MEASURING ECONOMIC PERFORMANCE

Module 5
Macroeconomics

NATIONAL INCOME ACCOUNTING/MEASURING TOTAL PRODUCTION

We measure our economy’s status in order to see how its performance has changed overtime. These
economic measurements are important to officials, private businesses, and investors. National income
accounting provides a uniform means of measuring national economic performance. The national
income accounting was pioneered by Simon Kuznet. The gross domestic product (GDP) is the most
important measure of aggregate national income. The GDP is the value of all final goods and services
produced within a country during a given period of time. Value is determined by the market prices and
quantities for the multitude of goods and services produced.

National Income Accounting (a standardize way to measure economic performance)

Final goods and services. Final means that the good is ready for its designated ultimate use as
against intermediate goods or services are used in the production of other goods.

The GDP measures only the final goods and services because if the market value of every good and
service sold were included in GDP, the same output would be counted more than once in many
circumstances. Only final goods and services are included in GDP to avoid such double accounting.
Example flour in making bread, the bread includes the value of the flour. Double counting is adding
the value of a good or service twice by mistakenly counting the intermediate goods and services in
GDP.

When we calculate GDP in the economy, we are measuring the value of total production – our total
expenditures. However, we are also measuring the value of total income. It is because when we
spend (the value of total expenditure) it ends up as someone’s income (the value of total income).
Buyers have sellers.

In relation to the circular flow: (expenditures equal income)

GDP equals the total amount spent by households in the market. Households use their income
• To buy domestic goods and services (C)
• To buy foreign goods and services (I)
• To pay taxes
• To invest financial markets (stocks, saving accounts)

When income flows into the financial system as saving, it makes it possible for consumers, firms and
government to borrow. This market for saving and borrowing is vital to a well-functioning economy.

Firms sell their goods and services to domestic and foreign consumers and foreign firms and
government. Firms use their factors of production to produce goods and services.
Firms pay these factors of production. Wages, rent, interest and profits comprise aggregate income in
the economy, which is also equal the GDP

Measuring Total Production/Gross Domestic Product (GDP)

There are three approaches to measuring GDP, and all give exactly the same measure of GDP:
1. Expenditure approach;
2. Income approach;
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3. Product approach (or value-added)

The Expenditure Approach to Measuring GDP

The Expenditure approach takes the sum of the spending on different final goods and services. It is
done by adding the expenditures by market participants on final goods and services over a given
period. Spending is usually grouped into four categories: Consumption (C); investment (I);
government purchases (G) and net exports = exports (X) minus imports (M) or (X-M). Then

GDP = C + I + G + (X – M).

What is total expenditure?

Total Expenditure = C + I + G + NX

C is total expenditure in consumption

I is investment expenditure
G is government expenditure
NX is net exports (= Exports in goods and services – Import in goods and services). A closed
economy is an economy that does not have trade with other countries, therefore, NX=0 in this
case.

The Expenditure approach divides GDP into six components as follows:

1. Personal Consumption Expenditure or Consumption (C) refers to the purchases of

final/consumer goods and services. It does not include purchases by businesses and
government., thus it the spending of households and non-profit organizations on goods and
services. Consumption spending is broken down into three subcategories:
a. Nondurable goods – include tangible consumer items that are typically consumed or used up
in a relatively short period such as food, clothing
b. Durable consumer goods – include longer-lived consumer goods such as automobile and
vehicles
c. Services – intangible items of value such as education, health care, hair cuts, domestic
housekeeping, professional football, etc. As income rise, service industries grow dramatically.

The difference between durable and non-durable goods is important because consumers’
buying behavior is somewhat different for each of these categories of goods. In boom periods,
expenditures on durables often increase dramatically, while in years of stagnant or falling GDP
sales of durable goods often plummet (drop) and sales of non-durable goods such as food
tend to more stable because such goods are more difficult to shift from one period to another.

2. Investment (I) or Gross Domestic Capital Formation – refers to the creation of capital goods –
inputs such as machine and tools whose purpose is to produce other goods
Two categories of investment are:

a. Fixed investment – includes all new investment on capital goods by producers – sometimes
called producer goods. All these goods increase future production capabilities. Examples:
machineries, tools, factory buildings
b. Inventory investment – includes all purchases that add to the stocks of goods kept on hand by
the firm to meet consumer demand. The greater the inventory, the greater the amount of
goods and services that can be sold to a consumer in the future.

