Topic 7 Circular Flow of Income Expenditure PDF

TOPIC 7: CIRCULAR FLOW OF INCOME 7.1 Understand the nature of macroeconomics. Economics traditionally has been divided into two major fields: Microeconomics and Macroeconomics. These words are derived from the Greek, ‘micro’ means small and ‘macro’ means large. 7.1.1 Define...

TOPIC 7: CIRCULAR FLOW OF INCOME 7.1 Understand the nature of macroeconomics. Economics traditionally has been divided into two major fields: Microeconomics and Macroeconomics. These words are derived from the Greek, ‘micro’ means small and ‘macro’ means large. 7.1.1 Define Macro economics. In microeconomics we study the behavior of individual-decision making units, the firms and the consumers are the individual decision-making units, and their decision is coordinated by the market mechanism. In macroeconomics we concentrate on the behavior of entire economies. Rather than looking at the decisions of a single unit, macroeconomists study the overall price level, unemployment rate, and other things that we call economic aggregates. Aggregation and Macroeconomics An economic aggregate is nothing but an abstract term that people use to refer to the concept of a whole or total economy. One of the important aggregates is the concept of national product. National product represents the total production of a nation’s economy – these are all the breads, ice creams, tinned fish, put together and termed as total output. 7.1.2 Outline goals of macroeconomics policy. Macroeconomics deals with inflation, unemployment,, economic growth and balance of payments problems. In macroeconomics we also look at the goals of monetary and fiscal policy (Stabilization policy) to curtail inflation and shorten recessions. 7.2 Understand circular flow of income. Let us begin our study of macroeconomics by discussing the circular flow diagram. The circular flow diagram is an economic model which shows how an economy works. ‘The circular flow of income’ is an expression used to describe the flow of money round the economy between consumers and producers and /entrepreneurs. We will start by looking at a model of a simplified economy that consists of two sectors: Households and Firms – with no government and international trade. 1. Households Households are the consumers of goods and services and firms are the producers of goods and services. Households provide firms with the factors of production – land, labor, capital and entrepreneur skills. House holds receive payment for these factors of production in the form of wages, interest, rent, and profit (income). 2. Firms supply households with goods and services and in return receive payment for it (consumption expenditure). 1 7.2.1 Define circular flow of income in a simple close economy (no leakages or injections). Income (rent, wages, interest, profit) Land, labor, capital, entrepreneurship Capital market H/holds Firms Goods market Goods & services Consumption Expenditure The above diagram illustrates how income circulates in a simple, static closed economy. In return for the productive services of the factors of production provided to firms, households receive income which they spend on goods and services supplied by the firms. Thus, income flows from firms to households and back to firms again. The diagram also shows an important relationship. That is, TOTAL INCOME = TOTAL EXPENDITURE = TOTAL OUTPUT The transactions between households and firms in the Goods Market and Factor Market generate the circular flow of expenditure and income. House holds receive factor income (y) from firms in exchange for factors they supply. The flow of income from firms to households and of consumption expenditure from households to firms is the circular flow of expenditure and income. 7.2.2 Explain the inclusion of the following on the circular flow: a. the capital market (savings and investment). b. The government (taxes, subsidies, transfer payments’ etc). c. The overseas sector (exports, imports, capital). Markets There are two markets in the simple circular flow model. In one, households exchange their resources Land, labor, capital and enterprise) for money incomes (wages rent, interest and profit). In the second market, money incomes are exchange for consumer goods and services. Leakages and injections In the two sector model of the economy there are no leakages from the flow. All payments which firms, as a group, make in the resource market, come back to them as 2 sales receipts in the consumer goods market. Any money which households, as a group, spend in the consumer goods market, comes back to them as income when they sell their resources to firms. There are no injections into the two-sector circular flow model either. Households cannot spend anymore money than they earn from selling resources. Firms cannot pay any more money than they receive from selling finished goods and services. If all income is spent, all production is consumed and there are no other sources of funds, the money flows will remain the same from week to week