Unit 3 Aggregate demand and the multiplier model
3.2 Measuring the aggregate economy: Gross domestic product
- national accounts
- The system used for measuring overall output and expenditure in a country.
How much does the economy produce? Estimates of a country’s total or aggregate output date back at least to the work of a seventeenth-century English medical doctor and professor of music, William Petty. Nowadays the calculations are the specialized task of a huge group of statisticians following internationally agreed guidelines for the compilation of national accounts.
- gross domestic product (GDP)
- A measure of the total output of goods and services in the economy in a given period.
The measure of aggregate output that is used is called gross domestic product (GDP). In this section we explain why this is also a measure of aggregate expenditure, and of the total incomes of the country’s residents.
The circular flow of income and three ways of calculating GDP
In eighteenth century France, a group of economists called the physiocrats, compared the flow of money through the economy to the circular flow of blood in the human body. This was a forerunner to how we think today about the circular flow that allows us to calculate GDP. Money flows from the spender to the producer of output, from the producer to its employees or shareholders, and then is spent again on further output, continuing the cycle.
There are three ways of constructing GDP from economic data, corresponding to measurements taken at three different points in the circular flow of macroeconomic life: output, incomes, and spending. The production of output in the form of goods and services generates incomes for the producers as wages, salaries, and profits; these incomes finance expenditure on goods and services; expenditures purchase output.
Figure 3.2 The circular flow model: three ways to measure GDP.
These three ways of thinking about economic activity allow GDP to be alternatively calculated as follows:
- value added
- The value of output minus the value of all inputs (called intermediate goods).
- The sum of the outputs of the different sectors of the economy. Production is measured by the value added by each industry: this means that the cost of goods and services used as inputs to production is subtracted from the value of output. These inputs will be measured in the value added of other industries, which prevents double-counting when measuring production in the economy as a whole. The example of the production of a cotton shirt, below, illustrates how this is done.
- The sum of the incomes paid to the various factors of production such as labour and capital. This comprises wages, profits, the incomes of the self-employed, and taxes received by the government.
- The sum of expenditures on total production in the home economy by its final users, which are households, firms, the government, and residents of other countries.
If accurate measurement were possible, the total of expenditure, output, and incomes in a year would be the same—so the point at which the measurement is taken would not matter.
Figure 3.3 shows the circular flow between households and firms (ignoring for now the role of government, and households and firms in other countries). Households and firms both receive income and spend it.
Figure 3.3 is similar to the model of the economy in Figure 1.21, which shows the physical flows of resources around the economy, between households, firms, and the biosphere. The focus here is on measuring those flows using the circular flow of income: the monetary flows that accompany the physical transactions. Read The Economy 1.0 Unit 20 for how to measure the interaction of households and firms with the biosphere.
Figure 3.3 The circular flow (expenditure, output, and income) model.
A simple example: An economy that produces a cotton shirt
The three methods for measuring GDP are best understood using a very simple economy comprising just three industries. The economy produces a single good, a cotton shirt. The shirt industry buys cloth for $80 from the cloth industry, which in turn buys cotton from the raw cotton industry for $50. Finally, the shirt is sold to a consumer for $100.
Measuring GDP according to the expenditure approach shows that the final product or GDP of this economy is equal to $100 because that is the value of the sale to the final consumer.
GDP can also be measured by the value added by each industry as shown in the final column of the table. The total value added in the economy is \(50 + 30 + 20 = 100\), exactly equal to the value of final production and equal to total final expenditure.
| Cost of input | Price of output | Value added | |
|---|---|---|---|
| Raw cotton industry | $0 | $50 | $50 |
| Cloth industry | $50 | $80 | $30 |
| Shirt industry | $80 | $100 | $20 |
| Total value added = final expenditure on shirts: $100 | |||
Figure 3.4 Measuring GDP using value added by each industry.
Incomes are received as wages and profits. Across all industries in the economy, wages plus profits will be equal to the value of final production (which is equal to the total value added).
Therefore, GDP can be defined according to any of these three perspectives. Section 3.3 explains the expenditure method and Extension 3.3 explains the value-added and income methods.
Imports, exports, and government spending
- imports
- Goods and services produced in other countries and purchased by domestic households, firms, and the government.
- exports
- Goods and services produced in a particular country and sold to households, firms, and governments in other countries.
Nonetheless, we do have to be careful with the definition of GDP because, while it is always the case that one person’s expenditure is another person’s income, globalization means that the two people may be in different countries. This is the case with imports and exports: if someone in China buys rice from someone in Japan, the expenditure is Chinese while the income is Japanese.
How do we account for a transaction like this? Since GDP is defined as domestic product, it counts as Japanese GDP because the rice was produced (and sold) by a firm in Japan. So exports are included in GDP because they are part of domestic production, but imports are not because they are produced elsewhere.
The circular flow model in Figure 3.2 considered only households and firms, but the government, and the public services the government provides, can be incorporated in a similar way. Households receive some goods and services that are supplied by the government, for which they do not pay at the point of consumption. A good example in many countries is primary school education.
The consumption and production of these services can be visualized using the circular flow model:
- Households to government: Households pay taxes.
- Government to households: These taxes pay for the production of public services used by households.
In this way, the government can be thought of as another producer, like a firm—with the difference that the taxes paid by a particular household for public services do not necessarily correspond to the services received by that household. Since public services are not sold in the market, we have to make a further assumption: that the value added of government production is equal to the amount it costs the government to produce.
So we can say that if, for example, citizens on average pay $15,000 per year in taxes (the equivalent to ‘expenditure’), that is $15,000 of revenues to the government (the income), which uses it to produce $15,000 worth of public goods and services (the value added).
The fact that expenditure, output, and incomes are all equal means that we can use any one of these perspectives to help us understand the others. For example, recessions are periods of falling output in the economy as a whole. From the model of the circular flow, this means they must also be periods of falling expenditure (if output is declining, people must be buying less). Often, we can even say that output declines because people are buying less. This is useful because we know a lot about what determines expenditure, which in turn helps us to understand recessions. This will be explored further in the following sections.
Question 3.1 Choose the correct answer(s)
In the diagram shown, the letters A, B, and C represent flows of spending, each corresponding to a method of measuring GDP. Based on this information, read the following statements and select the option(s) that correctly match the flows to the method of measuring GDP.
- Path A cannot represent output since it is a monetary flow from households to firms.
- Path A represents consumption spending (expenditure on domestic production). Path B is the output produced by the firms. Path C represents the incomes received by the households when they rent out their land/machines and provide labour to firms.
- Path C cannot represent household expenditure. Path C represents the firms’ expenditures, which households receive in the form of income.
- Path C cannot represent household expenditure. Path C represents the firms’ expenditures, which households receive in the form of income.
