Measuring Economic Performance

Understanding how income flows around an Economy

The economy consists of many different groups of people or "stakeholders". Within an economy, there are the following stakeholders.

Households/Consumers
Firms/Producers
Governments
Foreign Consumers and Producers (Imports and Exports)
Financial Sector (Banking)

All of these stakeholders interact all the time. Transactions happen through the various stakeholders. In these transactions, money or income will flow between the stakeholders.

To help us understand, we will first assume a "Closed Economy". This means we will only assume there are only Households and Firms and only interactions between these two stakeholders.

The Product Market

In the previous section we looked to understand the Resource Market and how households provide Factors of Production and in return receive Factor Payments. Now we will look at the opposite side of this closed economy.In this part, we can see that firms provide households with Goods and Services in the Product Market. So goods and services flow from firms to households. In return, households use their income to buy goods and services. This is called consumer expenditure. This expenditure represents a firms Revenue. In turn, firms use this Revenue to pay households for factors of production.

In this situation, a households income would determine their economic well being. Those who receive more factor payments can in turn spend more on goods and services. Those who receive lower factor payments, will spend less.

The Resource Market

Let's first of all look at the "Resource Market". In the resource market, households provide firms with factors of production. Households provide firms with Land, Labour, Capital and Enterprise.

In return, Firms provide Households with Income. We call these Factor Payments. For providing Land, households receive Rent, for Labour they receive a Salary or Wage. For Capital, households receive Interest. (This could be for investing or saving money.) Finally, for Enterprise, households receive Profits.

Looking at an Open Circular Flow of Income

A Circular Flow of Income with Injections and Leakages

In the above diagram, we can see we have our original closed circular flow of income with households and firms. However, no economy in the world has closed system. Income and money can flow to either other parts of the economy (financial sector such as banks and to the Government) or abroad (other countries by importing and exporting of goods).

In this situation we can see that money can leak out of the circular flow (through savings, taxes and imports). For example, when a household saves pays taxes to the government or buys goods from abroad (imports), the amount of money flowing through the circular flow decreases. For example, if a person saves their money in the bank, they are not using it for expenditure on goods or services. This is why Savings, Taxes and Imports are all considered a Leakage to the Circular flow. Firms can also keep money in the bank,

On the other side of the model, we can see that money can be injected back into the circular flow of income. If a bank lends money to a firm and the firm uses this to invest in new machinery or building a new factory, this is an injection back into the circular flow. It is important to note, that in economics, investment here refers firms investing in additional Factors of Production and not financial investments like stock markets. As well as this, Governments are also able to spend money, for example building roads or airports or providing subsidies to households, and this means Government Spending is an injection of money back into the circular flow. Finally, when a firm exports goods to another country, whilst the goods leave the country, the firm receives money from abroad for those goods, therefore spending on exports by foreign individuals in an injection into a countries circular flow.

Measuring Economic Activity and the Circular flow of Income

The circular flow of income model showed that the value of aggregate output produced is equal to the total income generated in producing that output, which is equal to the expenditures made to purchase that output. For this reason, the term national income, or the total income of an economy are sometimes used interchangeably with the value of aggregate output

To measure the size of an economy, we have two methods.

1) We can total up the sum of all the factor payments (Rent+Salaries+Interest+Profits). This is called the Income Approach

2) We can total up the sum of all the expenditures in an Economy. To calculate this we total up; Consumption (by households) + Investment (on capital goods by firms) + Government Spending + Net Imports X-M (Money received from selling a countries goods abroad (Exports) minus the money spent on goods from outside a countries borders (Imports) ) This is called the Expenditure Approach.

We will look at these in more detail in Macroeconomics. For now we understand that the sum of either of these approaches measures the Gross Domestic Product (GDP).

Note: We will cover this in more detail in Macroeconomics Part.

Overall Levels of Macroeconomic Activity.mov

The following video will discuss the ways to measuring economic activity or Gross Domestic Product (GDP). We do this through using the circular flow of income to measure the value of the income, expenditure or output in the economy.

Income Approach = Sum of Factor Payments (Wages,Rent, Interest, Profits)

Expenditure Approach = C+I+G+(X-M)

Output Approach = Sum of all goods and services produced in an economy.

