21 Nov 2018

Week 2
National Income Accounting (NIA) Circular Flow Diagram

• is the measurement of indicators of national • summarizes the transactions between the different
output/income; .e.g. GDP, GNP economic agents

• agents: households, firms (business), banks,

government, and foreigners (RoW - rest of the world)

Circular Flow Diagram Circular flow diagram

• Assumption: The economy composed of households • Upper loop of the circular flow diagram: transactions in
and firms only (Microeconomics) the goods and services markets
• Households: own factors of production, consume
goods and service
• Lower loop: transactions in the factor markets
• Firms: hire factors of production to produce goods and
services

Revenue Spending
(=GDP) (=GDP)
MARKETS FOR
GOODS AND With government and foreign agents
SERVICES Good and
Good and services
services sold bought
• Need to account for :
a. Government purchases of goods and services.
FIRMS HOUSEHOLDS b. Government payments for factor services (wages, rent,
interest, profit).
c. Transfer payments between different agents.
Land, labor d. Firms and households pay taxes to government.
Inputs for and capital
Production e. Taxes paid on income, property, goods and services.
MARKETS FOR
FACTORS OF
f. Transactions with the foreign sector.
PRODUCTION Income
Wages, rent, interest (=GDP) Flow of goods
and profit (=GDP) & services

Flow of
THE CIRCULAR FLOW DIAGRAM money

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Transfer Payments
• Transfer payments – are transactions wherein one
party is not obliged to deliver a good or service in
return for the payment.
• Examples: retirement benefits, unemployment
benefits,4P's (CCT) scholarships, and donations.
Measurement of economy’s output:
The Gross Domestic Product (GDP)
• The GDP measures the market value of all final
goods and services produced within an economy
in a given period.
• GDP only measures current production. Transfer
payments and transactions involving goods
produced in other periods are not included in the
calculation of GDP.
• GDP is usually expressed in the currency of a
particular country, e.g., Philippine
peso….indicates the market value of the goods
and services
GDP includes final goods and services
only
• Final goods - goods and services that are not purchased
for the purpose of producing other goods and services or
for resale
• Eg. Rice (final) and palay or unhusked rice
(intermediate product)
• Including intermediate goods and final goods will result
in “double counting”.
21 Nov 2018
Transactions with foreign sector
• Includes sales of goods and services, assets, and
transfers
• Exports - sales of domestically produced goods to other
countries
• Imports - goods bought from other countries
• (X-M) = NX
Definition of GDP
GDP = sum of the market values of all final goods and
services produced within a country in a period of time.
3 Approaches for measuring GDP
8-9/2-5
1. Expenditure Approach - measures GDP as
the sum of expenditures on final goods and
services.
2. Income Approach - measures GDP as the
sum of incomes of factors of production
(wages, rent, interest and profit.
3. Value-added Approach – measures GDP as
the sum of value added at each stage of
production (from initial to final stage)
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Expenditure Approach Income Approach

• Uses the lower loop of the circular flow diagram: sum of
payments to the various factors of production.
• Example: Suppose the economy has only one product, • Suppose in the production of rice - the sales and expenses
which is rice. are as follows:
Sales P 45,000
Good Price Q sold Expenditure
Expenses:
per kilos
Wages 15,000
kilo
Rent 5,000
Rice 45 1000 45,000 Interest 2,000
GDP 45,000 Total 22,000
Profit 23,000
GDP=Sum of 45,000 P 45,000
Payments to factors

GDP and National Income By Industrial Origin / Value Added

Value Added Approach INDUSTRY AMOUNT (in M prices)
Agri, Fisheries, forestry : 701,660
• Suppose that rice is the only final product of an economy: It
goes through several (3) stages of production. Industrial Sector: 815,844
Mining and Quarrying 41,068
Manufacturing 612,876
Construction 105,334
Electricity, Gas and Water 56,566
Value of Service Sector: 1,205,188
Stage of Prod’n intermediate Value of Value-added Transportation 125,712
good Sales Trade 579,234
Finance and Housing 203,488
Farmer - Palay 22,000 22,000
Private services 130,966
Rice Miller -Milled Rice 22,000 33,000 11,000 Gov't. Services 165,780
GDP at market Price 2,722,692
Retailers - Rice 33,000 45,000 12,000 Other Deductions 196,040
GDP= Total Value 45,000 Indirect Tax net of subsidies 85,225
Added Depreciation 110,815
National Income GDP 2,526,652

Notes of the 3 approaches

• The expenditure approach, income approach, and the value-added
approach all come up with the same estimate of the GDP. They are THE NATIONAL ACCOUNTS OF THE PHILIPPINES
equivalent approaches.

• In the income approach, profit is also considered a payment to the

entrepreneur. So the incomes are (1) wages, (2) rent, (3) interest, and
(4) profit. Profit adjusts to make the sum equal to the final value of the • same principles as above but need to make
good.
adjustments in order to accommodate the realities in
• In the value added approach, only the value added in each stage of modern economies
production are included. If we add the value of intermediate product
with the value of the final product, we commit the sin of “double-
counting.”
• Expenditure approach
GNP = C + G + I + (X –M)+ SD
• At each stage of production, the value-added is equal to wages, interest,
rent, and profit. Therefore the value of the final product is likewise the
same of all payments to the factors of production.