and year to year. The economy s said to be in equilibrium. Equilibrium means that there is no tendency for change. The three sector model: the financial sector Most house holds do save some of their income. They may save for security, for an expensive purchase in the future or for other reasons. When households save, the money paid by business firms will not all be receive back as payment for goods and services. Savings are a leakage from the circular flow, and cause the money flow to diminish. The money which firms pay to resource-owners represent the value of the resources used in production, and therefore the value of the goods produced. When households save, the funds which the firms get back as sales receipts are less than this amount. They do not receive enough to pay for the same amount of resources in the next period, nor do they sell all the goods they produce in this present period. As a result the firms will not want to produce as much next time, so they employ fewer resources. The household’s income will fall. Lower incomes mean less spending, smaller sales receipts for firms, lower production, less employment, lower income in the next stage of the cycle, and so on. As consumer spending falls, production and income continue to fall, fewer resources are used, and unemployment rises. The situation will also worsen if business firms also save. Most firms retain some of their income as undistributed profits to pay for future expansion or to pay shareholders in less profitable times. In the real world, rising unemployment and falling production are not always the result of leakages through savings. The reason is that (1) many consumers borrow and (2) most firms invest. Consumer borrowing There are other households who do save, whilst there are others who borrow to buy the goods and services they consume. One family does not spend all its income and so it does not consume the full value of its productive resources- but when another family borrows money, it can spend more than it has earned. As long as one group’s savings is offset by another group’s borrowing there is no net saving by households, and firms can sell all their output in that period. Credit buying is an important part of modern life and plays an important role in maintaining production levels in the economy. Investment In the real world some firms produce capital goods and some produce consumer goods. When firms buy capital goods to use in the production of other goods, they 3 invest. Capital goods are usually expensive and, as they are expected last through a number of production periods, firms do not pay for them from current sales receipts as they do other factors of production. They are financed by borrowing funds from financial institutions. The financial market allows firms to borrow the accumulated savings of households and other firms. Instead of savings being a leakage from the circular flow, they are mobilized and injected back into circulation as investment. The productive resources supplied by households can be used to produced either capital goods or consumer goods. As long as any income not spent on consumer goods (i.e., saved) is diverted through the financial market to spending on capital goods (i.e., invested), there are no leakages from the circular flow. The income received from the sale of productive resources is equal in value to the total output of consumer goods plus capital goods which equals the total expenditure of households and firms. With the leakage to savings exactly balanced by the injection from investment, the flows will continue at the same level and the economy will remain in equilibrium. Fluctuations in savings and investments The effect on the circular flow when saving is greater than investment When the leakage to saving (S) greater than the injection (I), households spend less but firms do not buy enough capital goods to make up for the loss to savings. The amount businesses receive from consumer spending plus investment is less than they paid out for productive resources. Some of the goods they produced remain unsold. Firms cut back on production and employ fewer resources, reducing household incomes. On lower incomes, households cannot afford to save as much, but if the saving leakage is still greater than the investment injection, production and income will be cut back further. The cycle of less spending, less production, and lower income, continues until the amount voluntarily saved is reduced to the same value as firms wished to invest. The economy is in equilibrium – but at a lower level of production, employment and income than before. The effect on the circular flow when investment is greater than savings When the investment injection is greater than the savings leakage, the flow will grow. Business firms can sell more consumer and capital goods than they have produced, so they employ more resources to increase their output. Household receive more income and they can afford to save more. They also want to buy more with their higher incomes, so firms increase production further, leading to more income, more saving and more consumer spending. The circular flow will continue to expand until the leakage to saving exactly offsets the injection from investment (S=I). The flow will then have regained equilibrium. The tendency for the economy to expand or contract in response to differences in the leakages from and injections to the economy, shows that while at any given time the amount which households or firms wish to save may not necessary be equal to the amount that firms wish to invest, the economy moves towards the level of income where they will be equal. This phenomenon helps to explain the trade cycles exper5ienced by market economies. 