LAMYA BINT-AL ISLAMSENIOR LECTURERFACULTY OF BUSINESS ADMINISTRATIONEASTERN UNIVERSITY

MEASURING A NATIONS INCOMEECO 201 : MacroeconomicsLecture 1*

Micro vs. MacroMicroeconomics: The study of how individual households and firms make decisions, interact with one another in markets.Macroeconomics: The study of the economy as a whole.We begin our study of macroeconomics with the countrys total income and expenditure.

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**This is the first strictly macro chapter of the textbook, so its worth spending a moment emphasizing the difference between microeconomics and macroeconomics.

Examples of questions that microeconomics seeks to answer:How do consumers decide how much of each good to buy?How do firms decide how much output to produce and what price to charge? What determines the price and quantity of individual goods and services? How do taxes on specific goods and services affect the allocation of resources?

Examples of questions that macroeconomics seeks to answer:How do consumers decide how to divide their income between spending and saving? What determines the total amount of employment and unemployment? What determines the overall level of prices and the rate of inflation? Why does the economy go through cycles, where things are great for a few years (like the late 90s) and then lousy for a year or two (like 2001-2002)?When unemployment is high, what can the government do to help?

Gross Domestic Product (GDP)Gross Domestic Product (GDP) measures total income of everyone in the economy. GDP also measures total expenditure on the economys output of goods & services.

For the economy as a whole, income equals expenditure because every taka a buyer spends is a taka of income for the seller.*

**Notes:

1. The text in the first bullet point is NOT the formal textbook definition of GDP. The formal definition is given and discussed in detail immediately after the Circular-Flow Diagram.

2. g&s = goods and services

A good way to judge how well someone is doing economically is to look at his or her income. We can judge how well a country is doing economically by looking at the total income that everyone in the economy is earning. GDP is our measure of the economys total income, often called national income.

GDP also measures total expenditure on the goods and services produced in the economy, and the value of the economys output (production) of goods and services. Thus, GDP is also referred to as output.

The equality of income and expenditure is an accounting identity (not, for example, an equilibrium condition): it must be true that income equals expenditure.

The Two Sector Circular-Flow DiagramThe circular flow model shows that a national economy is a system. Income and output flow between segments of the economy.

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

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**If your students already know the terms factors of production and factor payments, you may wish to delete the preliminaries from this slide.

The Two Sector Circular-Flow DiagramHouseholds:own the factors of production, sell/rent them to firms for incomebuy and consume goods & services

Firms:buy/hire factors of production, use them to produce goods and servicessell goods & services

Suppose the economy consists of 2 sectors: households and firms.*

**This and the following slide build the Circular-Flow Diagram piece by piece.

The Two Sector Circular-Flow Diagram

In the absence of government and international trade this simple model shows that households provide the factors of production for firms who produce goods and services. In return the factors of production receive factor payments, such as wages, which in turn are spent on the output of firms. This basic flow is shown in the next slide.

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The Circular-Flow Diagram*

**In this diagram, the green arrows represent flows of income/payments. The red arrows represent flows of goods & services (including services of the factors of production in the lower half of the diagram).

To keep the graph simple, we have omitted the government, financial system, and foreign sector, as discussed on the next slide.

Changing the animation on this slide:If you wish, you can easily change the order in which the markets and arrows appear. From the Slide Show drop-down menu, choose Custom Animation Then, a box will appear (maybe along the right-hand-side of your PowerPoint window) that allows you to modify the order in which things appear (as well as other aspects of the animation). For further information, open PowerPoint help and search on change the sequence of animations.

The Circular-Flow DiagramHouseholds and firms interact in two types of markets.In the market for goods and services, households are buyers and firms are sellers. Households buy the goods and services that firms produce.In the market for the factors of production, households are sellers and firms are buyers. Households provide the inputs that firms use to produce goods and services.

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The Circular-Flow DiagramThe inner loop represent the flow of inputs and outputs. The household sell their labor, land and capital to the firms in the markets for the factors of production.The firms use these factors to produce goods and services, which are then sold to households in the market for goods and services. So the factors of production flow from households to firms, and goods and services flow from firms to households.

