the inner flow.
The green arrows represent the injections into the circular flow.

2. National Income Accounting

National Income Accounting involves the techniques used to measure the overall production of the
economy and other related variables for the nation as a whole. One of the best available measures of the
overall production is based on the total output of goods and services .i.e. the aggregate output. This
aggregate product is measured by its Gross Domestic Product (GDP).
Gross Domestic Product or GDP is the total market value of all final goods and services produced within
a country in a given year.
As long as the final goods and services are produced within the country they will contribute to the GDP.
There are other related variables and these include:
1. Gross National Product
2. Net Domestic Product
3. Net National Product
GDP measures total spending, income and or output made from home-based resources and therefore
exports are included. It does not include output made from the nation's resources abroad.
GNP
This measures the total output of goods and services produced by the country in the year whether they are
made from domestically owned resources locally or abroad.
GNP = GDP + Income earned by Barbadians abroad - Income earned by foreigners in Barbados.
GNP = GDP + Net property income from abroad
Net Domestic Product
GDP gives an exaggerated value of the output available for consumption and for addition of new capital.
Hence, Net Domestic Product is GDP - Consumption of fixed capital.
Net National Product
NNP is GNP - Depreciation or Capital Consumption (Consumption of Fixed Capital)
Recall that GDP is the total final value of all goods and services produced within a country in one year.
Avoidance of Multiple Counting
In order to measure output accurately the goods and services produced in a given year must only be
counted once. The majority of products go through a series of production stages before they reach the
market. Hence, the parts of some products may be bought and sold many times. GDP will only include
the market value of final goods and ignores transactions involving intermediate goods.

A final good or service is ultimately purchased for use by the consumer and is not for further resale or
purchasing. For example, a new sofa.
An intermediate good or service is purchased for further processing and manufacturing or resale. For
example, molasses.
Example 2
Let us look at the stages involved in the production of a suit.
Stage 1 Sheep rancher, Firm A, provides $200 worth of wool.
Stage 2 The wool processor, Firm B, sells the processed wool to a suit manufacturer for $240.
Stage 3 The suit manufacturer, Firm C, sells it to a clothing wholesaler for $300.
Stage 4 The clothing wholesaler, Firm D, sells it to the clothing retailer for $350.
Stage 5 The clothing retailer, Firm E, sells it to the customer for $420.
Total sales value = 200 + 240 +300 + 350 + 420 = $2510
Total output = 200 + 40 + 60 +50 + 70 = $420
Value Added
This is the market value of a firm's output minus the value of the inputs which it has purchased from
others.
Exclusion of Non-Production Transactions
They are some monetary transactions that are not included in the calculation of GDP.
These are:
1. Purely financial transactions. These are three general kinds.
a. Public transfer payments. Example welfare - These are made to households and firms
who have not made any contribution to current production.
b. Private transfer payments. Example gifts and allowances.
c. Security transactions. Example stocks & bonds - Stock market activity involves
the exchange of paper assets. The amount spent on these assets does not directly create current
production. It should be noted that the sales of new issues of securities transfers money from
savers to businesses. The business then spends this money on capital goods. Therefore these
transactions might indirectly contribute to spending which actually accounts for current output
and is added to GDP.
2. Second Hand Sales - These either reflect no current production or involved multiple counting.
Since the initial sale would have been in a previous period.

3. Measuring GDP
The value of ALL final goods and services generated by businesses (TOTAL OUTPUT) is equivalent to
the amount of money spent by consumers to purchase the output (TOTAL EXPENDITURE).
TOTAL OUTPUT = TOTAL EXPENDITURE (1)
Additionally, the expenditure on annual output (TOTAL EXPENDITURE) is equivalent to the cost or the
factor payments that are derived from producing this year's output (TOTAL INCOME).
TOTAL EXPENDITURE = TOTAL INCOME (2)
When equations (1) and (2) are combined the National Income Identity is derived.
TOTAL INCOME = TOTAL EXPENDITURE = TOTAL OUTPUT (3)
This identity implies that national income can be calculated using three methods:
The expenditure approach
The income approach
The output approach

The Expenditure Approach

The Expenditure Approach focuses on aggregating of spending all final goods and services generated
within the economy. This approach calculates GDP.
Components
A. Personal Consumption Expenditures
This is spending by households
Non-durable - bread, vitamins
Durable - fridges, car
Service - doctor
The letter C denotes this part of GDP.
B. Gross Private Domestic I nvestment
All final purchases of fixed K(capital) by business enterprises (for example machinery and tools)
All construction (like new factories, stores)
Changes in inventory ( increased vol. of unsold finished goods and work in progress)
Gross Private Domestic Investment (I
G
) involves the productions of all domestic goods. It includes both
investments in replacement capital and investment in added capital.

