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Summary Final Principles of Economics
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A summary for the Endterm of the course Principles of economics.
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Principles of Economics Notes for the Final ExamLECTURE 7: MEASURING AGGREGATE INCOME AND PRICE LEVEL
Where we learn what GDP, GDP deflator and Consumer Price Index are, and what they are good for. These are the
indicators you hear about most often in economy related news. They are often misunderstood though.
MACRO ECONOMICS
Today we begin our first topics in macroeconomics.
Macroeconomics is concerned about the economy as a whole, while microeconomics was concerned about
individual decisions by firms and consumers of certain goods.
So, if you ask what is going to happen to the demand for bread if the income of consumers grows, you are still in
the domain of microeconomics.
If you ask, however, how a change in total (aggregate) income would affect total consumption in the economy,
you have a macroeconomic problem.
GDP – GROSS DOMESTIC PRODUCT
GDP is our main measure of an economy’s performance. When you divide it by population, you obtain GDP per
capita, which is one of the basic measures of welfare.
GDP is the total income created in an economy in a particular period (income approach)
GDP also equals the total expenditure in an economy in a particular period (expenditure approach).
This is logical since what is income or revenue for one, is expenditure to others. ALL INCOMES=ALL
EXPENDITURE=GDP
For example, when you buy something in a shop, that is going to be expenditure to you, but a revenue (and
income) for the shop’s owner.
All transactions are interlinked in the economy, as demonstrated by the circular flow model.
GDP can also be defined as the market value of all final goods and services produced within a country in a
given period of time (output approach). This is the most common definition.
Let us discuss each of the key terms in the definition:
Market value: The biggest problem of measuring GDP is aggregation. How can you aggregate (add up) different
goods and services? The answer is by adding them up by their value. When goods and services are traded then the
market price can be used for this purpose. But when they are not (government services) then we use the known
costs. For example, if you buy 1kg apple for 2 euros in the supermarket, then the transactions value is simply €2.
If you study a year in a school financed by the state, then this activity will be measured by the total costs of you
studies (say €10,000).
o The cost-based valuation is a weak point of GDP: perhaps if education was market based, you would have
been willing to pay more for it. So cost based valuation may underestimate the actual value added of an
activity.
Of All: GDP is meant to be a comprehensive measure, taking all activities into account. This may be done when a
transaction is recorded. There are two important types of value creating activities you may not known enough
about to include in GDP.
1) Housing services: When you are an owner of a house, you will not pay any rent. So this would be missing
from the GDP. This is done by assuming that as owner you pay a rent to yourself. This requires some
assumptions. Statistical agencies estimate the value of housing services for those living in self-owned homes by
assuming some rental price based on the market rents.
2) Activities outside the legal markets: this includes domestic services (children working in the garden, people
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, cooking for themselves), hidden activities to avoid taxation (black economy, shadow economy), illegal activities
(smuggling, selling illegal goods and services).
Final: We only add up final goods to GDP. Final goods and services are those which are sold for consumption.
All others, which are going to be used to produce other goods are called intermediate goods.
o Example: A farmer sells 10 kg of potatoes to a consumer who cooks and eats it. Potato is a final good in
this case and its value can be added to the GDP. A farmer sells 10 kg of potatoes to another farmer who
feed it to the pigs. Now, the potato was used to create another good (pork) hence it is an intermediate
good. Its value is not added to GDP.
o Double counting: the value of a final good already contains the value of all intermediate goods used in its
production. So, adding the value of intermediate goods to the GDP would include their value twice. Once
as intermediate goods, and once as part of the value of the final good. This error is called double
counting.
Goods and Services: Both tangible and intangible goods are included. The latter includes services, such as
software engineering, hairdressing or giving legal advice.
o Not all national accounting systems include services. For example, the state-socialist (“communist”)
countries did not follow the System of National Accounts (this includes GDP), but instead used the
Material Product System (MPS). In this system only material production and those services were included
that affected material goods (for example repairing a car or a radio). Services such as education or
healthcare were not included.
Produced: We are only interested in the new value added created in a given period. Goods and services that were
created earlier are not included in the GDP.
o For example, if I sell my car to someone, then it does not enter the GDP because it does not create any
new value. If, however, a used car dealer buys my car for €2000 and sells it to someone for €3000 then
the trader created a new value of €1000. This was the value of the dealer’s service, but not of the car.
Only €1,000 is added to the GDP.
Goods and Services: Both tangible and intangible goods are included. The latter includes services, such as
software engineering, hairdressing or giving legal advice.
o Not all national accounting systems include services. For example, the state-socialist (“communist”)
countries did not follow the System of National Accounts (this includes GDP), but instead used the
Material Product System (MPS). In this system only material production and those services were included
that affected material goods (for example repairing a car or a radio). Services such as education or
healthcare were not included.
Produced: We are only interested in the new value added created in a given period. Goods and services that were
created earlier are not included in the GDP.
o For example, if I sell my car to someone, then it does not enter the GDP because it does not create any
new value. If, however, a used car dealer buys my car for €2000 and sells it to someone for €3000 then
the trader created a new value of €1000. This was the value of the dealer’s service, but not of the car.
Only €1,000 is added to the GDP.
Within a country: GDP only includes activities within a country. So if a foreign citizen works in the
Netherlands, then her income will appear in the Dutch GDP. Similarly, when a Dutch investor gets some return on
her investments in the US, it will be added to the US GDP.
In a given period of time: GDP is calculated over a year or a quarter. Only transactions taking place in a given
interval count.
NUMERICAL EXAMPLE, CALCULATING GDP – OUTPUT APPROACH
In a simple country only three people live: the farmer grows 100 tons of wheat and sells it to the baker for €100 per ton.
The baker uses this wheat and prepares 150 tons of bread, which he sells to the shopkeeper at €200 per ton. The
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, shopkeeper sells the bread to the three of them at €250 per ton. What is the GDP of this simple country?
THE CIRCULAR FLOW MODEL OF THE ECONOMY
This diagram is a simple version, for a closed economy (no interaction with foreign markets) and without
government.
The arrows denote flows of money (green), goods and services (red), and production factors (blue).
For example, firms will be buyers at the factor market, they buy capital, labor, land and knowledge in exchange
for factor costs (interest, wages, rents).
Firms are sellers in the product market, they supply goods, in exchange for revenue.
CALCULATING GDP – EXPENDITURE APPROACH
GDP can be defined as the sum of all expenditures in an economy in a given period.
What do economic agents spend their revenue on? First, they will consume some goods and services (C -
consumption), then some of the revenues will be spent by the government (G – government spending). A part of
the income is spent on buying equipment and buildings (including housing) or piling up inventories (I –
investment). Finally we need the net exports (NX) which is difference between exports (the purchase of domestic
goods and services by foreigners) and imports (the purchase of foreign goods and services by domestic agents).
Y C I G NX
THE DUTCH GDP BY THE EXPENDITURE APPROACH
C=326,885
G=178,697
I=151,199
NX=611,411-532,303=79,108
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