National income as a measure of economic activity

National income is the money value of a country's output of final goods and services produced in one year. Economic activity is where scarce resources are allocated to produce goods and services to satisfy human wants. Macroeconomics is the study of economic activity from a whole economy perspective.

For example, the German economy is well known for its high-performing manufacturing sector with famous names like Volkswagen, Daimler AG, Allianz and BMW. Microeconomics allows us to examine these individual businesses and the industries they operate in. 

Macroeconomics looks at Germany’s manufacturing sector in the context of the whole economy where it accounts for 47 per cent of the country’s GDP. So, any change in Germany's manufacturing sector has a significant impact on its national output.

The circular flow of income

An economic model

The circular flow of income is an economic model that illustrates the flow of money between firms and households at a macroeconomic level. It can be further developed to include foreign trade, government and banking sectors.  Whilst the model has been around since the 17^th century, its importance as an economic theory was developed by John Maynard Keynes in his book, General Theory of Employment, Interest and Money which was published in 1936. The circular flow model is a useful aid to economic forecasting and policymaking.

How the model works

The model we are going to use in our analysis of the macroeconomy is a simplified version of the model used by institutions such as banks, universities, hedge funds and governments, but it is still very useful as a method of understanding how the macroeconomy works.

The flow of income is illustrated in diagram 3.1. It can be explained by considering the following principles:

• The economy can be divided into two sectors, firms and households. 
• Firms combine the factors of production to produce goods and services and households buy the goods and services and consume them.  This is shown by the blue flows in the circular flow diagram 3.1.
• To produce the goods and services firms need to employ people from the households which include labour and entrepreneurs and in return, the firms pay the households an income.  This is shown by the red flows in diagram 3.1.

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• Injections of funds come into the circular flow of an economy in the form of investment, government expenditure and exports.
• Withdrawal or leakages of funds from the circular flow of income go out in the form of savings, tax and imports.

Injections to the circular flow

Injections are the flow of funds into the circular flow that come from firms investing, government spending and exports resulting from foreign trade. The three injections are:

• Investment by businesses when they buy capital such as new buildings and machinery
• Government expenditure on public services such as health and education
• Exports of goods and services to other countries lead to an inflow of funds.

Withdrawals from the circular flow

Withdrawals from the circular flow occur when money leaves the economy through household savings, taxation by the government and imports resulting from foreign trade. The three withdrawals are:

• Savings by households of income they do not spend on goods and services
• Taxation by governments on household income, business profits and indirect tax on goods and services
• Imports bought by firms and households lead to an outflow of funds.

Application of the model

Like the other models we use in Economics, the circular flow model lets us analyse the causes and consequences of changes in economic variables. The demand and supply model helps us examine how, for example, changes in household income affect price and output in a market. Here are some examples of how the circular flow model can be used to analyse how a change in injections and withdrawals affect the macroeconomy. Consider the following examples:

• An increase in the value of exports by an economy increases the value of funds in the circular flow which leads to increases in household incomes and consumption, output by firms and employment.
• An increase in taxation in the economy reduces the value of funds in the circular flow. This leads to a decrease in household incomes and consumption, output by firms and employment.

Gross Domestic Product (GDP)

Defining GDP

A country’s GDP is the money value of all final goods and services produced by that country in one year. It is a statistic used to measure macroeconomic activity. The GDP of a country is normally considered an annual figure, but economists and governments also use quarterly figures to track economic growth over time so they can closely monitor what is happening to economic activity. The GDP is expressed in money terms using the country’s currency, although for international comparison the value in $US is used.

Using final goods and services

When the GDP of a country is being calculated only the value of final goods is used. The value of intermediate goods such as raw materials and components are not included because this would lead to ‘double counting’. If you included the value of a television produced when it is sold by the manufacturer to a retailer (an intermediate good) and then count it again when it is sold to the consumer as a final good then you would count the value of the television twice.

Using the circular of income to measure GDP

The circular flow of income gives us 3 ways of measuring the GDP.

Income method

This is the total value of income earned by households in one year in the form of:

• Wages paid to labour
• Interest paid to capital
• Rent paid to land
• Profits and dividends paid to entrepreneurs.

It is important not to count income in the form of transfer payments where no economic activity has been engaged in to generate the income.  Transfer payments include pensions, unemployment benefits and student grants, etc.

Output method

This is calculated by taking the value-added of firms in different sectors of the economy. The sectors are:

• Primary – commodities such as agricultural goods, mining, forestry and fishing, etc.
• Secondary – manufacturing such as cars, mobile phones, pharmaceuticals and clothing, etc.
• Tertiary – services such as education, restaurants, tourism and transport, etc.