Net Private Domestic Investment (I
N
) - this refers only to investment in added capital.
I
G
= I
N
+ Consumption of Fixed Capital
2

Example 3
In 1997 the US Private Sector produced and purchased $1238 billion of capital goods. However in
producing that output, it used $900 billion of machinery and equipment. Calculate Net Private Domestic
Investment.
Soln: I
G
= I
n
+ Consumption of Fixed Capital
I
n
= I
G
- Consumption of Fixed Capital
I
n
= $1238 - $900 = $338
C. Government Purchased (G)
All purchases of durables and non-durables in the public sector
Expenditure to build Government offices
D. Net exports (Xn)
This is the amount by which foreign spending on a nation's good and services, exports (X), exceeds the
nation's spending, on foreign goods and services, imports (M):
X
n
= X - M
The GDP equation is therefore:
GDP = C + I
G
+ G + X
n

OR
GDP = C + I
G
+ G + X M

Example 4
The national accounts of a country are as follows:
Compensation of employees $4703.
Rents $148.
Gross private domestic investment $1238
Interest $450.
Proprietors' Income $545.

2
Consumption of fixed Capital is also called depreciation

Corporate income tax $319.
Dividends $336.
Government $1454
Undistributed corporate profits $149.
Net profits -$97
Indirect business taxes $545
Consumption of fixed capital $868
Net foreign factor income earned in the country $21
Personal consumption expenditures $5489

Calculate:
1. GDP
2. NDP
3. GNP
4. NNP.
Solution
GDP = $5489 + $1238 + $1454 - $97 = $8084
GNP = $8084 - $21 = $8063
NDP = $8084 - $868 = $7216
NNP = $8063 - $868 = $7195

The Income Approach
Components
a. Compensation of Employees
This is the largest income category and it comprises of payments to labour by private businesses and
government. It also includes wage and salary supplements (payments by employers into social insurance
and private pensions, health and welfare funds for workers). These supplements are part of the employer's
cost of obtaining labour and are treated as a component of the firms total wage payments.

b. Rents
Rent is the payment received by the owners of property resources (households and businesses). It is net
rent. i.e. Gross rental income minus depreciation.
c. I nterest
This is the payment received by the suppliers of capital. It is inclusive of interest payments that
households receive on saving deposits and even corporate bonds.
d. Profits
This includes proprietors' income and corporate profits.
1. Proprietors' income - this is the income of unincorporated businesses. i.e. sole traders &
partnerships
2. Corporate profits - three things happen to corporate profits:
a. A portion flows to the government as corporate income taxes
b. They are distributed as dividends.
c. They may be retained as undistributed corporate profits.

The summation of a, b, c and d give national income.

We can calculate GDP from National Income but three adjustments have to be made.
Adjustments of National Income

1. Indirect business taxes - These taxes are treated as cost of production and therefore added to the prices
of products that are to be sold. They include general sales taxes and excise taxes.
2. Depreciation or Consumption of Fixed Capital - Capital may be purchased one year and used
productively for many years after that. Consumption of fixed capital is added to National Income when
balancing and economy's expenditure and income.
3. Net Foreign Factor Income - National Income is the total income accruing to the residence of a country
whether earned domestically or abroad. However GDP measures domestic output. When moving from
Nation Income to GDP the income that citizens gain from supplying the sources abroad and the income
that foreigners gain by supplying resources domestically have to be considered. Net Foreign Factor
Income must be added to National Income when computing the value of domestic output.
National Income (NY)


Example 5
Using the information given before
a. Calculate national income for the country.
b. Adjust National Income to calculate GDP.
Soln:
National Income = Compensation of employees + Rents + Interest + Proprietors' Income + Corporate
income tax + Dividends + Undistributed corporate profits
= $4703 + $148 + $450 + $545 + $319 + $336 + $149 = $6650
GDP = NY + Indirect business taxes + Consumption of fixed capital + Net foreign factor income earned
in the country

= $6650 + $545+ $868 +21
= $8084
Other Types of Income
Personal Income
This includes all income received whether earned or unearned. Personal income differs from National
Income (Income earned) because some income earned is not actually received by households (social
security payments, corporate income taxes and undistributed corporate profits) also some income that is
received is not actually earned (National insurance benefits). When moving from National Income to
Personal Income first subtract income earned but not received and add income received but not actually
earned.
Disposable Income
This is personal income - personal taxes. Personal taxes include personal income taxes, personal property
taxes and even inheritance taxes. Disposable income is the amount of income that people have available
for both spending and saving.
Example 6:
From the following data find:
a. national income
b. Personal Income
c. Personal Disposable Income
d. Personal Saving

