Economic Activity Notes
The Level of Overall Economic Activity
Macroeconomic Objectives
Economic Growth: A sustained increase in a country's productive capacity, typically measured by the percentage increase in real GDP over a period of time.
Sustainable growth: Balancing current growth with the needs of future generations.
Inclusive growth: Ensuring the benefits of growth are shared across all sections of society.
Employment: A high level of employment and low unemployment rate.
Natural rate of unemployment: The unemployment rate that exists when the economy is at full employment. It includes frictional and structural unemployment.
Full employment: The level of employment at which there is no cyclical unemployment.
Price Stability: Maintaining a low and stable rate of inflation.
Inflation: A sustained increase in the general price level in an economy.
Deflation: A sustained decrease in the general price level in an economy.
National Debt: A sustainable level of government (national) debt.
Government debt: The accumulation of past government deficits.
Fiscal sustainability: The ability of a government to maintain its spending and debt levels without risking insolvency.
Income Distribution: An equitable distribution of income.
Gini coefficient: A measure of income inequality, ranging from 0 (perfect equality) to 1 (perfect inequality).
Progressive taxation: A tax system where the percentage of income paid in taxes increases as income increases.
The Circular Flow of Income Model
The model simplifies the economy to illustrate the flow of resources, income, and expenditure.
Two-Sector Model: Includes households and firms.
Households provide factors of production (land, labor, capital, entrepreneurship) to firms.
Firms pay wages, rent, interest, and profits to households.
Households spend income on goods and services produced by firms.
Firms generate revenue from household expenditure.
Closed Economy Model: Assumes all household earnings are spent on goods and services. This is different from reality. In reality, there are leakages (income that leaves the economy) and injections (additions to the circular flow).
Leakages and Injections
Leakages: Income earned but NOT spent on goods and services.
Taxes: Portion of income paid to the government; reduces disposable income.
Saving: Portion of income saved in financial institutions or markets; represents deferred consumption.
Imports: Expenditure on foreign goods; money leaving the domestic economy.
Injections: Allow for additions to the circular flow.
Government Spending: Government expenditure on goods and services, education, healthcare, etc. (funded by taxes).
Fiscal policy: Government use of spending and taxation to influence the economy.
Transfer payments, however, are not injections (e.g., unemployment benefits, subsidies).
Investment: Firms borrowing money from financial institutions to expand their businesses and buy capital goods.
Exports: Revenue from foreign consumers purchasing domestic goods.
Trade balance: The difference between a country's exports and imports.
Equilibrium in the Circular Flow
Leakages and injections do not have to be equal.
Leakages > Injections: The circular flow gets smaller.
Saving > Investment: Fewer goods and services are purchased, businesses cut back output, people become unemployed, and household income decreases.
Implications for economic growth and employment.
Injections > Leakages: The circular flow gets bigger.
Revenue from exports > Spending on imports: More goods are demanded by foreign consumers, businesses increase output, hire more workers, and household income increases.
Potential for inflationary pressures.
Measuring the Economy - GDP
Gross Domestic Product (GDP): The total value of all final goods and services produced within a country over a year.
Avoid intermediate goods: Only final goods and services are counted to avoid double counting.
It is represented in the circular flow diagram by each arrow (they are all theoretically equal to one another assuming no leakages or injections).
Three Methods of Measurement:
Output Method: Measures the actual value of goods and services produced by summing all the value added by all firms in an economy (costs of inputs are deducted to avoid double counting).
Value added: The increase in the market value of a product at each stage of production.
Grouped by sector: Primary, Secondary, Tertiary
Income Method: Measures the values of all incomes in an economy.
Includes wages, rent, interest, and profit.
Expenditure Method: Measures the value of all spending on goods and services in an economy by households, firms, the government, and net exports.
GDP, National Output, National Income & National Expenditure
Because of the circular flow of income:
The expenditure method is commonly used:
Where:
C = Consumption
I = Investment
G = Government Spending
X = Exports
M = Imports
Note: These values are very difficult to calculate so there will be inaccuracies when calculating them.
GDP vs. GNI
GDP: The total value of all final goods and services produced within a country over a year, regardless of who owns the factors of production.
GNI (Gross National Income): The total income received by the nationals of a country, equal to the value of all final goods and services produced by the factors of production supplied by the country’s nationals regardless of where the factors are located.
Includes income earned abroad by domestic residents and firms.
GNI = GDP + net property income from abroad
GDP - Expenditure Approach Components
Household Consumption (C): The purchase by households of all goods and services.
Non-durables: bread, milk, toothpaste, t-shirts, socks, toys, etc.
Durables: TVs, computers, cars, refrigerators, etc.
Services: dentist visits, haircuts, taxi rides, accountants, lawyers, etc.
Investment (I): All final purchases of machinery, equipment, and tools by businesses, all construction (including residential), and changes in business inventories.
