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Macroeconomics Notes
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Complete Macroeconomics notes at university level for IF1203 City University Module.
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IF1203Week 1 - Macroeconomic issues and National income accounting:
The main measure of national economic activity is GDP.
We refer to this as the National Product, The National Income, and the National Output.
GDP
Gross domestic product, [GDP] can be calculated in three different ways:
1. as the sum of all values added by all producers of both intermediate and final goods;
2. as the income claims generated by the total production of goods and services; and
3. as the expenditure needed to purchase all final goods and services produced during a period.
By standard accounting conventions these three aggregates define the same total, so long as we add taxes on products
[minus subsidies] to the first two in order to measure GDP at market prices.
“Market prices” are the prices paid by consumers…….not to be confused with “constant” or “base year” prices which
are used to take the effects of inflation out of nominal GDP (or the current money value of GDP) to get a measure of
REAL GDP.
The circular flow of income:
The circular flow shows domestic incomes earned by households giving rise to spending, which in turn gives rise to the
output of firms, which creates incomes for households. Withdrawals are income that is not passed on through spending,
while injections are spending that does not arise out of domestic incomes and thus is exogenous.
Thus, corresponding to the two halves of the circular flow in Figure 15.2 are two ways of measuring GDP: by determining
the value of the final goods and services that are produced and by determining the value of the income claims generated
by this production.
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Because, by definition, everything that is produced must generate an income claim by some entity, both measured values
yield the same total—the GDP.
● When it is calculated by adding up the total spending for each of the main components of final output, the result is
called GDP spending-based.
● When it is calculated by adding up all the incomes generated by the act of production, it is called GDP
income-based.
GDP Based Spending:
GDP spending-based for a given year is calculated by adding up the spending going to purchase the final output produced
in that year.
Total spending on final output is expressed in the National Accounts as the sum of three broad categories of spending:
consumption, investment, and net exports. Consumption is further divided into the consumption spending of the
government and that of private households (and non-profit organisations serving households).
● So, there are four important categories of spending that we will discuss: private consumption, government
consumption, investment, and net exports.
Private consumption Spending:
Private consumption spending includes spending by households on goods and services produced and sold to their final
users during the year.
● It includes services, such as haircuts, telephone calls, meals out, and legal advice, non-durable goods, such as
fresh meat, clothing, cut flowers, and fresh vegetables, and durable goods, such as cars, TV sets, and microwave
ovens.
- However, it excludes purchases of newly built houses, as these are counted as investment.
Government Consumption Spending:
The UK National Accounts distinguish two different categories of government consumption. When the government pays
for the goods and services that are consumed by private households, this is referred to as individual government final
consumption.
In contrast, the government also pays for street lighting, national defence, and law and order, but the benefit is consumed
by the population at large rather than some specific household. This is spending on public goods
The output of public services is not (generally) sold in the marketplace, so government output is not observed
independently of the spending that produces it. What, for example, is the market value of the services of a court of law?
No one knows. However, we do know what it costs the government to provide these services, and so we value them at
their cost of production.
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A great deal of government spending is not a part of GDP. For example, when the Department for Work and Pensions
(DWP) makes a payment to an old-age pensioner, the government is not purchasing any currently produced goods or
services from the retired. The payment itself adds neither to employment nor to total output.
All such payments are examples of transfer payments, which is government spending not made in return for currently
produced goods and services. It is not a part of spending on the nation’s total output, and therefore is not included in GDP.
Investment spending:
Investment spending is defined as spending on the production of goods not for present consumption but rather for future
use. The goods that are created by this spending are called investment goods (or capital goods). Investment spending can
be divided into three categories: changes in inventories, fixed capital formation, and the net acquisition of valuables.
Changes in Inventory:
● An accumulation of stocks and unfinished goods in the production process counts as current investment because it
represents goods produced (even if only half-finished) but not used for current consumption.
● A drawing down of inventories, also called destocking, counts as negative investment because it represents a
reduction in the stocks of finished goods (produced in the current period) that are available for future use.
● Inventories are valued at what they will be worth on the market, rather than at what they have cost the firm so far.
Fixed capital formation:
All production uses capital goods. These are manufactured aids to production, such as machines, computers, and factory
buildings.
- Creating new capital goods is an act of investment and is called fixed investment or fixed capital formation.
The economy’s total quantity of capital goods is called the capital stock. Much of the capital stock is in the form of
equipment or buildings used by firms or government agencies in the production of goods and services.
● This includes not just factories and machines, but also hospitals, schools, and offices.
● A house or a flat is also a durable asset that yields its utility (housing services) over a long period of time.
● This meets the definition of fixed capital formation, so (as we pointed out previously) housing construction is
counted as investment spending rather than as consumption spending.
When a family purchases a house from a builder or another owner, the ownership of an already produced asset is
transferred, and that transaction is not a part of current GDP.
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Gross and Net Investment:
Total investment spending is called gross investment or gross capital formation.
● Gross investment is divided into two parts: replacement investment and net investment.
● Replacement investment is the amount of investment that just maintains the level of existing capital stock; in other
words, it replaces the bits that have worn out or have been discarded as obsolete.
● Replacement investment is classified as the capital consumption allowance, or simply depreciation.
● Gross investment minus replacement investment is net investment.
Positive net investment increases the economy’s total stock of capital, while replacement investment keeps the existing
stock intact by replacing what has been used up, has worn out, or has been discarded as obsolete.
All gross investment is included in the calculation of GDP. This is because all investment goods are part of the nation’s
total output, and their production creates income (and employment) whether the goods produced are a part of net
investment or are merely replacement investment.
Imports:
Private consumption, government consumption, and investment all have import content. To arrive at total spending on UK
output, we need to subtract from total UK residents' actual spending on imports of goods and services, which is
represented by the symbol IM.
Exports:
It is convenient to group imports and actual exports together as net exports. Net exports are defined as total exports of
goods and services minus total imports of goods and services (X—IM), which will also be denoted by NX. When the
value of exports exceeds the value of imports, the net export term is positive. When the value of imports exceeds the value
of exports, the net export term becomes negative.
Market prices and basic prices:
● There is one important difference that arises when calculating the level of GDP from the spending side of the
economy compared with calculating it by summing the values added in production.
● This difference arises because the price paid by consumers for many goods and services is not the same as the
sales revenue received by the producer. Some taxes place a wedge between what consumers pay and what
producers receive.
● Taxes attached to transactions are known as indirect taxes. Examples of UK indirect taxes include VAT and excise
duties.
- Thus, if you pay £120 for a meal in a restaurant, the restaurateur will receive only £100, and £20 will go to the
government in the form of VAT
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