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Chapter 8: The level of overall economic activity

Circular flow of income model:
illustrates a number of concepts and relationships that will
hjelp us understand the macroeconomy
Closed economy (simplest version): no international trade
and no goverment.
households: are the ownersof the four factors of production.
Firms buy the factors of production at resource markets and
use them to produce good and/or services
These goods and services are then sold to consumers in
product markets.
We therefore see a clockwise direction of factors of
production from households to firms and of goods and services
from firms to households.
In the counterclockswise direction, there is a flow of money
used as payment in sales and purchases. Wjem househols sell the
factors of produciton to firms they recieved payments taking the
form of rent (for land), wage (labour), intrest (for capital) and profit
(for entrepeneurs).
household expenditures: the payements that houselhold
make to buy goods or services.
costs of production: the payments that firms make to but
factors of production.
revenues: payements firms recieve by sellling goods and
payyments flows = money flows

Circular Flow of income model:

Shows that in any given time period, the value of output
produced in an economy is equal to the total income generated

in producing that output, which is equal to the expenditures

made to purchase that output.
Leakeages and injections:
The real world economy is more ocmplicated than this simple
model. More real by adding injections and leakeages (withdrawal)
to the money flow
Are paired together so that what leakes out of the flow can
come back in as an injection.





government spending


1. Saving and Investments:

When households save some fo their income this represents

a leakage from the circular flow of icome (because it is income that
is not spent in buying goods or services)
Households place savings in financial markets (bank
accounts, purchases of stocks and bonds)
Firms obtain funds from financial markets (borrowing etc) to
finance investment or the production of capital goods.
These funds therefore flow back into the flow as injection.
2. Taxes and Government spending
Taxes and government spending are connected to each
other through the government.
Households pay taxes to the government (leakage because
income is not spent in buying goods or services)

The government uses taxes to finance foveremtn

expeditures on education, health, defence etc, and this spending is
returend as an injection into the expenditure flow
3. Imports and Exports
Imports: goods and services produced in other countries purchased by
domestic buyers.
Exports: are fooss and ervices produced domestically which are
purchased by foreigners.
When an economy has interational trade through imports
and exports its known as an open economy.
Exports and imports liked together thorugh other coutnries.
Imports are a leakeage because they represent household
spenigin that leakes out as payements to other countries that
produced the goodsd and services.
Exports are an injection because they are speding by
foreginers who buy goods and services produced buy domestic
Size of circular flow in relation to size of leakages and injections:
If leakeage is greater than injection: the ciurcular flow will be
Ex: Suppose savings (as a leakage) is greater than investment
(as injection) . This results in fewer goods and services purchased, firms
cut back on production, less workers are needed so unemployement
increeaes and household income is reduced.
If leakeage is smaller than the injection: the circular flow will
become larger.
Ex: Suppose spenign on exports is greater than spending on
imports, then the expenditure flows increases since the injections is
larger than the leakeage. Foreginers demand more goods and services,
firms begin to produce more and therefore purchase more factors of
production, unemployement falls (asd firms buy a larger quanity of
labour in order to produce the output demanded) and hosehold income

Leakes from the ciruclar flow of income are matched by

inections into the ciruclar flow of income.
Though these need not to be equal to each other. If
injections are smaller than leakeages there will be a smaller flow of
income. if injections are larger and leakages the income flow
becomes larger.
Measures of economic activity
Involves meausuring an economys national income or value
of ourput.
output of an economy = agreggate output = national income:
why? This idea is shown with the circular flow of income model, that
demosntrates that the value of aggregate ouput produced is equal to the total
income generated in producing that output, which is equal to the expenditures
made to purchase that output.

Useful to measure to:

assess an econoomys performance over time.
make comparisons of income and output performance with other
establish a basis for making policies that will meet economic

How Economic Activity is measured:

There are three ways to measure the value of aggregate put suggested
by the circular flow of income model all giving the same result:
1. EXPENDITURE APPROACH: adds up all spenging to buy
final goods and services produced within a country over a period of
2. INCOME APPROACH: adds up all income earned by the
factors of production that produce all goods and srvices within a
coutnry over a period of time.
3. OUTPUT APPROACH: calculates the value of all final goods
and services produced in a country over a time period .