Real V Nominal GDP

When we measure GDP using one of the above approaches, the value we have is based on the prices of goods at that time, what we call the nominal value. However, due to inflation, prices rise over time. This presents a problem. Let's look at the prices of three goods and prices increase due to 10% inflation. (A sustained increase in the average price levels in an economy, over a period of time)

Good A: 2019 Price: $10 2020 Price: $11

Good B: 2019 Price: $20 2020 Price: $22

Good C: 2019 Price: $30 2020 Price: $33

For simplicity, let's say that an imaginary economy produces just these three goods. If we measured the GDP, in 2019 the GDP $60. In 2020, this would rise to $66. This poses a problem with measuring overtime because whilst the output has remained constant, nominal GDP has increased by $6.

However, this additional increase in the value has not come from an increase in the output and instead, simply due to an increase in inflation.

Therefore, we need to use changes in Real GDP. Real GDP measures the changes in economic activity adjusted for inflation. This is an important measure to use to accurately measure if an economy's economic output is increasing.

To calculate real GDP: (this is covered more here)

Real GDP = Nominal GDP / GDP deflator

If Nominal GDP > Real GDP, this suggests the economy is experiencing inflation.

If Real GDP > Nominal GDP, this suggests the economy is experiencing deflation.

GDP V GNI

When we looked at the income and expenditure approach to GDP, we said that the Income approach, Expenditure approach and Output approach are all equal. However, some of the income generated within an economy is done so with factors of production owned by foreign individuals. For example, a UK owned Multinational Corporation (MNC) based in Malaysia sends the profits it earns in Malaysia back to the UK. Whilst the output by the UK MNC is produced in Malaysia, the income (in this case profits) are sent back to the UK (what are called remittances).

Therefore we use these measures to distinguish between domestic (what is produced within a countries borders by both residents and foreigners) and national (what is produced by a countries residents regardless of where that income comes from). Based on this, the UK MNC producing in Malaysia would be included in Malaysia's GDP but the UK's GNI.

Therefore to calculate GNI:

GNI = GDP + net income from abroad.

If GDP > GNI, this would suggest more income is flowing out of an economy.

If GNI>GDP, this would suggest more income if flowing into an economy from abroad.

This idea will be looked at in more detail when we study development as having a net outflow of income (GDP>GNI) is common in countries that have a high number of MNCs operating in them and could present problems for developing economies.

Understanding Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP) is an economic concept used to compare the relative value of currencies by determining the equivalent amount of goods and services each currency can purchase in different countries. It operates on the principle that in the long run, exchange rates should adjust so that a specific basket of goods and services will cost the same in any two countries, once currency differences are accounted for. This adjustment allows for a fairer comparison of economic indicators like GDP or income across countries, as it eliminates distortions caused by differing price levels. For example, the cost of a meal, rent, or education can vary significantly between a high-cost economy (like Switzerland) and a lower-cost one (like India), and PPP adjustment accounts for these disparities.

PPP is especially useful for measuring standards of living and economic well-being across nations because it reflects local prices, making it more relevant for comparisons than market exchange rates, which can fluctuate due to factors unrelated to consumer costs (e.g., trade imbalances or investor sentiment). By using PPP-adjusted figures, economists can compare economic productivity, per capita income, and other indicators on a more level playing field, offering insight into real purchasing power across different economies. This is why PPP is commonly used in international comparisons, such as GDP (PPP) and GNI (PPP), to present a realistic view of economic capacity and average living standards.

Understanding GDP (PPP) vs. GNI (PPP)

In economics, both GDP and GNI are commonly used indicators for assessing the economic performance of a country, with the “PPP” adjustment providing a more accurate picture by accounting for differences in the cost of living. While these indicators may appear similar, they measure different aspects of a country’s economic output and income, and each has unique implications for understanding economic development.

What is GDP (PPP)?

Gross Domestic Product (GDP) is the total monetary value of all goods and services produced within a country over a specified period (usually a year). When adjusted for purchasing power parity (PPP), GDP reflects what that money can actually buy within the country, considering local prices for goods and services. GDP (PPP) measures the domestic economic productivity of a nation while factoring in the relative cost of living. By using PPP, it adjusts for price level differences between countries, making GDP comparisons across countries more meaningful.

If the cost of living in Country A is lower than in Country B, GDP (PPP) adjusts Country A's GDP to reflect this difference, which may raise its comparative GDP figure even if the nominal GDP is lower.

What is GNI (PPP)?

Gross National Income (GNI) is the total income earned by a country’s residents, both domestically and from abroad. This includes all income from domestic production (GDP) plus income earned from foreign investments and remittances, minus income paid to foreign investors. Like GDP, GNI can also be adjusted for PPP. GNI (PPP) reflects the total income available to a country’s residents, regardless of whether it was earned domestically or abroad. This measure is particularly useful for countries with significant international income flows, such as remittances or investments abroad.

