TOPIC TWO: MEASUREMENT OF ECONOMIC PERFORMANCE

This chapter presents some of the conceptual and practical issues involved in measuring economic
performance. It focuses on the national income accounts, a framework for measuring economic
activity that is widely used by economists. And because the national income accounts are set up in
a logical way that mirrors the structure of the economy, working through them is an important first
step toward understanding how the macro economy works. At the end of this chapter, you will
have a clearer understanding of the relationships that exist among key macroeconomic variables
and among the different sectors of the economy.

SECTORS OF AN ECONOMY
The aggregate sectors of the macro economy reflect key macroeconomic functions. There are four
aggregate macroeconomic sectors that form the foundation for macroeconomic analysis.
These include,
 Household sector,
 The business sector,
 Government sector
 Foreign sector.

Each sector is responsible for a different expenditure on gross domestic product: consumption
expenditures by the household sector, investment expenditures by the business sector, government
purchases by the government sector, and net exports by the foreign sector.

 Household Sector or consumer sector This sector includes the entire, wants-and-needs-
satisfying and consuming population of the economy. In a word, it includes everyone, all
consumers, all people, and every member of society.
 Business Sector: This sector contains the private, profit-seeking firms in the economy that
combine scarce resources into the production of goods and services. It includes
proprietorships, partnerships, and corporations.
  Government Sector: This sector includes all government entities that impose resource
allocation decisions, on the rest of the economy. It consists of the three primary levels of
central and local government divisions responsible for passing and enforcing laws.
 Foreign Sector: This sector is comprised of everyone and everything outside the political
boundaries of the domestic economy. It includes households, businesses, and governments
in other countries.

Macroeconomic Functions of the Different sectors

Each of the four sectors has a distinct functional role to play in the macro economy.

 Consumption: The primary macroeconomic function of the household sector is the

consumption of goods and services that satisfy wants and needs. Promoting consumption
by members of the household sector is, in essence, the ultimate objective of economic
activity.
 Production: The business sector exists to combine the resources used for the production
of the goods that satisfy wants and needs of the household sector. If not for the productive
efforts of the business sector, consumption would be less satisfying.
 Regulation: The macroeconomic function performed by the government sector is
regulation. The government sector establishes the "rules of the game" and regulates
resource allocation decisions of the other sectors.
 External: The foreign sector is responsible for any and all economic activity that transpires
beyond the political boundaries of the domestic macro economy. It is responsible for all
external activity, which directly or indirectly affect national output.

Macroeconomic markets:

There are three sets of markets that make up the macro economy--product, financial, and resource
markets. These markets exchange three primary types of macroeconomic commodities, which
include gross production, legal claims, and factor services. The four macro-economic sectors--
household, business, government, and foreign--interact through these three sets of markets.
  Product Markets: The product markets, also termed as goods or output markets, exchange
the production of final goods and services, generally referred to as gross domestic product.
The buyers of this production are the four macroeconomic sectors--household, business,
government, and foreign. The seller of this production is primarily the business sector.
 Financial Markets: The commodity exchanged through financial markets is legal claims.
Legal claims, or financial instruments, represent ownership of physical assets (capital and
other goods). Because the exchange of legal claims involves the counter flow of income,
those seeking to save income buy legal claims and those wanting to borrow income sell
legal claims.
 Resource Markets or factor markets: The services of the four factors of production are
traded through resource markets. Resource markets, also termed factor markets, are used
by the business sector to acquire the factor services needed for production. Payment for
these factor services then generates income received by the household sector, which owns
the resources.

Linkage between the Macroeconomic Sectors

First, the household sector includes all of the consumption-seeking members of society--the entire
population. In effect, the economy exists to satisfy the wants and needs of the household sector.
Secondly, the household sector owns all of the factors of production, all resources. Every
resource, every worker, every factory, every acre of land, every risk-taking entrepreneur is all
owned by someone in the household sector. Lastly, the business and government sectors exist to
address the wants and needs of the household sector. The business sector uses the resources owned
by the household sector to produce the goods and services consumed by the household sector. The
government sector oversees the provision of public goods and regulates economic activity so that
the wants and needs of the household sector are satisfied.
CIRCULAR FLOW OF INCOME AND NATIONAL INCOME ACCOUNTING

National Income refers to the total monetary value of all the goods and services produced by a
nation during a specified period. It is the final outcome of all economic activities of a nation
expressed in monetary terms for a given period of time, usually one year. Two things must be
noted about this definition of national income, first, that it measures market value of annual output
i.e. national income is a monetary measure. Secondly, for calculating national income accurately,
all goods and services produced in any given year must be counted only once.