Salaries $1866.3 (National Income)
Business Interest Payments $ 264.9.(National Income)
Rent $ 34.1.(National Income)
Corporate Profits $ 164.8.(National Income)(-Personal Income)
Proprietors' Income $ 120.3.(National Income)
Corporate Dividends $ 66.4 (Personal Income)
Social Security Contributions $ 253.0(-Personal Income)
Personal Taxes $ 402.1 (-Personal Disposable Income)
Interest paid by consumers $ 64.4(-Personal Saving)
Interest paid by government $ 105.1(Personal Income)
Government and Business Transfers $ 374.5(Personal Income)
Personal Consumption Expenditures $ 1991.9(-Personal Saving)

National Income = $2450.4
Personal Income = $2450.4 - (164.8 - 253.0) + (374.5 + 105.1 + 66.4) = $2578.6
Personal Disposable Income = $2578.6 - 402.1 = $2176.5
Personal Saving = Personal Disposable Income - (Interest Paid by consumers + Personal Expenditure) =
2176.5 - (64.4 +1991.9) = 120.1

Homework
Research the Output Approach pg. 388 of Sloman. The page might be different according to the Edition
that you have.

4. Interpreting National Income statistics

The calculation of GDP using the expenditure approach reflects the actual prices that consumers pay for
final goods and services and is therefore called GDP at market prices. This calculation of GDP will
consist of indirect business taxes like VAT. Additionally, some firms receive subsidies from the
government to encourage production. GDP measured using the income approach values the cost of the

factors of production used to produce goods and services. This reflects GDP at factor costs. Indirect taxes
make market prices exceed factor costs. Subsidies make factor cost exceed market prices. To move from
market prices to factor cost:
GDP at market price indirect taxes + subsidies = GDP at factor cost
5. Uses Of National Income Accounts

1. It allows us to keep a finger on the economic pulse of a nation. It permits us to measure the level
of production or economic performance from year to year. We could therefore attempt to explain
why performance is at that level.

2. By comparing national accounts over a number of years we can track the long run course of the
economy and seen whether it has grown, has been steady, stagnant or declines.

3. Information supplied by national accounts provides a basis for designing and applying public
policies to improve the performance of the economy.

4. It allows for inter-country comparisons. You have to be careful because countries have different
sizes, climatic conditions and therefore resources. You have to use a per capita measure. GDP per
capita is GDP/Total Population.

6. Nominal & Real GDP

A nominal value (money) is used as a common denominator to sum a heterogeneous into a
meaningful whole. The value of different years' outputs can only be usefully compared if the value of
money does not change because of inflation (rising overall prices) or deflation (falling overall prices).
Year 1
Sofa $10 5 = 50
Chair $20 10 = 200
250 <--Nominal value
Year 2
Sofa $15 5 = 75
Chair $30 10 = 300
375 <-- Nominal value
Definition
Nominal GDP is GDP measured at current prices.
Real GDP is GDP adjusted for inflation.
Year Sofa Price Quantity of Sofas Chair price Quantity of Chairs
1 $10 8 $8 26
2 $15 6 $16 15

Nominal GDP in Year 1 = $288
Nominal GDP in Year 2 = $330
Real GDP
Year 1 = $288
Year 2 = Sp1(10) x Q2(6) + Cp1(8) x Q2(15) = Year 2 = $180


The Adjustment Process Between Nominal and Real GDP
Price Index
Example 7
Assume a country makes blenders according to the following table.
Year Units of
output
Price of
blenders per
unit
Price Index Nominal GDP Real GDP
1 5 $10 100% $50 50
2 7 20 200% 140 70
3 8 25 250% 200 80
4 10 30 300% 300 100
5 11 28 280% 308 110

Suppose the drastic changes in Nominal GDP were a result of inflation shown in column 2 and the
remainder owing to the changes in output shown in column 1. Both output and price increases would be
reflected in nominal GDP. Once the prices changes are known a price index with compares prices
between years and estimates overall changes in the price level, can be derived.
Definition - a price index measures the combined prices of a particular collection of goods and services
called a 'market baskets', in a specified period relative to the combined price of an identical group of
goods and services in a referenced period. This reference period is called the base year.
Price Index = Price of market basket in a specified year price of the same market basket in the base year
x 100
In our example the base year is year 1.
In year 2 the price index = 20/10 x 100 = 200
In order to calculate real GDP use the following formula:
Real GDP = nominal GDP price index (on hundredths)
GDP Deflator
This method is a very direct method. The GDP deflator is basically an index.
The formula is:
GDP Deflator = Nominal GDP Real GDP





Example 8:
An economy has the following real GDP and nominal GDP in 1994, 1995, 1996.
Year Real GDP $bn Nominal GDP $bn
1994 100 100
1995 105 120
1996 120 150

a. Which year is the base year?
b. Calculate the GDP deflators.
c. What is the inflation rate as measured by the GDP deflator between 1995 and 1996?
d. What is the % increase in the price level as measured by the deflator between 1994 & 1996?

