EEB Project

8/14/2019 EEB Project

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EEB ProjectComponents of real GDP; the circularflow of income; the role of government

and international trade; aggregatedemand and aggregate supply

By:

Robin KapoorSourabh GargDeepak KumarSanjay Pal

Sakshi JoshiVikas SharmaTushar GargPankaj JainPrateek NaharNitin Raheja

Section: Finance, F12


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Real GDP

Real GDP Definition

Real GDP is a macroeconomic measure of the size of an economy adjusted for

price changes and inflation. Real GDP measures the output of final goods andservices produced and incomes earned at constant prices.

Real GDP = [(Nominal GDP)/ (GDP deflator)] x 100

RealGDP for a given year is the given year's nominal GDP stated in the based-

yearprice level. Real GDP growth on an annual basis is the nominal and abnormalGDP growth rate adjusted for inflation and expressed as a percentage.

Because Real GDP is adjusted for changes in prices and inflation throughout the

year, it can be thought of in terms of 'purchasing power.'

Real GDP per Capita reflects GDP purchasing power of each individual in theeconomy.

Real GDP per capita is found by dividing real GDP by the size of the population.

Unlike nominal GDP, real GDP can account for changes in the price level,

and provide a more accurate figure. Let's consider an example. Say in 2004,nominal GDP is $200 billion. However, due to an increase in the level of pricesfrom 2000 (the base year) to 2004, real GDP is actually $170 billion. The lowerreal GDP reflects the price changes while nominal does not.

By eliminating the effect of price changes, real GDP allows economists to make

useful comparisons of a nation's output and services. Note that real GDP is also

known as constant-price GDP and inflation-corrected GDP.

GDP is the sum of consumer spending, investment, government purchases, and net

exports, as represented by the equation:Y = C + I + G + NX

Because in this equation Y captures every segment of the national economy, Y represents both GDP and the national income. This because when money changes hands, it isexpenditure for one party and income for the other, and Y, capturing all these values, thusrepresents the net of the entire economy.

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Components of GDP

Consumer spending , C, is the sum of expenditures by households on durable

goods, nondurable goods, and services. Examples include clothing, food, andhealth care.

Investment , I, is the sum of expenditures on capital equipment, inventories, and

structures. Examples include machinery, unsold products, and housing.

Government spending , G, is the sum of expenditures by all government bodies on

goods and services. Examples include naval ships and salaries to governmentemployees.

Net exports , NX, equal the difference between spending on domestic goods by

foreigners and spending on foreign goods by domestic residents. In other words,net exports describe the difference between exports and imports.

Circular flow of income

In economics, the term circular flow of income or circular flow refers to a simpleeconomic model which describes the reciprocal circulation of income between producersand consumers. In the circular flow model, the inter-dependent entities of producer andconsumer are referred to as "firms" and "households" respectively and provide each otherwith factors in order to facilitate the flow of income. Firms provide consumers with goodsand services in exchange for consumer expenditure and "factors of production" fromhouseholds.

The circle of money flowing through the economy is as follows: total income is spent(with the exception of "leakages" such as consumer saving), while that expenditure allowsthe sale of goods and services, which in turn allows the payment of income (such as wagesand salaries). Expenditure based on borrowings and existing wealth i.e., "injections"such as fixed investment can add to total spending.

In equilibrium (Preston), leakages equal injections and the circular flow stays the samesize. If injections exceed leakages, the circular flow grows (i.e., there is economicprosperity), while if they are less than leakages, the circular flow shrinks (i.e., there is arecession).

Two Sector Model

In the simple two sector circular flow of income model the state of equilibrium is definedas a situation in which there is no tendency for the levels of income (Y), expenditure (E)and output (O) to change, that is:

Y = E = O

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This means that the expenditure of buyers (households) becomes income for sellers(firms). The firms then spend this income on factors of production such as labor, capitaland raw materials, "transferring" their income to the factor owners. The factor ownersspend this income on goods which leads to a circular flow of income.

Five sector model

The five sector model of the circular flow of income is a more realistic representation ofthe economy. The first is the Financial Sector that consists of banks and non-bank

intermediaries who engage in the borrowing (savings from households) and lending ofmoney. In terms of the circular flow of income model the leakage that financialinstitutions provide in the economy is the option for households to save their money. Thisis a leakage because the saved money can not be spent in the economy and thus is an idleasset that means not all output will be purchased. The injection that the financial sectorprovides into the economy is investment (I) into the business/firms sector.

The next sector introduced into the circular flow of income is the Government Sector thatconsists of the economic activities of local, state and federal governments. The leakagethat the Government sector provides is through the collection of revenue through Taxes(T) that is provided by households and firms to the government. The injection provided bythe government sector is Government spending (G) that provides collective services andwelfare payments to the community.