The simple circular flow of income

The simple circular flow of income shows the relationship between the Household (HH) and
Busies sector (I). Specifically, it explains the flow of factors of production from the (HH) Sector
to the business actor and goods and services from the business (I) sector to the (HH) Sector and
payments for them.

Illustration
The real flow of goods and services is shown in the illustration above. In the upper loop, resources
such as land, labor, capital and entrepreneurship flow from households to business firms, in the
opposite direction, money flow from business firms to the households as factor payments such as
wages, rent, interest and profits. In the lower part of the illustration, money flow from households
to firms as consumption expenditure made by households on the goods and services provided by
the firms, while the flow of goods and services is in the opposite direction i.e. from businesses to
households. Thus, there is in fact, a circular flow of money or income, which will continue
indefinitely.

This flow of money does not always remain the same in volume, e.g. in a year of depression,
circular flow will contract i.e. money flow become less in volume while during the years of
prosperity, it will expand. This is so because the flow of money is a measure of national income
and therefore it changes with the changes in national income

The assumptions made here are

i) Neither households save from their incomes nor the firms save from their profits
ii) The government does not play any part in the national economy i.e. it doesn’t receive any
money from the people by way of taxes, nor does the government spend any money on goods
and services produced by the firms or on the resources and services supplied by the
households
iii) It is a closed economy

Injections and leakages

Savings are a leakage from the economy; investments are an injection into the economy
NATIONAL INCOME
This refers to the total monetary value of goods and services produced annually in a country.

EXPRESSIONS OF NATIONAL INCOME

a) Gross Domestic Product (GDP): This is the total value of goods and services produced within
a country's borders in a given period of time usually a year.

GDP = C + I + G
Where C: the household sector
I: The business sector
G: The government sector
-Nominal GDP, This refers to the value of goods and services measured at current prices.
-Real GDP, This refers to the value of goods and services measured at constant prices.
GDP deflator =Nominal GDP
Real GDP

Example: The Republic of Coconuts

Assume that

Output (2015) = 20 coconuts

Price (2015) = $3

Output (2010) = 15 coconuts

Price (2010) = $2

The base year is 2010

Therefore,
Nominal GDP (2015) = Output (2015) x Price (2015) = 20 x $3 = $60

Real GDP (2015) = Output (2015) x Price (2010) = 20 x $2 = $40

Nominal GDP (2010) = Output (2010) x Price (2010) = 15 x $2 = $30

Real GDP (2010) = Output (2010) x Price (2010) = 15 x $2 = $30

In the above example, the nominal GDP in 2015 was $60 and the nominal GDP in 2010 was $30.
Therefore, the nominal GDP grew by 100% [($60 – $30)/$30 x 100] from 2010 to 2015. However,
much of the increase in the nominal GDP from 2010 to 2015 was due to an increase in the general
price level. The real GDP in 2015 was $40 and the real GDP in 2010 was $30. Therefore, the real
GDP grew by only 33% [($40 – $30)/$30 x 100] from 2010 to 2015, which was lower than the
100% increase in the nominal GDP.

GDP Deflator

With nominal GDP and real GDP, we can measure the GDP deflator. The GDP deflator is an index
of the average price of all the final goods and services produced in the economy over a period of
time. It is used by economists to monitor the general price level. The GDP deflator measures the
general price level in the current year relative to the general price level in the base year chosen by
the government.

Nominal GDP (t)

GDP Deflator (t) = ————————— × 100

Real GDP (t)

From the above example, GDP deflator2015 = (Nominal GDP2015/Real GDP2015) x 100 = $60/$40 ×
100 = 150, which means that the general price level rose by 50% from 2010 to 2015.
Inflation is a sustained rise in the general price level. The inflation rate is the percentage increase
in the general price level. In theory, it can be calculated as the percentage increase in the GDP
deflator.

GDP Deflator (t) – GDP Deflator (t–1)

Inflation Rate (t) = —————————————————— × 100

GDP Deflator (t–1)

b) Gross National Product (GNP): This is the total monetary value of goods and services
produced by nationals of a certain country irrespective of where they are located excluding output
by foreign nationals in the domestic economy (net factor earnings from abroad). The GNP equals
the Gross Domestic Product plus income earned by domestic residents through foreign investments
(X) minus the income earned by foreign investors in the domestic market (M). The (X – M) is also
called the net foreign sector earnings, measured as the difference between a nation’s value of
exports and imports.

