Unit 3: Macro economics

Chapter 8: Level Of Overall Economic Activities

 Real-world issue 1:
Why does economic activity vary over time and why does it matter?

- Change in the condition of the demand and supplied sides of the economy causes economic
activities to vary over time.
- Fluctuations in economic activity impact the economic-wellbeing of the individuals and
societies.
- Different schools of macroeconomic thought identify different causes and offer different
solutions to macroeconomic problems.

Key concepts: scarcity, choice, efficiency, equity, economic well-being, sustainability, change,
interdependence, intervention
 How Is The Overall Level Of Economic Activity Measured?
Objectives of this section: By the end you should be able to:

- Describe using a diagram, the circular flow of income between households and firms in a
closed economy with no government.

- Identify the standard measurements of the four macroeconomic objectives.

- Explain the three approaches to measure gross domestic product.

- Identify the four factors of production with their respective payments and explain that these
constitute the income flow in the model.

- Outline that income flow is numerically equivalent to the expenditure flow and the value of
the output flow.
 8.1 Economic Activities
Macro economics studies the economy as a whole. It is different from micro economics in the
following ways.

MICROECONOMICS MACROECONOMICS

Studies the behavior of individual decision

Focuses on the economy as a whole which is
making units in specific product and factor
composed of many consumers, firms, resource
markets like consumers, firms and owners of
owners and markets.
resources.
Example: It studies
- Individual product price Example: It studies
- The demand of individual products - General price level in the economy
- The supply of individual firms and - Total demand for goods and services
industries - Total output produced in the economy

Further more in macro we come to the understanding of aggregates (overall economic activities) such as total
employment, total investment , total export and import, not in specific industries but in the economy as a whole.
In seeking to improve general livelihood of their citizens, governments have four priority
objectives which are:
• Full employment, as measured by a low unemployment rate
• Economic growth, as measured by increasing national income
• Price stability, as measured by low inflation rate
• Income distribution, as measured by a more equitable distribution of income.

Hence, economic activities can be measured using; Unemployment rate, National income
(GDP), Inflation rate and the level of income distribution.
 To better understand how economic activities are measured, we need to look at the circular
flow of income model.

The circular flow of income model is a simple model which shows that in any given time
period, the value of output produced in an economy is equal to the total income generated in
producing that output which is equal to the expenditures made to purchase that output.

It illustrates some economic concepts and relations that will help us understand the overall
economy. Let’s look at the figure below (copied)
  The simplified circular flow model, for a closed
economy with no government illustrates two types
of markets; Product market and factor market.

 In the product market, households own and supply

factors of production; land, labor, capital and
entrepreneurship while the firms demand and use
these factors of productions to produce goods and
services.

 Income flows from firms to the households as

payment for the factors of production and the
households incurs expenditure which flows to the
firm for the payment of goods and services.

 These two flows represent the circular flow of

income and they are equal.

 These flows must be equal to the value of the

output produced by firms. Which is known as the
output flow.
 Injections And Leakages
 A more realistic model of the circular flow of income includes injections and leakages.
Injections refer to those items that add income into the circular flow while leakages are
those expenditures that remove income from the circular flow.
 Lets consider the figure below that represents an open economy (copied).
Added to the simplified model are injections and leakages. Their various components are
linked as below

Leakages Injections
Savings: is part of income that the Investment: is the purchase or the
household does not spend on goods and creation of capital goods. Firms get
Financial
services. It is kept in banks (financial funds for this purpose by borrowing
markets
market). This leaks out income from the from banks. This goes back into the
circular flow. circular flow as injection.

Taxes : are compulsory payments that Government spending; such as on

the households make to the government. education, health etc. is financed from
Government
This can’t be used to buy goods and the taxes paid by the household. This
services, hence it’s a leakage. injects income back into the economy.

Exports: are spending by foreigners in

Imports: household spending on goods
Other buying domestically produced goods.
produced by other countries. It causes
countries This injects income into the circular
income to leak out of the economy.
flow.
 The size of the circular flow;
More or lesser income will circulate in the economy. This depends on the size of total leakage
and total injection.
 If leakages is greater than injections, then the size of the circular flow becomes smaller. For
instance let assume that tax is larger than government spending. This will mean that a lesser
amount out of the total collected by the government as tax is reinjected into the circular
flow.
 If injections are larger than leakages then the size of circular flow becomes larger.
 8.2 Measures of economic activity
To measure the economic activity of an economy requires that we measure the economy’s
national income or the value of total output of the economy. This is useful because;

 It gives us information about the economy’s performance over time

 Permit us to be able to compare income and output between countries
 Establishes a good base for policy making in order to achieve macroeconomic objectives.

There are three methods used in measuring national income (the value of total output);
-Expenditure method.
-Income method
-Output method

These are illustrated on the circular flow represented by the three flows; Expenditure flow,
income flow and output flow.
 Methods of measuring national income;

1. Expenditure (spending) method: This method counts the total spending on final new
goods and services within a given a given period usually one year. Final goods are ready for
consumption.

- In order to avoid double counting which will give us a wrong national income value, it is
important not to include the value of goods that will be input or intermediary goods, but rather
take only the value of the final. For instance;

- Apples bought at the grocery store count as final goods, but apples sold to a baker for
apple pie are not counted until they are sold in their final form.

- Wood bought for fire wood counts as final good, but wood sold to a carpenter for chair
making is not counted until its is sold in its final form (Chair)
 The expenditure method groups total spending into four categories which include;
 Consumption (C); which includes spending on durable and non durable goods and services
by individuals and households. This excludes houses or buildings

 Investments (I); which is spending by firms on new capital equipment and by households on
new buildings.

 Government spending (G) ; that is, spending on government purchases, which includes
salaries for workers as well as capital goods spending and transfers.

 Net exports (X-M); which deducts the outflow of import purchases (M) from the inflow
derived from export revenue (X).

We therefore express the expenditure approach as;

GDP = C + I + G + (X-M)
 GDP is Gross Domestic Product, which is commonly defined as measuring the final
value of all goods and services produced in a country in a given period, usually a year. An
example of the expenditure method is the USA GDP figures in US$ billion in 2019 shown on
the table below.
The largest spending sector is consumption while net export is negative implying the more was
imported than exported.
 2. Income method; This approach adds all the income earned by all the factors of production
used in the production of the national output within the country over a period of one year.
These are wages(W), Interest(I), rent(R) and profit(P)
 These forms of income are used to buy goods and services in the product market, and should
be roughly equivalent to those expenditures.

 It is assumed that for every transaction there is a buyer and a seller. A buyer’s
spending is recorded by the expenditure approach, and that same spending is
recorded as revenue income on the income approach. Thus, economists assume
the identity as:
W + I + R + P = C + I + G + (X-M)
(GDP from income) = (GDP from expenditure)
 3. The output method; by this approach, GDP is obtained by adding up the value of the final
output produced by all the economic sectors of the economy within a period of one year. It
takes the value of final product or the value added at each stage of production of the goods so
as to avoid double counting.

For instance An automobile’s raw materials, then parts, then the whole are calculated separately
to measure each interval of production. The total is then added to the national income number.

The different economic sectors include; agriculture, fishing, banking, transport, insurance,
manufacturing etc.

As you study macroeconomics, it is useful to keep in mind that the overall economic activity
of a country can go by any of these categorizations:
GDP = national output = national income = national spending