IB Economics SL8 - Overall Economic Activity

ECONOMICS SL chapter eight - the level of overall economic activity

8.1 Economic activity CIRCULAR FLOW OF INCOME • The circular flow of income model shows the concepts and relationships of an economy. The simplest one shows a closed economy, where there is no government and has no international trade.

• The income flow is equal to the expenditure flow in a given time period. These flows are equal to the value of output flow. • Injections and leakages complicate the circular flow. They are often paired together. injections investment gov’t spending exports

leakages saving taxes imports 1 THE LEVEL OF OVERALL ECONOMIC ACTIVITY

• Saving - part of consumer income that is not spent. Investment is spending by firms for capital good production. • When households pay taxes, there is a leakage because the taxes are not used to by goods and services. When the gov’t spends money on expenditures, there is an injection. • Imports are g/s produced by other countries and purchased by domestic buyers. Exports are g/s produced domestically and bought by other countries. There is an open economy when there is international trade. • In the graphic below, the red boxes above households are the leakages, and the boxes below firms are injections.

• Leakages are matched by injections. However, if injections are smaller than leakages, the income flow becomes smaller. If injections > leakages, the income flow increases in size.

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8.2 Measures of economic activity • Involves measuring an economy’s national income (value of output). • Output of economy known as aggregate output. This allows us to: • assess economy’s performance • compare income/output performance • establish basis for making policies • In macroeconomics, the output is measured in value, and not quantities. MEASUREMENTS OF ECONOMIC ACTIVITY • Value of aggregate output = total income. National income is used synonymously with aggregate output. • There are three ways to measure the value of aggregate output. THE EXPENDITURE APPROACH • Adds up all spending to buy final goods and services produced within a country • Only includes final goods, and not intermediate goods. • Spending is categorized into: • Consumption (C) • all purchases by households on final g/s (but not housing) • Investment (I) • firm spending on capital goods • spending on construction (housing and buildings) • Government spending (G) • spending by gov’ts such as factors of production and government investment • Net exports (X-M) • value of exports (X) minus value of imports (M) • GDP = C+I+G+(X–M) THE INCOME APPROACH • Adds up income earned by factors of production within a country over time period. The national income isn’t same as GDP, and requires adjustment if GDP calculation is wanted. THE OUTPUT APPROACH • Measures value of each good and service produced in economy over time period and sums them up. Includes final goods/services to prevent double counting. 3 THE LEVEL OF OVERALL ECONOMIC ACTIVITY

DIFFERENT MEASURES OF VALUE OF OUTPUT • Gross domestic product (GDP) - market value of all final goods and services produced in a country over a time period, regardless of who owns the factors of productions. • value of final goods/service made in a country • Gross national income (GNI) - Total income received by residents of a country equal to value of all final goods/services produced by factors of production supplied by residents (regardless of location of factors). • value of final goods/services made by people of a country REAL AND NOMINAL • Nominal value - value measured of the prices at the time of measurement • Can be affected by changing price because it doesn’t account for it • Real value - measure that takes in account of price changes • Used when comparisons are made to eliminate other factors TOTAL AND PER CAPITA • Per capita - per person; per capita measure of total value divides it by the population of a country. • More useful than total value when figuring out the standard of living. Two countries with the same total GDP may have different per capita GDP. NATIONAL INCOME STATISTICS • GDP and GNI don’t measure true value of output because they • don’t include non-marketed output • don’t include underground market sold output • don’t take into account of quality improvements • don’t account for negative externalities and resource depletion • don’t account for different price levels • GDP and GNI can’t measure standards of living because they • don’t make distinctions about composition (military & merit goods both count as GDP) • can’t reflect education, health, and life expectancy • have no info about distribution of income and output • don’t take account increased leisure • dont’ account for quality of life • Because of the above, even real values can be misleading for comparisons over time and between countries. 4 THE LEVEL OF OVERALL ECONOMIC ACTIVITY

GREEN GDP • GDP and GNI fail to count for the loss of environmental resources and include spending that is used to clean up pollution. • Green GDP is the proposed method that would account for the environment and environmental destruction: • Green GDP = GDP - value of environmental degradation • Another way is to also account for costs from cleaning up pollution (P). • Green GDP = GDP – value of environmental degradation – P. • This would be more accurate, but also will be lower than GDP itself.

8.4 The business cycle • A decrease in GDP is different from a decrease in GDP growth. BUSINESS CYCLE

actual GDP

• The business cycle plots real GDP against time. Each cycle has: • Expansion - positive growth in real GDP. Employment increases and the general price level rises. • Peak - cycle’s maximum real GDP, end of expansion. Unemployment falls substantially, price level rises rapidly. There may be inflation. 5 THE LEVEL OF OVERALL ECONOMIC ACTIVITY

• Contraction - real GDP begins to fall. If there is a contraction for more than two quarters, there is a recession. Real GDP falls and unemployment increases. Price levels slow and may fall down. • Trough - cycle’s minimum real GDP, end of contraction. Wide spread unemployment followed by expansion (recovery). • Sometimes called economic fluctuations because they are not predictable. #TRENDS • Long-term growth trend - the straight line that shows how output grows when the fluctuations are removed. The output is known as the potential output. • Unemployment falls when real GDP grows (expansion) • firms hire more labor and increase quantity of output • Unemployment increases when real GDP falls (contraction) • firms cut production and have to fire some workers • When an economy experiences full employment, there is still a natural rate of unemployment. • If actual GDP > potential GDP, unemployment is lower than the natural rate. • If potential GDP > actual GDP, unemployment is greater than the natural rate. • There is a GDP (output) gap if the actual GDP is above/below the potential GDP. REASONS TO STUDY CYCLE • Real output growth mean that there’s a chance to have higher standards of living. • Large fluctuations not desirable, because with expansion, inflation could happen and with a contraction, unemployment increases. • Some key macroeconomic objectives: rapid economic growth, full employment, and price stability.

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