Introduction to

Macroeconomics
Dr. Rania Moaaz
Learning Objectives
• Define the Circular Flow of Expenditure and Income
• Explain how GDP Equals Expenditure Equals Income
• Explain the uses and limitations of real GDP as a measure of
economic well-being
Gross Domestic Product
• GDP and the Circular Flow of Expenditure and Income
‒ GDP measures the value of production, which also equals
total expenditure on final goods and total income.
‒ The equality of income and value of production shows the link
between productivity and living standards.
‒ The circular flow diagram in Figure 21.1 illustrates the equality
of income and expenditure.
The Circular Flow Diagram
The Circular Flow Diagram
• Firms sell and households buy consumer goods and services in
the goods market.
• Consumption expenditure is the total payment for consumer
goods and services, shown by the red flow labelled “C” .
• Firms buy and sell new capital equipment in the goods market
and put unsold output into inventory.
• These purchases of new capital equipment and the additions to
inventories are investment, shown by the red flow labelled “I”.
The Circular Flow Diagram
• Governments
‒ Governments buy goods and services from firms and their
expenditure on goods and services is called government
expenditure.
‒ Government expenditure is shown as the red flow “G”.
‒ Governments finance their expenditure with taxes and pay
financial transfers to households, such as unemployment
benefits, and pay subsidies to firms.
‒ These financial transfers are not part of the circular flow of
expenditure and income.
The Circular Flow Diagram
• Rest of the World
‒ Firms in the United States sell goods and services to the rest of
the world—exports—and buy goods and services from the rest
of the world—imports.
‒ The value of exports (X ) minus the value of imports (M) is
called net exports, the red flow (X – M).
‒ If net exports are positive, the net flow of goods and services is
from U.S. firms to the rest of the world.
‒ If net exports are negative, the net flow of goods and services is
from the rest of the world to U.S. firms.
The Circular Flow Diagram
• The circular flow shows two ways of measuring GDP.
• GDP Equals Expenditure Equals Income
• Total expenditure on final goods and services equals GDP.
GDP = C + I + G + X – M.
• Aggregate income equals the total amount paid for the use of factors of
production: wages, interest, rent, and profit.
• Firms pay out all their receipts from the sale of final goods, so income equals
expenditure,
Y = C + I + G + (X – M).
Measuring GDP (The Expenditure Approach)
• The Expenditure Approach
‒ The expenditure approach measures GDP as the sum of
consumption expenditure, investment, government
expenditure on goods and services, and net exports.
GDP = C + I + G + (X − M)
‒ Table 21.1 on the next slide shows the expenditure approach
with data (in billions) for 2014.
GDP = $11,729 + $2,714 + $3,139 − $538
= $17,044 billion
Measuring GDP (The Expenditure Approach)
Practice
1. Using the information in
the table above, calculate
the value of GDP.
• A) $185 million
• B) $145 million
• C) $195 million
• D) $140 million
• Answer: D (80 + 30 + 20 +
(20 -10) = 140; we do not
include net taxes)
Measuring GDP (The Income Approach)
• The Income Approach
• The income approach measures GDP by summing the
incomes that firms pay households for the factors of
production they hire.
• Two broad categories are
‒ Wages, salaries, and other labor income.
‒ Other factor incomes.
Measuring GDP (The Income Approach)
• The Income Approach
‒ The income approach measures GDP by summing the
incomes that firms pay households for the factors of
production they hire—wages for labor, interest for
capital, rent for land, and profit for entrepreneurship.
• The National Income and Expenditure Accounts divide
incomes into two broad categories:
1- Compensation of employees.
2- Net operating Surplus.
Measuring GDP (The Income Approach)
• Compensation of employees is the payment for labor
services. It includes net wages and salaries (called “take-
home pay”) that workers receive plus taxes withheld on
earnings plus fringe benefits such as Social Security and
pension fund contributions.
• Net operating surplus is the sum of all other factor incomes.
It has four components: net interest, rental income, corporate
profits, and proprietors’ income (income earned by the owner
of a business).
Measuring GDP (The Income Approach)
• The sum of all factor incomes is net domestic income at factor
cost.
• Two adjustments must be made to the net domestic income
get GDP:
‒ Indirect taxes less subsidies are added to get from factor cost
to market prices.
‒ Depreciation is added to get from net domestic income to
gross domestic income.
Measuring GDP (The Income Approach)
Measuring GDP (The Income Approach)
• Measuring GDP (Income Approach)
• Step One:
• Net Domestic Income at Factors Prices= Compensation of
employees + Net Interest + Rental Income + Corporate Profit +
Proprietors Income
• Step Two:
• Net Domestic Income at Market Prices = Net domestic income
at factors prices + Indirect taxes less subsidies
Measuring GDP (The Income Approach)
• Step Three:
• GDP (income approach) = Net domestic income at market prices
+ depreciation
Practice
1. Using the data in the
above table, gross
domestic product as
calculated by the income
approach equals .
• A) $2,333
• B) $2,592
• C) $2,925
• D) $2,205
• Answer: C
Answer
• GDP (Income approach)
• Net Domestic Income at Factors Prices = 239 + 1735 + 37 + 128 +
194 = 2333
• Net Domestic Income at Market Prices = 2333 + 259 = 2592
• GDP (income approach) = 2592 + 333 = 2925
End of Unit