4 EXERCISE: 1. Explain why savings caused the circular flow to diminish. 2. What two injections to the circular low of income help compensate for the leakage to savings? 3. What happens to circular flow of income when saving is greater than investment? 4. Under what circumstances will the circular flow of income remain in equilibrium when saving and investment are included in the analysis? 5. What happens to circular flow of income when is investment is greater than saving? The four sector model; the government sector in the circular flow In all modern economies the government has some influence on the production process. The government sector is responsible for some leakages from the circular flow through various taxes. It inject funds into the circular flow through various types of government spending. Taxation Taxation (T) is a compulsory payment made by the government without there being a direct service received directly in exchanged for it. Taxation is a leakage form the circular flow. The money firms pay for resources cannot all be spent buying goods and services because the government takes some of it in income tax. The money consumers pay for goods and services is not all available for firms to spend on more resources because the government takes sales tax, excise duties and other taxes from it. Government spending Government spending (G) is the injection to the circular flow that helps offset the leakage to taxation. Government funds which are spent buying productive resources are similar to other earnings by households. The wages of nurses, teachers and army personnel come into this category. Government payment for road building equipment, office supplies and patrol boats are similar to other sales receipts of business firms. The two main forms of government spending that are different form other payments mentioned so far are social service benefits and subsidies. Social service payments such as unemployment benefits and age pensions are made to households without the usual exchange for productive resources. Subsidies are payments made to business firms without the usual exchange for goods and services. For example, Coffee farmers will be paid a subsidy when they buy a particular fertilizer. Both social service benefits and subsidies are examples of transfer payments. They destroy the balance between household income and the value of productive resources supplied by households and between firm’s receipts and the value of their output. Income is transferred, firstly by taxation and then by social service benefits and subsidies, from those who have earned it (by contributing resources to production) to other persons or firms who are considered to need it. Taxation also destroys the balance between the value of productive resources supplied and the income actually received, and between total expenditure by consumers and business receipts by firms. But as long as the government spends the full amount it 5 takes from income earners (i.e., as long as the leakage to taxation is exactly offset by the injection from government spending), the circular flow will remain in equilibrium. Total income (Y) will equal total production (O) and total expenditure (E). When government spending is greater than taxation (G > T) the circular flow of income will expand. Rising incomes lead to more spending and more production – and also to higher taxes. Eventually taxes rise to a level where T = G and the economy is in equilibrium again. When T > G the economy contracts as spending an income fall. The government can regulate the economy using its power over taxation and its own spending. During a recession – when unemployment is high and business activity is low – the government can stimulate incomes and production by cutting taxes and/or increasing its own spending. (Governments can spend more than the taxes collected by borrowing from the public, from the Central Bank, or from overseas) When the economy is “overheated” with high levels of spending and insufficient resources to meet the demand for goods and services, the government can increase taxation or cut its own spending (or both) to reduce some f the pressure. Higher taxes result in less consumer spending and falling incomes for firms – who then employ fewer resources, so incomes fall, as do taxation receipts. Less government