• 2-8/9-8
• 2-9/430

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Table. Expenditures on GDP, 2010 in million pesos. Income Approach

Item Symbol Value
Personal Consumption C 2,750,900 ITEMS SYMBOLS VALUE
Expenditure
Government Consumption G 488,700
Expenditure Compensation of COE 4,000,800
Gross Domestic Capital I 776,200 Employees
Formation
Net Operating Surplus NOS 3,215,100
GDP 4,015,800
Exports of Goods and Services X 1,968,500
Imports of Goods and Services M 1,989,100
Depreciation D 357,200
NFY -20,600
Indirect Business Taxes IBTS 427,800
Statistical Discrepancy SD 27,500
less Subsidies
Gross National Product GNP 4,022,700 Gross Domestic Product GDP 8,000,900

Expenditure Approach
C - spending of households and private non-profit
institutions on goods and services
• Non-durables - goods and services that are
consumed rapidly
• Durable goods - that last for a longer period of
time
I - investment spending of domestic agents. Its
major components are “changes in” Fixed Capital
and Changes in Stocks
X - earnings from the rest of the world on
goods and non-factor services produced in the
country
M- the country’s purchases of goods and
non-factor services from the rest of the world.
SD - accounts for accounting and reporting
errors in the accounts. Needed to ensure that
GDP value from all approaches are the same.

G - government’s payments for the salaries of its

workforce as well as purchases of goods and
services  used for the government’s day to day
operations and projects.

Value added or Industrial Origin

Income Approach approach
• GDP = COE + NOS + D + IBTS GDP = value added of different activities (sectors)
• In a simple world, GDP = COE + NOS. In
practice, require two adjustments (D and IBTS)
• D - accounts for the wear and tear of physical ITEM VALUE
capital
• “D” is treated as a business cost  not included Agriculture, Fishery and 876,600
in NOS. However, “D” is part of “I” in the
expenditure side of the national accounts Forestry
• IBTS - includes taxes on the use or purchase Industry 3,000,400
goods and services and grants from
government to firms. E. g sales taxes, value Services 4,123,900
added tax
• Not included in NOS but is part of the market Gross Domestic Product 8,000,900
prices, of which the items in the expenditure
accounts are quoted

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GDP and National Income By Industrial Origin / Value Added

INDUSTRY AMOUNT (in M prices) The distinction between GDP and GNP
Agri, Fisheries, forestry : 701,660
Industrial Sector:
Mining and Quarrying 41,068
815,844
GNP = GDP + Net Factor Income from
Manufacturing
Construction
612,876
105,334
the Rest of the World (NFY/RoW)
Electricity, Gas and Water
Service Sector:
56,566
1,205,188 •NFYRoW - measures the difference
Transportation
Trade
125,712
579,234
between the earnings of Philippine
Finance and Housing
Private services
203,488
130,966
residents in other countries and
Gov't. Services 165,780 foreign residents in the Philippines
GDP at market Price 2,722,692
Other Deductions 196,040
Indirect Tax net of subsidies 85,225
Depreciation 110,815
National Income GDP 2,526,652

The distinction between GDP and GNP GDP GROWTH RATE

• GDP YR.2 LESS GDP YR.1 OVER GDP YR. 1 TIMES 100
Gross Domestic Product GDP 8,000,900 • Cite example:
Net Factor Income from NFY 2,267,500 • 8,500-8,000/8,000 x 100 = 6.25
the Rest of the World
Gross National Product GNP 10,268,400

Nominal or Current GDP vs. Real GDP Real GDP

Nominal or current GDP – referred to as the final value
of goods and services based on the existing prices on
the period of production. Is the value of all final goods and services produced during a given time
ALSO referred as the current market price period based on the prices existing in selected base year. Phils. Uses
1995 as base year.
Nominal GDP grows in 3 ways:
Therefore, we can convert Nominal GDP to real GDP by using the ff.
1. Output rises and prices remain unchanged formula:
2. Prices rise and output is constant Real GDP = Nominal GDP over
3. Both output and prices rise (Tucker 2008) GDP Deflator times 100

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Real GDP Analysis

Suppose GDP of 2000 =20,000B Given the result of the deflated GDP for 2009 we can
2009 =35,000B say that the of amt. 35,000B GDP at current price is
equivalent to 28,000B in real terms. This is because
GDP deflator 2009 = 125
we tried to remove the effect of price increase during
Substitute the values in our formula: that period using a GDP deflator.
Real GDP = Nominal GDP We can compare the GDP on a year-on-year basis
GDP Deflator times 100 without encountering the problem of overstatement
Real GDP = 35,000B x 100 = 28,000B because of price increase.
125
8-9/2-10

