2.1. Level of Economic Activity

Syllabus Content

• Economic activity - the circular flow of income model & Measures of economic activity: gross domestic product (GDP), and gross national product (GNP) or gross national income (GNI)
• The Business Cycle - Short-term fluctuations and long-term trend

Triple A Learning - the level of economic activity

Triple A Learning - the level of economic activity questions

2.1. The level of overall economic activity

Economic Activity

Macroeconomics is the study of the economy as a whole. Its goal is to explain the economic changes that affect many households, firms, and markets at once.

The circular flow of income model

National income, output, and expenditure are generated by the activities of the two most vital parts of an economy, its households and firms, as they engage in mutually beneficial exchange.

Households

The primary economic function of households is to supply domestic firms with needed factors of production - land, human capital, real capital and enterprise. The factors are supplied by factor owners in return for a reward:

· Land is supplied by landowners,

· Human capital by labour,

· Real capital by capital owners (capitalists) and

· Enterprise is provided by entrepreneurs.

Entrepreneurs combine the other three factors, and bear the risks associated with production.

Firms

The function of firms is to supply private goods and services to domestic households and firms, and to households and firms abroad. To do this they use factors and pay for their services.

Factor incomes

Factors of production earn an income, which contributes to national income. Land receives rent, human capital receives a wage, real capital receives a rate of return, and enterprise receives a profit.

Members of households pay for goods and services they consume with the income they receive from selling their factor in the relevant market.

Production function

The simple production function states that output (Q) is a function (f) of: (is determined by) the factor inputs, land (L), labour (La), and capital (K), i.e.

Q = f (L, La, K)

The Circular flow of income

Income (Y) in an economy flows from one part to another whenever a transaction takes place. New spending (C) generates new income (Y), which generates further new spending (C), and further new income (Y), and so on. Spending and income continue to circulate around the macro economy in what is referred to as the circular flow of income.

In another respect, for an economy as a whole, income must equal expenditure because:

· Every transaction has a buyer and a seller.

· Every dollar of spending by some buyer is a dollar of income for some seller.

The equality of income and expenditure can be illustrated with the circular-flow diagram.

Injections and withdrawals

The circular flow will adjust following new injections into it or new withdrawals from it. An injection of new spending will increase the flow. A net injection relates to the overall effect of injections in relation to withdrawals following a change in an economic variable.

Savings and investment

The simple circular flow is, therefore, adjusted to take into account withdrawals and injections. Households may choose to save (S) some of their income (Y) rather than spend it (C), and this reduces the circular flow of income. Marginal decisions to save reduce the flow of income in the economy because saving is a withdrawal out of the circular flow. However, firms also purchase capital goods, such as machinery, from other firms, and this spending is an injection into the circular flow. This process, called investment (I), occurs because existing machinery wears out and because firms may wish to increase their capacity to produce.

The public sector

In a mixed economy with a government, the simple model must be adjusted to include the public sector. Therefore, as well as save, households are also likely to pay taxes (T) to the government (G), and further income is withdrawn out of the circular flow of income.

Government injects income back into the economy by spending (G) on public and merit goods like defence and policing, education, and healthcare, and also on support for the poor and those unable to work.

Including international trade

Finally, the model must be adjusted to include international trade. Countries that trade are called ‘open’ economies, the households of an open economy will spend some of their income on goods from abroad, called imports (M), and this is withdrawn from the circular flow.

Foreign consumers and firms will, however, also wish to buy domestic products, called exports (X), and this is an injection into the circular flow.

Summary of Injections & Leakages

Leakages (withdrawals) from the circular flow

Not all income will flow from households to businesses directly. The circular flow shows that some part of household income will be:

• 1.Put aside for future spending, i.e. savings (S) in banks accounts and other types of deposit
• 2.Paid to the government in taxation (T) e.g. income tax and national insurance
• 3.Spent on foreign-made goods and services, i.e. imports (M) which flow out of the economy

Withdrawals are increases in savings, taxes or imports so reducing the circular flow of income and leading to a multiplied contraction of production (output)

Injections into the circular flow are additions to investment, government spending or exports so boosting the circular flow of income leading to a multiplied expansion of output.

