Creating Wealth and Macroeconomic Indicators

Topic 2: Creating wealth and macroeconomic indicators

2.1 Macroeconomic models of the national economy.

The goal of macroeconomics is to monitor the macroeconomic performance of the economy and, when appropriate, use economic policy instruments that positively affect this performance. For the creation of economic output, production factors (labor, capital, and land) are needed.

In the interpretation of this issue, we are interested in the cycle of product and income between different sectors of the national economy. We distinguish between the so- called two, three and four sector economy.

The dual-sector economy Assumption: There are only two sectors - the household sector and the business sector. Fig. 1 shows the so-called stationary two-sector model of the economy.

Fig. 1 – The stationary dual-sector model of the economy.

Households own the production factors (labor, capital, and land) that are offered to the production factors of companies on the market. Businesses pay households for production factors in the form of income arising from production factors (wages, profits, interest, and rent). Companies offer products and services on the market to households. Households buy products for their income. It is a cycle, so the payment for goods and services must be equal in value to payments for production factors (income).

The evolutionary dual-sector model of the economy (Fig. 2) shows that firms can develop (by means of investment) and households do not have to spend all of their income (consumption), but may save part of it. Savings deposited into banks (financial markets) receive interest. Companies may borrow capital for investment from banks (financial markets). For these loans, they pay interest to the banks.

Fig. 2: The evolutionary dual-sector model of the economy.

Three-sector economy The third sector is the government sector. See Fig. 3 (note the names of the individual terms).

Fig. 3: A model of the three-sector economy

In a two-sector economy, the sum of all incomes can be called nominal income. In the three-sector economy, we must distinguish between ordinary income and disposable income. The reason is the existence of taxes that economic entities pay into the state budget out of their nominal income. The government also provides various households with social benefits (transfer payments) that are part of their disposable income. In other words, if we subtract taxes from normal income and add transfer payments, we get disposable income. Part of households' disposable income is used to purchase goods and services (consumption) and some is saved. The government sector shares in the purchase of goods and services that businesses offer.

Four sector economy If domestic firms sell their products and services on foreign markets (export) and at the same time buy (import) on these markets, we extend our previous considerations by the existence of foreign trade and are speaking about an open economy. Payments for exports flow from foreign firms to domestic firms as payments for imports by domestic firms flow to foreign firms.

Fig. 4: A model of the four-sector economy.

2.2 Macroeconomic aggregates - methods of calculating GDP.

Question: How is macroeconomic output measured?

Various economic outputs are measured using various macroeconomic indicators. The most commonly used indicator of the gross domestic product (GDP) is the sum of all final production of goods and services in monetary terms produced during one year in a given area, respectively, the territory of a given nation.

The GDP can be calculated by three methods - production, expenditure and income.

The production approach measures the GDP in terms of its production. This is the sum of the added values of all manufacturers, i.e. all industries. The value added is the difference between the total cash value of product sold by the companies and the value of what they consume, with respect to processed intermediates and raw materials.

The expenditure approach of calculating the GDP is the sum of all aggregate expenditures of all businesses. This can be expressed as:

GDP = C + IG + G + NX

C – household consumption, i.e. household expenditure for consumer goods and services IG – gross investment of private companies, i.e. gross private investment spending G – government purchases, i.e. government expenditures on goods and services NX – net exports, i.e the difference between exports (X) and imports (M). Net exports may be positive or negative in value.

Gross investment consists of net investment (IN) and restitution investment. (IR). Net investment increases the stock of capital goods (the purchase of additional equipment above the original level). The replacement investment value is approximately equal to the wear and tear of fixed capital goods that are covered and amortization (a). Gross investment can be expressed as:

IG = IN + IR = IN + a.

The gross domestic product calculated using the expenditure method is expressed by the prices of goods and services. These prices include so-called indirect taxes (VAT, excise duties).

The income method of calculating the GDP shows the disaggregation of produced product. This is the sum of all incomes resulting from the operation of production factors. These incomes are received by the owners of the production factors, which, for businesses, are expenditures, as they are payment for the services of production factors.

GDP = w + nii + r + a + p + Te, where nii = iP – iV. w – wages and salaries nii – net interest income (the difference between interest received and paid) r – rent (income from the ownership of land and real estate) a – amortization p – income from self-employment and profits Te – indirect taxes

The calculation of the gross domestic product using the income method is expressed in production factor prices. The prices of production factors, however, do not include indirect taxes. So that the results of the two methods of calculating the GDP are equal, you need to add indirect tax to the income method.

2.3 Other macroeconomic indicators. Other commonly used macroeconomic indicators that measure economic output are listed in this section.

Task: Look up other unlisted indicators of macroeconomic output.

Net domestic product (NDP) is reduced as compared to the gross domestic product by the value of replacement investments. Net domestic product thus contains only those goods and services that were produced in the year "as new", i.e. it does not contain goods and services in a given year that have been produced, but used only for the renewal or replacement of worn-out capital.

NDP = C + IN + G + NX = w + nii+ r + p + Te NDP = GDP – IR = GDP – a.

Gross national income (GNI) (gross national product (GNP) was the formerly used indicator) represents the sum, expressed monetarily, of the final output produced by businesses owned by citizens of a given country, regardless of the site of the implementation of their production factors (at home or abroad).

GNI = GNP = GDP + NPI

NPI – the net income of domestic economic entities with assets or business abroad.

National income (NI) is the sum of all income before taxes that are accrued by the owners of production factors during their use for production.

NI = w + nii + r + p

Personal income (PY) can be calculated by subtracting undistributed corporate profits, tax on corporate profits, social contributions and health insurance from the national income, and transfer payments are added to it.

Disposable income is the income that economic entities can utilize. It can be calculated by subtracting income from personal income tax.

Assumption: if all corporate profits are distributed and amortization is zero, then:

YD = GDP – TA + TR = Y – TA + TR

TA – total amount of taxes, social security and health insurance TR – transfer payments

Notes Macroeconomists would be delighted if all production capacities were used in the economy, respectively, production factors. Then the economy would achieve a product output which is called potential output. Real product output if often very different from potential output, especially in the short term.

For the purpose of comparing the development of the domestic economy to foreign economies a good indicator is gross domestic product per capita, best expressed in some "worldwide" currency, e.g. American dollars.

For the purpose of comparing developments in the GDP over several consecutive years, it is necessary to distinguish the causes of output growth. Whether this is actually the growth of the physical quantities of the product, or just a rise in prices, i.e. the price level.

The price level expresses the aggregate level of prices utilizing price indices.

Consumer Price Index (CPI) includes prices of consumer goods and services. It estimates the price level on the basis of the so-called market basket, a collection of commodities containing typical household consumer goods. Calculated as:

P Q CPI   t 0 .100  P0 Q0

Pt – the price of selected commodities in the market basket, in which the price level is determined, Q0 – the scale of the said commodity in the market basket, P0 – the price of the same commodity in the base year, i.e. the year in which the structure of the market basket was drawn up or updated.

GDP deflator (Implicit Price Deflator - IPD) records the prices of all goods and services produced in the economy. The deflator shows the share of nominal and real output. It is calculated as:

P Q  t t nGDPt IPDt  100  100  P0 Qt rGDPt

Nominal output is expressed in prices current in the reference year t. Real output is expressed in constant prices, i.e. prices in the year which is chosen as the base year (in the formula variable with index 0). The real output is therefore an indicator, which is adjusted for the effects the growth of the price level.

In macroeconomics, we commonly distinguish between a range of real and nominal variables. For example: nominal and real wages, nominal and real interest rate, the growth rate of real and nominal output, etc.