Soln:
a. 1994
b.
Year Real GDP $bn Nominal GDP $bn GDP Deflator
1994 100 100 1
1995 105 120 1.14
1996 120 150 1.25

c. 1.25 1.14 x 100 = 9.65%
1.14
d. 1.25 1 x 100 = 25%
1







Example 9:
The following table shows nominal GDP and the price index for a group of selected years. Compute real
GDP. Indicate in each calculation whether you are inflating or deflating the nominal GDP data.
Year Nominal GDP
$bn
Price
Index(1996=-100)
1960 527.4 22.19
1968 911.5 26.29
1978 2295.9 48.22
1988 4742.5 80.22
1998 8790.2 103.22


Soln
Year Nominal GDP
$bn
Price
Index(1996=-100)
Real GDP $bn Inflating/Deflating
1960 527.4 22.19 2376.75 Inflating
1968 911.5 26.29 3467.10 Inflating
1978 2295.9 48.22 4761.30 Inflating
1988 4742.5 80.22 5911.87 Inflating
1998 8790.2 103.22 8515.99 Deflating

7. Limitations of GDP

GDP gives an indication of the level of production of goods and services and also the level of income.
Production will therefore be an inadequate indicator of societys well-being.
1. Non-inclusion of the informal sector - Certain production does not take place in markets. Hence
the economic activity generated is not included in GDP. The underground economy or the informal sector
includes both legal and illegal activities.
Legal activities include:
Moonlighting people working outside their normal job and not declaring the income for tax
purposes
Unemployed individuals who do jobs that they do not declare because they fear that they might
lose welfare benefits
Small retailers selling on roadsides, like coconut vendors, people selling clothing and food
Drivers of taxis, small plumbers
All of these will be considered as tax avoidance. Tax avoidance is the legal usage of the tax regime to
one's own advantage, to reduce the amount of tax that is payable by means that are within the law.

Therefore it is the lawful minimization of tax liability through sound financial planning techniques
such as phasing the sale of assets over a period long enough to effect maximum exemption from
capital gains tax.
Illegal activities include:
Gambling
Prostitution
The narcotics trade and money laundering
Tax evasion accounts for all situations where a person, organisation or corporation unlawfully
attempt to minimize tax liability through fraudulent techniques to circumvent or frustrate tax
laws, such as deliberate under-statement of taxable income or willful non-payment of due taxes.
The existence of the informal sector will significantly underestimate the calculation for GDP (refer to the
Barbados Business Authority of May 24
th
2009).
2. Non-payment for do-it-yourself activities Do-it-yourself activities include activities done by
housewives and family members for which no payment is made. The exclusion of these activities
indicates that GDP statistics understate the true level of production in the economy. If the activities
increase over time the rate of growth of national output will also be understated. Do-it-yourself activities
can also be called the NON-Monetary Sector. It also includes subsistence farming and barter.
3. Non-accounting for externalities, environmental degradation Rising national output (especially
for manufactured products) might have been accompanied by an increase in pollution (carbon emissions
and destruction of natural habitats). An agricultural sector that increases production and productivity by
intensive use of pesticides and chemical based fertilizers (like ammonia) can have a negative impact on
the environment. Pesticides and run-off from fertilizers can end up in underground reservoirs and can
reduce the quality of ground water which is part of the water supply. GDP statistics do not record
environmental side effects of industrial growth polluted air and waters, toxic waste, ozone depletion and
global warming. These spill-over costs are not deducted from total output. GDP can therefore overstate
national economic well-being.
4. Changing output and changes in the quality of life increased production maybe a result of
technological change. Alternatively rising national output might be achieved because people are working
harder or longer hours and having reduced leisure time. Individuals who work longer hours may tend to
have depressed immune systems, higher stress levels, and sickness is the end result. People will have
more income and a reduced quality of life. GDO would be of limited use since it does not consider the
number of hours that people work nor the number of leisure hours available. Additionally if output is
changing, (that is, there is the production of more capital or defence goods as opposed to consumer goods,
then the quality of life would be reduced. Consumer goods and services satisfy immediate wants and
needs and therefore improve the standard of living. Capital goods are not consumed directly by
consumers, neither are defence goods. Defence goods add no value to the quality of life. In the long run
capital goods invigorate growth and enable higher production and therefore consumption of consumer
goods and services.

The production of certain undesirables leads to an increase in GDP. There can be an increase in crime
levels, alcohol and tobacco. Increased crime levels lead to more expenditure on security and therefore
increase GDP. Consumer goods such as alcohol and tobacco add to national output but do not necessarily
add to the quality of life.