8: The level of overall economic activity

Question 1

What does the circular flow diagram show?

Answer 1

The circular flow on income 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.

Question 2

Describe the circular flow model:

Answer 2

Households and firms in square boxes, linked to through two markets: product markets and resource markets, shown in diamonds.

Firms receive factors of production (land, labour, capital, entrepreneurship) from households in return for household income (rend, wages, interest and profit), which are costs of production for firms.

They then use these factors of production to produce goods and services, which they provide to households in exchange for household expenditure, which acts as revenues to the firms.

Question 3

What are types of leakages and injection? What is the difference between a leakage and injection?

Answer 3

Saving and investment, taxes and government expenditure.

A leakage takes money away from the economy, an injection puts it back in.

Question 4

Define investment:

Answer 4

Spending by firms or the government for the production of capital goods.

Question 5

Why does saving and investment represent a leakage from the circular flow?

Answer 5

Saving is income that is not spent to buy goods and services. Households place their savings in financial markets, and firms obtain funds from financial markets to finance investment or the production of capital goods.The funds therefore flow back into the expenditure flow as injections.

Question 6

Describe the circular money flow diagram with leakages and injector:

Answer 6

Firms to households:
Factor incomes

Households to firms:
Consumer expenditure

Saving through financial markets which goes to firms as investment.
Taxes through government which goes to firms as government spending.
Spending on imports through other countries which goes to the firms as spending on exports.

Question 7

Explain the size of the circular flow in relation to leakages and injections:

Answer 7

Leakages from the circular flow of income (saving, taxes and imports) are matched by injections into the circular flow of income (investment, government spending and exports), though these need not be equal to each other. If leakages are larger than injections, the income flow becomes smaller. If leakages are smaller than injections, then the income flow becomes greater.

Question 8

What are the three ways to measure a country’s aggregate output?

Answer 8

1. Expenditure approach
2. Income approach
3. Output approach

Question 9

What is the expenditure approach?

Answer 9

Adding up all spending to buy final goods and services within a country over a time period.
Spending is broken down into:
1. Consumption (C) - spending by households on final goods + services
2. Investment (I) - spending by firms on final goods
3. Government spending
4. Net exports (X-M)

This is also how you calculate GDP

Question 10

What is the income approach?

Answer 10

Adding up all the income earned by the factors of production that produce all goods and services within a country over a time period. This includes rent from land, wages from labour, investment from capital and profit from entrepreneurship. The result is national income.

Question 11

What is the outcome approach?

Answer 11

Calculating the value of all final goods and services produced in a country over a time period. The goods and services are final in order to avoid the double counting problem.

Question 12

Define GDP:

Answer 12

GDP is defined as the market value of all final goods and services produced in a country over a time period, usually a year. It includes spending by the four components (C + G + I + (X - M).

Question 13

What is the difference between GDP and gross national income (GNI)?

Answer 13

GDP is the total value of all final goods and services produced within a country over a time period, usually a year. GNI or GNP is the total income received by the residents of a country, equal to the value of all final goods and services produced by the factors of production supplied by the country’s residents regardless of where the factors are located. The value of multinational coorporations would be incorporated into the GNI of the country of origin. For example a mcdonalds in India would contribute to India’s GDP but the GNI of the US.

Question 14

What is the value of a good?

Answer 14

The quantity of a good produced multiplied by its price.

Question 15

Distinguish between nominal GDP and real GDP:

Answer 15

Nominal GDP is measured in terms of current prices which does not account for changes in prices. Real GDP or GNI are measurements of economic activity that have eliminated the influence of changes in price. This is so they can measure the change in quantity of goods produced rather than prices. They measure the value of current output at constant (base year) prices.

Question 16

What is the difference between total and per capita?

Answer 16

Total provides a summary of the overall size of the economy but per capita measures per head, which can be used as an indication of standard of living in a country.

Question 17

Why is the distinction between total and per capita necessary?

Answer 17

1. There are differing population sizes amongst countries.

2. Population growth.

Question 18

Why do national income statistics not accurately measure the true value of output?

Answer 18

National income statistics are GDP and GNI.