1. Capital spending by firms, i.e. investment expenditure (I) e.g. on new technology

2. The government, i.e. government expenditure (G) e.g. on the NHS or defense

3. Overseas consumers buying UK goods and service, i.e. UK export expenditure (X)

An economy is in equilibrium when the rate of injections = the rate of withdrawals from the circular flow.

Source: http://www.tutor2u.net/economics/reference/circular-flow-of-income-and-spending

Task 2: Questions on Circular flow of Income

1. Refer to the following circular flow diagram to answer the question below.

What do X and Y represent?

2. What are the leakages from the circular flow of income in an open economy?

3. Which of the following are injections into the circular flow of income in an open economy?

[-A-] Government taxation

[-B-] Imports

[-C-] Savings

[-D-] VAT

[-E-] Exports

[-F-] Income tax

[-G-] Investment

4. Which of the following are leakages out of the circular flow of income in an open economy?

[-A-] exports

[-B-] taxes

[-C-] government spending

[-D-] investment

[-E-] imports

[-F-] creation of real capital goods

[-G-] machinery and factories

5. What would be the effect of an increase in investments in an economy?

[-A-] The level of the national income would rise, as investments are injections.

[-B-] The economic situation in the country would worsen.

[-C-] National income would decrease, as investments are leakages.

[-D-] National income would fall and then remain constant for a period of time.

[-E-] Increased investment in an economy would not affect national income.

[-F-] National income would increase, since Y = C + I.

[-G-] Investments would be equal to leakages; therefore national income would not be affected.

6. Which of the following factors would lead to an increase in national income?

[-A-] A 15% increase in value added tax

[-B-] Increased investment in domestic-made capital goods

[-C-] Purchasing a foreign-made video camera

[-D-] An increase in the exports of locally produced machinery

[-E-] A decrease in goods sold abroad

[-F-] Imposing a progressive tax on individuals’ income

[-G-] Increased investment in a foreign country

7. Which of the following factors will reduce the level of national income?

[-A-] Increase in government spending

[-B-] Increase in investment

[-C-] Increase in exports

[-D-] Increase in savings

[-E-] Decrease in taxation

[-F-] Increase in imports

[-G-] Decrease in savings

8. The diagram below shows the circular flow of income in a two sector economy.

Measures of Economic activity

Gross Domestic Product (GDP)

Gross domestic product (GDP) is a measure of the income and expenditures of an economy.

‘It is the total market value of all final goods and services produced within a country in a given period of time’.

“GDP is the Market Value . . .”

· Output is valued at market prices.

“. . . Of All Final . . .”

· It records only the value of final goods, not intermediate goods (the value is counted only once).

“. . . Goods and Services . . “

· It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits).

“. . . Produced . . .”

· It includes goods and services currently produced, not transactions involving goods produced in the past.

“ . . . Within a Country . . .”

· It measures the value of production within the geographic confines of a country.

“. . . In a Given Period of Time.”

· It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months).

Legal vs illegal

GDP includes all items produced in the economy and sold legally in markets. GDP excludes most items that are produced and consumed at home and that never enter the marketplace. It excludes items produced and sold illicitly, such as illegal drugs.

• Which country is the world's top economic power?

Gross National Product (GNP)

GNP and GDP both reflect the national output and income of an economy. The main difference is that GNP (Gross National Product) takes into account net income receipts from abroad.

• GDP (Gross Domestic Product) is a measure of national income / national output and national expenditure produce in a particular country.
• GNP = GDP +/- Net factor income from abroad. This net income from abroad includes, dividends, interest and profit.
• GNP includes the value of all goods and services produced by nationals whether in the country or not.

Example of GNP

If a Japanese multinational produces cars in the UK; this production will be counted towards UK GDP. However, if the Japanese firm sends £50m in profits back to shareholders in Japan. Then this outflow of profit is subtracted from GNP. UK nationals don’t benefit from this profit.

If a UK firms makes profit from insurance companies located abroad, then if this profit is sent back to UK nationals, then this net income from oversees assets will be added to GNP.