Value added is the method of calculating GDP to avoid ‘double counting’. Value added is the monetary difference between the purchase cost of the material inputs used to produce the good and its selling price. If a car manufacturer, for example, pays for the materials and components to produce a car valued at $4,000 and sells the car to a dealer for $10,000 then the value added is $6,000. If the dealer takes the car they have bought for $10,000 and sells it for $14,000 their value-added is $4,000. The value-added of each sector is used to calculate the GDP by the output approach.

Expenditure method

This is calculated by aggregating the total expenditure of different sectors of the economy. There are four types of expenditure:

• Consumption (C) spending by households on final goods and services
• Investment (I) spending by firms on capital equipment
• Government (G) spending on public services
• Net Exports (X-M) The surplus of the value of exports over the value of imports

The table sets out the GDP of the five largest economies in the world.

Gross national income (GNI)

Calculating GNI

The gross national income is the total income generated by a country and is calculated by adding net property income from abroad to the GDP.

GDP + net property income = GNI

Net property income from abroad

Property income is money earned by households on different assets.  This income comes in the following forms:

• Interest on loans made
• Profit from businesses owned
• Rent on property owned.

Net property income is income on domestic assets owned overseas that flow into the domestic income less income on foreign assets that flow out of the domestic economy.

Examples of property income inflows to the UK economy include income sent back to the UK in the form of:

• Interest on UK loans made to German companies
• Profits made by a UK company in Russia
• Rent paid to UK-owned commercial property in the US.

Examples of property income outflows from the UK economy would include income sent to foreign countries in the form of:

• Profits made by a German car manufacturer in the UK
• Interest paid on loans made by an Australian bank to UK businesses
• Rent paid to Chinese owners of luxury property in London.

GNI per capita

GNI per capita is measuring GNI per head of population. GNI per capita is calculated as:

GNI / population = GNI per capita

Last year the GNI for the US was $20.84 trillion and the population of the US was 328 million

20,840,000 million / 328 million = $63,537

Economists like to use GNI per capita when analysing national income data because it allows them to make inter-country comparisons. A per capita figure is much smaller than the total GNI so it is an easier number to interpret. GNI per capita is particularly useful when measuring a country’s economic development.

Adjusting for inflation

Importance of real terms

The value of a country’s GDP is adjusted for inflation to turn the GDP in nominal terms into GDP in real terms.  Nominal GDP is expressing GDP with no allowance for inflation. Expressing economic values in real terms is important because inflation distorts data and makes it difficult to interpret. For example, if a country’s GDP rises by 3 per cent this would be an acceptable rate of economic growth. But if that country’s inflation is 3 per cent then the country would not have grown at all. 

Calculating real GDP

Calculating real GDP is done by dividing the nominal GDP by the GDP deflator and multiplying by 100. The table below sets out the GDP data for a country. For 2014 the real GDP is:

1792/96 x 100 = 1867

The growth rate is calculated by working out the annual percentage change in real GDP. For 2015 this would be:

1870 – 1867 / 1867 x 100 = 0.16%

Economic Growth

Measuring growth

Economic growth is the increase in a country’s real GDP over time.  The economic growth rate of a country is the percentage increase in its real GDP over one year. GDP figures are released quarterly so a country’s economic activity can be continuously monitored.   

The annual growth rate is calculated by:

GDP current year – GDP previous year / GDP previous x 100 = current year growth rate

Business cycle (trade cycle)

Economies do not grow at a constant rate because the rate of growth of a country rises and falls over time and this is called the business cycle. The average rate of growth over a number of years is called the trend rate of growth. Amongst more developed countries (MDCs) the trend rate of growth is normally around 2-3 per cent

Diagram 3.2 illustrates a conventional business cycle.

Conventional business cycle

Business cycles are all slightly different, but the conventional cycle normally follows the changes set out below:

• The boom phase occurs when the rate of growth is above the trend rate. High rates of economic growth in a boom are normally associated with rising incomes, falling unemployment, and rising inflation.
• The slowdown phase of the business cycle is when the economy goes past its peak rate of growth and the growth rate falls. Household incomes do not rise as fast, unemployment might start to rise and there is less pressure for inflation to increase.
• The recession phase of the cycle is when real GDP falls. A recession is technically defined as a period of two consecutive quarters of negative growth in real GDP.  Household incomes might fall, unemployment normally increases and inflation falls
• The recovery phase of the business cycle is when the economy emerges from a recession and the real GDP starts to increase. The rate of economic growth is slow to start with and then it accelerates. Household incomes start to rise, unemployment starts to fall and there is upward pressure on inflation.