THE REAL SECTOR OF THE ECONOMY Chapters 5, 6, 7,8,9,10 of Waud ============================================== ============== CHAPTER 5 NATIONAL INCOME ============================================== =============

This can be considered from two sides: receipt of income and its expenditure. -----------------------------------------------------------PART I: RECEIPTS SIDE -----------------------------------------------------------National income is a stock concept. It is taken as the total income over a period of one year. This is an accounting procedure for national income. I.A. CONCEPTS TAKEN AT MARKET PRICE/ MARKET VALUE GDP/ GNP/ NDP/ NNP are always taken at market price, i.e., the market value, unless stated otherwise. 1. Domestic income: Domestic Income = Wages and salaries + rents + interest + dividends + undistributed profits (including depreciation or CCA) + mixed incomes direct taxes

Domestic income is known as GDP. Nothing is counted twice. Therefore, only goods and services bought for final use are considered; i.e., no unfinished goods are considered. 2. National Income or GNP/ GNE/ GNI/ Y: National Income = Domestic Income + net asset income abroad GNP GNI = = earned from

unduplicated (final) value of the flow of goods and services produced by a nation annually. Gross national income

GNE

Gross national expenditure

Note: GNP = GNI = GNE = Y GNP is usually denoted by Y, the national income, and is used in Keynesian economics GNP = GDP + net property income from abroad (X-M) where E = exports, M = imports => GNP = GDP + (E - M) = GDP + X where X is net exports NOTE: GNP > GDP We do a detailed breakup of Y later on. 3. Net increase in capital stock:

Depreciation goes towards replacing old stock. Therefore, by removing depreciation from GDP/NDP, we get the new buildup of new capital stock. Of course, to this is added the total output of consumer goods in the year, etc. Therefore, NDP is GDP less depreciation. NNP is GNP less the depreciation. Further, NNP = NDP + (E - M) 4. Net Disposable income NDI

If net income paid overseas is subtracted from GNP, then that gives the net income available to the nation, including depreciation, i.e., NDI = GNP - net disposable income. 5. National income NI

Out of the NNP, the amount of income received by the country's residents is the national income. This is calculated by removing net income paid overseas from NNP. NI = NNP - net income paid overseas. 6. Personal income PI, or Household income HI:

If we subtract undistributed profits from NI, then we are left with the income which normal residents receive.

7.

PDI Personal disposable income: or HDI: If we subtract the personal taxes from PI, we are left with PDI.

I. B. CONCEPTS TAKEN AT FACTOR COST Not all the market value of goods and services is received by factors of production. Some is paid to government in indirect taxes. At the same time, some subsidies are received from government. E.g., out of our personal income, we pay sales tax, and receive the benefits of subsidised public transportation system. Hence we have actually received Wages - indirect taxes + subsidies. This is what a factor receives, leading to a series of concepts "at factor cost". 1. GDP at factor cost = + 2. GDP at market prices indirect taxes subsidies

GNP at factor cost = + GNP at market prices indirect taxes subsidies

3.

NDP at factor cost = GDP at factor cost depreciation

4.

NNP at factor cost: = GNP at factor cost depreciation

-----------------------------------------------------------PART II: EXPENDITURE SIDE -----------------------------------------------------------Here we consider how the money which is received is spent. The money spent/ saved must be equal to the money received. Therefore, from either side, national income must be the same. Let C= consumption, I= investment. 1. Two sector economy: Here, there is no government. Only the producers and consumers. Therefore, consumers consume C (and save S), and this goes towards new investment. Simultaneously, producers (use the savings S to) invest I.

Y=C+I Further, if S is savings, then, I=S

- (1)

This is obvious, since producers can only invest what all the consumers save. However, there is a simple proof: Now, Income = expenditure on goods and services + savings (in all three government, business and household) Therefore, Y = C + S Equating, (1) and (2) C+I = C+S or, 2. I=S -(2) sectors:

Three sector economy: Here there is government, in addition to producers and Let G = government spending. Therefore, Y=C+I+G Let T be the taxes. Then, I+G=S+T i.e., the total money available in economy for investment purposes, plus government spending, comes from savings and taxes. Usually, I = S and G = T. consumers.

