Measuring Economy??

What is the level of economic activity in a country ? Why is it

important?
How do we measure the extent of economic activity in a country?
Why do countries have different levels of economic activity?

How does an economy work??

Circular Flow of Income

simplistic depiction of the macro economy.

The Circular-Flow Diagram

Illustrates GDP as spending, revenue, factor payments, and income.

First, some preliminaries:

Factors of production are inputs like labor, land, capital, and natural resources.
Factor payments are payments to the factors of production. (e.g., wages, rent)

The Two-sector Model of the Economy

Factors of production

Factor market
Factor Incomes

Household
sector

Firms sector
Goods and Services

Expenditure

Product
market

Introduction of financial system

Income
Household
sector

Firms
sector
Expenditure

L
E
A
K
A
G
E
S

Savings

Financial
sector

Investment

I
N
Savings J
E
C
T
I
O
N
S

The three-sector Model of the Economy

Income
Household
sector

Firms
sector
Expenditure

L
E
A
K
A
G
E
S

Savings

Taxation

Financial
sector
Government
sector

Investment

Government
expenditure

I
N
J
E
C
T
I
O
N
S

The four-sector Model of the Economy

Income
Household
sector

Firms
sector
Expenditure

L
E
A
K
A
G
E
S

Savings
taxes

Financial
sector
Government
sector

Rest of the
world

Investment

Government
expenditure
Receipts from
Exports

I
N
J
E
C
T
I
O
N
S

Payments on
imports

Twin Deficit Identity

Equilibrium occurs when Leakages= Injections
(T+ M + S) = (G + X + I)
(S - I) = (G -T) + (X - M)
Alternatively,
S = (G -T) + (X - M) + I

What is GDP?
Gross Domestic Product (GDP) is the total market value of all final
goods and services produced in an economy in a one-year period.
GDP is a measure of final output per year.
It is the single most-used economic measure.
There are 4 kinds of transactions that are NOT included in GDP.
1.
2.
3.
4.

Non-Market Activities
Unreported Incomes
Intermediate Goods
Second hand transactions

Calculating GDP: Some Examples

Selling your car to a neighbor, will this add to GDP? (WHY?).
Selling your car to a used car dealer who sells your car to someone
else for a higher price, will this add to GDP ?(WHY?).
Selling a stock or bond, will this add to GDP? (WHY?).
The stock broker's commission for the sales, will this add to GDP
(WHY?).

Three methods of measuring GDP

1. Product method
Compute the value of the final output.
Count only the value added at each stage of production.
2. Income method
3. Expenditure method

Product method
Value added method - measures the value added by each producing
enterprise in the production process in the domestic territory of a
country on an accounting year.
Final stage value

The Value-added Approach to Measuring GDP

Production
Farmer

harvest wheat

Miller

Baker

Generated

Added

$100

$100

makes into flour

200

100

makes into bread

300

100

Rs. 600

Rs. 300

GDP counts only the Rs. value of the final good

This is the same as the value-added.

Two Ways of Eliminating Intermediate Goods

GVAi =Value of sales by the firm(Vi)+ Value of change in inventories (Ai)- value of the
intermediate good used by the firm (Zi)

Income method
Sum of the incomes received by all the factors of production,
that is, Salaries, Wages, Profits, Interest and Rents
GDP= W + P + I + R

Expenditure method
GDP is equal to the sum of the four categories of expenditures.

GDP = C + I + G + (X - M)
Four components:
Consumption (C)
Investment (I)
Government Purchases (G)
Net Exports (NX=X-M)

Significance of GDP calculation

Measurement of inflationary gap
Economic forecasting
Importance in international field
Promotion of research

# Problem
Mangoland is a closed economy where people live only on mango juice. There is only one farm that produces
mango and a single company that manufactures mango juice. In 2010, the mango farm produced 10
mangos and sold them to mango juice company at Rs. 1 each. The mango juice company produced 3 bottles
of mango juice, and sold them all at a unit price of Rs. 10 plus 10% indirect tax collected by the govt. (So the
price paid was actually Rs. 11). The mango farm paid total wages of Rs. 6. The mango juice company paid
total wages of Rs. 10. both companies retained their 50% net profits after depreciation and paid the rest of
it as dividends to the households. After receiving their wage income and their dividends, the households
paid 10% direct tax on their total income to the govt. the govt. bought one mango juice for Rs. 11. The govt.
made no social transfer. Notice that the entities are not paying any direct taxes on their retained profits.
Compute the GDP of mango land using
(1) Income method
(2) Value added method and
(3) Expenditure method.