Gross vs. Net Investment: Accounting for depreciation of capital.
If total output exceeds current sales, inventories build up.
If businesses are able to sell more than they currently produce, this entry will be a negative number.
Government Spending (G): Includes spending by all levels of government (federal, state, and local) and all direct purchases of resources (labor in particular).
Capital vs. Current Expenditures: Distinguishing between long-term investments and day-to-day operational costs.
This entry excludes transfer payments since these outlays do not reflect current production.
Net Exports (X-M): All spending on goods produced in the country must be included in GDP, whether the purchase is made here or abroad.
Factors affecting net exports: Exchange rates, trade policies, and relative economic performance.
Real vs. Nominal GDP
Nominal GDP: The value of a nation’s output produced in a year, expressed in the value of the prices charged for that year.
Affected by both changes in quantity and price.
If the average price level of a nation’s output increases in a year, the nominal GDP would increase even if the actual amount of output does not change.
Real GDP: The value of a nation’s output in a particular year adjusted for changes in the price level from a base year. It offers a more accurate measure of output because it adjusts for price changes.
Uses a base year to compare output across different time periods.
Per Capita Values
Per capita: A Latin phrase that means per person.
GDP per capita: The total GDP divided by the country’s population.
It is useful as a summary measure of the standard of living in the country (same applies to GNI per capita).
Provides an indication of how much output or income in the economy corresponds to each person on average.
Note the limitations of averages.
Distinction between total and per capita is important because of differences in size of population and population growth.
Purchasing Power Parity (PPP)
Purchasing Power Parity (PPP): A method of currency conversion that accounts for differences in price levels between countries.
Allows for more accurate comparisons of living standards across countries.
GDP or GNI per capita gives an indication of the standard of living, but we need to also account for price differences across different countries to see what that amount of money can actually purchase.
Why Gather National Income Statistics?
Seen as a report card for a country's economic policies.
Governments use the statistics to develop policies.
Monetary policy: Central bank actions to influence the money supply and credit conditions.
Economists use statistics to develop models and make forecasts.
Businesses use them to forecast demand.
Can be used to analyze the performance of an economy over time.
Used to evaluate the standard of living.
Used as a basis of comparing countries.
Limitations of National Income Statistics
Inaccuracies - very difficult to calculate because of how many sources you must gather data from
Unrecorded or under recorded economic activity - informal markets (do-it-yourself, subsistence farming, hidden economy)
External costs such as resource depletion
Other quality of life concerns are unaccounted for - working longer hours, taking fewer holidays, spending less time with family
Composition of output - some output does not benefit consumers so they don’t necessarily raise the standard of living
Considers what is produced and for whom; highlights inequality.
Business Cycle
Business cycle: The periodic fluctuations in economic activity measured by changes in real GDP.
The phases are expansion (recovery), peak (boom), contraction (recession), trough (bust).
This is highly irregular, but the economy generally moves in this cycle.
GDP increases at a rising rate in the expansionary (recovery) phase because of increased demand by households so firms hire more workers and increase output.
As more people are employed, more people demand goods, and thus there is an increase in the average price levels (inflation). GDP growth will decrease (note it still grows, but just not as fast until it reaches the peak).
Recession: Two consecutive quarters of negative real GDP growth (now there is a decrease in real GDP).
Impact on employment, investment, and consumer confidence.
The economy contracts (contraction)
Firms lay off workers because people are not interested in spending as much which causes even less spending, perhaps deflation.
Eventually the contraction comes to an end at the trough.
Alternatives to GDP
There are limitations of GDP as a measure of economic well-being.
Other holistic measures can be better indicators of economic well-being:
OECD Better Life Index
Happiness Index
Happy Planet Index
OECD Better Life Index
OECD - Organization for Economic Cooperation and Development
Created in 1961 to promote policies that will improve economic and social well-being of people around the world
35 member nations including most of the world’s developed economies and some emerging economies
OECD Better Life Index compares well-being across countries based on 11 topics:
Material Living Conditions (housing, income, jobs)
Quality of Life (community, education, environment, governance, health, life satisfaction, safety, work-life balance)
Happiness Index
UN Sustainable Development Solutions network puts this composite index together
Happiness Index: Based on GDP per capita, social support, healthy life expectancy, freedom to make choices, generosity, and perception of corruption
Happy Planet Index (HPI)
Measures sustainable wellbeing - how well countries are doing at achieving long and happy lives, taking into account sustainability.
Wellbeing: How satisfied the residents of a country say they feel overall.
Life expectancy: Average number of years a person is expected to live.
Inequality of outcomes: The inequalities between people in a country in terms of how long they live and how happy they feel.
Ecological footprint: Average impact of each resident on the environment.calculate it
National Income Statistics Calculations
Calculating nominal GDP using the expenditure method:
Calculating GNI:
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