1) Expenditure approach:
adds up all spending to buy final goods or services
produced within a country over a period of time
Total spending can be broken down into 4 components:
Consumption ( c ): includes all purchasases by households on
final goods and services in a year (except housing).
Investment ( I ): spending by firms on capital goods (machines,
equipments, buildings). or spenidng on new contructions (housing and
other buildings).
Goverment Spending (G): refers to spending by the goverments
within a country. Includes purchases by the gov. of factors of prodctuin
and investement by the goverment (public investement) ususally on
capital goods including roads, airports, building hispitals and schools.
Net Exports [exports minus imports] (X-M): refers to the value
of all exports minus the value of all imports.
If we add the 4 components ( consuption, investment,
goverments pending and net exports) we obtain a measure of agregate
output now as gross doemstic product (GDP).
GDP: Is the market value of all the final goods and services priduced within
a country during a specific period of time.
It includes soending by the 4 components.
One of the most commonly used measures of the value of
aggregate output.
2) The income approach:
adds up all income earned by the factors of production within
a country during a specific time period. That is:
rent earned by land
wages earned by labour.
intrest earned by capital
profits earned by entrepeneurship

When all of these are added up we get the national income.

3) The output approach

Measures the value of each good or service produced in
the economy over a particular period of time and then sums them
up to obtain the total value of output produced.
It includes the value of all final goods and services in
order to avoid the double counting that would arise if the values of
intermediate goods and services were to be measured.
It calculates teh value of output by economic sector
such as agriculture, manufacturing, banking ransports etc.
The value of output of each sectors is then added upto
the obtaing the total value of output of the entire economy.

Distinctions relating to measures of the value of output:

Distinction between GDP and GNI
GDP: Is the total value of all final goods and srvices produced
within a coutnry during a secific period of time, regardless of who owns
the factors of production.
GNI: Is the total income recieved by the residents of a country, equal
to the value of all final goods and services produced by the factors of
production supplied by the countrys residents regardless where the
factors are located.
a Russian worker who lives and works in Spain, and sends a large aprt
of her income to her family in Russia. Her output is produced in Spain,
but the income is sent to Russia.
The value of her output would be included in Spains GDP.
Her income sent to russia is part of Russias GNI.
Distinction between nominal values and real values:

Nominal GDP (or nominal GNI): is measured in terms of current prices

(prices at the time of measurement), which does not account for
changes in prices.
Real GDP (or real GNI): are measures of the economy which have
eliminated the influence of changes in price. When a variable is being
compared over time, it is important to use the real values.

Distinction between total and per capita:

Total GDP and GNI: provide a summary statement of the overrall size of
an economy.
Per capita figures: are useful as a summary measure of the standards of
living in a country because they provide an indication of how much of the
total output in an economy corresponds to each eprson in teh population
total output / total population
The distnction between totat and per capita meausres is very
important for two reasons:
1. differing population sizes across countries: contries may
have the same total GDP, if they have different population sizes,
theyll have different GDP per capita values.
2. Population growth: changes in size of the GDP per capita
over tiem depend very much on the relationship between growth in
the total GDP and in growth in population.
If GDP increases faster than the population then the GDP
per capita icnreases.
Distinction between gross and net
physical capital ( a factor of production-such as machinery,
buildings, equipment).

All these have a finite life- they get worned out and some
are thrown away (this capital is called depreciation).
Each year the worned otu capital must be replaced.
Meaning that in any year of the total new proudction of
capital goods a part goes to replacing capital goods that have
been thrown out and the rest are new additions of capital goods.
Investment: spending by firms to buy capital goods.
Gross investmen: total investment. Can be divided in 2 parts:
1. that part that goes towards replacing the thrown out capital
goods (depreciation).
2. the part that consists of new additions of capital goods
known as as net investment.
In GDP, the I stands for total investment ( depreciarion + net
As it measures an economys total outpu, theregore includes
total spengin on capital goods.
NDP: is an alternative way of measuring aggregate output,
and uses net investemt to arrive to the net domestic production.
NDP= C+ In +C+ X-M (In= net investment)
NDP= GDP - depreciation
GDP: includes total spending on capital goods uncluding
replacement of depreciated capital and new additions to capital
NDP: here net investement is used to arrive to the ent
domestic productt (NDP).

Evaluating National icnome statistics

GDP and GNI per capita figures may be misleading when:

used to make comparisons over time
making comparisons between countries
when used as basis for standard of living conclusions

1. national income statistics do not accurate measuure the true
value of output produced in an economy.
2. Standards of living are related to a variety of factors which are not
accounted for in GDP and GNI measusures.

