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Distinction between microeconomics and macroeconomics



After studying this chapter, you will be able to:

   explain how GDP is measured
   explain the relationship between GDP , GNP , and National Income
   explain how CPI and GDP deflator are measured
   explain how real GDP is measured
   explain the shortcoming of real GDP as a measure of rising in living standards


 focus on individual market
 concerned with the demand and supply of particular goods and services

 examine the economy as a whole
 studies the determination of national output and its growth over time , national employment,
  general level of prices, level of import and export and the exchange rates


   The broadest measure of aggregate economic activity is the GDP
   GDP is defined as the market value of final goods and services produced within the nation
    during a given period of time

   market value means the monetary value of goods and services at today's prices.
   For example, suppose only 10 units of a single good are produced and sold for $3 each. The
    total market value of this good would be $30, or the price of the good times the quantity
    produced and sold.
   For this reason, GDP is sometimes referred to as GDP at current prices or more often as
    nominal GDP.

   Goods and services produced during a given period fall into 2 categories
        intermediate goods and services
        final goods and services

   intermediate goods and services are those inputs to be resold and used in further stages of
    e.g. the apples that are produced and then used to make apple juice are intermediate goods

   final goods and services are those that are purchased for final use and ready for consumption
    and not for resale or further processing or manufacturing
   e.g. apple juice purchased by households for home consumption is a final good

    in computing GDP , the sale of final goods is included while the sale of intermediate goods is
    this is because the value of intermediate goods is already included in the prices of final goods.
    therefore , adding up value of intermediate goods involve double counting
    double counting can be avoided
          by counting the final value of the output or
          by summing the value added at each stage production

1.2.1. The measurement of value added
 e.g. production of blue jeans
Computing value added
         Sales transaction            Intermediate                        Value added
                                        purchase                  (Sales receipt –Intermediate
1.    RM1m sale of cotton by                  None                        RM1 million
      farmers to weavers

2.    RM2m sale of cloth by                RM1 million                    RM1 million
      weavers to manufacturers of
      blue jeans

3.    RM4m sale of blue jeans by           RM2 million                    RM2 million
      blue jeans manufacturer to

Market value of all         -       Market value of       =    Total Value Added
productions                         intermediate
RM7 million                 -       RM3 million           =    RM4 million

Assume farmers produce cotton without purchasing any materials from other firms


    There are 3 different ways in calculating GDP
      The 1st method is to add up all the value of all goods and services producing in the country
        known as output method

        the 2nd method is to add up all incomes for households in the form of wages and salaries ,
         profits , rents , and interests , known as income method

        the 3rd method is to focus on the expenditure necessary to purchase the nation’s production

      Although these 3 methods differ, their result, GDP is the same, apart from minor
       'statistical discrepancies'.
   The reason is that, what is spent on total output must ultimately become income to those
    produced the output in the first place

                          1) Output


                                         2) Expenditure
                  3) Incomes


        Figure 1.1 The circular flow of national income and expenditure

   In a simple circular flow of income (closed economy), the economy is divided into 2 major
    groups of people; households and firms.
   In this economy, households buy goods and services from firms; these expenditures flow
    through the markets for goods and services.
   The firms in turn use the money they receive from sales to pay workers’ wages, rent, and
    profit; this incomes flow through the market for factors of production.
   In this economy, money continuously flows from households to firms and then back to
   Assume for the moment that there are no inflows (injections) and outflows (withdrawals).
   In real world , however,
         there were injections ( investment , government expenditure , exports ) and
             withdrawals ( savings , taxes , imports )
         we must take into account the role of government , foreign trade and investment .
         we must careful not to engage in ‘ double counting ’ .

1.3.1. The output / product method of measuring GDP

   measures economic activity by adding the market values of newly produced goods and
    services , excluding intermediate goods and services used up during the manufacturing or
    production stage

   In national accounts these figures are grouped into broad categories such as manufacturing,
    construction, and transport etc.
   for more detail refer to

    Product / Output Approach to 2002 GDP (RM million)
     Agriculture , Forestry and Fishing                                             32,550
     Mining and Quarrying                                                           34,029
     Manufacturing                                                                  110,461
     Construction                                                                   14,606
     Electricity , Gas and Water                                                    11,759
     Transport , Storage and Communication                                          24,680
     Wholesale and Retail Trade , Hotels and Restaurants                            50,946
     Insurance , Real Estate and Business Services                                  43,221
     Government Services                                                            27,625
     Other services                                                                 24,764
     Less : Imputed Bank Service Charges                                            20,776
     Add: Import duties                                                             6,793
     GDP                                                                            360,658

1.3.2. The expenditure method of measuring GDP

   involves adding up the total expenditure on final goods and services produced
   this includes:

1. Consumption ( C )
 Refers to the purchase of consumer goods and services by households including those
   produced abroad.
 fall into 3 groups
    consumer durables – longer -lived consumer goods e.g. cars , television sets , furniture etc.
    non-durable consumer goods - goods which are immediately consumed , such as food ,
       clothing , fuel etc.
    services - intangible ( nonphysical ) consumption items such as educational services ,
       health services , financial services and legal services