3.

Four sector economy:

Here, there is interaction with the rest of the world in addition. Let E= exports, M= imports, then: Y = C + I + G + (E-M) or, Y = C + I + G + X Further, (think a bit) I+C+E=S+T+M

NOTE: many books use X instead of E to represent exports.

============================================== ============== CHAPTER 7 AGGREGATE DEMAND AND SUPPLY ============================================== ============== Now we look at the economy. THIS IS THE MACROECONOMICS (till now we were just accountants) AGGREGATE DEMAND The Aggregate Demand curve (AD) represents what all the entities in the economy - consumers, businesses, foreigners, and governments - would buy at different aggregate price levels. Thus it shows the relationship between the economy's total demand for output and the price level of that output. It measures the total demand in the economy for goods and services. Who demands? a) b) c) d) e) consumers demand to consume, i.e., C producers demand to invest, i.e., I government demands to spend, i.e., G exporters demand to export, i.e., X importers demand to import, i.e., M Therefore, Aggregate demand D = C + I + G + X-M Obviously, D will depend on the wealth of a country. If a country is rich, it will demand more goods and services, than if it is poor. In other words, consumption C will be higher. Wealth is a "real balance" and this effect is known as the real balance effect. Further, it will depend on the price of money, i.e., the interest rate. If the interest rate is low, there will be a greater demand for investment I. Finally there is foreign purchases effect. If the price level declines, then the domestic goods are cheaper, and there is a demand for exports X. If the price level is high, then foreign goods are cheaper and there is a demand for imports M. It is assumed that the demand for government spending G, will remain constant, irrespective of the price level. BEGINNING OF

The "demanders" keep demanding. But how much can they demand? Obviously the demanders are limited by the size of the national income. Indians cannot demand imports beyond what they can afford; similarly they cannot demand to consume more than their income, and they cannot demand to invest more than the money they have. They cannot also demand to export more than what the foreigners want. The demanders will keep demanding till the limit is reached, i.e., there is equilibrium. Therefore, in equilibrium, D = Y In equilibrium, Demand = Income AGGREGATE SUPPLY Now we come to the output or the supply. The demanders keep on demanding what they want. But obviously, the economy may not be able to fulfil the demand. Consumers may not be willing to save the money required by producers to invest, exporters may not wish to export what foreign purchasers want to purchase, etc. The aggregate supply curve (AS) represents the relationship between the prices businesses will charge and the volume of output they produce and sell. The businesses cannot supply less goods than what is demanded, for that will lead to unused capacity. They will therefore supply more even at the given price level, since they have unused capacity. Therefore real output keeps on increasing at a given price level until the existing capacity is fully utilised (Keynesian range). Further, if there is still some unfulfilled demand, then the suppliers can expand their capacity, but they will demand a higher price. Therefore, at this point the price increases, and output also increases. We assume that this is possible because there is still some unemployed people who can be used to produce these goods. (Intermediate range) However, if there is still unfulfilled demand, then there is a problem. The producers cannot produce more than their maximum capacity (which includes fully employing all possible workers). At this point, it is not possible to supply further, no matter what the demand. The only effect of the demand is that the prices start rising (wages rise first, as there is a competition for workers). At this point the ratchet effect comes into force: nominal wages rise but tend not to fall. (Classical range) A very important Keynesian assumption is that prices tend to rise, but not fall. Upto the point of full employment, all increases in nominal income occur because real income rises, i.e., prices are constant. Beyond the point of full employment, all increases in nominal income occur because prices rise, (I)

i.e., real income remains constant. This has been modified by modern Keynesians, through the Philips curve. The curve measures unemployment against the rate of change in prices (or, inflation). The curve shows that at lower levels of unemployment there is more inflation, and this inflation is reduced at higher levels of unemployment. Aggregate supply depends on: * * potential output wage-price behaviour

EQUILIBRIUM At the equilibrium, of course a nation can produce only that output which is demanded. Therefore, Demand = Output (II)