spending have the same effect. The economy regains equilibrium when taxation receipts fall to the same level as government spending. The government makes known its plans for raising revenue and expenditure in its annual budget, usually delivered each November. It sometimes adjust this plans, in the light of changed conditions in the economy, by means of a ‘mini-budget’. The budget is a very important instrument which the government can use to expand or contract the economy as part f its policy of economic management. When savings and investment are included in the circular flow analysis along with the effect of government, we see that the economy reaches equilibrium when total leakages (S + T) are exactly balanced by total injections (I + G), It will contract if total leakages are greater than total injections. Equilibrium is regained when they are equal. EXERCISES: 1. Define taxation. 2. Explain why taxation reduces the circular flow of income. 3. What happens when G does not equal T? 4. How can the government use its spending and taxing powers to regulate the economy? 5. Under what circumstances will the economy be n equilibrium when both he financial sector and the government sector are included in the circular flow analysis? The five sector economy: the foreign sector in the circular flow The final sector in the circular flow analysis is the exports and imports of goods and services involving foreigners or rest of the world (ROW). All economies are now interdependent, which means they depend on each other. 6 Imports (M) consist of goods and services received from abroad and any other payments (such as interest on money borrowed overseas, investments in foreign countries, tourist spending and foreign aid) made by our economy to overseas countries. These payments are a leakage of funds from the circular flow of income. The resources used in the production of imported goods were foreign resources and the payment for them goes to foreign firms and then to foreign households. They are no longer part of our circular flow, and continued leakages to imports will cause income to fall. Exports(X) represent an injection of funds, because we receive the payment in return for supplying goods and services to foreigners. Foreign investment in PNG and spending by overseas tourist increases total spending in PNG. The circular flow expands. The values of exports and exports are shown in the balance of payments. When the financial market and the government sector are taken into account along with the overseas sector, the economy will be in equilibrium only when all leakages are offset by an equal value of total injections. This situation occurs when S + T + M = I + G + X. If leakages exceed injections the economy will keep contracting until equilibrium is regained. If injections are greater than leakages the economy will grow until the equilibrium position is reached EXERCISES: 1. Why is M considered to be a leakage from the circular flow of income? 2. When is the five-sector model of house holds, firms, the financial sector, the government sector and the overseas sector in equilibrium? The circular flow of income model and the economy The two-sector model was in equilibrium because there was no leakages or injections to the circular flow of income. The expanded model is in equilibrium when all the leakages are exactly balanced by all the injections, that is, when S + T + M = I + G + X. The flow does not expand or contract, so we can draw the same conclusions as in the simple model. The total income receive by households (Y) equals the total value of production (O), which is called the gross domestic product. Therefore Y = GDP The gross domestic product is made up of consumer goods (C), capital goods (I), government spending (G), and Goods and services sold overseas (X). Household income in turn, is either spent on locally produced goods and services or siphoned into the leakages of savings (S), taxation (T), or spending overseas (M). Income spent overseas is lost to our economy. The circular flow of income includes only our net earnings from the foreign sector, so the circular flow consists of Y = GDP = C + I + G + (X – M) 7 7.3 Understand aggregate demand. 7.3.1 Define the term “aggregate demand”. 1. Aggregate demand is the total demand in the economy for goods and services. 