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 Investment spending is the most volatile category of GDP however, tends to fluctuate considerably
with changing business conditions. When the economy is booming, investment purchases tend to
increase dramatically and the reverse happens.

3. Government Purchases (G). the portion of government purchases included in GDP is

expenditures on goods and services such as salaries, payments for the construction of roads, etc.
However, transfer payments are not included in government purchases, because this spending
does not go to purchase newly produce goods and services but is merely a transfer of income
among the country’s citizens

4. Net exports (NX) are calculated by subtracting total imports (M) from total exports (X) or NX = X –
M. We include exports because they are produced within the country we are considering and we
subtract imports because goods produced abroad are included in C, I and G and we don’t want to
include them in the calculation of GDP (remember “within borders”).

4.1. Exports of goods and services represents earning on Philippine-made goods which are sold
overseas
4.2. Less: Imports of goods and services represents the spending of the Philippines on goods
which are produced in other countries

5. Statistical Discrepancy captures reporting and recording errors that arise in the estimation
process

The Income approach

In this case the GDP is defined as the sum of all income received by economic agents contributing to
production. Income is defined as the sum of wages, profits, rents, etc., received by the agents in the
economy, it takes the sum of the payments to the different factors of production (ex. Wages + interest
+ rents + profits)

Other Measures of Total Production and Income

1. Gross national product – the difference between net income of foreigners and GDP.
2. Net national product
3. National income
4. Personal income
5. Disposable personal income

The income approach provides a breakdown of the sources of income and two adjustment items
1. Compensation of employees represents wage payments
2. Net Operating Surplus is a composite of profits, rents and interest
3. Depreciation represent the consumption or wear and tear of existing capital
4. Indirect Taxes less Subsidies. Indirect taxes are taxes on the use and purchase of goods and
services and subsidies are grants from government to firms

Factor payments – incomes received by people providing goods and services. Wages, salaries, rent,
interest payments and profits paid to owners of productive resources. Net factor payments = income
earned abroad by domestic factors minus the income earned domestically by foreign factors of
production.

Gross National Product (GNP) = GDP + Net Factor Payments (NFP). The GNP measures the value
of output produced by domestic factors of production, regardless of whether the production takes
place. Remember that the GDP instead measures total income earned by domestically-located factors
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of production, regardless of nationality. Gross national product (GNP) is also the difference between
net income of foreigners and GDP.

To find national income we must subtract from GDP (1) indirect business taxes such as sales taxes,
(2) depreciation – payments set aside for the replacement of worn-out capital, and (3) net income of
foreigners in the country.

Indirect business taxes – taxes such as sales tax levied on goods and services sold.

National income is measured by adding together the payments to the factors of production – wages,
rent, interest and profit

Personal income (PI) measures the amount of income received by households (including transfer
payments) before personal taxes

Disposable personal income is the personal income available after personal taxes.

The Value Added Approach

According to this approach, to calculate the GDP: we add the market value of all goods and services
produced and then subtract the value of all intermediate goods used in production. The value added
approach takes the sum of value added of each firm or economic activity. Value added of each firm is
computed as the difference between sales of the firm and its spending on goods produced by other
firms.

The value-added (or industrial origin) approach classifies the GDP estimates according to various
activities such as:
1. Agriculture, Fishery and Forestry – value added from agricultural crops, plants, livestock,
fishing, aquaculture, harvesting of marine and forestry products, and logging.
2. Industry sector includes mining and quarrying, manufacturing, construction and utilities
3. Services – includes activities related to transportation, communication and storage, wholesale
and retail trade, real estate and private and government services.

Intermediate Good: a good that is produced and then used as an input to another production process.
For example the value of the tomatoes you buy in the supermarket is part of the GDP. The value of
the tomatoes used by firms to make the tomato sauce you buy in the supermarket is not. We subtract
the value of the intermediate goods to avoid double counting in the calculation. Using this approach
the GDP is simply defined as the sum of value added to goods and services across all productive
units in the economy.