1. They do not include non-marketed output, such as a house wife who who provides service without paid. Non marketed output is much greater in LEDCs, as they are more self sufficient for example with agriculture.
2. They do not include output sold in underground markets.
3. They do not include quality improvements in goods and services such as technological advancements leading to a price decrease. This benefits consumers and yet does not appear on the data, in fact GDP may decrease.
4. GDP does not account for negative externalities.
5. They do not account for the depletion of natural resources.
6. They do not account for differing domestic price levels. This affects the purchasing power of people. In South Africa for example all though they have a lower GDP per capita they can purchase more with this amount, so their GDP may not accurately reflect their standard of living.

Question 19

Why do national income statistics not accurately measure the true standard of living?

Answer 19

1. There is no distinguishing in the goods produced. If a country produces huge amounts of military goods but no merit goods such as education and healthcare, it may have a high GDP but a low standard of living.
2. There is no reflection on education or health which is important to standard of living.
3. There is no information on income distribution.
4. They do not take into account increased leisure e.g. Greece has a high level of leisure but a lower GDP. US has very little leisure which could reflect a stressful life.
5. GDP does not tell you quality of life, such as crime.

Question 20

How can comparisons of national income statistics over time be misleading?

Answer 20

Because of improvements in product quality, improvements in health and education, increased leisure, improvements in quality of life. These things will not change the GDP over a period of time.

Question 21

How can comparisons of national income statistics between countries be misleading?

Answer 21

GDP per capita does not indicate income inequality, but rather how much each person would have if it were spread evenly. It may be concentrated on a small number of people.

Question 22

What is green GDP?

How is it calculated?

Answer 22

GDP that accounts for the value of resource and environmental destruction

green GDP = GDP - the value of environmental degradation

Question 23

What is an alternative to green GDP?

Answer 23

Genuine saving measure developed by the world bank. It estimates how much national income and output is being saved for future generations, accounting for the destruction of national capital.

Question 24

Downfalls of green national statistics?

Answer 24

They are not yet standardised nor widely recognised so they cannot be compared internationally.

Question 25

How do you calculate GNI?

Answer 25

GNI = GDP + income from abroad - income sent abroad 
GNI = GDP + net income from abroad

Question 26

How do you calculate nominal GDP and real GDP over the course of several years?

Answer 26

For nominal you just do P * Q of each product for each year and add them up.
For real you do P of the base year * Q of each product each year.

Question 27

How do you calculate real GDP using a price deflator?

Answer 27

Real GDP = nominal GDP/price deflator x 100

Question 28

What is the gdp inflator for the base year?

Answer 28

It is always 100 as real GDP will equal nominal GDP for the base year.

Question 29

What does an increasing/decreasing GDP deflator indicate?

Answer 29

Increasing GDP deflator indicates rising prices on average while a decreasing GDP deflator indicates falling prices on average.

Question 30

What does a GDP deflator of less than 100 indicate?

Answer 30

It indicates that the prices are lower than the base year.

Question 31

What is economic growth?

Answer 31

Increases in the quantity of output produced over a period of time, usually a year, expressed as a percentage change in real GDP over a period or time or a percentage change in GDP per capita over a period of time.

Question 32

What is the difference between a decrease in GDP and a decrease in GDP growth?

Answer 32

With a decrease in GDP growth GDP is still increasing, just at a slower rate.

Question 33

What are the phases of the business cycle?

Answer 33

1. Expansion = + growth in real GDP. Slopes upward.
2. Peak = maximum GDP, end of expansion.
3. Contraction = - growth in real GDP.
4. Trough = minimum level of GDP.

Question 34

What is a recession?

Answer 34

A recession occurs when contraction lasts sixth months or more. It is characterised by falling real GDP and growing unemployment of resources.

Question 35

What is a long term growth trend?

Answer 35

It presents the general direction of GDP despite short term fluctuations. It shows potential output.

Question 36

What is a long term growth trend?

Answer 36

It presents the general direction of GDP despite short term fluctuations. It shows potential output, or potential GDP.

Question 37

How does unemployment relate to actual and potential output?

Answer 37

along the long term growth trend, economy experiences “full employment” meaning unemployment is equal to the natural rate of unemployment. When actual GDP is higher than the potential GDP, unemployment is lower than the natural rate. When the real GDP is lower than potential GDP, unemployment is higher than the natural rate.

Question 38

What is an output gap?

Answer 38

When actual GDP is greater or lower than potential GDP there is an output gap.