The final sector in the circular flow of income model is the overseas sector whichtransforms the model from a closed economy to an open economy. The main leakage fromthis sector are imports (M), which represent spending by residents into the rest of theworld. The main injection provided by this sector is the exports of goods and serviceswhich generate income for the exporters from overseas residents.

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In terms of the five sectors circular flow of income model the state of equilibrium occurswhen the total leakages are equal to the total injections that occur in the economy. Thiscan be shown as:

Savings + Taxes + Imports = Investment + Government Spending + Exports

OR S + T + M = I + G + X.

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The Role of Government in the Economy

The Rationale for Regulation

1. Efficiency2. Regulation3. Equity

Economic Considerations

1. Market Failure2. Externalities: differences between private and social costs or benefits.3. Political Considerations - play an important role in the design of regulatory

policies:

a. Preservation of consumer choice.b. Limit concentration of economic and political power.c. Important political considerations lead to the argument -- compelling power

for government to be in the marketplace.

Who pays for Regulation?

1. Depends on the elasticity of demand for the final products of affected firms

a. Tax incidence vs. tax burden. The point of tax collection versus the issue of

who really pays.

b. Highly elastic product demand places the burden of regulation-induced costincreases on producers. Production must be cut from Q1 to Q2.

c. Low elasticity of product demand allows producers to raise prices from P1to P2.

Consumers bear the burden of regulation-induced cost increases.

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2. Problem of UnderproductionUtility Price Regulation

1. Unrestricted monopoly

2. Reduced dollar profit3. Lower return on investment

Problems in the Utility Industry

a. Pricing problemsb. Output level problemsc. Inefficiencyd. Investment levele. Regulatory lag and political influencef. Cost of regulation

Price Controls

When markets are free to choose a price and quantity, the result is equilibrium. Pricesbecome the mechanism that directs demanders and suppliers toward this point. If, in theopinion of government, the resulting equilibrium price is too high or too low, then thegovernment may intervene in the market by imposing price controls. That is, governmentmust decide exactly how high is too high or how far a price can fall before its too low.

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The government may restrict the price from rising above a certain point by placing a priceceiling on the good sold in this market. The price ceiling serves as a price maximum.Similarly, if the price was too low, then the government could impose a price floor (priceminimum).The point here is that if prices cannot reach what would be the equilibrium, then a gap will

emerge between the quantity demanded and quantity supplied.

Price Ceilings A Welfare Economics

One way in which the central authority may regulate an industry is by controlling themarket price. Price ceilings set below the equilibrium price cause shortages.With a shortage, it is necessary to determine how the product will be allocated.

Rule 1. Product is allocated according to people's willingness to pay for itIn this regime, we allow consumers to purchase the good on the basis of their willingnessto pay.

Rule 2. Product is allocated by the lottery methodIn this regime, the government allocates the good randomly by giving consumers the rightto purchase the good if their name is selected from a lottery.

Rule 3. The goods suppliers allocate productWhen suppliers allocate the good, consumers compete against one another to acquire theproduct. This competition may occur in a variety of ways, but we expect that the highvalue consumers will be willing to pay extra for the good - up to the difference betweentheir respective reservation price and the ceiling price. There are several ways in whichthey may do so. One is to wait in line.

Role of International Trade in the Eonomy

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International trade has been a major driver of global growth and prosperity over the lastfifty years. As trade has expanded, global incomes have grown. Open economies havebeen able to harness the power of trade to boost competitiveness and productivity, helping

improve living standards and sustain economic growth.The world today is significantly more economically interdependent than it was fifty yearsago. World trade has expanded, with exports growing from $84 billion in 1953 to $6,272billion in 2002. Much of the increase has been in trade between industrialized countries.But developing countries and emerging markets are playing a growing role: exports fromdeveloping countries as a whole accounted for 29 per cent of world trade in 2001.

Benefits of international trade

Openness to trade helps drive productivity improvements and hence economic growth.Income growth depends crucially on a countrys capacity to raise its productivity, i.e. its

capacity to find new ways of making more effective use of the resources which it hasavailable.

Trade has focused on five key drivers of productivity performance:-

improving competition, to sharpen the incentives for producers to develop and

adopt more productive techniques

promoting enterprise, to encourage the adoption of innovative processes and

products

supporting science and innovation, to promote the development of new

technologies and more efficient ways of working

raising skill levels to create a more productive workforce

Encouraging investment, to increase the stock of physical capital used in

production

Globalisation and trade expansion will impact on the importance of these drivers for future prosperity. For example, a continued pace of technological advance that drivesglobalisation and innovation will further increases the demand for a highly skilledworkforce with the ability to absorb and generate new ideas and adapt to changingtechniques and shifting product demand.

Openness to trade strengthens the drivers of productivity through six important (and

mutually reinforcing) routes:

More efficient allocation of resources. Trade enables each country to specialise in

the production of those goods and services which it can produce most efficiently.Countries can raise overall consumption by exchanging their surplus productionfor the surplus production of other countries which have a different comparativeadvantage.