2. Aggregate demand is the total quantity of goods and services, or real GDP, demanded. Gross Domestic Product (GDP) is the value of all the final goods and services produce in the economy in a year. Real GDP measures the value of output of final goods and services using base year prices (sometimes referred to as constant dollar GDP). Nominal GDP measures the value of the output of final goods and services using ( current prices) prices that prevailed at time of measurement (sometimes referred to as current dollar GDP) It is the sum of: a. Consumption of goods and services households plan to buy. b. Investment goods firms plan to buy. c. Goods and services governments plan to buy. d. Net exports foreigners plan to buy. The level of real GDP demanded depends on decisions made by the firms, households, governments and foreigners. You can see the connection between the aggregate expenditure that we discussed previously and the aggregate quantity demanded. That is, both refer to the amount of goods ad services produced in the economy, which is GDP – the value of all the final goods and services produce in a year. The aggregate quantity demanded is the planned expenditure of households, firms, government, and foreigners at a given price level. Aggregate demand is the total amount that all consumers, business firms, government Therefore, aggregate demand = C + I + G + NX, agencies, and foreigners wished to spend on all final goods and services. 8  where; C = planned consumption expenditure, I = planned investment expenditure, G = planned government expenditure, NX = planned net exports. We can understand the nature of aggregate demand best if we break it up into its major components. Consumer expenditure (‘consumption’ for short) is simply the total demand for all goods an services. Investment spending, which we represent by letter I, is the amount that firms spent on factories, machinery, and the like, plus that amount that families spent on new homes. Notice that this is very different usage of the word ‘investment’ form that use in every day language. Most people speak of ‘investing’ in the stock market or in a bank account. When economists speak of ‘investment’, they mean instead the purchase of some new physical asset, like a drill press, an oil rig, or a home. It is only this kind of investment that leads directly to additional demand for newly produced goods in the economy. Another major component of aggregate demand is government purchases (or spending) of goods and services; that is, things like paper, type writers, airplanes, ships, and labor that are bought by all levels of government – national, provincial and local. We use the letter G to denote this variable. (Note: this variable does not include transfer payments, such as social security, sickness and unemployment benefits, made by governments). The final major component of aggregate demand is net exports. This consists of exports, which we will represent by the letter X, and imports, denoted by IM. Exports are the sum of all expenditures by foreigners on Papua New Guinean produced final goods (such as coffee, cocoa, copper) and services (such as transportation, accommodation, entertainment purchase by foreigners while holidaying in Papua New Guinea).Papua New Guinean expenditure ons on imports from other countries must be deducted when calculating total demand for domestic production, since the spending by households, firms, and governments include their overseas purchases. Given all these abbreviations, we have the following shorthand definition of aggregate demand: Aggregate demand is the sum C + I + G + (X- IM) 7.3.2 Predict changes in aggregate demand given changes in rates of flow as a result of leakages or injections to the circular flow. Aggregate expenditure = Aggregate income This relationship is illustrated by the expenditure on goods and services received by the firms and the firms payment foe factors of production. We have four flows representing firms’ revenues for sale of goods and services: 9 (C) consumption expenditure, (I) investment, (G) government purchases of goods and services and (NX) net exports. The sum of these four flows is equal to aggregate expenditure. As before everything that a firm receives from the sale of its output, is paid out as income to owners of factors of production. i.e., Y = C + I + G + NX GDP also equals Aggregate expenditure = Aggregate income. Therefore, Y = GDP = C + I + G + NX (b) Disposable income Personal disposable income is the amount of income individuals receive and have available for spending. This is the net income after tax has been deducted. The algebraic formula is: Total income =Y = C + S + NT Disposable income = YD = Y – NT = C + S INJECTIONS AND LEAKAGES Injections are expenditures that add to the circular flow of income and expenditure – investment spending, government expenditure, and exports. Investment refers to the purchase of new plant, buildings, vehicles and machinery to produce capital goods or consumer goods not intended for current consumption. Leakages are income that is not spent on domestically produced goods and services – savings, taxes and imports. In the real world injections must equal leakages. What ever is leaked out from the circular flow would eventually return to the circular flow. The algebraic representation goes like this: Y = C + I + G + NX If we divide NX into X – M, we get Y=C+I+G+X–M We also know that Y = C + S + NT Combine this equations: Y = C + I + G + X – M = C + S + NT 10  If we subtract C from both sides: = C – C + S + NT = C-C + I + G + E – M = S + NT = I + G + E – M If we add M to both sides: = S + NT + M = I + G + E – M + M = S + NT + M = I + G + E i.e., INJECTIONS = LEAKAGES 7.3.3 State implications for the level of employment given a change in aggregate demand. Aggregate demand is the total demand in the economy for goods and services. Changes in the circular flow influence aggregate demand which in turn influences the level of employment. CHANGES IN THE AGGREGATE LEVEL OF CIRCULAR FLOW DEMAND EMPLOYMENT An increase in the flow: Rises Rises A decrease in the flow: Falls Falls 7.4 KNOW HOW TO CALCULATE THE NATIONAL INCOME, NATIONAL EXPENDITURE, AND NATIONAL PRODUCTION. 