4.1 National income statistics

4.1.1 meaning of national income

4.1.2 measurement of national income

Method of calculating GDP

• Income method: the income paid to all FoPs.
• Expenditure method: amount of spending on G&S by ultimate purchases.
• Output method: the sum of all market values of all products.

GDP/GNI cannot measure the true value of output due to lacking

• non-marketed output
• black market
• quality improvements to G&S
• value of externalities

GDP/GNI cannot measure the standard of living due to lacking

• inequality
• quality of life factors
• healthcare and education
• pollution
• leisure time

4.1.3 adjustment of measures from market prices to basic prices

$$\text{Market prices}=\text{Basic prices}+\text{Taxes}-\text{Subsidies}$$ $$\text{Basic prices}=\text{Market prices}-\text{Taxes}+\text{Subsidies}$$

4.1.4 adjustment of measures from gross values to net values

$$\text{Gross values}=\text{Depreciation}+\text{Net values}$$ $$\text{Net values}=\text{Gross values}-\text{Depreciation}$$

4.2 Introduction to the circular flow of income

4.2.1 circular flow of income in a closed economy and an open economy
4.2.2 injections and leakages

• Simple closed economy: households and firms
• Closed market economy: households and firms + financial sector
• Closed mixed economy: households and firms + financial sector + government
• Open economy : households and firms + financial markets + government + international trade

4.2.3 equilibrium and disequilibrium

The income in an economy stays in equilibrium if the injections are equal to the leakages, and vice versa.

An economy will move towards the equilibrium point if the injections or leakages changes, causing a change in GDP.

4.3 Aggregate demand and aggregate supply analysis

4.3.1 definition of aggregate demand

4.3.2 components of AD and their meanings

$$\mathrm{AD}=C+I+G+(X-M)$$

where

• $C$ is consumer expenditure (spending by households on G&S)
• $I$ is investment (spending by private firms on capital goods)
• $G$ is government spending
• $X$ is export
• $M$ is import
• $(X-M)$ is net export

4.3.3 determinants of AD

Change in any component of AD will cause a change in AD itself.

4.3.4 shape of the AD curve

The AD curve is downward sloping due to the following reasons:

• Wealth effect: a rise in price level cases a fall in purchasing power, assuming money supply is held constant. Hence, consumption falls as price rises.
• Interest rate effect: a rise in price level will increase the demand for money from consumers, hence higher interest rate. Hence, consumption and investment falls as price rises.
• International effect: a rise in price level decreases the competitiveness of the country's exports. Hence, net export falls as price rises.

4.3.5 causes of a shift in the AD curve

Change in any component of AD will cause a change in AD itself.

4.3.6 definition of aggregate dupply

4.3.7 determinants of AS

See 4.3.9.

4.3.8 shape of the AS curve in the short run and the long run

The shape of short-run aggregate supply (SRAS) is upward sloping due to

• Cost effect: Average cost may rise due to overtime payments as output rises.
• Profit effect: As price rises, inefficient firms can enter the market, leading to higher quantity supplied.
• Misinterpretation effect: Firms seeing a price rise may misinterpret it as a rise in the popularity of their products, increasing quantity supplied.

The long-run aggregate supply (LRAS) curve may be one of the following two shapes, each advocated by a group of economists.

The curve on the left is advocated by Keynesian economists, whereas the one on the right is represented by new classical economists.

Keynesian LRAS

• Supply is elastic at lower levels of output as there is a lot of spare production capacity in the economy
  • Struggling firms will increase output without raising prices
• Supply is perfectly inelastic at a point of full employment of all resources

New classical LRAS

• In the long run, the economy operates at a fixed maximum possible output (production capacity).

4.3.9 causes of a shift in the AS curve in the short run and in the long run

Shifters of SRAS

• Change in the prices of FoP
• Change in factor productivity
• Change in government policies
• Change in quantities of FoP

Shifters of LRAS

• Change in quantity of resources
• Change in quality of resources

4.3.10 distinction between a movement along and a shift in AD and AS

This is exactly the same with the difference between a movement along and a shift in demand and supply curves.

4.3.11 establishment of equilibrium in the AD/AS model and the determination of the level of real output, the price level and employment

The equilibrium level of output and the price level are determined where AD is equal to AS.

The level of real output, price level and employment should be self-explanatory with the help of a diagram.