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Economies of scale. In the absence of trade, economies of scale are constrained by

the size of the domestic market. Trade removes this constraint, allowing industriesand firms to produce on a more efficient scale than would otherwise be possible.

Innovation similarly, trade increases incentives for firms to innovate, because the

rewards from successful innovation will be proportionately greater if firms areselling in larger (i.e. export as well as domestic) markets. Where highly productivefirms expand as a result of exports, this boosts the productivity of the economy asa whole.

Greater competition. Trade openness exposes domestic firms to greater

competition. This helps to encourage exit from the marketplace of the leastproductive firms; reduces monopoly rents; drives down margins; and reduces prices for consumers. Competition further reinforces incentives to innovate,helping to create more competitive firms which can then compete more effectivelyin world markets.

Access to new technology. Trade can provide direct access to goods and services

that incorporate new technologies, particularly where more open trade regimeshave led to different stages of the production process being undertaken in differentcountries.

Incentives for investment. Better access to imports and to export markets increases

the scope for productive investment by creating new business opportunities.Foreign direct investment (FDI) enables technology and innovation developedabroad to be applied to domestic production, enhancing competition and leading toa faster diffusion of more efficient and innovative processes.

Foreign direct investment- openness to trade can directly affect the amount of

foreign investment that a country attracts. For example, access to imported inputsand to export markets may be critical in determining the viability of an investment

project. In such circumstances, countries with substantial barriers to trade mayattract less foreign investment than they otherwise would.

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Aggregate Demand

Aggregate demand is the total demand for final goods and services in the economy (Y) ata given time and price level. This is the demand for the gross domestic product of a

country when inventory levels are static. It is often called effective demand or abbreviatedas 'AD'. The aggregate demand curve (AD) slopes downward (indicating that higheroutputs are demanded at lower price levels).

Aggregate planned expenditure for goods and services in the economy

= C + I + G + (X-M)

C, Consumers' expenditure on goods and services : This includes demand for

durables & non-durable goods.

I, Gross Domestic Fixed Capital Formation - i.e. inv estment spending by

companies on capital goods. Investment also includes spending on working capitalsuch as stocks of finished goods and work in progress.

G, General Government Final Consumption . i.e. Government spending on publicly

provided goods and services including public and merit goods. Transfer paymentsin the form of social security benefits (pensions, job-seekers allowance etc.) arenot included as they are not a payment to a factor of production for outputproduced. A substantial increase in government spending would be classified as anexpansionary fiscal policy.

X, Exports of goods and services - Exports sold overseas are an inflow of demand

into the circular flow of income in the economy and add to the demand for UK produced output. When export sales from the UK are healthy, production in

exporting industries will increase, adding both to national output and also theincomes of those people who work in these industries.

M, Imports of goods and services . Imports are a withdrawal (leakage) from the

circular flow of income and spending in the economy. Goods and services comeinto the economy - but there is a flow of money out of the economic system.Therefore spending on imports is subtracted from the aggregate demand equation.

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The Aggregate Demand Curve

Aggregate demand normally rises as the price level falls. This can be explained in threemain ways:

Real money balances effect

As the price level falls, the real value of money balances held increases. This increases thereal purchasing power of consumers.

Prices and interest rates

A lower price level increases the real interest rate - there will be pressure on the monetaryauthorities to cut nominal interest rates as the price level falls. Lower nominal interestrates should encourage an increase in consumer demand and planned investment.

International competitiveness

If the UK price level is lower than other countries (for a given exchange rate), UK goodsand services will become more competitive. A rise in exports adds to aggregate demandand therefore boosts national output.

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Aggregate Supply

Aggregate Supply (AS) measures the volume of goods and services produced within theeconomy at a given overall price level. There is a positive relationship between AS and the

general price level. Rising prices are a signal for businesses to expand production to meeta higher level of AD. An increase in demand should lead to an expansion of aggregatesupply in the economy.

Short-run aggregate supply curve

Aggregate supply is determined by the supply side performance of the economy. It reflectsthe productive capacity of the economy and the costs of production in each sector.

Shifts in the AS curve can be caused by the following factors:

changes in size & quality of the labor force available for production

changes in size & quality of capital stock through investment

technological progress and the impact of innovation

changes in factor productivity of both labor and capital

changes in unit wage costs (wage costs per unit of output)

changes in producer taxes and subsidies changes in inflation expectations - a rise in inflation expectations is likely to boost

wage levels and cause AS to shift inwards

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In the diagram above - the shift from AS1 to AS2 shows an increase in aggregate supply ateach price level might have been caused by improvements in technology and productivityor the effects of an increase in the active labor force.

An inward shift in AS (from AS1 to AS3) causes a fall in supply at each price level. Thismight have been caused by higher unit wage costs, a fall in capital investment spending(capital scrapping) or a decline in the labor force.

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