Why do icome statisctisc (GNI and GDP) do not accurately

measure the true value of output?
1) Dont include non-marketed output:
GDP measusures the value fo goods and services sold in the
market place ad that generate incomes for the factors of production
however there are some output goods and services which are not
sold in the market and that do not generate income- non-marketed
Ex: Ones own work repariring and imporving ones home, if the
home repairs were handled by hired workers GDP would be greater by
the amount of their wages.
LEDCS households are quite selfsuffieecient with a great portion
of output being produced is consumed and enver reaches the amrket
place. (agriculture).

2) Dont account for underground/ parrallel markets.

Some goods are traded in markets that do generate income, but
that go unrecorded, and therfore not included in GNI or GDP measures.
These can be:

Sale of legal goods and services:

such as resselling a good at a higher price if there is a price
when a plumber does not report the income recieved to avoid
paying taxes.
Transactions involving illegal goods and services ( such as
SOLUTION: estimated of the size of udnerground markets can be
madem and when added to the official, economy, can arrive to a closer
aprocximation of the true GDP and GNI.
3) Dont take into account quality improvements in goods and srvices.
quality of many products improve over time, yet this is not
accounted for in calculating teh value of total output.
technological advances permit improved proudct to be sold at
lower prices.
This offers significant benefits to consumers, whichi do not show
up in GDP and GNI figures,
4) Dont account for the value of negative externatilities such as
pollution, toxic wastes and other undesirable by products of production.
All countries contrivute to enviromentaal degradation, reducing
societys well being, though this isnt reflecged in GDP nor GNI figures.
5) Dont account for consumption/ depletion of natural resources.
The depletition of natural resources (such as rainorests, wildlife,
agricultutal sols etc) also reduced societys well being.
6) GDP and GNI and differing domestic price levels
Goods and services often sell for very different prices in different
If two counties have the same GDP per capita, but in one a same
good is sold at a higher price, it will result in less purchasing power and
less benefits for consumers

SOLUTION: Converting teh values of GDP and GNI, of different

coutnries into a single common currency.
purchasing porwe parities: special exchange rates that take into
consideration the differing price levels.

Why do GDP/GNI cannot accurately measusre standards of

Even if national income statistcs were improved so thay they
become closer to the true value of output, they would still be
inaccurate as measusres of standard of living.
1) GDP/ GNI dont make distinctios about the composition of
These national income statistics measusures the value of all the
foods without distniction regarding the degree to which they contribute
to the standards of living of the people.
Whether the coutrny produced military goods or merit goods
such as goods isnt accounted for through the GDP and GNI measures
One country may have a lower per capita GDP than another, but
have higher levels of socials services and merit good provision than the
2) Cannot reflect the achievements in levels of education, health and life
A societys levels of health and education contribute significantly
to standards of living of the population.
Countries may achieve higher or lower levels of health and
education with a given amount of GDP/GNI per capaita, but these
remain anaccoutned for in in these measures.
3) Dont provide information on teh distribution of income and output.
GDP or GNI per capita only provide an indication of average
output or average income per person.
how equally or unequallly is income and output distributed id
another factor affecting societys well beingl
4) Dont take into account increased leisure time
In many coutnries the averahe number of hours worked per week
has decliend significantly, with a number of leisure hours icnreasing.

THis contributes to the stabdard of living and yet is not accounted

for in GDO or GNI.
5) Dont account for quality of life factors.
A societys well-being depends upon a variety of non-economic
ex: crime rates, well functioning institutions, stress levels from
working confitions, the degree of political freedom etc.
National income measusures and standards of living comparisons over time
and between countries:
Comparisons over time: we must use real values of income and output
measures, which take into account changs in the price level over time.
Howver the comparisons of of real GDP/ GNI over time bay be
An icnrease in real GDO of some country does no necessarily
mean d that there is higher standards of living.
because of such factors such as: improved product quality,
improvements in health and educatiun, increased leisure, improvement
in quality life factors, possible changes in the value of non-marketed
output or in the size of undergrownd markets and so on, etc
Comparisons between countries:
both the inability of the GDP/GNI factors to measure the true
value of output, and the exclsuion of many standard of livign factors,
contributes to limiting the validity of international comparison by the use
of these measures.
Example: Country A may have a high level of GDP per capita
which is concentrated among a few, whle Country B may have a lower
level of GDP per capita but which is more equally distributed. A
comparison of GDP/GNI does not reveal info. regarding this point.
An important issue regarding intenrnational comparisons involve
different doemstic price levels. Which if ignored, presents misleading
GDP and GNI meausures do not taki into account the negative
enviromental externalities and envirometnal defradation and

