Ł
ukasz Goczek
Macroeconomics I
Class 3-4
CIRCULATION IN THE ECONOMY AND THE SYSTEM OF NATIONAL ACCOUNTS (ver. 27-02-2007)
System of National Accounts (SNA) or National Account Systems (NAS) are statistical surveys designed to provide a systematic summary of aggregate national economic activity based on accounting principles. National accounts provide measures of national income and output as well as measures of stocks and flows of capital. Typical systems of national accounts includes national income and product accounts, financial accounts, national balance sheets, input-output tables and external transaction accounts.
The original motivation for the development of national accounts and the systematic measurement of employment, was the need for accurate measures of aggregate economic activity as a basis for Keynesian macroeconomic stabilization policy and wartime economic planning. The first efforts to develop such measures were undertaken in the 1920s and 1930s, notably by Colin Clark and Simon Kuznets. However, the systematic construction of annual national accounts by public statistical agencies began only in the 1950s.
Cicular flow
The circular flow of income, or simply the circular flow, is a simple economic model showing the relationship between money income and spending for the economy as a whole. The circle of money flowing through the economy is as follows: total income is spent (with the exception of "outflows" such as consumer saving), while that expenditure allows the sale of goods and services, which in turn allows the payment of income (such as wages and salaries). Expenditure based on borrowings and existing wealth – i.e., "inflows" such as fixed investment – can add to total spending.
In equilibrium (Preston), outflows equal inflows and the circular flow stays the same size. If inflows exceed outflows, the circular flow grows (i.e., there is economic prosperity), while if they are less than outflows, the circular flow shrinks (i.e., there is a recession).
Key assumptions:
1) No government, the economy is closed (no other countries)
2) The households own production factors and supply them to the firms 3) Households are the only owners of the firms
4) Firms supply goods and services
5) Households spend their whole income on consumption, the whole revenue is spend by firms on production inputs.
Figure 2-1, Circular flow in the economy
There exist three ways to measure economic activity: 1) The value of produced output
2) Income of the factors of production 3) Expenditures on goods and services
The expenditure approach determines aggregate demand, or Gross National Expenditure, by summing consumption, investment, government expenditure and net exports. On the other hand, the income approach and the closely related output approach can be seen as the summation of wages, rents, interest, profits, nonincome charges, and net foreign factor income earned. The three methods must yield the same results because the total expenditures on goods and services (GNE) must by definition be equal to the value of the goods and services produced (GNP) which must be equal to the total income paid to the factors that produced these goods and services (GNI). In other words, the income, denoted by Y is equal to expenditures. All this is equal to GDP.
Gross domestic product - is one of the ways for measuring the size of the economy. The GDP of a country is defined as the market value of all final goods and services produced within a country in a given period of time. It is also considered the sum of value added at every stage of production of all final goods and services produced within a country in a given period of time.
Investment and saving
Now there will be three more sectors introduced. The first is the Financial Sector that consists of banks and non-bank intermediaries who engage in the borrowing (savings from
Ł
ukasz Goczek
Macroeconomics I
Class 3-4
outflow that financial institutions provide in the economy is the option for households to save their money. This is a outflow because the saved money cannot be spent in the economy and thus is an idle asset that means not all output will be purchased. The inflow that the financial sector provides into the economy is investment (I) into the business/firms sector.
Investment (I) is the expenditure of firms on capital goods
Saving (S) is the fraction of income, which is not spend on goods and services Meaning of symbols:
Y – income of factor inputs C – consumption
I – investment S – saving
Y=C+S – GDP as the income, which can be either saved or consumed E=C+I – GDP as en expenditure, either on investment or consumption In equilibrium
Y=E From this: C+S=C+I S=I
In equilibrium, outflows equal inflows and the circular flow stays the same size.
Taxes and government spending
The next sector introduced into the circular flow of income is the Government Sector that consists of the economic activities of local, state and federal governments. The outflow that the Government sector provides is through the collection of revenue through Taxes (T) that is provided by households and firms to the government. For this reason they are a outflow because it is a outflow out of the current income thus reducing the expenditure on current goods and services. The inflow provided by the government sector is Government spending (G) that provides collective services and welfare payments to the community. An example of a tax collected by the government as a outflow is income tax and an inflow into the economy can be when the government redistributes this income in the form of welfare payments, that is a form of government spending back into the economy.