7.4.1 Explain the terms: National income may be measured in terms of either output or earnings or expenditure. NATIONAL OUTPUT = NATIONAL INCOME = NATIONAL EXPENDITURE a. National income. Is the total earnings of the factors engaged in the production of goods and services in a country. National income is a measure of the economic performance of a country. GDP is the most commonly used indicator of performance of the economy over time. GDP is the value of the out put of goods and services produced by the country in a year, after deducting the cost of intermediate goods and services but before deducting depreciation. b. National expenditure. 11  Is the same as national income because the income or earnings are either spent, or saved with the Capital market or the Money market which loans it to others to spend. c. National output. Is the value at factor cost of all goods and services produced in a country in a given period (say, 1 year). d. Gross Domestic Product (GDP). Is the value of all the final goods and services produced in a country in a given period, usually one year. Gross domestic product (GDP) measures total output in the domestic economy. Nominal GDP, real GDP, and potential GDP are three different measures of aggregate output. Nominal GDP is the market value of all final goods and services produced in the domestic economy in a one-year period at current prices. By this definition, (1) only output exchanged in a market is included (do- it-yourself services such as cleaning your own room are not included, home repairs etc); (2) output is valued in its final form, and (3) output is measured using current year prices. Because nominal GDP values are inflated by prices that change over time, aggregate output is also measured holding the prices of all goods and services constant over time. This valuation of GDP at constant prices is called real GDP. The third measure of aggregate output is potential GDP (trend GDP), the maximum production that can take place in the domestic economy without putting upward pressure on the general level of prices. As a matter of illustration, potential GDP represents a point on a given production-possibility frontier. A final good is one that involves no further processing and is purchase for final use. An intermediate good is one that (a) involves further processing during the year (b) is being purchase, modified, and then resold by the purchaser, or is resold during the year for profit. e. Gross National Product (GNP). Is GDP plus ‘net property income from abroad’. In the case of Papua New Guinea, ‘the net property income from abroad’ is the difference between income earned abroad and what PNG has to pay to foreigners who own assets or have invested in PNG. GNP is the market value of all final goods and services produced in an economy by the factors of production owned by residents of that country. GDP also measures the market value of goods and services produced in an economy but includes only that output produced by economic resources located within that country. Hence, a country’s GNP could be K100 billion, K2 billion of which may be produced by capital which is owned by residents of that country but is located outside that country. The output of resources located within the country would be K98 billion, which is the country’s GDP. GDP is therefore the same as GNP when all resources owned by residents of that country are producing output in that country. GNP is greater than GDP when residents of that country employ their resources to produce output outside that country. As a rule, GNP will be lower than the GDP in countries where there are foreigners earning wages, salaries, and profits from their operations. This is true 12  for all Third World countries. In the case of developed countries, by contrast, GNP will be higher than the GDP since their citizens go abroad and bring back their wages, salaries and profits which they earn from their operations in the foreign countries. In other words, for countries like PNG There are net factor payments which go out of PNG, and for countries like the U.S.A. there are Net Factor Incomes which come into the U.S.A.. f. Gross National Expenditure (GNE). GNE is the sum of C + I + G + inventory. (Refer Table 6.4 in the Hand-out and the following notes) g. Net National Product (NNP). GNP includes depreciation or Capital Consumption Allowance. When you deduct depreciation, or CCA from the GNP figure, you get what is called NNP or Net National product. In other words: GNP – CCA = NNP By the same token GDP also includes