4.4 Economic growth

4.4.1 meaning of economic growth

4.4.2 measurement of economic growth

Economic growth can be measured by real GDP and real GNI.

4.4.3 distinction between growth in nomial GDP and real GDP

$$\text{Real prices}=\frac{\text{Nominal prices}}{\mathrm{CPI}}=\text{Nominal prices}\times \frac{\text{Price index in the first year}}{\text{Price index in current year}}$$ $$\text{GDP deflator}=\frac{\text{Nominal GDP}}{\text{Real GDP}}\times 100$$

4.4.4 causes of economic growth

• Short run growth is caused by a shift in AD.
• Long run growth is caused by a shift in LRAS.

4.4.5 consequences of economic growth

Benefits

• Increase living standards
• Increase tax revenue, more spending on public services
• Reduction in unemployment
• Increase in profits and business confidence
• Reduction in income inequality if income distributed more equally

Costs

• Depletion of resources is not sustainable
• Inequality without progressive ax and social protection
• Pollution and other externalities
• Increase working time
• Structural unemployment
• Demand-pull inflation

4.5 Unemployment

4.5.1 meaning of unemployment

4.5.2 measures of unemployment, with reference to possible difficulties in measurement

1. Claimant count - measuring those claiming unemployment benefits
2. Labor force survey

Difficulties

1. Sampling errors
2. Inactive workers
3. Discouraged workers
4. Disguised unemployment
5. Unreported legal employment
6. Unreported illegal employment

4.5.3 causes and types of unemployment

1. Frictional unemployment - temporary unemployment caused when workers are between jobs
   • Search unemployment
   • Casual unemployment
   • Voluntary unemployment
2. Structural unemployment - unemployment that arises due to changes in the structure of the economy
   • Regional unemployment
   • International unemployment
3. Cyclical unemployment - unemployment that arises due to a lack of aggregate demand
4. Seasonal unemployment - unemployment that occur due to seasonal changes
5. Technological unemployment - unemployment that is caused by technological advancements

4.5.4 consequences of unemployment

4.6 Price stability

4.6.1 definition of inflation, deflation and disinflation

4.6.2 measurement of changes in the price level

Constructing a CPI

1. Selecting a base year
   • Select a relatively standard year in which there are no dramatic changes
   • The base year is given CPI=100.
2. Carry out a survey to find peoples' spending patterns in order to work out the weights of different types of goods
3. Attaching weights of grouped items of expenditure
4. Find their prices
5. Constructing a weighted price index $\text{CPI}={\Sigma }_{\forall i}(w_i{p}_i)$

Difficulties in measuring CPI

• Price collection (difficult to collect accurate and timely data on the prices of all relevant items, especially in undeveloped market conditions)
• Substitution bias
• Quality change
• New products
• Measurement error
• Shadow economy
• Geographical variations

4.6.3 distinction between money values (nominal) and real data

See 4.4.3.

4.6.4 causes of inflation: cost-push and demand-pull inflation

Reasons for cost-push inflation

• Wages increasing more than labor productivity
• Increase in the cost of raw material
• Higher cost of capital goods
• Firms reducing supply to increase profit margins
• Increase in indirect taxes

Reasons for demand-pull inflation: increase in any component of AD.

4.6.5 consequences of inflation

Costs

1. Income effect and wealth effect – a fall in the value of money and hence a fall in the purchasing power of money.
2. Redistribute income
   • Borrowers will gain and savers will lose. Saving discouraged.
   • Those with weak bargaining power will lose.
   • Those with physical assets will gain but those on fixed incomes will lose.
3. Increased costs on firms
   • Menu costs
   • Shoe-leather costs
   • Planning costs – uncertainties may discourage investment
4. Reduce net exports due to reduction in international competitiveness. Higher inflation rate compared to rivals makes export less price competitive leading to a deterioration in current account position.
5. Fiscal drag
6. Inflation noise
7. Inflation causes inflation

Benefits

1. Stimulating output
2. Reduce the real burden of debt
3. Reduce labor costs for the firms and therefore may reduce unemployment
4. Encourage consumers to buy now rather than later

The impact of inflation depends on:

1. The cause of inflation (demand-pull / cost-push)
2. Inflation rate
3. Stability of the rate
4. Expected or unexpected relations
5. Inflation rate relative to the inflation rates of trading partners