FUNDAMENTAL IDENTITY OF MACROECONOMICS From (I) and (II), we see that Demand = Income = Output This is the fundamental identity of MACROECONOMICS: ============================================== ============== CHAPTER 8 CLASSICAL AND KEYNISIAN THEORIES ============================================== ============== TOPIC I: AGGREGATE DEMAND AND SUPPLY See Waud: 194, Fig. 8.2 I.SUPPLY SIDE ANALYSIS BY CLASSICALS: Assumption: Prices and wages are flexible. Classicals think that prices react instantaneously and Say's law holds (i.e., all markets clear and there is no excess of supply of goods and services). Key factor in eqbm: Interest rate:

Further, the interest rate is flexible and ensures that savings equal investment. If the savings are less than the demand for investment, then the interest rate rises and people have an incentive to save more. Obviously, interest rate will rise only till the point at which it becomes uneconomical for business to pay more for money. If they can get 16% return from business, they will not borrow at 17%. Full employment: According to the classicals, the wages also adjust instantaneously, and this leads to full employment at all levels of price. In fact, they assume full employment. Equilibrium: The classical supply curve is vertical. If the aggregate demand falls, then the prices fall, but the total output and employment remains the same. Effect of macroeconomic policy: Nil. Macroeconomic policy cannot affect the level of unemployment and output. II. DEMAND SIDE ANALYSIS BY KEYNESIANS: Assumption: Prices and wages are sticky. According to Keynes, Says law is true of a barter economy, but not for an economy in which individuals can hold financial assets such as bonds and money. Key factor in eqbm: Disposable income (Income-expenditure approach): According to Keynes, it is disposable income and not interest that determines savings. It is therefore the aggregate demand that determines employment. Hence this is called the demand side analysis of the economy. Effect of macroeconomic policy: Government can stimulate the economy toward high employment, by increasing aggregate demand. TOPIC II: DETERMINING THE EQUILIBRIUM INCOME A. INCOME EXPENDITURE APPROACH TO EQULIBRIUM Fundamental identity:

Savings + consumption = disposable income Consumption function: According to Keynes, consumption is a function of income (sounds obvious). Therefore, C = a + bY, where b = the marginal propensity to consume MPC, i.e., the fraction of any change in GNP that is consumed. This is given by the slope of the consumption schedule i.e., C = C (Y)

Savings function: The savings function relates savings to disposable income. The savings and consumption functions are mirror images since MPS = 1- MPC Determinants of consumption (and therefore, savings) * * * * * * disposable income (current year's income) permanent income (long-term income) wealth other influences credit conditions expectations about employment prices and income.

Determinants of investment: * * * * * overall level of output (GNP) costs expectations the interest rate technological change and new products

Keynesian Cross diagram:

A diagram showing the aggregate desired expenditure schedule and a 45 degree line showing equilibrium between desired expenditures and income at each level of income. Determination of equilibrium: This is when E = C + I where E = expenditure At this point, the expenditure line crosses 45 degrees, and equilibrium income is obtainted. At equilibrium, S = I see Waud, diag. on p.206 Multiplier model: v. good diagram: Waud/246 The multiplier M in the economy is equal to: 1 --MPS i.e., Change in output = 1/MPS x change in investment This arises due to the chain of spending. When savings are low, i.e., MPS is low, then the multiplier is high. Income which goes into the economy rebounds from one person to the other, as it were, and each time generates more income. This is the paradox of thrift. Paradox of thrift: What is true of the part may not be true of the whole (fallacy of composition). An example is the paradox of thrift, where the more you save, beyond a point, the lower the income falls. Keynes therefore showed that savings is not necessarily a good thing for an economy. On the other hand, we must understand that S = I, and therefore, new investment is closely linked to savings. Therefore, low savings are required to achieve current increase in output and therefore, full employment, but high savings are required to achieve long term increase in output. = 1 ----1-MPC

Measuring a Nation's Income

Highlighted Sections
The Circular Flow Diagram GDP and GNP Real and Nominal GDP

The Circular Flow Diagram - (Back to Top)

This is the second time you have seen the circular flow diagram - the first was in chapter 2. The circular flow diagram is crucial to your understanding of macroeconomics because this is the picture economists have in mind when they talk about the economy. The important parts of the circular flow diagram, focused on in chapter 2, are repeated in the following list:

Notice that goods & services and resources flow around the economy in one direction, while money flows around the economy in the opposite direction. This is because money is normally exchanged for goods & services, or for resources. Recall that factors of production in the economy are generally lumped into three broad categories: labor, land, and capital. The respective names for the prices of labor, land, and capital are wages, rent and profit. Households (people), in the circular flow, own all the labor, land and capital. In markets for factors of production, households sell the services of labor, land and capital to firms in exchange for wages, rent and profits.
*Many students will observe that economists assume all labor, land and capital is owned by people, yet many firms in the economy own land and capital. This apparent incongruency can be cleared up by noting that all firms are ultimately owned by people, so any land and capital owned by firms is actually owned by the owners of these firms.

In markets for goods & services, households spend their income on products that are produced by firms. The money spent on goods & services is called spending (by households) and income (by firms), but spending and income are the same number.
*Suppose you go to McDonalds and spend $3.99 on a Big Mac Extra Value Meal. You have made

an expenditure of $3.99 but, at the same time, McDonalds just made $3.99 in income. Think of expenditures and income as two sides of the same coin.

Households (people) have two functions in the economy. First, they sell their labor, land and capital to firms in order to make income, and second, they spend their income on the goods & services that firms produce. Firms have two functions in the economy. First, they purchase the services of labor, land and capital, and second, they use labor, land and capital to produce goods & services, which they sell to households. In economics, technology is represented by a firm's ability to transform labor, land and capital into goods & services. When firms can produce MORE goods & services than before, while using the SAME amount of labor, land and capital, economists say technology has improved.

GDP and GNP - (Back to Top)

The two most important measures of economic activity (the size of the economy) are gross domestic product and gross national product. GDP the market value of all final goods and services produced within a country in a given period of time GNP the market value of all final goods and services produced by permanent residents of a nation within a given period of time The table below will help you understand the difference between GDP and GNP. The columns of the table measure the output of the factors of production of the US or the UK. The rows of the table measure the output of factors that are located geographically within the US or UK. For example, the upper left (100) cell of the table tells the value of output produced by US factors of production (ie: US labor or capital) that are located within the US. The upper right cell (5) measures the value of output produced by UK factors of production (ie: UK labor or capital) that is located within the US.

To measure GDP for the US or the UK, simply add up the value of all output produced IN the US or IN the UK. In other words, sum across the rows of the table to find GDP. To measure GNP for the US or the UK, add up the value of all output produced by US or UK factors of production. In other words, sum down the columns of the table to find GNP.

Because expenditures and income in the economy are equal, there are different ways to add up economic activity.

GDP as the sum of expenditures - There are four categories of expenditures consumption, investment, government spending and net exports. GDP as the sum of expenditures is given by: GDP = C + I + G + NX

GDP as the sum of incomes - Since income must equal expenditures, GDP can also be calculated by summing the income of factors of production (labor, land and capital). GDP as the sum of incomes is given by: GDP = wages + rent + profits

Real and Nominal GDP - (Back to Top)

Over time, the value of GDP tends to rise. Being the sum of expenditures on final goods and services, there are two reasons why GDP could increase - either there are more goods and services being produced, or the prices of goods and services has risen, causing the size of expenditures to rise. If GDP rises because more goods and services are being produced, the economy has gotten larger. If GDP rises because the prices of goods and services has risen, the economy is the same size as before, and has experienced inflation.

In reality, GDP increases for BOTH reasons - the goal of this section is to help you see how economists separate the two. Q: Can you compare GDP from year to year to learn about the size of the economy? A: No. You first have to take into account that prices have changed and negate the effects of inflation. Q: How do economists negate the effects of inflation? A: By calculating the value of expenditures in different years at constant year prices. nominal GDP the production of goods and services valued at current prices To calculate the value of 1997 nominal GDP, sum the value of all expenditures in 1997, using the prices that prevailed in 1997 real GDP the production of goods and services valued at constant prices To calculate the value of 1997 real GDP (in constant 1995 prices), sum the value of all expenditures in 1997, using the prices that prevailed in 1995 By choosing a base year, and valuing expenditures at constant prices, economists are able to negate the effects of inflation over time. With inflation out of the picture, real GDP is a measure of the size of economic activity. You should spend some time studying table 2 in your textbook chapter, which demonstrates how to calculate nominal and real GDP. When economists want to know how large inflation has been, they use the following relationship between nominal and real GDP:

