Unit 3 Macroeconomic concepts (2) (1).docx

Unit 3 Macroeconomic Concepts [National Income /output concept] National income is the single most important macro variable that represents the 'economy as a whole'. The level of national income determines the level of all other macroeconomic variables aggregate consumption, savings and investmen...

Unit 3 Macroeconomic Concepts [National Income /output concept] National income is the single most important macro variable that represents the 'economy as a whole'. The level of national income determines the level of all other macroeconomic variables aggregate consumption, savings and investment, employment and price level. The national income concept can be viewed from both the theoretical and practical points of view. At the theoretical level, a major part of macroeconomic theories seeks to explain the determination of national income, the relationship and interaction between its various components and growth of, and fluctuations in national income. From the practical point of view a country\`s national income data is used for - Measuring the standard of living and economic welfare of its people - Formulation of economic policies for the management of the economy and - Making international comparisons about the status of the economy In general sense of the term, 'national income' refers to the aggregate money value of all final gods and services resulting from the economic activities of the people of a country over a period of one year. [Gross Domestic Product] The Gross Domestic Product (GDP) can be defined as the sum of market value of all final goods and services produced in a country during a specific period of time, generally one year. It is important to note here that in estimating GDP, the income earned by the foreigners in the country are included and the income earned by residents abroad and remitted at home country are excluded. In simple words, GDP includes income earned by the foreigners in the country and excludes income earned abroad by the residents. [Gross National Product ] The Gross National Product (GNP) is another measure of national income which often figures in macroeconomic analysis and policy formulations. The concept of GNP is similar to that of GDP with a significant difference, of course. The concept of GNP includes the income of the resident nationals which they receive abroad and excludes the income generated locally but accruing to the non-nationals. In case of GDP, however it is just the other way around. The GDP includes the incomes locally earned by the non-nationals and excludes the incomes received by the resident national from abroad. A comparative definition of GDP and GNP is given below **GNP = Market value of domestically produced goods and services + income earned by resident of a country in foreign countries -- incomes earned by the foreigners in the country** **GDP = Market value of goods and services produced by the residents in the country + incomes earned in the country by the foreigners -- incomes received by residents of a country from abroad** [Net National product (NNP)] Net national product (NNP) is another concept of national income often used in macroeconomics analyses. The concept of NNP is closely related to the concept of GNP. The concept of GNP includes the output of both final consumer and capital goods. However, a part of capital goods is used up or consumed in the process of production of these goods. This is called depreciation or capital consumption. While GNP is gross depreciation, NNP is net of depreciation. NNP is obtained by subtracting depreciation from GNP. That is **NNP = GNP -- Depreciation or capital consumption** [Personal Income (PI)] Personal income (PI) can be defined as the sum of all kinds of incomes received by the individuals from all sources of income. Personal income includes wages and salaries, fees and commission, bonus, fringe benefits, dividends, interest earnings and earnings from self-employment. It also includes transfer incomes like pension, family allowances, unemployment allowances, sickness allowances, old age benefits and social security benefits. Personal income also includes the incomes earned through illegal means, e.g. bribe, smuggling, cheating, theft, prostitution, at least for the taxation purpose. [Disposable Income] In wider sense of the term, disposable income refers to personal income of the income earners against which they do not have any legally enforceable payment obligations. Legally enforceable payment obligations include such payment obligations as income tax, payment due against government loans and fines and penalties imposed by legal authorities. In specific terms, disposable income can be defined as follows **Disposable income = Personal income -- Personal Taxes** Nominal GDP and Real GDP The GDP and also GNP, are estimated at both current and constant prices. The GDP estimated at current prices is called nominal GDP and GDP estimated at constant prices in a chosen year (called base year) is called real income. Similarly GNP estimated at current prices and constant prices is called nominal GNP and real GNP respectively The need for estimating GDP (or GNP) at constant prices arises because GDP at current prices produces a misleading picture of economic performance when prices are continuously rising or decreasing. In a country having a high rate of inflation, the nominal GDP produces an inflated estimate of the national income and creates false sense of richness or economic growth. GDP valued at current prices shows rise in GDP. In order to avoid misleading estimates of national income, GDP is estimated at constant prices of chosen base year. The GDP estimated at constant prices of the base year is called real GDP; it gives national income estimates free from distortion caused by inflation or deflation. However estimating GDP at the prices of the base year is not an easy task. The economist use a simple adjustment called GDP deflator or National Income Deflator to eliminate the effect of rising prices of the GDP and to work out real GDP at the base year whose real GDP is to be estimated. The method of working out GDP deflator is given below. GDP deflator =[\$\\ \\frac{\\text{Price\\ index\\ number\\ of\\ chosen\\ year}}{100}\$]{.math.inline} The formula for converting Nominal GDP of a year into real GDP may be written as follows. Real