Note if a Japanese firm invests in the UK, it will still lead to higher GNP, as some national workers will see higher wages. However, the increase in GNP will not be as great as GDP.

• If a county has similar inflows and outflows of income from assets, then GNP and GDP will be very similar.
• However, if a country has many multinationals that repatriate income from local production, then GNP will be lower than GDP.

For example, Luxembourg has a GDP of $87,400 but a GNP of only $45,360.

Gross National Income (GNI)

GNI (Gross national Income) is based on a similar principle to GNP. The World Bank define GNI as

‘The sum of value added by all resident producers plus any product taxes (minus subsidies) not included in the valuation of output plus net receipts of primary income (compensation of employees and property income) from abroad’

The World Bank now uses GNI rather than GNP.

• US Real Gross Domestic Product - https://fred.stlouisfed.org/series/GDPC1#0

• US Real Gross National Income - https://fred.stlouisfed.org/series/A023RX1A020NBEA

Task 3: Questions on GDP

1: Classify each of the following items as a final good or service or an intermediate good or service:

(a) Banking services bought by a student.

(b) New cars bought by Hertz, the car rental firm.

(c) Newsprint bought by USA Today from International Paper.

(d) Ice cream bought by a diner and used to produce sundaes.

2: GDP does not include the value of used goods that are resold. Why would including such transactions make GDP a less informative measure of economic well-being?

Nominal and real GDP/GNP/GNI

Taking GDP as an exemplar

• Nominal GDP values the production of goods and services at current prices.

• Real GDP values the production of goods and services at constant prices.

An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator.

• Converting nominal GDP to real GDP - https://courses.lumenlearning.com/suny-macroeconomics/chapter/converting-nominal-to-real-gdp/

• If the base year is 2005, what will be the relationship between real GDP and nominal GDP pre-base year and post base year?

Distinguish between total GDP/GNP/GNI and per capita GDP/GNP/GNI

Per capita GDP is a measure of the total output of a country that takes the gross domestic product (GDP) and divides it by the number of people in the country. The per capita GDP is especially useful when comparing one country to another because it shows the relative performance of the countries. A rise in per capita GDP signals growth in the economy and tends to translate as an increase in productivity.

The gross domestic product (GDP) is one of the primary indicators of a country's economic performance. It is calculated by either adding up everyone's income during the period or by adding the value of all final goods and services produced in the country during the year. Per capita GDP is sometimes used as an indicator of standard of living as well, with higher per capita GDP being interpreted as having a higher standard of living.

Source: http://www.investopedia.com/terms/p/per-capita-gdp.asp

Relevant Statistics

GDP per capita (current prices US$) - http://data.worldbank.org/indicator/NY.GDP.PCAP.CD

GDP per capita (constant 2010 prices) - http://data.worldbank.org/indicator/NY.GDP.PCAP.KD

GNI per capita (constant 2010 prices) - http://data.worldbank.org/indicator/NY.GNP.PCAP.KD

Task 4: Questions on Nominal GDP & Real GDP

1: Why is the growth of per capita real national income a better measure of living standards than the growth of real national income?

2: What is the level of output after four years if initial output is $1000 and the economy grows at a rate of 10% a year?

3: Use the data in the table to determine the 5-year growth rate for each country in terms of real GDP growth and per capita real GDP growth. Which country grew at the fastest rate?

4: If Kenya’s economy grew at a rate of 4% during 1998 and real GDP at the beginning of the year was 170,000 shillings (million), what was the real GDP value at the end of the year?

5: Suppose a country has a real GDP equal to $1 billion today. If this economy grows at a rate of 10% a year, what will be the value of real GDP after 5 years?

6: How would each of the following affect productivity in the US?

(a) The quality of education increases in secondary schools

(b) The number of patents issued falls significantly

(c) A cutback in oil production by oil-exporting nations raises oil prices.

(d) A large number of unskilled immigrant labourers moves into the country

7: Mexico’s real GDP was 1,448 billion pesos in 1998 and 1501 billion pesos in 1999. Mexico’s population growth rate in 1999 was 1.8%. Calculate:

(a) Mexico’s economic growth rate in 1999.