GDP in market prices is a measure of marketed output including indirect taxes
GDP in producer prices is a measure of marketed output without indirect taxes Te – indirect taxes
GDP in market prices – C + I +G
Figure 2-2, Circular flow in the economy with government and financial sector Net National Income (NNI) is NNP minus indirect taxes
Personal Income (PI) is NNI minus retained earnings, corporate taxes but it includes transfer payments, and interest on the public debt
Personal Disposable Income (PDI) is PI minus personal taxes Td – Direct (income) taxes
B – Transfers DPI = Y + B – Td
Saving is the fraction of DPI, which was not spend on consumption:
S = (Y + B – Td) – C (1)
From the production side of the GDP:
Y = C + I + G – Te (2)
From (1) and (2) we get:
C + I + G – Te = Y = S + C – B + Td From this we can see that:
S + Td + Te = I + G + B
Ł
ukasz Goczek
Macroeconomics I
Class 3-4
Rewriting it:
S – I = (G + B) – (Td + Te) S – I = BD
Where BD is the budget deficit. Circular flow in the open economy
The final sector in the circular flow of income model is the overseas sector which transforms the model from a closed economy to an open economy. The main outflow from this sector are imports (Z), which represent spending by residents into the rest of the world. The main inflow provided by this sector is the exports of goods and services which generate income for the exporters from overseas residents. An example of the use of the overseas sector is Australia exporting wool to China, China pays the exporter of the wool (the farmer) therefore more money enters the economy thus making it an inflow. Another example is China processing the wool into items such as coats and Australia importing the product by paying the Chinese exporter; since the money paying for the coat leaves the economy it is a outflow.
Net Exports NX = Export – Import = X - Z
Now we modify GDP in producer prices in order to incorporate the rest of the world: Y = C + I + G + NX - Te
Export is an outflow, and import is an outflow, so: S + (Td + Te) + Z = I + (G + B) + X
In equilibrium, outflows equal inflows and the circular flow stays the same size.
Rewriting it:
S – I = [(G + B) – (Td + Te)] + (X – Z) S – I = BD + NX
Figure 2-3, Circular flow in the open economy GDP criticisms
GDP is widely used by economists to follow how the economy is moving, as its variations are relatively quickly identified. However, its value as an indicator for the standard of living is considered to be limited. An alternative for this purpose is the United Nations' Human Development Index in which the GDP is a contributing factor in its calculation. Criticisms of how the GDP is used include:
• GDP does not take into account the black market, where the money spent isn't registered, and the non-monetary economy, where no money comes into play at all, resulting in inaccurate or abnormally low GDP figures. For example, in countries with major business transactions occurring informally, portions of local economy are not easily registered. Bartering may be more prominent than the use of money, even extending to services (I helped you build your house ten years ago, so now you help me).
• This mainstream economic analysis ignores externalities such as the environment, subsistence production and domestic work. The current system counts oil spills and wars as contributors to economic growth, while child-rearing and housekeeping are
Ł
ukasz Goczek
Macroeconomics I
Class 3-4
would in part, undo the injustices of unpaid (and in some cases, slave) labor, and also provide the political transparency and accountability necessary for democracy. Also, when GDP is used as a measure of success over time, the amount of housework that was done 50 years ago compared to the present time is much greater. Thus, comparing GDP over time cannot take into account the changes in society and lifestyle.
• It ignores volunteer, unpaid work. For example, Linux contributes nothing to GDP, but it was estimated that it would have cost more than a billion US dollars for a commercial company to develop. Wikipedia, an open-source online encyclopedia is another good example.
• GDP counts work that produces no net change or that results from repairing harm. For example, rebuilding after a natural disaster or war may produce a considerable amount of economic activity and thus boost GDP, but it would have been far better if the disaster had never occurred in the first place. The economic value of health care is another classic example—it may raise GDP if many people are sick and they are receiving expensive treatment, but it is not a desirable situation. Alternative economic measures, such as the standard of living or discretionary income per capita better measure the human utility of economic activity.
• Quality of life—human happiness—is determined by many other things than physical goods and services. Even the alternative economic measures of standard of living and discretionary income do not take these factors into account.
• As the single most important figure in statistics it is subject to fraud.
• Cross border trade within companies distorts the GDP and is done frequently to escape high taxation. Examples include American companies that have founded holdings in Ireland to "buy" their own products for cheap from their continental factories (without shipping) and selling them for profit via Ireland - thereby reducing their taxes and increasing Irish GDP.
• People may buy cheap, low-durability goods over and over again, or they may buy high-durability goods less often. It is possible that the monetary value of the items sold in the first case is higher than that in the second case, in which case a higher GDP is simply the result of greater inefficiency and waste. (This is not always the case; durable goods are often more difficult to produce than flimsy goods, and consumers have a financial incentive to find the cheapest long-term option. With goods that are undergoing rapid change, such as in fashion or high technology, the short lifespan may increase customer satisfaction by allowing them to have newer products.)