GDP deflator the ratio of nominal to real GDP, times 100. Q: What is the value of the GDP deflator in the base year? A: The value of the GDP deflator in the base year is always going to equal 100. Calculating the nominal GDP for 1995 would mean summing all expenditures from 1995 at the prices that prevailed in 1995. Calculating the real GDP for 1995 (in constant 1995 prices) would ALSO involve summing all expenditures from 1995 at the prices that prevailed in 1995. Nominal and real GDP for the base year MUST be equal. If nominal and real GDP are equal, then the 1995 GDP deflator MUST equal 100. Suppose that 1997 nominal GDP was $8 trillion, and 1997 real GDP (in constant 1995 prices) was $7.5 trillion. The GDP deflator is:

The percentage change in the GDP deflator (from 1995 to 1997) is given by:

Q: What does the 1997 GDP deflator of 106.7 tell economists? A: Inflation in the two year period from 1995 to 1997 was 6.7% As the ratio of nominal to real GDP, the GDP deflator is a measure of the effect of price changes on the size of GDP - therefore, the GDP deflator is one way economists measure inflation.

Macroeconomics 102

A SHORT NOTE ON INFLATION, UNEMPLOYMENT AND PHILIPS CURVE Macroeconomic policies are implemented in order to achieve governments main objectives of full employment and stable economy through low inflation. We can use Philips Curve as a tool to explain the trade-off between these two objectives. Philips Curve describes the relationship between inflation and unemployment in an economy. You already know that the Inflation is defined by increase in the average price level of goods and services over time. When there is inflation, value of money falls. A low inflation rate indicates that average price of goods would not rise as high. Unemployment exist when someone is actively seeking for job but unable to find any despite their willingness to accept the going market wage rate (we discussed it many times right? See Ch5) New Zealand-born economist A.W Philips first put this theory forward in 1958 gathered the data of unemployment and changes in wage levels in the UK from 1861 to 1957. He observed that one stable curve represents the trade-off between inflation and unemployment and they are inversely/negatively related. In other words, if unemployment decreases, inflation will increase, and vice versa. Macroeconomics 102

The original Philips Curve: wage inflation against unemployment Inflation (%) Unemployment For example, after the economy has just been in recession, the unemployment level will be fairly high. This will mean that there is a labor surplus. As the economy has just started growing, the aggregate demand (AD) will increase and therefore leading to an increase in employment. In the beginning, there will be little pressure for a raise in wages. However, as the economy grows faster and more people are employed, wages will start rising slowly. This will increase the firms cost of production and the high costs are usually passed on to the customers in the form of higher prices. Therefore a decrease in unemployment has led to an increase in inflation and vice versa. Not only that, unemployed might suffer from money illusion as they thought the increase in wages offered to them represented a real wage (Sloman 2000). They underestimate inflation by not realizing that higher wages will be eaten up by higher prices. Thus they will accept job more readily and this will reduce the frictional unemployment (we discussed this in Ch5.. right??) in the short run. Macroeconomics 102

The relationship we discussed above is a phenomenon in the short-run. But in the long run, since unemployment always returns to its natural rate (unemployment rate at which GDP at its full-employment level that is, with no cyclical unemployment. we discussed this in Ch5right??), there is no such trade-off. [Remember that When unemployment rate is below natural rate, GDP is greater than potential output Economys self-correcting mechanism will then create inflation When unemployment rate is above natural rate, GDP is below potential output Self-correcting mechanism will then put downward pressure on price level] Using the data from the 1950s and 1960s where the world economy tend to be stable, Philips Curve relationship proved to be true for many economies such as United States and UK (Griffiths and Wall, 1999). However, during 1967-1970 most countries such as US, Britain and France had doubled their inflation (Ormerod, 1995). This was the first sign that the downward relationship in Philips Curve was not always true. In 70s the concept of a stable Philips Curve shows a break down as the economy suffered from both high inflation and high unemployment simultaneously. The economists refer this kind of situation as stagflation where stagnant economies and rising inflation occurs together.