GNP = C+I+G+X-M
GNP = GDP + Net factor earnings from abroad

c) Net National Product (NNP)

This refers to Gross National Product minus depreciation.
i.e. GNP – Depreciation. NNP is a better proxy for estimating national income.
DEFINITIONS OF OTHER CONCEPTS
Disposable Income (Yd.)
It is the amount of income available for an individual or household to spend after Tax plus Transfer
payments.
Yd. = Y – T+ TR
Yd. = Disposable income
Y = Gross income
T = Taxes
TR = Transfer payments that is, incomes from friends and relatives.
MEASUREMENT OF NATIONAL INCOME

i) The Factor Income Method (Income Approach)

Under this approach, national income is calculated by adding up all the incomes accruing to basic
factors of production used in production of goods and services. The income method records all the
incomes received by each sector because of transactions that take place over the period of time
under consideration. This will include incomes received as wages and salaries of employees and
the self-employed, money earned by corporations, money received by the government from its
activities, interest payments received, payments from rent and so on.

i.e. NY = Rent + Wages + Interest + Profit in respect of the four sectors of the economy. All
transfer payments are excluded in national income measurement to avoid double counting for
example, gratuity and pocket money.

ii) The Expenditure Method

This is also known as the final product method. It measures national income at the final
expenditure stages. Expenditures include all money spent on goods and services at market prices.
These expenditures are computed and added to obtain the total value of products finally sold.
Hence, the expenditure approach involves aggregation of the household sector expenditure
(consumption), business firms’ expenditure (investment), government expenditure (provision of
social services) including net expenditure in the foreign sector (X-M).

NE=C+I+G+X–M
iii) The Value Added Approach/ the output method
All goods and services have a price. That price represents the value of the inputs that went into the
production of that item - land, labour, capital and enterprise. At each stage of the production
process therefore, the value of the output carried out can be recorded - this is the value added.
We add the net value added at different stages in production of goods and services in an economy
per period of time. It is difficult to trace the intermediate stages under this approach. The total
value added is the price at which the commodity is sold .To avoid double counting, it is only the
net value that is added and not the intermediate values
An example in the production of a shirt:
ITEM VALUE VALUE ADDED
Raw cotton 70 -----
Lint 100 30
Fabric 130 30
Shirt 160 30
This means therefore that 70+30+30+30=160 is the total value added by all production process.

Note: The three methods must yield the same results because the value of the goods and services
produced (O) must be equal to the total income paid to the factors that produced these goods and
services (Y) and the income paid to factors of production must equal to total expenditures on goods
and services (E)
Hence, O =Y=E

PROBLEMS OF NATIONAL INCOME MEASUREMENT

1. Definition of income: It is difficult to separate income that accrues to factors of production
arising from economic activity and the transfer payments.
2. The problem of double counting: Difficulty of differentiating between intermediate and final
goods especially in the product approach. If care is not taken in estimating the income, the
cost of the commodity is likely to be counted twice or thrice and national income will be
overestimated.
3. Errors of Omissions: This is due to insufficient statistical data. Some economic activities are
not considered (domestic related activities). Such as work done by housewives, leisure
foregone, output for subsistence etc.
4. Errors of Commission: These arise because values of certain activities are not estimated for
example, effect of pollution and rate of exploitation of resources. These affect national income
figures.
5. Some of the transactions are informal and therefore not recorded for example, smuggling
6. Large non-monetized sector. There is a large non-monetized sector in developing countries
.This is the subsistence sector in the rural areas in which a large portion of production is partly
exchanged for other goods and is partly kept for personal consumption .Such production and
consumption cannot be calculated in national income.
7. It is a very expensive venture (inadequate funds)
8. Inadequate qualified personnel (statisticians, economists, etc.)

IMPORTANCE OF NATIONAL INCOME

1. Used for policy analysis. Policies on employment for example can be based on the level of
output; investment etc. Policies on inflation, taxation can also be based on national income
statistics.
2. For comparison purposes in respect of economic performance between two periods in time.
3. For purposes of estimating Per-Capita Income which is a good indicator of either an
improvement or decline in the standards of living.
4. The information helps us to show the distribution of income among different sectors of the
economy for example, the Household Sector, the Business Sector, government etc.
5. For budgeting purposes, allocation of resources to different sectors
6. Comparison in standard of living over time
7. Comparison of standard of living between two countries
8. To compare sector contribution to national economy.
NATIONAL INCOME AND WELFARE

Per-capita income refers to income per head of a given population.

It is denoted as Total National Income

Total Population
It may be used to determine the standard of living (welfare) of a given population.

