Chapter 7 Measuring Economic Aggregates and the Circular Flow of Income



If we are to put macroeconomic theories to work, and even develop economic theory, we must have some measure of the economy's performance.



I.                   National Income Accounts


National income is based on double -entry bookkeeping. One person's spending is another person's receipts.


Gross Domestic Product (GDP)- The market value of all final goods and services produced by resources located in the US, regardless of who owns those resources.


- GDP includes U.S. production by foreign firms, but it excludes foreign production by U.S. firms.


A.   GDP can be measured two ways:


1.     Expenditure Approach- A method of calculating GDP by adding up expenditure on all final goods and services produced during the year.

2.     Income Approach- A method of calculating GDP by adding up all payments to owners of resources used to produce output during the year.


GDP only includes final goods and services, those goods and services sold to final, or ultimate, users.


Intermediate Goods and Services- goods and services purchased for addition processing and resale


**These are excluded from GDP to avoid double counting. --A grocer pays $1.00 for a can of soup he sells to you for $2.00. If we included the $1.00, the value of the can of soup would be counted twice. GDP also ignores used goods, because they were counted in the GDP of previous years.



I.                   GDP-The Expenditure Approach


-         Adding all expenditure on final goods/services in a given year.


A. Aggregate expenditure can be divided into 4 components:


1.     Consumption (personal consumption expenditures)- All household purchases of final goods and services.


2.     Investment (gross private domestic investment) The purchase of new plants, new equipment, new buildings, new residences, and net additions to inventories. (Spending on current production that is not used for current consumption.)



a.      Physical capital-manufactured items used to produce goods and services.

Includes - new buildings and machinery used to produce goods and services


b.     new residential construction


c.     Changes in inventories Inventories (stocks of goods in progress and stocks of final goods)

Net increase counts as investment because those inventories are not used for current consumption.

Net decrease counts as negative investment (disinvestment) because it represents the sale of output already credited to another years GDP.



***Investment does not include purchases of existing buildings, machines, and financial assets (stocks and bonds)


3.     Government purchases (Government consumption and gross Investment)- spending at all levels of government for goods and services; government outlays minus transfer payments.

4.     Net Exports- value of US exports minus the value of US imports. (includes invisibles like tourism)



Aggregate Expenditure = C + I + G + (X-M) = GDP




II.                GDP based on the Income Approach

-         Adding up all payments to resource owners (Aggregate Income)


A.   Value Added


In general, several firms usually process a good before it becomes available to the consumer.


Each firm adds a certain value to the product. We call this VALUE ADDED- the difference at each stage of production between the value of a product and cost of intermediate goods bought from other firms.


For Example:


Computation of Value Added for a 5 pound bag of flour:


Stage of Production Sale Price Intermediate Value Added


Farmer $.30 -- $.30

Miller $.50 $.30 $.20

Wholesaler $1.00 $.50 $.50

Grocery $1.50 $1.00 $.50



Market Value of Final Good $1.50


Value added at each stage represents income to resource suppliers at that stage.


B.    Aggregate Income


1.     Aggregate Income = The sum of all income earned by resource suppliers in an economy during a given time period = Sum of the value added at each stage of production.

2.     The price of the final product reflects the income to all resource suppliers who produce it, so the sum of the value added at all stages = the market value of the final good.

3.     Sum of the value added at all stages = market value of final good

Sum of the value added for all final goods/services = GDP based on income approach


Aggregate Income = GDP = Aggregate Expenditure.



**The expenditure approach adds up the total spending on new production, while the income approach adds up all of the income earned by the resource suppliers in producing those goods and services. And in the end they add up to the same thing GDP.



III.             Circular flow of income and expenditure


Income and spending are equal.


A.   Income/Expenditure in Circular Flow


Assumptions: No depreciation, firms pay all profits to owners



1.     Production of aggregate output (GDP) supplies equal amount of aggregate income. Households supply labor, land, capital, entrepreneurial ability, and they receive wages, rent, interest, and profit.

2.     GDP = Aggregate Income

3.     Not all income available to households. The government collects taxes.

4.     Some of taxes returned as transfer payments.

5.     Households receive Disposable Income (DI) The income households have available to spend or save after paying taxes and receiving transfer payments.

6.     Net Taxes (NT) Taxes minus transfers. DI = GDP - NT or GDP = DI + NT = Aggregate Income.

7.     Households either spend (Consumption) or save (Savings) disposable income. DI = C + S.

Financial Markets banks and other institutions that facilitate the flow of loanable funds from savers to borrowers. Firms in our model must borrow to invest (all payments go to resource owners.)

8.     Investment (I) consists of investment spending on new capital by firms, spending on residential construction (investment in new homes by households.) C + I

9.     G = government spending (does not include transfers that already went to households.)

10. Some spending goes for imports (M). X is foreign spending on U.S. exports.

11. Impact of flow is (M-X)

12. C + I + G + (X-M) = Aggregate expenditure = GDP


B.    Big Picture


Aggregate Income arising from production equals the aggregate expenditure on that production.


DI + NT = C + I + G + (X-M) Aggregate Income = Aggregate Expenditure


C + S + NT = C + I + G + (X-M)


S + NT = I + G + (X-M)


Leakage - any diversion of income from the domestic spending stream (includes saving, taxes, and imports)


Injection Any payment of income other than by firms or any spending other than by domestic households; includes investment, government purchases, transfer payments, and exports.