These three approaches are equivalent. For example, the spending of one person is the
income of another. For example the firm spends for wages (P200), interest (P200), rent (P200) and
purchases of goods from other firms (P600) with sales of P2000. Profit = Sales – cost of production
(P1,200) = P800. The value added of the firm is P1,400 (P2000-P600 = P1400). Using the income
approach, 200 + 200 + 200 + 800 = 1400.

Example:

Consider an economy in which there are only two firms, Pineapple Inc. that produces pineapple and
Juice Ltd that produces pineapple juice.

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 Pineapple Inc
Wages paid to employees 20,000
Profits 15,000
Rent for land 10,000
Revenues from selling pineapples to the public 15,000
Revenues from selling pineapples to Juice Ltd 30,000
Juice Ltd
Wages of employees 10,000
Sales reveneues 50,000
Pineapples purchased by Pineapple Inc 30,000
Juice boxes purchased from abroad 10,000

Value Added approach: the value of production of Pineapple Inc. is 15000 + 30000 (its revenues).
Pineapples Inc. does not use any intermediate good. Juice Ltd has a value given by: 50000. Juice Ltd
uses intermediate goods for a value of 30000+10000=40000. Therefore, according to the product
approach the GDP is given by: 45000 + 50000 - 40000 = 55000

Expenditure approach: In this example there is no expenditure in investment so I = 0, there is no

government and so G = 0 and NX = -10000. We have that total consumption expenditure is: 15000
(what the public consumes from Pineapple Inc.) + 50000 (the sales revenues of Juice Ltd. Those
represents also the value of the juices bought by the consumers) - 10000 (net exports) = 55000

Income approach: Here we have: 20000 of wages paid by Pineapple Inc., 15000 of profits distributed
by Pineapple Inc., 10000 of rent paid to the owner of land by Pineapple Inc. Then we have 10000 of
wages paid by Juice Ltd. Summing up all those values we have: 20000 + 15000 + 10000 + 10000 =
55000.

Estimates of the GDP and GNP are adjusted to make them meaningful indicators for analysis. The
adjustments account for changing prices, differences in population and conversion to a common
currency.

GNP at current prices is calculated using the prices that exist for the year it is computed. This is not
very useful to track the overall production of a country over time it capture the changes in prices.

Real GNP or GNP at constant prices overcomes the weaknesses of nominal GNP by removing the
impacts of price changes. This is calculated as follows:

Nominal GNP
Real GNP = ------------------------ x 100
GNP deflator

The GNP deflator measures the cost of a given bundle of goods in one year relative to the cost of the
same bundle of goods in the base year.

Nominal GNP
GNP deflator = ---------------------
Real GNP

GDP per Capita or GNP per capita (per capita GDP/GNP at constant prices (Real GNP/GDP per
capital) – measures how much output or income was produced or received, on the average, by an
individual in the economy
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 GDP (or GNP)
GDP (or GNP) per capita = ---------------------
Population

GDP/GNP for cross country comparison – GDP/GNP estimates are converted into a common
currency using the exchange rate

GDP (or GNP) in pesos

GDP (or GNP) in US dollars = ------------------------------------
Exchange rate

Problems in Calculatinmg GDP

The primary problem in calculating accurate GDP statistics becomes evident when attempts are made
to compare the GDP over time, because of the changing value of money over time.

Per capita real GDP is real output of goods and services per person. In some cases, real GDP may
increase but per capita real GDP may actually drop as a result of population growth

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 = 𝑥 100
𝑃𝑟𝑖𝑐𝑒 − 𝑙𝑒𝑣𝑒𝑙 𝐼𝑛𝑑𝑒𝑥

Problems of GDP as a Measure of Economic Welfare

Several factors make it difficult to use GDP as a welfare indicator. These factors include nonmarket
transactions, the underground economy, leisure, externalities and the quality of the goods purchased.

a) Nonmarket transactions are the exchanges of goods and services that do not occur in traditional
markets and for which no money is exchanged.
b) The underground economy is the unreported production and income that come from legal and
illegal activities
c) The presence of positive and negative externalities makes it difficult to measure GDP accurately.
An externality is a benefit or cost from consumption or production that spills over onto those who
are not consuming or producing the good.