They dont account for the loss of enviromental resources and

losses of enviromental quality. (they may overestimate the true value
of output and standards of living).
they include expenditures undertaken for the purpose of cleaning
up pollution as increases in the value of national output and makees the
coutnry look better. The value of output and well-being is overestimated
Green GDP: accounts for the value of resource and eviroemtnl
The rationale of green accounting methods is that if enviromental
destruction were included in measusres of agreggate income and
outpit, these measusres would focus attention on the links between the
economy and the enivroment.
green GDP= GDP - The value of enviriomental degradation.
green GDP= GDP- the value of enviromental degradation- p6
p6= expenditures resulting of cleaning up pollution, avoiding
further enviromental damage and health care costs of pollution-induced
Green GDP has not yes been standariseed and are not widely

The Buissness Cycle

Introduction to economic growth:

Economic growth: refers to increases in the quanity of output produced over
a period of time (typically a year) and is usually expressed as:
a percentage change in real GDP or real GNI over a secifieed
period of time
a percentage change in real GDP per capita (or real GNI
Example: If real GDP in country A was 50 bilion in 2004 and icreased to 51
billion in 2005, its rate of growth over this period would be:
[(51-50)/ 50] x 100%= 2% growth int he perdio 2004-2005
(final GDP - original GDP) / original GDP x 100% = economic growth

IF real GDP has fallen then the value will be negative.

Distinguishing between decrease in GDO and decrease in GDP growh.

Decrease in GDP: involves a fall in the value of output produced such as from
60$ billion in 2006 to 57$ billion in 2007 which results in a negative rate of
growth of -5%.
Decrease in GDP growth: involves the falling in rates of growth- though the
rates of growth may be positive the are lower relative to the growth of the
previous year.

Understanding the Buisness cycle:

Buisness cycles or economic fluctiarions: are fluctuations in the growth of
real output cosnisting of alternating period of expansions ( increasing real
output) and contractions ( decreasing real output).
Why the buisness cycle curve has an irregular shape?
are irregular and unpredictable, for these reasosn many
economists prefer to call them short term economic fluctuations.
While each cycle typically lasts several years, it is not possible to
generalise, as there is a wide variation in:
duration (how long the cycle lasts)
intensity (how strong the expansion is and how deep the
contraction or recession is). Expansions usually last longer than
Short- Term fluctuations and long-term growth trend
long.term growth trend: shows the average growth of an economy
over long periods of time.
It is represented in a straight line going through the cyclical line.
It shows how output grows over time when cyclical fluctiations
are ironed out.

potential output or potentail GDP: the output represented by the

long-term growth trend.
When GDP fluctuates so does other macroeconomic variables
such as unemployement of labour.
When GDP grows (expansion phase) unemployement falls, when
GDO falls (contraction phase) unemployment increases.
For every economy there is a lvel f real GDP ar which teh
economy experiences full employemet (that is that all labour resources
are emplyed to the greates extent possiblem however there is always
unemployment known as the natural rate of unemployment)
potential output: Is the level of output produced when there is full
emplyment meaning that unemployment is equal to thenatural rate of
We can also say that along the long term growth trend,
unemplyement is equal to the natural rate of unemployment.
BUT: when actual GDP is greater than potential GDP,
unemployement is less than the natural rate.
AND: when actual GDP is less than potential GDP,
unemployment is greater than the natural rate of unemployment.
Cyclical fluctuations, potentiall output and output gaps
When actual GDP lies above or below potential GDP, it results into a
GDP gap also known as an output gap.
ouput gap (GDP gap) = actual GDP - potential GDP [result may be
positive or negative]. When actual GDP is equal to potential GDP the output
gap is equal to 0.
Using the buisness cycle we can understand macroeconomic pbjectives to include
the following:
Redcing the itnesity of expansions and contractions:
This is aimed at makig output gaps as small as possible by flattening the cyclical
curve. This would lessen the problems regarding rising price levels in expansions
and unemployment in contractions
Increasing the steepness of the line representing potential output by

achievieng more rapid economic growth over long periods of time.