Leakages = Injections S + taxes + M = I + G + transfers


C.   Planned Investment v. Actual investment


Planned Investment The amount of investment firms plan to undertake during a year.


Actual Investment - The amount of investment actually undertaken during a year; equals planned investment plus unplanned changes in inventories.


Suppose firms produce $8.0 trillion in output, but spending adds up to only $7.8 trillion.

Firms end up with $.2 trillion in unsold products which they add to inventory.

Increase in inventory is added to investment.

So actual investment is $.2 trillion more than planned investment.


*National income accounting reflects actual investment, not planned investment.


IV.            Limitations of National Income Accounting


A.   Some Production is not included in GDP


1.     Products not sold in markets (child-care, meal preparation, house cleaning, home repair, and maintenance)- An economy with largely self-sufficient householders will underestimate its GDP.


2.     Production where no official records are kept.


UNDERGROUND ECONOMY-All market exchange that goes unreported either because it is illegal or because those involved want to avoid paying taxes.


Imputed (estimated) income from some activities that are not recorded is included.

- Wages paid in kind, such as employers' payments for employees' medical insurance.

- Imputed rental income that homeowners' receive from home ownership (read more about this in the chapter appendix)


A.   Leisure, Quality, Variety


GDP does not reflect:

1. Changes in the availability of leisure time-not explicitly bought and sold

2. Changes in the quality of existing products

3. Changes in availability of new products.



B.    GDP ignores depreciation


Depreciation- the value of capital stock that is used up or becomes obsolete during a year in producing GDP.


Truck-gets wear and tear in a year of producing the make it a less valuable resource.


Net Domestic Product (NDP) = GDP - depreciation (value of the capital stock used up)


C.   GDP does not reflect all costs.


Negative externalities-costs that fall on those not directly involved in the transactions.


These costs are ignored in GDP accounting.


Growth in GDP involves growth in negative externalities.


-Housing developments displace forests.

-Factory farms cause pollution.

-Intensive farming increases current productivity, but deplete soil fertility


Depreciation of buildings is included (NDP), but accounting ignores the depletion of natural resources.


U.S. Commerce Department is now in the process of developing "green" accounting to reflect the impact of production on air and water pollution, soil depletion, and the loss of other natural resources.


D.   GDP Values all Output Equally


Researchers at Fordham University calculate an Index of Social Health using data in 16 categories such as infant mortality, teen suicide, unemployment, drug abuse, poverty rates, health insurance coverage, high school dropout rates, etc. The index dropped in 1993, although GDP rose by 3.1 percent.


All output is counted equally without making value judgements.



Must consider these limitations when using GDP to measure the nation's economic welfare. Is higher and higher GDP what we want given the way it is calculated?


V.               Accounting for Price Changes


National Income Accounts are based on the current market value of the goods and services produced in that year. (Current dollars)


We call this:


Nominal GDP- GDP based on prices prevailing at the time of the transaction (current-dollar GDP).


This is good for examining expenditure components in a particular year. But what if we want to compare GDP from different years?



Total output Value 1999 $ Value 2000 $

5 cars $60,000 $70,000

99 restaurant meals $ 2,000 $ 2,200


Output has not really gone up, but price level has, it seems as if GDP has increased.


Real GDP-A measure of GDP that removes the impact of price changes from changes in nominal GDP.


How do we calculate real GDP?


A.   Developing Price Indexes


To compare price levels over time, you must first choose a base year to which prices in other years can be compared.


The year selected is called the BASE YEAR--prices in other years are expressed in terms of the base year price.




Using 1997 as the base year, we can develop a PRICE INDEX for the cost of a candy bar.


Year Price in current year Price in base year Price index

1997 $1.25 $1.25 100



1998 $1.50 $1.25 120



1999 $1.70 $1.25 136



You can use the index to compare prices to the base year.


The price in 1998 is 20% higher than in 1997(base year).

The price in 1999 is 36% higher than in 1997(base year).


You can also use an index to compare two years.


What happened to the price between 1998 and 1999?

136/120 * 100 = 113.3 Prices rose 13.3%.


This is how to develop a price index when a price is given. But how do we determine the PRICE LEVEL? (Price Level- composite measure reflecting the prices of all goods and services in the economy)


B.    Price Indexes and the Price Level


1.     CPI (Consumer Price Index)- A measure over time of the cost of a fixed "market basket" of consumer goods and services.


Market basket represents the goods and services bought by a typical family. And changes in the cost of this basket are often called changes in the cost of living.


EXAMPLE MARKET BASKET- pg. 172 Exhibit 4



2.     Problems with the CPI


a.      By underestimating quality improvements, the CPI overstates the true extent of inflation.


b.     The CPI overestimates inflation by assuming uneconomical consumer behavior.



3.     GDP Price Index


GDP price index- A comprehensive price index of all goods and services included in the GDP.


GDP Price Index = (nominal GDP/Real GDP) X 100


C.   Using price indexes to calculate real values? (Putting values into BASE YEAR prices)


RULE: Real Value = (Nominal Value / Price Index) X 100




Real GDP = (Nominal GDP/GDP price index) X 100


Market value in base year dollars = (Nominal value in current year dollars/price index) X 100