Limitations of GNP (also applies to GDP)

1. Higher GNP estimates tend to be associated with improved standards of living is not exactly
correct as GNP is but one of many other indicators
2. GNP does not say anything about the distribution of income and poverty
3. GNP estimates are silent on the costs of achieving higher output
4. GNP is an imperfect measure of output, many transactions that do not go through organized or
formal markets are excluded from the calculation of GNP

Inflation

Inflation refers to the rise in the general price level over time. A useful measure of the changes in the
general price level (GP) is the inflation rate.

GPt – GPt-1
Inflation rate = ----------------------- x 100
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 GPt-1

Unemployment

Unemployment implies that productive resources are not being fully utilized in the economy.
Unemployment refers to those people who are part of the labor force but cannot find work. The labor
force includes people belonging to the working age population that are: (a) working or engaged in
business, and (b) are not working but are actively looking for work. A useful indicator of this variable is
the unemployment rate calculated by dividing the number of unemployed members of the labor force
by the total force multiplied by 100. A person is considered unemployed if he/she is a member of the
labor force but is not engaged in work or business. Employed individuals who are not able to work as
much as they want or they work less than the standard say 40-hours per week.

Income Determination

Aggregate Expenditure and National Income

Aggregate expenditure (AE) refers to the total amount that economic agents want or plan to spend
of goods and services. In an economy composed of households and firms, aggregate expenditure is
made up of consumption spending (C) and investment spending (I), AE = C + I. As consumption
spending increases with income, so does aggregate expenditure. This means that higher income or
output (Y) leads to higher consumption spending. This relationship also implies that:
• Consumption spending tends to be higher than income at relatively low levels of income and
this spending may that for basic necessities
• The amount of consumption spending (∆C) changes in response to changes in income (∆Y)
known as the marginal propensity to consume.

Change in consumption spending (∆C)

mpc = --------------------------------------------------
Change in income (∆Y)

An mpc is 0.80 means that consumption spending goes up by 80 centavos whenever income
increases by one peso.

Equilibrium is determined by the equality between aggregate expenditure and income. An increase in
aggregate expenditure, via an increase in investment, causes an increase in equilibrium income.
Since AE = C + I, equilibrium also corresponds to Y = C + I

Savings, Investment and Income

Just like an ordinary household, the country’s national income can be allocated for consumption (C)
and savings (S), Y = C + S and therefore S = Y – C. this implies that savings represent the component
of income that is not spent for consumption. Linking savings and equilibrium income Y = AE. Since Y
= C + S and AE = C + I, then C + S = C + I. if we eliminate C from both sides of the equality, we arrive

S=I

In other words, equilibrium also requires savings to be equal to investment. An increase in investment
is likely to lead to an increase in income that is larger than the increase in investment. The reason for
this is the effect of the investment multiplier (α = ∆Y/∆I). The investment multiplier measures the
increase in equilibrium income for a one peso increase in investment spending.

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The paradox of thrift – the phenomenon of lower output due to higher savings, this is because higher
savings means lower aggregate expenditure.

Government and Economic Activity

Role of the Government in Modern Economies

There are basic roles of the government even in pure market economies. The government is needed
to:
a) formulate and enforce the “rules of the game” or laws in any economy,
b) deal with market imperfections such as monopoly. Government can intervene in this case
through regulation and taxation
c) deal with externalities, externalities occur because economic agents have effects on each
other’s activities that are not reflected in market transactions. It can be positive or negative
d) provide public goods. Goods and services that exhibit the properties of non-excludability and
non-rivalry are called public goods. Non-excludability occurs when it is not possible to prevent
anyone from consuming a good or using a resource. Non-rivalry occurs when people can use
a good or resource at no extra cost

In many cases, the government goes beyond these basic roles and pursues policies that , among
others, aim to promote economic growth and development.