2. Distribution, kind and quality of products

GDP SHORTCOMINGS
GDP excluded the ff: a. GDP is blind what fraction of the population
1. Nonmarket Transactions/unpaid activities consumes most of a countries GDP
e.g homemade services (repair and maintenance) child b. GDP also wears a blindfold with respect to the
care, backyard gardening quality and kinds of goods and services
GDP ignores the value of these activities. GDP does not reflect whether the products/services
produced are of good quality or not. GDP only
Nonetheless: accounted how much have been produced.
2 reasons why nonmarket are excluded from GDP
1. Extremely difficult to collect data and assign value
2. Difficult to determine w/c nonmarket transaction to
exclude or include

3. Neglect of Leisure time 4. The underground economy

In general, wealthier nation becomes, the more leisure 1.
its citizens can afford. Thus, rather than working 2.
longer hours, workers often choose to increase their 3.
time for recreation and travel.
4.
As such, GDP also understates well-being because no
allowance is made for people working fewer hours.
Illegal gambling
Manufacture and sale of illegal drugs and guns
Loan sharking and illegal lending
Small time trading such as:
 Ambulant selling of food products, cigarettes etc.
Are goods and services that meet GDP requirements/ final
products
Hence , if underground economy is sizable, GDP understates
economic performance.

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Philippine estimated underground economy 5. Economic Bads

40-45 percent of GDP –Viray et al 2015
If this is the case, then the Philippines can have a
higher national income if underground economy has
been included in the accounting of GDP.
More production means larger GDP regardless of
pollution created in the production process.
Air, Water and noise pollution are economic bads that
impose costs on society and environment

Measures NatioNal iNcoMe

Shortcomings of GDP as a Measure of National Economic Well-being

• Production that is excluded

CLOSED
• Household production
• Illegal production
and
• The underground economy e.g illegal gambling/drugs
• Treatment of leisure time OPEN ECONOMY
• Human cost and benefits
• GDP gives us a ballpark idea of how much we produce, not
necessarily how well off we are

Y = C + I + G + NX
After some manipulation, the national income accounts identity
Y = C + I + G + NX can be re-written as:

Investment NX = Y - (C + I + G)
Total demand
is composed spending by Net exports
for domestic
of businesses and or net foreign
output
households demand Net Exports Domestic
Output
Spending
Consumption Government
spending by purchases of goods This equation shows that in an open economy, domestic spending need
households and services not equal the output of goods and services. If output exceeds domestic
spending, we export the difference: net exports are positive. If output
Notice we’ve added net exports, NX, defined as X-M. Also, note that
falls short of domestic spending, we import the difference: net exports
domestic spending on all goods and services is the sum of domestic
are negative.
spending on domestics goods and services and on foreign goods and
services.

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Start with the national income accounts identity. Y=C+I+G+NX.
Subtract C and G from both sides and obtain Y-C-G = I+NX.
Let’s call this S, national saving.
So, now we have S=I+NX. Subtract I from both sides to obtain the new
equation, S-I=NX.
This form of the national income accounts identity shows that an
economy’s net exports must always equal the difference between its
saving and its investment.
S-I=NX
Trade Balance
Net Foreign Investment
If a gov’t. wanted a balance international flows of
capital and goods. Then, we’ll address issues such as
how the trade balance responds to changes in policy.
Today we will introduce an analysis of the
economy as originally described by the
economist John Maynard Keynes. His
theory of how the macro economy works
will help us explain how the economy’s
income (GDP) is determined. Today we
analyse the model in its simplest form and
we will assume that the economy does not
have a government and that it does not
trade with the rest of the world. We will relax
these assumptions.
John Maynard Keynes (right) and Harry Dexter White at the Bretton Woods
Confer..
21 Nov 2018
Net Capital Outflow =
Trade Balance
S-I=NX
If S-I and NX are positive, we have a trade surplus. We would be net
lenders in world financial markets, and we are exporting more
goods than we are importing.
If S-I and NX are negative, we have a trade deficit. We would be net
borrowers in world financial markets, and we are importing more
goods than we are exporting.
If S-I and NX are exactly zero, we have balanced trade since the value
of imports equals the value of exports.
Recall that the trade balance equals the net capital
outflow, which in turn equals saving minus investment,
our model focuses on saving and investment. But won’t
assume that the real interest rate equilibrates saving
and investment. Instead, we’ll allow the economy to
run a trade deficit and borrow from other countries, or
to run a trade surplus and lend
to other countries.
The Keynesian Theory of Income
Determination: the theory that will be
presented hereafter was developed by the
Cambridge economist John Maynard
Keynes in the wake of the 1920s Great
Depression. He argued that the cause of a
low level of income (GDP) in the economy
was given by the lack of AD.
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The Economy Operates at less than full Employment
this implies that firms are willing to
supply any amount of the good at a
given price. In other words, assume that
the supply of goods is completely
elastic at price. This assumption is
generally valid only in the short run
21 Nov 2018
Closed Economy and No Government:
we assume that the economy does not
trade with the rest of the world so that
both exports and imports are equal to
zero (X=M=0). We also assume that there
is no government in the economy so that
government expenditures and taxes are
equal to zero (G=T=0). This implies that
aggregate demand is therefore reduced
to the following expression:
AD  C + I