• If a nation does not spend, but saves and invests overseas, its GDP will be diminished in comparison to one that spends borrowed money; thus accumulated savings and debt are not taken into account so long as adequate financing continues.
• GDP does not measure the sustainability of growth. A country may achieve a temporarily high GDP by over-exploiting natural resources or by misallocating investment. For example, the large deposits of phosphates gave the people of Nauru one of the highest per capita incomes on earth, but since 1989, their standard of living has declined sharply as the supply has run out. Oil-rich states can sustain high GDPs without industrializing, but this high level would no longer be sustainable if the oil runs out. Economies experiencing an economic bubble, such as a housing bubble or stock bubble, or a low private-saving rate tend to appear to grow faster due to higher consumption, mortgaging their futures for present growth. Economic growth at the expense of environmental degradation can end up costing dearly to clean up; GDP does not account for this.
• The annual growth of real GDP is adjusted by using the "GDP deflator", which tends to underestimate the objective differences in the quality of manufactured output over
time. (The deflator is explicitly based on subjective experience when measuring such things as the consumer benefit received from computer-power improvements since the early 1980s). Therefore the GDP figure may underestimate the degree to which improving technology and quality-level are increasing the real standard of living. • In 'poor' countries, it may just be that most essentials are affordable, except for a few
western goods. So one may have little money, but if everything is cheap that evens out nicely. Thus, the standard of living may be quite reasonable; it's just that there are, say, fewer TV-sets, meaning people have to share them.
• GDP does not take disparity in incomes between the rich and poor into account. See income inequality metrics for discussion of a variety of complementary economic measures.
The sum of the value added in each of the different stages of production equals the value of the final product, the product that drops out of the production process and is thus not incorporated in some new product. Final products include consumer goods and fixed capital equipment. A numerical example illustrating the double counting issue further explains this concept below. In a microeconomic context, Value Added is simply measured as the value of the output produced (by a firm for example) minus the costs of the intermediate goods. The result must be equal to the sum of wages and profits. The issue of how the value added is shared between factors of production (usually considered simply as "labor" and "capital") translates to the question what part of value added goes to wages and what part to profits. System of national accounts
The two terms GDP and GNP are almost identical - and yet entirely different; GDP being concerned with the region in which income is generated and GNP (or GNI - Gross National Income) being a measure of the accrual of income to a region. The most common approach to measuring and understanding GDP is the expenditure method:
GDP = consumption + investment + (government spending) + (exports − imports) GDP – Gross Domestic Product (GDP)
GDP = C + I + G + NX Where, I – gross investment
We go from gross to net by subtracting depreciation
"Gross" means depreciation of capital stock is not included. With depreciation, with net investment instead of gross investment, it is the net domestic product.
Gross Investment (I)= Net Investment + depreciation (A) NDP – Net Domestic Product
NDP = GDP – A
We go from national to domestic category by subtracting factor income payments to foreigners
Ł
ukasz Goczek
Macroeconomics I
Class 3-4
sources. To convert from GDP to GNP you must add factor input payments to foreigners that correspond to goods and services produced in the domestic country using the factor inputs supplied by foreigners.
GNP – Gross National Product (PNB)
GNP = GDP + factor input payments to foreigners National Income
We go from product category to national income by subtracting indirect taxes Te
National income is the net national product in producer prices
Net National Income (NNI) is NNP minus indirect taxes NNI – National Income
NI = NNP – Te
GNI – Gross National Income
GNI = NI + A = GNP – Te GDI – Gross Domestic Income
GDI = GDP – Te
NNP – Net National Product
NNP = GNP – A Personal Income
Personal Income (PI) is NNI minus retained earnings, corporate taxes but it includes transfer payments, and interest on the public debt
PI – Personal Income
PI = NI – (those parts of NI, that do not go directly to households) + (those elements of household income which are not a part of NI)
PI = NI – [(T
π
– D) + US + π] + (B + N) Where: Tπ = corporate income taxNet firm tax= Subsidies (π – subsidies)-taxes US – social security payments
π - retained corporate earnings
B – Household government benefits, transfers (TR) N – Interest income from the public debt (G%) Disposable Personal Income
Personal Disposable Income (PDI) is PI minus personal taxes DPI – Disposable Personal Income
DPI = PI – Td DPI = C + S
Budget
BD – Budget Deficit
BD = (sum of expenditures) – (sum of inflows) BD = (G + B + subsidies) – (Te + Td + Tk) S +T + Z = I + G + X
S = I + BD + NX