If a large number of citizens from Country C work abroad and send money home, GNI (PPP) would add these remittances to the GDP (PPP), often resulting in a higher GNI (PPP) compared to GDP (PPP).

Relevance of GDP (PPP) and GNI (PPP) in Economic Development

Both GDP (PPP) and GNI (PPP) are useful for understanding a country’s economic development, but they offer different insights into economic well-being and living standards. Here’s why each metric matters:

GDP (PPP) and Economic Productivity

Insight into Domestic Production: GDP (PPP) focuses on the productive capabilities within a country. A high GDP (PPP) suggests strong domestic economic activity, with ample resources for creating jobs, investing in infrastructure, and driving economic growth.
Relevance in Development: For many developing countries, a high GDP (PPP) can signal progress toward industrialization, economic diversification, and improved domestic capacity for goods and services. For instance, countries like China have focused on increasing GDP (PPP) through domestic manufacturing and service sectors, which creates jobs and raises the overall standard of living.

GNI (PPP) and National Income

Insight into Income and Wealth: GNI (PPP) captures all income earned by citizens, whether earned at home or abroad. In countries with significant overseas employment, such as the Philippines and India, remittances contribute heavily to GNI, boosting total income available for residents and enhancing the standard of living.
Relevance in Development: GNI (PPP) is particularly useful for understanding economic resilience, especially in developing countries. When GNI (PPP) is higher than GDP (PPP), it indicates reliance on foreign income, which can be beneficial for local economies, providing stability and additional funds for education, healthcare, and infrastructure.

When One is Bigger Than the Other: What it Means for Development

For analysing economic development and individual prosperity, GDP (PPP) per capita and GNI (PPP) per capita are generally more informative. These indicators better capture average income, quality of life, and standards of living and are more useful in understanding how economic output or income translates to benefits for the average citizen.

For a broad analysis of a country’s economic power or capacity, total GDP (PPP) and GNI (PPP) figures are suitable, especially in comparisons of global influence or market size.

GDP (PPP) is Higher than GNI (PPP) (GDP > GNI)

A higher GDP (PPP) than GNI (PPP) suggests that the country’s economic activity is primarily domestically driven, with minimal foreign income inflows. This could be due to a small expatriate community, few overseas investments, or limited reliance on remittances.

In this case, the economy’s growth relies more on internal resources, which can be a sign of strong domestic production and economic independence. However, it may also mean limited access to additional income sources that can help reduce poverty and stimulate local spending.

GNI (PPP) is Higher than GDP (PPP) (GNI > GDP)

When GNI (PPP) exceeds GDP (PPP), it indicates that a significant portion of the nation’s income comes from abroad, either through remittances or investments. This is common in countries with many citizens working overseas or countries with substantial foreign-owned assets.

A higher GNI (PPP) reflects a reliance on foreign income, which can have both positive and negative effects. On the positive side, remittances and foreign investments bring additional funds, which can enhance residents’ quality of life and support local economies. However, excessive dependence on foreign income can be risky, as economic issues in other countries could reduce these income sources.

The Business Cycle

The Business Cycle.mov

The following video will discuss the economic model of the business cycle. This model plots the Real GDP of an economy over time. The business cycle shows how economic activity fluctuates over time. This model can therefore help us understand the stages of the business cycle:

Expansion - increasing actual GDP compared to previous moments in time
Peak - point in which the actual GDP slows and begins to decrease
Recession - two consecutive quarters of negative economic growth (decreasing actual GDP)
Recovery - the stage when actual GDP begins to grow again after a recession

Why do we study the business cycle?

Governments around the world have a number of objectives that they wish to achieve. We will look into each of these in more detail later on, but they can include:

By understanding the overall levels of economic activity and the business cycle, governments can intervene in the macroeconomy in order help achieve these economic objectives. For example, during a recession, unemployment tends to rise as the economic activity decreases (and firms therefore need less labour as a FOP), resulting in higher unemployment.

Over the next unit we will look at each of these macroeconomic objectives in more detail and then look at the policies governments can use in order to achieve them. These policies can include:

Monetary Policy - Demand Side policy whereby the central bank of a country manipulates interest rates in order to influence the levels of spending in the economy.
Fiscal Policy - Demand side policy whereby the government influences the overall levels of taxation and government spending in an economy to influence the levels of economic activity.
Supply Side Policies - Policies aimed at increase the production capabilities of an economy through different policies. These can be either Market Based or Interventionist.

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