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The Circular-Flow DiagramThe outer loop of the diagram represents the flow of money. The households spend money to buy gods and services from the firms in the market for goods and services.The firms use some of the revenue from these sales to pay for the factors of production such as wages of their workers. Whats left is the profit of the firm owners who themselves are members of households.

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The Circular-Flow Diagram

So spending on goods and services flows from households to firms, and income in the form of wages, rent and profit flows from firms to households.Flows in and out of each sector must balance.The circular flow shows that there are several different ways to measure the level of economic activity.

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The Two Sector Circular-Flow Diagram

The circular flow of income highlights a critical fact of national income accounting:GDP = production = income = spending .GDP measures the production of an economy. Now we see that GDP is equally a measure of the income/ spending of an economy.

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The Two Sector Circular-Flow Diagram GDP = income = production = spending.Spending = Production. The total value of all spending by households is the revenue of firms. The revenues received by firms provide us with a measure of the total value of production in an economy(GDP). So if the revenue equals to Tk x then the GDP will equal Tk x. Production = Payment to factors of production. If production equals Tk x then that amount will be paid as payment to households for factors of production (= Tk x) .Payment to factors of production = Income. The payment to factors of production is the income of the household sector (= Tk x).Spending = Income Total income of the household equals to total expenditure by the household (= Tk x).

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The Complete Circular-Flow Diagram

The complete circular flow includes five sectors: i) Household ii) Firm sectors iii) Government sector iv) Financial sector and v) Foreign sector.*

COMPLETE CIRCULAR FLOW MODEL*

HouseholdsHouseholds receive income from firms as a payment for factors of production. They also receive money from the government in the form of government transfers ( muktijodha benefit, unemployment benefit, old age benefit) and must pay money to the government taxes. Households spend some of their income on firms to buy goods and services (consumption) and save the rest. Households take their savings to financial markets. These money are then available for firms to borrow to build new factories, install up-to-date equipment, and so on. That is, they are available for investment. Households also buy goods made in other countries, that is they buy goods that are imported.

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The Firm SectorThe firms buys factors of production from households. It produces goods and services which it sells to the households, this is consumption for the households.Firms also sell goods and services to the government and exports to the world economy.Firms pay the government taxes.Firms borrow from the financial market to invest in their business.

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The Government Sector

It collects revenues through personal and corporate taxes and other fees.The revenue is used to purchase goods and services from firms, it is known as government expenditure.It gives transfers ( muktijodha benefit, unemployment benefit, old age benefit) to households.The amount that the government collects in taxes does not need to equal the amount that it pays out for government purchases and transfers. If the government spends more than its revenue, it borrows from the financial markets. If government revenue is greater than its spending, it saves in the financial market.

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The Financial Sector

The financial sector of an economy is the banks, share market, bond market and other financial institutions. Households save some of their income in financial markets. This savings of households provide the source of investment funds for firms. if the government spends more than its income there is government deficit, The government then borrows from the financial markets. If the government income is higher than its spending then it has a surplus, the government saves in the financial market.The foreign sector can provide an additional source of funds for investment, if those in other countries decide they want to use some of their savings to purchase assets in our economy. In this case, there is a flow from the foreign sector into the financial sector. If we lend to other countries, then the flow goes in the other direction.

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The Foreign Sector

Export: Some of the goods produced in an economy are not consumed by domestic households or firms in an economy but are exported to other countries. Import : Similarly, some of the goods consumed in our economy are not produced locally. They are imported from other countries.The foreign sector can also save/ lend from the financial sector.

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GDPThe flows in and out of the firm sector of an economy must balance. The total flow of dollars from the firm sector measures the total value of production in the economy which is GDP. The total flow of dollars into the firm sector equals total spending on GDP, so

Value of GDP = Total spending on GDP

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*The Components of GDPFour components make up GDP.Four components:Consumption (C)Investment (I)Government Purchases (G)Net Exports (NX)These components add up to GDP (denoted Y):

Y = C + I + G + NX

**Each of the four components is defined and discussed in detail on the following slides.

*Consumption (C)The value of all goods and services bought by households. Includes: durable goods last a long time ex: cars, home appliances(tv, refrigerator)nondurable goodslast a short time ex: food, clothingserviceswork done for consumers ex: mobile phone service, travel, medical service.

