The Circular Flow of Income Four sectors in an economy Basic flow of income Withdrawals and Injections National Income identity

Four Sectors in an economy Households Firms Government International Owners of factors of production & consumers of goods & services Employers of factors of production & producers of goods & services The ruling political body of a country. It taxes people and spends that tax. Trade with other countries of the world. A country that trades in this way is “open” and one that does not is “closed.”

Households Firms Payments for goods & services Factors of production Payments for factors of production Goods & Services Gov’t Spending (G) Money from exports (X) Investment money (I) Taxes (T) Money spent on imports (M) Savings Firms

Circular flow (continued) The circular flow of income is a simple flow of income between households and firms in an economy. Injections are additions to the circular flow (money flowing in) – transfer payments, investments and money received from exports. Withdrawals or leakages are subtractions from the circular flow (money flowing out) – taxes, savings and money spent on imports. Injections must equal withdrawals for the economy to be in equilibrium.

Definition National income is a measure of the total level of income in an economy over a specific period of time.

National Income Identity National Income = National Expenditure = National Output

Three Approaches to measuring national income Income approach Output approach Expenditure approach

The Income Approach Add all of the following together to get the National Income Income received by Land Income received by Labour Income received by Capital Income received by Entrepreneurs Rent Wages Interest Profit

The Output Approach Add together the value of the output produced at each stage of production Primary Stage Secondary Stage Tertiary Stage Extraction of natural resources Manufacturing, using the natural resources that were extracted Services

The Expenditure Approach C I G +X -M Consumers’ expenditure Investment expenditure Government expenditure Exports (foreigners’ expenditure on domestic goods & services) Imports (domestic expenditure on foreign goods & services)

The Expenditure Approach (continued) Add together all the expenditures (but minus imports) to obtain national income. National Income = C+I+G+X-M The more popular name for national income, when this approach is used, is GDP: Gross Domestic Product. Thus GDP = C+I+G+X-M

From GDP to DI GDP: market value & factor cost GNP: market value & factor cost NNP PI DI

GDP GDP, Gross Domestic Product, is the value of all final goods and services produced within a country’s borders within a specific period of time. It doesn’t matter if foreigners produced the goods & services, as long as it was done domestically (within the borders). Transfer payments are not a part of the GDP because they are not an expenditure on a final good or service. They are grants given, money donated, or money transferred by the government, that cause no increase in economic activity. Examples: subsidies, GATE, pension.

GDP (continued) Since expenditure is added up to obtain GDP, it reflects the prices in the markets at that time. Thus: C+I+G+X-M = GDP at market prices But prices are influenced by government’s subsidies or taxation. The true value of the item might be overstated or understated because of this. What to do?

GDP (continued) Since taxes can cause price to be higher than it should be, subtract the taxes to get the true picture. Since subsidies can cause price to be lower than it should be, add back the cost of the subsidy to the price to get the true picture. Thus GDP at factor cost = GDP at market value – indirect taxes + subsidies

GDP (continued) GDP per capita is GDP per head or per person, so: GDP per capita = GDP/total population

Nominal and Potential GDP Nominal GDP is the regularly calculated GDP using current prices (today’s prices). It is also called GDP at current prices or GDP at market price. Potential GDP is the GDP that the country could earn if all of its resources are fully employed. It can be illustrated by any point of the PPF. Good X Good Y

Real GDP Real GDP is GDP adjusted to erase the effects of inflation. In other words, GDP at constant prices. A base year is chosen, and the general price level of all other years are compared to the base year. They might be higher, lower, or the same as the base year. Higher is a sign of inflation. Real GDP = (Nominal GDP÷GDP deflator) x 100.

Real GDP (continued) Year Price Index, also called GDP deflator Nominal GDP (GDP at current prices) Real GDP 1985 75 $9m $9m/75 x 100 = $12m 1990 100 $21m $21m/100 x 100 = $21m 1995 110 $22m $22m/110 x 100 = $20m In 1995, the prices were 10% higher than the base year so that 10% is taken away. In 1985, the prices were 25% lower than the base year, so that 25% is added.

GNP Gross National Product measures almost the same things as GDP but from a different perspective. It measures what nationals (citizens) produce or own, whether they live at home or abroad. Income from citizens abroad or their property abroad will be counted. Income from foreigners living domestically or from any property that they own domestically will NOT be counted.

GNP (continued) Thus, GNP = GDP + Income earned by citizens or property abroad – income earned by foreigners or their property in T+T Or shortened: GNP = GDP + Net Property Abroad

NNP Since property is a part of the GNP, bear in mind that property can depreciate in value. NNP, Net National Product, is GNP minus depreciation (or capital consumption). NNP = GNP – Capital Consumption

PI PI, Personal Income, is as follows: PI = NNP – income earned but not received (such as retained earnings and corporate taxes)+ income received but not earned (such as transfer payments)

DI DI, Disposable Income, is what remains when income taxes paid by households are subtracted from PI. DI = PI – income taxes

Recap GDP at market prices= C+I+G+X-M GDP at factor cost = GDP at market prices – indirect taxes + subsidies GNP = GDP + net property income from abroad NNP = GNP – capital consumption PI = NNP – income earned but not received (retained earnings and corporation taxes)+ income received but not earned (transfer payments) DI = PI – income taxes

Uses of National Income statistics It measures the level of economic activity in a country, by GDP per capita, which indicates living standards and poverty levels. This can be used by governments and firms in planning. Comparison over time: it can be used to compare changes in economic activity of a country over time Comparison over space: it can be used to compare living standards among countries in a given year and over time

Limitations of National Income statistics The limitations stem from what it does NOT measure: The underground economy/black market (tax evasion) and illegal activities Non-monetary activities e.g. DIY activities, housewives, barter Negative externalities Differences in culture, literacy rates, climate

Limitations of National Income statistics (continued) Distribution of income Type of goods produced (demerit goods) and ostentatious spending (spending on projects for image/vanity rather than social benefit) Leisure versus working hours Differences in exchange rates and purchasing power