(b) The growth rate of real GDP per person in Mexico in 1999.

(c) The approximate number of years it takes for real GDP per person in Mexico to double if the 1999 economic growth rate and population growth rate are maintained.

(d) The approximate number of years it takes for real GDP per person in Mexico to double if the 1999 economic growth rate is maintained but the population growth rate slows to 1% a year.

8: The table below provides some data on the Canadian economy in 1998 and 1999.

(a) Calculate the growth rate of real GDP in 1999.

(b) Calculate the labour productivity in 1998 and 1999.

(c) Calculate the growth rate of labour productivity in 1999.

(d) If the one-third rule applies in Canada, what were the sources of labour productivity growth in 1999? Explain.

9: The table below provides some data on the US economy in 1990 and 1991.

(a) Calculate the growth rate of real GDP in 1991.

(b) Calculate labour productivity in 1990 and 1991.

(c) Calculate the growth rate of labour productivity in 1991.

(d) If the one third rule applies in the United States, what were the sources of labour productivity growth in 1991? Explain.

(a) Compute nominal GDP, Real GDP and the GDP deflator for each year using 2013 as the base year

(b) Compute the percentage change in nominal GDP, Real GDP and the GDP deflator in 2014 & 2015

(c) Did economic well-being rise more in 2014 or 2015?

11: An island economy produces only bananas and coconuts. Table 1 gives the quantities produced and prices in 2014 and 2015. The base year is 2014.

Calculate:

(a) Nominal GDP in 2014

(b) Nominal GDP in 2015

(c) The value of 2015 production in 2014 prices

(d) Percentage increase in production when valued at 2014 prices

(e) The value of 2014 production in 2015 prices

(f) Percentage increase in production when valued at 2015 prices

(g) Real GDP in 2014 and 2015.

(h) The GDP deflator in 2015.

12: Consider the following data on US GDP

Year Nominal GDP GDP Deflator

1996 7,662 billion 110

1997 8,111 billion 112

(a) What was the growth rate of nominal GDP between 1996 & 1997?

(b) What was the growth rate of the GDP deflator between 1996 and 1997?

(c) What was real GDP in 1996 measured in 1992 prices?

(d) What was real GDP in 1997 measured in 1992 prices?

(e) What was the growth rate of real GDP between 1996 & 1997?

(f) Was the growth rate of nominal GDP higher or lower than the growth rate of real GDP? Explain

Methods of measuring output

Income Approach

Some government statistics agencies use the Income Approach by collecting data from sources (including tax agency) on the incomes that firms pay households for the services of factors of production they hire – wages for labour, interest for the use of capital, rent for the use of land and profit for entrepreneurship – and summing those incomes. This approach is like attaching a meter to the circular flow of income diagram on all the flows of factor incomes from firms to households and measuring the magnitude of those flows.

The National Income Account divide incomes into five categories:

· Compensation of employees

· Net interest

· Rental income of persons

· Corporate profits

· Proprietors’ income

Explanation of income categories

1. Compensation of employees – is the payment for labour services. It includes net wages and salaries plus fringe benefits paid by employers such as health care, insurance, social security payments and pension fund contributions

2. Net Interest – is the interest households receive on loans they make minus the interest households pay on their borrowing.

3. Rental income of persons – is the payment for the use of land and other rented inputs. It includes payments for rented housing and imputed rent for owner-occupied housing (Imputed rent is an estimate of what homeowners would pay to rent the housing they own and use themselves)

4. Corporate profits – is a combination of interest on capital and profits for entrepreneurship

5. Proprietors’ Income – people who run their own business. Their income is a mixture of the previous four items.

GDP: The Income Approach

The sum of all incomes equals net domestic product at factor cost. GDP equals net domestic product at factor cost plus indirect taxes less subsidies plus capital consumption (depreciation).

From Factor Cost to Market Price

The expenditure approach values goods and services at market prices and the income approach values them at factor cost – the cost of the factors of production used to produce them. Indirect taxes and subsidies make these two values differ. Sales taxes make market price exceed factor cost, and subsidies make factor cost exceed market prices. To convert the value at factor cost to the value at market prices, we must add indirect taxes and subtract subsidies.