2. Investment ( I )
 Refers to the purchase on goods not meant for present consumption
 divided into 3 categories :
   a) fixed investment
       include all spending on capital goods e.g. on plant and equipment , machinery tools ,
          factory and office buildings

    b) residential investment

           spending on the construction of new houses and apartment buildings

    c) inventory investment
        include all purchases by businesses that add to their inventories

3. Government Purchases of Goods and Services ( G )
 expenditure by government for a currently produced goods or services , both domestic and
 e.g. govt. spending on education , health , infrastructure , etc.
 welfare payments are excluded since no corresponding good or service flow from the
   individual to the government

4. Net Exports ( NX )
 NX equals to the purchase of domestically produced goods by foreigners ( exports ) minus the
   domestic purchase of foreign goods ( imports )
 Since some goods and services that are produced are exported and some other goods are
   imported, thus to arrive at total expenditure on domestically produced output , exports should
   be added to , and imports should be subtracted from ( C + I + G ) because C , I , and G are
   defined to include imported goods and services
 i.e. GDPmp = C + I + G + NX

GDP: Expenditure approach
Item                      Symbol                     Amount in 2003          Percentage of GDP
                                                     (billions of dollars)
       Personal              C                      7674                    70.7
       Gross private         I                      1624                    15.0
       Government            G                      2054                    18.9
        purchases of goods
        and services
       Net export of goods   X-M                    -505                    -4.7
        and services
GDP                           Y                      10847                   100.0

1.3.3. The income method of measuring GDP

   involves adding up all the incomes earned in the production of final goods and services
   generally , there are 5 main components of factor incomes:

1. Compensation of employees

          is the payment for labour services
          includes wages , salaries , worker benefits and other wage and salary supplement if

2. Proprietor’s income
       represents income of incorporated businesses such as farmers, partnerships ,
          professionals and cooperatives

3. Rental income
       is the payment for the use of land and other rented inputs
       includes not only payment for rented housing but also imputed rent for owner-
           occupied housing ( i.e. estimated amount of rent if the owner of the house rented the
           house out to someone else )

4. Net interest
       is the interest households receive on loans they make minus the interest households
           pay on their borrowing
       includes items such as interest earned on bank deposit , interest earned on loans to
           firms , and other miscellaneous investment income

5. Corporate profits
    are the profits of corporations, some of these profits are paid to households in the form of
      dividends , and some are retained by corporations as undistributed profits

6. Capital consumption allowances
    cost to replace these capital goods is called capital consumption allowance or depreciation

7. Indirect business Taxes
    comprise indirect business taxes like excise taxes, sales taxes and property taxes, taxes are
       not part of national income because they are not considered a payment to any resource
       (land, labour)

        In summary;
       GDP (income’s method)      =
          compensation of employees
          +Proprietor's income
          +Corporate profits
          +Rental Income
          +Net interest
          +Adjustments
             = National income
          +Indirect taxes less subsidies
          +Depreciation

               +Net factor incomes from rest of world (Income earned from abroad - Income
                payments abroad)
                = GDP

GDP: Income approach
Item                             Amount in 2003                  Percentage of GDP
                                 (billion of dollars)
Compensation of employees        6165                            56.8
Net interest                     582                             5.4
Rental income                    153                             1.4
Corporate profits                1023                            9.4
Proprietor’s income              839                             7.7
Indirect taxes minus subsidies   782                             7.2
Capital consumption              1303                            12.0
GDP                              10847                           100.0

   Thus,
    National Income =         Compensation of employees
                                          + Proprietors' income
                                          + Corporate profits
                                          + Rental income
                                          + Net interest
                                          - Income earned from abroad
                                          - Income payments abroad
                                          - Depreciation
                                          - Indirect taxes + subsidies


   National income (also known as Net National Product at Factor Cost, NNPfc) is not GDPmp ,
    thus to obtain national income (NNPfc) from GDPmp, 3 adjustments have to be made:

    i)    substract to GDPmp the net income earned by firms and resident abroad
          when GDP is calculated, we include the income earned by foreigners who work and
            live in Malaysia, but we do not include income earned by Malaysian citizens who
            work and live in other countries
          thus, to measure national income, first add to GDP any income earned from abroad
            and subtract any income payments abroad
          the result of these adjustments is called gross national product (GNPmp)

              GNPmp     =       GDP - (income earned from abroad -
                                 income payments abroad)
                        =        GDP - net income earned from abroad

    ii)     next, subtract depreciation ( or capital consumption allowance) from GNPmp
            depreciation is the wear and tear on plant and equipment that occurred during the year
            income is reduced because buildings and machines are wearing
            the result from these adjustment is called net national product (NNPmp)
            NNPmp = GNPmp - depreciation

    iii)    finally, subtract indirect taxes from NNPmp to reach national income
             indirect taxes are sales taxes or excise taxes on products
             these taxes are not part of national income because they are not considered a payment
              to any resource
            NNPfc = NNPmp - indirect taxes+subsidies