**Mostly, the term consumption refers to what students probably already think of as total consumer spending. The note about the treatment of owner-occupied housing is an exception, and some of the test bank questions are designed to see if students remember this exception.

(For more on this issue, see the notes accompanying the following slide.)

*Investment (I)Is total spending on goods that will be used in the future to produce more goods. Includes spending oncapital equipment (e.g., machines, tools)structures (factories, office buildings, houses)inventories (goods produced but not yet sold)

Note: Investment does not mean the purchase of financial assets like stocks and bonds.

**More on the treatment of owner-occupied housing:

In the national income and product accounts, a house is considered a piece of capital that is used to produce a flow of services housing services.

When a consumer (as a tenant) rents a house or apartment, the consumer is buying housing services. These services are considered consumption, so the price paid for these services rent is counted in the consumption component of GDP .

When someone buys a new house to live in, she is both a producer and a consumer. As a producer, she has made an investment (the purchase of the house) that will produce a service. She is also the consumer of this service, which is valued at the market rental rate for that type of house. So, the accounting conventions treat this situation as if the person is her own landlord and rents the house to/from herself.

When students begin to understand this, they may wonder why certain other goods (like cars) that produce a flow of consumer services are not also treated this way. There really is no good answer. Its just a convention of the national income and product accounts.

Investment vs. CapitalNote: Investment is spending on new capital.Example (assumes no depreciation): 1/1/2006: economy has $500b worth of capitalduring 2006:investment = $60b1/1/2007: economy will have $560b worth of capital*

*Government Purchases (G)Is all spending on the goods & services purchased by government.

G excludes transfer payments, such as Social Security or unemployment benefits, old age allowance, muktijodha allowance.

**You might tell your students that transfer payments, like Social Security checks, are excluded from G to avoid double-counting: retired persons spend part or all of their Social Security benefits on food, rent, prescriptions, and so forth, all of which count in consumption. If we also counted the Social Security check as part of G, then the same money would be counted twice, which would make GDP look bigger than it really is.

*Net Exports (NX)NX = exports importsExports represent foreign spending on the economys goods & services. Imports are the portions of C, I, and G that are spent on goods & services produced abroad. Adding up all the components of GDP gives:

Y = C + I + G + NX

**The net in net exports refers to the fact that we are subtracting imports from exports. This subtraction is important, because imports are also counted in the other components of GDP; failing to subtract them would cause GDP to measure not just the value of goods produced domestically, but also goods produced abroad and imported.

For example, if a consumer spends $100 on a DVD player imported from Japan, that $100 counts in consumption, even though the player was not produced domestically. We subtract off that $100 import so that GDP ends up including the value of only domestically-produced goods and services.

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U.S. GDP and Its Components, 2007

**This data is slightly different than that shown in Table 1 in this chapter of the textbook. The data on this slide was obtained after the BEA had slightly revised its initial GDP figures.

Source for data on GDP & components: http://www.bea.govhttp://www.bea.gov/national/index.htm

Source for population data (used to calculate the per capita figures): http://research.stlouisfed.org/fred2/categories/104, series POP, value for July 1, 2007, Source: U.S. Department of Commerce: Census Bureau, www.census.gov

GDP and Its Components, Bangladesh, 2013(est.)Source: CIA World Factbook*

% of GDPC75.3G5.7I29.2Export24.5Import-34.7GDP100

**This is the first strictly macro chapter of the textbook, so its worth spending a moment emphasizing the difference between microeconomics and macroeconomics.

Examples of questions that microeconomics seeks to answer:How do consumers decide how much of each good to buy?How do firms decide how much output to produce and what price to charge? What determines the price and quantity of individual goods and services? How do taxes on specific goods and services affect the allocation of resources?