depreciation or CCA. By deducting CCA from GDP You can get NDP or Net Domestic product. In other words: GDP – CCA = NDP 7.4.2 Understand that per capita income is the measure of the standard of living. By standard of living, we mean ‘how well off an individual or a nation is at a point in time. A country’s standard of living depends on how much it produces. The level of national income is thus an important, but imperfect measure of the standard of living. It is imperfect in the sense that the level of national income does not provide any clue to either the size of the population or the manner of its distribution. Some sections of the community may be better off while others may be living in poverty. A better measure, therefore, is the per capita income- i.e., income per person (or per head). PER CAPITA INCOME = NATIONAL INCOME ÷ POPULATION Total and per capita GDP The total out put of goods and services produced in a year and valued at current market price is called current (nominal) GDP, and when that output is valued at some constant base year price, it is called Constant (real) GDP. The difference between the two is the type of price used (current or constant price). When you divide the total GDP (current or constant) by the number of people in the country, you get what is called Per Capita GDP (current or constant, depending on which one you have used). The following formula expresses the per capita GDP: Total GDP Per Capita GDP = Population 400 million = 4million = K1 000 13  If the total GDP of PNG is K4 000 million and population is 4 million, the per capita GDP in that year will be K1000. It should be remembered that per capita income does not indicate the income level of each and every individual in the country. It will do so only if there is perfect income equality. Consider the following two situations: Situation A Situation B Population Income Population Income 1. John 5 000 1. John 15 000 2. Joseph 5 000 2. Joseph 3 000 3. Mary 5 000 3. Mary 1 800 4. Angela 5 000 4. Angela 200 4 20 000 4 20 000 7.4.3 Explain the effect which inflation has on the GDP and the per capita income figures in simple terms. Inflation can slow down economic growth, redistribute income and wealth, and cause economic activity to contract. Inflation impairs decision making since it creates uncertainty about future prices and/or costs and distorts economic values. 7.4.4 Calculate National Income and National expenditure. THE VALUE OF GDP Economic planners need to be able to measure the level of production within the economy. They must know if the economy needs to be stimulated to lift employment level or if it needs to be contracted to reduce inflation. They need some way to tell if various policy measures have done the job intended. Analysis of the circular flow of income model shows that the value of production can be measured in three different ways. The income received method measures the income of the owners of the factors of production. They add up to the total income earned producing the economy’s total output, the GDP. The production method measures the value of the actual goods and services produced and sold. The expenditure method measures the total spending on goods and services produced in the economy. The important point here is that all three methods will provide basically the same result because all three measure the same flow at different points of it. The income Method The income Method of measuring GDP includes all income which the owners of factors of production receive in return for their use in the production process. Statistics are obtained from taxation returns. The income method of calculating GDP gives us the following formula: GDP (Y) = [Rent + Wages + Interest + Profits] + [CCA] + [NIT] where: CCA is depreciation NIT is indirect taxes minus subsidies. 14 (Refer to Table 6.3 in the Hand-out) The Production Method The production method measures the total value of the production of final goods and services in the economy. The value of each firm’s production is the amount it pays for the resources it uses in production. The value of production can also be found by taking the final selling price of a good when it is sold for the last time. In this case the value of intermediate goods, that is, goods sold to other firms for further processing, are not counted. The main difficulties with this method is the risk of double counting (counting the same product more than once. The following formula is used to calculate GDP using this method: GDP (Y) = P x Q where P is price and Q is the Quantity. (Refer to Table 6.2 in the Hand-out) The expenditure method The expenditure method measures the amount spent buying finished goods and services in our economy. It measures spending by consumers (C), investment spending by firms (I), spending by Governments (G), and spending by overseas buyers on PNG’s goods and services. The expenditure method for measuring GDP can be expressed by the following formula. GDP (Y) = [C + I + G ] + [X – M] Where C = consumption expenditure (or