From Gross to Net

The expenditure approach measures gross product and the income approach measures net product. The difference is depreciation, the decrease in the value of capital that results from its use and from obsolescence – also called capital consumption.

Expenditure includes investment which is the purchase of new capital. Because some new capital is purchased to replace depreciated capital, the expenditure approach gives a gross measure. So to get gross domestic product from the income approach we must add depreciation to total income.

Task 5: Questions on Income & Expenditure methods

1: US GDP Values 1998

2: US GDP values 1995

Green GDP

The Green Gross Domestic Product is an economic growth index that quantifies and calculates the environmental consequences of that growth.

What is it?

China's the only major nation that's used Green Gross Domestic Product to measure its economic viability. Chinese premier Wen Jiabao announced in 2004 that the Green GDP would replace the traditional GDP as a financial productivity measure. Published back in 2006, the Chinese Green GDP showed that the financial loss caused by pollution in China was 511.8 billion yuan ($66.3 billion), which was 3.05 percent of the nation's economy.

What does it measure?

Green GDP monetises the effects of the loss of biodiversity and the costs of climate change.

How do they get there?

Like other alternative indicators, such as the Sustainable Development Index or the Genuine Progress Indicator, the Green GDP quantifies the costs of pollution, climate change, waste and other factors likely to cause costly damages in the future.

What can it tell us (really)?

This is just another way to try to quantify and measure the monetary impact of the environmental damage caused by a country's economic growth. The idea is that, while the economy might look like it's growing now, the damages caused by that growth will inevitably drag it downward in the future. The preciseness of the Green GDP's measurement methods is debatable; after all, since the future costs are not actually known, those calculations are based on speculation - well-informed speculation, but still. What it really gives us is another way of looking at economic growth, putting it in perspective alongside its potential future economic consequences.

But nobody's perfect

Now that you've read all this, we'll let you know that no one uses Green GDP as an economic indicator anymore. Chinese officials put a stop to that back in 2007, after it was found that the Green GDP caused their economic growth rate to drop to unattractively low levels, nearly zero in some provinces. The government thereby withdrew its support for the index and went back to the old school Gross Domestic Product.

Source: http://www.marketplace.org/topics/business/economy-40/alternative-indicator-green-gdp

• Access the following website regarding the concept of an ecological footprint - http://data.footprintnetwork.org/

• Evaluate the use of national income statistics, including their use for making comparisons over time, their use for making comparisons between countries and their use for making conclusions about standards of living

The Business Cycle

Parkin and Bade's text Economics gives the following definition of the business cycle:

"The business cycle is the periodic but irregular up-and-down movements in economic activity, measured by fluctuations in real GDP and other macroeconomic variables."

To put it simply, the business cycle is defined as the real fluctuations in economic activity and gross domestic product (GDP) over a period of time.

The fact that the economy experiences these ups-and-downs in activity should be no surprise. In fact, all modern industrial economies like that of the United States endure considerable swings in economic activity over time.

The ups may be marked by indicators like high growth and low unemployment while the downs are generally defined by low or stagnant growth and high unemployment. Given its relationship to the phases of the business cycle, unemployment is but one of the various economic indicators used to measure economic activity. For most detailed information about how various economic indicators and their relationship to the business cycle, check out A Beginner's Guide to Economic Indicators.

Parkin and Bade go on to explain that despite the name, the business cycle is not a regular, predictable, or repeating cycle. Though its phases can be defined, its timing is random and, to a large degree, unpredictable.

The Phases of the Business Cycle

While no two business cycles are exactly the same, they can be identified as a sequence of four phases that were classified and studied in their most modern sense by American economists Arthur Burns and Wesley Mitchell in their text Measuring Business Cycles.

The four primary phases of the business cycle include:

1. Expansion: A speedup in the pace of economic activity defined by high growth, low unemployment, and increasing prices. The period marked from trough to peak.

2. Peak: The upper turning point of a business cycle and the point at which expansion turns into contraction.

3. Contraction: A slowdown in the pace of economic activity defined by low or stagnant growth, high unemployment, and declining prices. It is the period from peak to trough.