Examples of questions that macroeconomics seeks to answer:How do consumers decide how to divide their income between spending and saving? What determines the total amount of employment and unemployment? What determines the overall level of prices and the rate of inflation? Why does the economy go through cycles, where things are great for a few years (like the late 90s) and then lousy for a year or two (like 2001-2002)?When unemployment is high, what can the government do to help?

**Notes:

1. The text in the first bullet point is NOT the formal textbook definition of GDP. The formal definition is given and discussed in detail immediately after the Circular-Flow Diagram.

2. g&s = goods and services

A good way to judge how well someone is doing economically is to look at his or her income. We can judge how well a country is doing economically by looking at the total income that everyone in the economy is earning. GDP is our measure of the economys total income, often called national income.

GDP also measures total expenditure on the goods and services produced in the economy, and the value of the economys output (production) of goods and services. Thus, GDP is also referred to as output.

The equality of income and expenditure is an accounting identity (not, for example, an equilibrium condition): it must be true that income equals expenditure. **If your students already know the terms factors of production and factor payments, you may wish to delete the preliminaries from this slide. **This and the following slide build the Circular-Flow Diagram piece by piece. **In this diagram, the green arrows represent flows of income/payments. The red arrows represent flows of goods & services (including services of the factors of production in the lower half of the diagram).

To keep the graph simple, we have omitted the government, financial system, and foreign sector, as discussed on the next slide.

Changing the animation on this slide:If you wish, you can easily change the order in which the markets and arrows appear. From the Slide Show drop-down menu, choose Custom Animation Then, a box will appear (maybe along the right-hand-side of your PowerPoint window) that allows you to modify the order in which things appear (as well as other aspects of the animation). For further information, open PowerPoint help and search on change the sequence of animations. **Each of the four components is defined and discussed in detail on the following slides. **Mostly, the term consumption refers to what students probably already think of as total consumer spending. The note about the treatment of owner-occupied housing is an exception, and some of the test bank questions are designed to see if students remember this exception.

(For more on this issue, see the notes accompanying the following slide.) **More on the treatment of owner-occupied housing:

In the national income and product accounts, a house is considered a piece of capital that is used to produce a flow of services housing services.

When a consumer (as a tenant) rents a house or apartment, the consumer is buying housing services. These services are considered consumption, so the price paid for these services rent is counted in the consumption component of GDP .

When someone buys a new house to live in, she is both a producer and a consumer. As a producer, she has made an investment (the purchase of the house) that will produce a service. She is also the consumer of this service, which is valued at the market rental rate for that type of house. So, the accounting conventions treat this situation as if the person is her own landlord and rents the house to/from herself.

When students begin to understand this, they may wonder why certain other goods (like cars) that produce a flow of consumer services are not also treated this way. There really is no good answer. Its just a convention of the national income and product accounts. **You might tell your students that transfer payments, like Social Security checks, are excluded from G to avoid double-counting: retired persons spend part or all of their Social Security benefits on food, rent, prescriptions, and so forth, all of which count in consumption. If we also counted the Social Security check as part of G, then the same money would be counted twice, which would make GDP look bigger than it really is. **The net in net exports refers to the fact that we are subtracting imports from exports. This subtraction is important, because imports are also counted in the other components of GDP; failing to subtract them would cause GDP to measure not just the value of goods produced domestically, but also goods produced abroad and imported.

For example, if a consumer spends $100 on a DVD player imported from Japan, that $100 counts in consumption, even though the player was not produced domestically. We subtract off that $100 import so that GDP ends up including the value of only domestically-produced goods and services. **This data is slightly different than that shown in Table 1 in this chapter of the textbook. The data on this slide was obtained after the BEA had slightly revised its initial GDP figures.

Source for data on GDP & components: http://www.bea.govhttp://www.bea.gov/national/index.htm

Source for population data (used to calculate the per capita figures): http://research.stlouisfed.org/fred2/categories/104, series POP, value for July 1, 2007, Source: U.S. Department of Commerce: Census Bureau, www.census.gov