consumption demand) I = investment expenditure (or investment demand) G = government expenditure (or government demand) X = export expenditure (or export demand) M = import expenditure (or import demand) (Refer to Table 4 in the Hand-out) The money value of GDP can be found by any one of three methods. These are income-received method, the value of production method, and the expenditure method. Each will give substantially the same result, because they all measure production at different points on the circular flow. The problem with measuring GDP in these ways is that they are monetary measures, measuring the market value of all goods and services produced. The money value of GDP may not give us an accurate estimate on changes in actual production from time to time, because this monetary value may be inflated by the increased prices of the goods and services produced. There may or may not be real increases in production levels. To measure the extent to which GDP changes in real terms, the figures must be corrected for price changes. This is done by price index numbers which are a measure of the average change in prices for the period. To avoid confusion, a GDP figure which has not been adjusted for changes in price is called ‘GDP at current prices’. A GDP figure which has been adjusted for price changes is called ‘GDP at 15  constant prices’. The table below and the following analysis show how current price GDP is adjusted to constant price GDP. Year GDP current Price index GDP constant Price (millions) Base year 1979-80 prices 1979 -80 (millions) 1979-80 116 417 100.0 116 417 1980-81 132 705 110.4 120 203 1981-82 150 253 121.6 123 563 1982-83 165 306 134.6 122 812 1983-84 186 550 144.8 128 832 1984-85 207 089 153.7 134 735 Between 1979-80 and 1980-81 GDP in money terms rose from K116 417 million to K132 705 million, a rise of approximately 14%. However, in the same time prices rose by 10.4%. Some of the increase in GDP was thus due to price increases. To find out the real level of GDP we must correct this current price figure to constant price terms using the following formula. Index base year GDP constant prices = GDP current prices  Index current year Thus, to find what the 1980-81 GDP figure would have been if the prices had stayed the same as they were in 1979 –80 (i.e., GDP at constant 1979-1980prices) we make the following substitutions in the above formula: 100 GDP cons tan t prices = 132 705  110.4 = K120 203 million Thus, between 1979 –80 and 1980-81, GDP rose in real terms from K116 317 million to K120 203 million – an increase of 3.35%. This shows the growth rate of the economy and of national income for these consecutive years. In the table it is interesting to note that between 1981-82 and 1982 –83 GDP in real terms fell, i.e. we had negative growth. 7.4.5 Calculate national output using the “Value added” Approach. Calculate per capita income and real per capita income. The value added method: Each stage in the production process adds utility and value to the product. The value added at each stage is calculated and total value of production found. For example, a wheat farmer produces ; a flour mill processes the wheat and sells the flour for K18 000. A bakery buys the flour and produces bread and cakes, which are sold for K38 000. The value added approach: Stages of Production Value of output Value Added 16  (P x Q) 1. Wheat farm K10 000 K10 000 (10 000 – 0) 2. Flour Mill K18 000 K 8 000 (18 000-1000) 3. Bakery K38 000 K20 000 (38 00-18 000) K58 000 K38 000 The value added to production by the flour mill is K8 000 (K18 000 – K10 000). A bakery buys the flour and produces bread and cakes, which are sold for K38, 000. The value added to production by the bakery is K20 000 (K38 000-K18 000). The total value added to production by the farmer (K10 000), flour mill (K8 000) and bakery (K20 000) is therefore K38 000. If you include all goods, the final goods, and the intermediate goods, in computing the GDP, you will be committing an error called ‘double counting’. Double counting would tend to overestimate the value of GDP. EXERCISE #1: PNG’s GDP by Value Added-Method, 1994 Commodity Quantity x Price = Value of output Value Added Wheat 10 x 2 = -------------- ---------------- Loaf of bread 30 x 3 = --------------- ---------------- Sandwiches 100 x 2 = ------------- ---------------- -------------- ---------------- EXERCISE : 1. What is referred to as ‘transfer funds’? 2. Explain what is aggregate demand. 3. Explain the difference between National income and National expenditure. 4. Explain the following terms: (a) GDP (b) GNP (c) Nominal GDP (d) Real GDP 5. What is the difference between GNP and GDP. 6. List and explain the three approaches to calculating GDP by the use of formulas. 7. The definition of GDP includes the word ‘… final goods and services’. What does the word ‘final’ means? 8. The words Gross Domestic Product and Gross National Product have in them the word ‘Product’. Explain the meaning of the word ‘Product’ in this particular context. 17