4. Trough: The lowest turning point of a business cycle in which a contraction turns into an expansion. This turning point is also called Recovery.

Short term fluctuations and long term trend – phases of the cycle

There should be no difficulties for you in finding your way through figure 3.3.12. The long run trend (potential real GDP) is upward sloping and in keeping with empirical evidence, which suggests a long run trend of around 1.5 to 3.5% yearly growth. (Yet note that the cycles are highly stylised.) The cycle is discernible as reoccurring expansions and contractions. Economic activity – measured by real GDP – at its lowest point is called a ‘ trough’, followed by ‘ recovery’, ‘ boom’ and ‘ peak’. When economic activity slows and then falls over a period of time, one speaks of ‘recession’. When the bottom of the cycle is reached once more a cycle has been completed – which is also measured as the time periods from peak to peak.

The graphics below provide a glimpse as to how long economic expansions have been in the US (months) and to what extent the stock market crashes (DJIA) during a recession.

Decrease in GDP growth (slowdown) and decrease in GDP

One common mistake seen in many an exam paper is when students fail to distinguish clearly between a decrease in GDP (e.g. negative growth) and a decrease in the rate of growth. In figure 3.3.12, the period just before the “peak” is characterized by a slower rate of growth – the slope of the business cycle curve falls. The period from t1 to t2 shows a slower rate of growth while t2 to t3 shows a decrease in growth.

During the period 2006 to 2007, the US growth rate (in GDP terms) fell from 2.7% to 1.9% - a fall in the rate of growth. During the economic crisis of 2008 and 2009, US growth went from 0% in 2008 to a low of-3.5% in 2009 – e.g. the US economy contracted by 3.5% during 2009. Thus in the latter period, the US economy experienced an absolute fall in GDP; this is because the economy experienced negative GDP growth i.e. a contraction.

• US Real GDP - application in business cycle/trade cycle

• US real GDP growth rate

• Hong Kong real GDP - application in business cycle/trade cycle

• Hong Kong real GDP growth rate

TOK: Can a recession be predicted?

• Role of emotions in the Business Cycle
• The Michigan Consumer Sentiment Index (MCSI) is a monthly survey of U.S. consumer confidence levels conducted by the University of Michigan. It is based on telephone surveys that gather information on consumer expectations regarding the overall economy.
• The University of Michigan Index of Consumer Sentiment - https://fred.stlouisfed.org/series/UMCSENT/

• Role of emotions in the Business Cycle -
• VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty, while values below 20 generally correspond to less stressful, even complacent, times in the markets.
• CBOE Volatility Index (Vix) - https://fred.stlouisfed.org/series/VIXCLS

• Role of the ISM's PMI - The Purchasing Managers' Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment. The purpose of the PMI is to provide information about current business conditions to company decision makers, analysts and purchasing managers. The information to produce the PMI is gathered using monthly surveys sent to purchasing executives at approximately 300 companies. A PMI of more than 50 represents expansion of the manufacturing sector when compared to the previous month. A PMI reading under 50 represents a contraction, and a reading at 50 indicates no change (https://www.investopedia.com/terms/p/pmi.asp)

• Is PMI correlated with recessions in the USA?

• Is PMI correlated with changes in World real GDP?

• Why would a index measuring manufacturing activity in the USA correlate with South Korean real GDP changes?

Task 6: If the PMI appears to follow the same trend for China, South Korea and Japan, what does that tell you about these East Asian economies?

Task 7: Questions on Business Cycle

1: Table 1 shows real GDP in Canada from the first quarter of 1989 to the fourth quarter of 1993.

(a) In which quarter was Canada at a business-cycle peak?

(b) In which quarter was Canada at a business-cycle trough?

(c) Did Canada experience a recession during these years?

(d) In what period did Canada experience an expansion?

2: Table 2 shows real GDP in Mexico from the first quarter of 1994 to the last quarter of 1996.

(a) In which quarter was Mexico at a business-cycle peak?

(b) In which quarter was Mexico at a business-cycle trough?

(c) Did Mexico experience a recession during these years?

(d) In what years did Mexico experience an expansion?

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