The Government Budget

The government budget shows its spending and sources of funds. If its revenues exceed its spending,
then the government has a budget surplus. If the opposite were true, then the government has a
budget deficit. The budget deficit or surplus is linked to the stock of the debt of the government. A
budget deficit, b) transactions in goods and services, as it requires the government to borrow more
than what it lends, causes an increase in its debt. Net budgetary position = total revenues – total
spending

The total revenues (or earnings) of the government can be classified into two categories:
a) Tax revenues - payment made to the government by economic agents that are based on their
earnings, ownership of assets and transactions (e.g. taxes from net income and profits, taxes
on goods and services, taxes on trade and international transactions)
b) Non-tax revenues – government earnings from its services to the public, capital and grants

The spending of the government maybe classified by sector such as:

a) Social services (funds allocated for education, health, social security, housing and land
distribution)
b) Economic services spending on agriculture, agrarian reform, natural resources, trade and
industry, tourism, power and energy, roads, communications and other networks.
c) Debt service – represents the interest on debts that the national government owes, domestic
and foreign institutions
d) General public service
e) Defense
f) Net lending

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Determination of Equilibrium Income

Equilibrium income requires the equality between income and aggregate expenditure. However,
aggregate expenditure is now the sum of consumption investment and government spending
moreover, consumption is a function of disposable income.

Income taxes (T) tend to reduce the consumption spending of households. Disposable income (Yd) is
the income that households are free to spend and save.

Yd = Y – T
Introducing government into the model to account for government spending will give

AE = C + I + G

Since equilibrium requires the equality between income (Y) and aggregate expenditure (AE), the new
equilibrium condition is

Y=C+I+G

Fiscal Policy

Fiscal policy refers to the use of government spending and taxation to influence the level of economic
activity. An expansionary fiscal policy (increase in government spending or decrease in income taxes
or both) tends to raise equilibrium income. In contrast, a contractionary fiscal policy tends to reduce
equilibrium income. These policies can, in turn, be used to address the issues of unemployment and
inflation.

The government can employ an expansionary fiscal policy to eliminate a deflationary gap. On the
other hand, it can use a contractionary fiscal policy to eliminate an inflationary gap.

Open Economy Macroeconomics

An open economy is one that engages in various transactions with the rest of the world.

The balance of payment (BOP) summarizes the transactions of one country with the rest of the world.
It presents information on a country’s transactions in goods, services and assets, transfer payments
and income flows. Its major components are the Current Account, Capital and Financial Account, Net
Unclassified Items and Net Changes in Reserve Assets. The sum of the four major components must
be equal to zero. A country has a BOP deficit if it is negative and BOP surplus if the opposite is true.

Current account captures trade in goods and services, income flows, and current transfer payments
Trade in goods represents exports and imports of tangible commodities while trade in services or
invisibles include transactions for transportation, travel, tourism, communication, insurance, etc.
Transfer payments include international transactions like foreign aid, contributions to international
organizations, pensions and international transfers among private individuals and institutions.
Capital account represents capital transfers, changes in resident claims on non-residents (changes
in assets), and changes in non-resident claims on residents (changes in liabilities)
Net change in reserve assets represents changes in the assets of the monetary authorities that can
be used for international transactions.

Exchange Rate

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Exchange rate is nothing more than a price, it is the price of foreign currency. An increase in the price
of foreign currency is called a devaluation or depreciation. On the other hand, a decrease on the price
of foreign currency is called a revaluation or appreciation.

There are three types of exchange rate regimes:

a) Fixed exchange rate regime – the government through the central bank sets a narrow band or
specific value for the exchange rate of the country against other currencies.
b) Flexible or floating exchange rate regime – the government allows the exchange rate to be
determined by market forces.
c) Managed float – a combination of fixed and flexible exchange rate regimes. It involves
government intervention in the foreign exchange markets in order to influence the exchange
rate. However, unlike in a fixed exchange rate regime, the government does not commit to a
narrow band or specific value for the exchange rate.

In an open economy, aggregate expenditure is the sum of consumption, investment, government

spending and the difference between exports and imports. Equilibrium income is determined by the
equality between income and aggregate expenditure.

Higher exports raise equilibrium income while higher imports generate the opposite results

Prepared by:

VILMA D. CONRADO, Ph.D.

Professor

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