GDP = [\$\\frac{\\text{Nominal\\ GDP}}{\\text{GDP\\ Deflator}}\$]{.math.inline} **Activity** Let us consider an example, suppose nominal GDP of a country, i.e. GDP estimated at current prices in year 2000 is given at N\$ 500 billion and price index number is given as base year 2000 = 100. Now let the nominal GDP increase to N\$600 billion in year 2005 and price index number rises to 110. **Feedback** Given this data, GDP deflator for the country can be obtained as follows GDP deflator = [\$\\frac{Price\\ index\\ number\\ (2005)}{100} = \\ \\frac{110}{100} = \\mathbf{1.10}\$]{.math.inline} Given the GDP deflator at 1.10, the Real GDP for the year 2005 can be worked out as follows Real GDP = [\$\\frac{600}{1.10} = \\mathbf{N\\\$ 545.45\\ billion}\$]{.math.inline} *Note that Nominal GDP increases from N\$ 500 billion to N\$600 billion, i.e., by 20% over a period of five years or at an annual average rate of 4%. Since Price Index Number increases from 100 to 110, i.e., by 10% over a period of 5 years, real GDP increases at a lower rate, i.e., at 9 % or at annual average rate of 1.8%* **[National Accounting ]** Given the important uses of national income estimates, estimating national income is an indispensable task of the government. However, estimating national income is an extremely complicated and gigantic task. The reason is that the process of income generation in a modern economy is extremely complex and therefore, collecting necessary data on sources and levels of income is beset with conceptual and data availability problems. The economists have, however, devised different methods of estimating national income. The basic approach in measuring national income is to measure the two kinds of flows generated by the economic activities of the residents of the country. As we know from the circular flows of income, the income generating process creates two kinds of flows: product flows and Money flows The money flows can be looked upon from two angles - Money flows as factor payment - Money flow as payment for goods and services Given the product flows and two ways of money flows, the economists have devised three methods of measuring national income I. Net Product Method or the Value Added Method II. Income Method III. Expenditure Method Any of the three methods can be adopted to measure GDP of the country provided required data is fully available. Where a single method cannot be adopted due to no availability of required data or due to conceptual problems as to what should be and what should not be included in national income accounting, a combination of the three methods is used to measure GDP. **[Income Method]** The income method is also known as factor share method. in this method, the national income is treated to be equal to all the " incomes accruing to the basic factors of production used in producing the national products". The factors of production are traditionally categorised as land labour capital and organisation. Accordingly, the national income is treated as the sum of factor payments, viz., rent wages interest and profits respectively, plus depreciation. In summary: The income method uses the incomes earned by the four factors of production to calculate the GDP. - Compensation of employees: This includes all salaries and wages. - Net operating surplus: This includes all profits earned by entrepreneurs. - Consumption of fixed capital: Capital goods such as machines and equipment are "consumed" when production takes place. A part of every year's production must be used to replace the old capital goods. Accountants call it provision for depreciation. - Taxes on production and products: These refer to indirect taxes (e.g. VAT) that are levied on economic transactions. They are added because they increase the market price of goods and services. - Subsidies on production and products: Subsidies are deducted because they decrease the market price of goods and services **[Expenditure Method]** The expenditure method, also known as the final product method, measures national income at the final expenditure stage. The expenditure method uses the expenditures by the four sectors of the economy to calculate the GDP. [Final consumption expenditure by households (C)] This refers to the expenditures by households on all final goods and services and can be classified into the following categories: - Durable goods: They are not used up in the process of consumption and normally last longer than one year, e.g. cars and furniture. - Semi-durable goods: They can be consumed for a period of time but they do not last as long as the goods mentioned above, e.g. shoes and clothes. - Non-durable goods: These goods can be consumed only once, e.g. food, petrol, cigarettes. - Services: These are intangible consumption items that are consumed as they are produced, e.g. transport and medical services. [Final consumption expenditure by the general government (G)] The general government includes the central, regional and local government and all other government institutions. It includes all current expenditures on salaries and wages as well as goods and services of a non-capital nature [Gross capital formation (I)] Gross capital formation is also known as investment expenditure and consists of two components: - Gross fixed capital formation: This item includes expenditures by producers on production goods such as new buildings, new machines and breeding livestock. It includes new capital goods of both the private and public sectors. - Change in inventories: Inventories include raw materials, semi-completed and completed products owned by businesses. These inventories change as goods are bought and sold [Exports (X)] Exports are goods produced in Namibia and sold in other countries. [Imports (M)] Imports are goods produced in other countries and sold in Namibia. They are not part of our GDP and are therefore deducted [Residual item (Discrepancy)] When we calculate GDP according to the income and expenditure methods we calculate the same thing but calculation errors can occur because the data are taken from different sources. Any discrepancy can be overcome by including the residual item. Total expenditure N\$877 934 Less: GDP at market prices N\$873 637 Residual item N\$ 4 297 In symbols we can write the expenditures as follows: GDP = Expenditure on GDP Thus: - GDP = C + I + G + (X-M) - GDE = C + I + G