1.5.1. Personal income
 Refers to all income received by individuals
 Personal income = National income - retained earnings –
                                    corporate taxes + transfer payment

1.5.2. Personal Disposable Income

   part of personal income that is available for spending or saving after deduction of personal
    taxes such as personal income taxes
   Personal Disposable income = Personal income – personal
                                                    income taxes
   For example, refer to page 402, table 17.4


   GDP based on expenditure approach was obtained by multiplying the quantity and market
    price of each good or service
   The sum of these values often called nominal GDP
   thus , nominal GDP measures the total value of output in terms of current prices
   therefore ,changes in nominal GDP could be due to changes in prices or changes in quantity or

   Real GDP , on the other hand , holds prices constant
   Therefore , changes in real GDP reflect changes in quantities
   To obtain real GDP , nominal value of GDP has to be deflated by the appropriate price index

1.6.1. GDP Deflator

   measures changes in the average level of prices of all goods and services that make up the
   calculated as
        nominal GDP x 100
        real GDP
   nominal GDP is calculated by valuing the current -period quantities produced at current-
    period prices.
   real GDP is calculated by valuing the current-period quantities produced at base-period prices
   the computation of GDP deflator is illustrated in Figure 1.2

     Products              Quantity       Prices in ( RM ’ 000 )     Expenditure ( RM ’ 000 ) in
                          produced in                               1994 quantities based on prices
                             1994                                                 in

                                           1994          1987           1994              1987
       (1)                   (2)           (3)           (4)            (5)*            ( 6 ) **

Computer                     100              4           3.5             400             350
Car                           50             20           16             1000             800
Total expenditure                                                        1400            1150

* (5) = (2) x (3)
**( 6 ) = ( 2 ) x ( 4 )

GDP deflator for 1994
= Expenditure 1994:1400 x 100 = 121 .74
  Expenditure 1987:1150

    Obtaining Real GDP from Nominal GDP
   To obtain the real GDP for a particular year , say 1994 , first express the GDP deflator for
    1994 in decimal form , then , divide the nominal GDP by this deflator , i.e.
    Real GDP for year X = Nominal GDP for year X x 100
                              (GDP deflator for year X)

1.6.2. Consumer Price Index ( CPI )

   measures changes in the average level of prices of some fixed basket of consumer goods and
    services purchased by a typical household

    Computation of CPI

    Good or service    Quantity of          Prices in (RM)           Cost of Fixed basket based on
                       fixed basket                                             prices in

                                          1994          1987             1994             1987

         (1)                (2)           (3)            (4)            (5)*             ( 6 ) **

      Groceries             20kg           40             32             800               640
                          150 litres      1.20           1.00            180               150
      Cable TV
                          12 months        20             15             240               180
Total expenditure
                                                                         1220              970
*(5)=(2) x (3)
**( 6 ) = ( 2 ) x ( 4 )

CPI = current’s period value of goods x 100
         Base period’s value of goods

       = (1220 / 970) x 100 = 126

1.6.3. Differences between GDP deflator and CPI

    both of them compare current prices to prices in a base period
    however , GDP deflator includes the prices of all final goods and services in the economy ,
     whereas , the CPI focuses on the prices of a fixed basket of goods and services consumed by a
     typical household
    CPI also covers a sample of imported goods
    On the other hand , GDP deflator covers only domestically produced goods


  to reveal how much output the economy has produced within certain period of time and help
   explain the immediate causes of this performance
 to measure economic growth rate
   Economic growth rate      =      Real GDP this year – Real GDP last year   x 100
                                            Real GDP last year
For example, real GDP was RM10, 288 billion in 2003 and RM10, 045 billion in 2002. So the
economic growth rate (percent per year) during 2003 was:
Economic growth rate= (10,288 – 10,045) x 100

=2.42 percent per year

   to track the performance of the economy and identify the areas of weakness as well as the
   to devise appropriate economic policies to address the areas of weakness in order to improve
    the economy’s overall performance
   to compare economic performance with other countries at similar level of development


   the most widely used statistics to measure changes in a country’s standard of living /
    economic welfare is GDP per capita, i.e. GDP divided by total population
   this provides measure of the average amount of output available per head per year .
   to be accurate we use real per capita GDP .
   otherwise per capita would probably rise because of inflation and this would not imply that
    living standards has increased .
   However , real GDP is misleading as an indicator of economic welfare for several reasons
         certain non-market goods and services
            if hires a person through the classified section of the newspaper to cook and clean-
            service is counted in GDP.
            If family members perform the same tasks, however their services will not be counted
            in GDP.
         sale of used goods
            GDP is a measurement of current production. A used car sale, does not enter into
            current year production.
         underground activities both legal and illegal
            omit the underground economy , economic activity that is legal but unreported or that
            is illegal .
         financial transactions
            the trading of stocks and bonds is not counted in GDP because it does not represent the
            production of new assets, but simply the trading of assets.
         value of leisure is not included in real GDP because it is too difficult to quantify
         government transfers payments.
         environmental damage is excluded from real GDP
         real GDP does not indicate the extent of political freedom and social justice enjoyed
            by a nation’s citizen .


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