Limitations of Using Per-Capita Income as a Measure of Standards of Living

i) Does not take into account the type of goods produced. Some goods do not directly improve
on human welfare but increase national income and hence per capita income. E.g. production
of firearms.
ii) Per Capita Income takes no account of the inputs used to produce the output. For example,
if everyone worked for twice the number of hours, then GNP might roughly double, but this
does not necessarily mean that workers are better off as they would have less leisure time.
Similarly, the impact of economic activity on the environment is not directly taken into
account in calculating GNP.
iii) Movements in exchange rates may distort comparison of Per Capita Income from one
country to another.
iv) Per Capita Income does not take into account many factors that may be important to quality
of life, such as the quality of the environment and security from crime, This can lead to
distortions - for example, spending on cleaning oil spill is included in GDP, but the negative
impact of the spill on well-being are not taken into account.
v) The per-capita income statistics does not consider income distribution. Sometimes total
national income or population may be wrongly estimated.
vi) Does not consider the cost of living (prices for goods and services).
vii) Inflationary tendencies make comparison in standard of living very difficult.
KEYNESIAN THEORY OF NATIONAL INCOME DETERMINATION
The Two-Sector Model (The Keynesian equilibrium) under aggregate demand and aggregate
supply functions
According to Keynes, the equilibrium income under the two sector model is determined where
aggregate demand (AD) equals aggregate supply (AS)
Aggregate supply refers to the total value of goods and services produced and supplied in the
economy per unit of time. Aggregate demand refers to the total value of goods and services
purchased in a given economy per period of time. If all that is produced is sold, then aggregate
supply grows at a constant rate of increase in income (Y).i.e AS =Y but Y= C + S. I.e. AS=Y=C+S

Aggregate Supply Function

AS AS = Y=C + S

Income/ output

Aggregate Demand Function

In a two-sector model, aggregate demand is composed of demand by the household sector and the
business sector. I.e. it has two components.
i) Aggregate demand for consumption goods (C) demand by the household
ii) Aggregate demand for capital goods (I) demand by the businesses
AD = C + I
In Keynesian theory framework, consumption is a function of income i.e. C = (Y).
However, the consumption function may be denoted as C = a + bY
Where a = Consumption at zero income i.e. autonomous consumption
(Autonomous consumption)
b= the marginal propensity to consume.
The Consumption Function

C C = a + bY

C = bY
Y

aO

Investment Function
According to Keynes, investment is said to be Autonomous. I.e. The level of investment does not
depend upon the level of income. I = Io
I

Io

I
O Y

The Aggregate Demand Function = C+I

AD = C + I AD = C + Io

C = a + bY
I Summing up
vertically
a
Io
Io
O

Y
The Keynesian equilibrium using (AD =AS) can be graphically illustrated as below

AS = C + S
AD
AS
AD = C + I

O ye Y

The quantitative approach

At equilibrium,
AD = AS……………………....(i)
But AD = C + I……………………(ii)
AS = Y………………………..(iii)
Substituting iii and ii into I
C + I = Y……………………..(iv)
But C = a +bY…………………….(v)
I = IO ……………………… (vi)
Substituting v and vi into iv
a +bY +IO = Y ……………...(vii)
Collecting like terms
a +IO = Y - bY …………... (viii)
a +IO = Y (1- b) …………... (ix)
1-b 1-b
Y = a +IO…………………… (x)
1-b
where a = autonomous consumption expenditure
Io = autonomous investment expenditure
b = the marginal propensity to consume (MPC)
MPC is the additional consumption resulting from an additional unit of income
MPS is the additional saving resulting from an additional unit of income

MPC+MPS=1 i.e. Y=C+S, ∆Y/∆Y= ∆C/∆Y + ∆S/∆Y

1= MPC + MPS

C
APC, The Average Propensity to consume =
Y
S
APS, The Average Propensity to Save =
Y
Y C S
But, Y= C+S, = + , 1= APC+ APS
Y Y Y

The Keynesian equilibrium savings and investment approach

According to Keynes, an economy also attains equilibrium when the level of savings equals that
of investments. S = I
The savings function
Y = C + S………………………(i)
S = Y- C……………………… (ii)
But C = a + bY…………………… (iii)
Therefore,
S = Y – (a + bY)………………(iv)
S = Y – a –bY………………….(v)
S = -a + Y – bY……………….(vi)
S = -a + Y (1 – b)…………… (vii)
-a implies that consumption at zero income leads to a reduction the level of past savings,
1-b is the MPS
Illustration of the Savings Function
S

S = -a + Y (1 – b)

The Keynesian equilibrium using savings and investment approach (illustration)

S = -a + Y (1 – b)

I0

Y
-a

Calculation of national income in a two, three and four sector model

MULTIPLIERS
Is the number of times a change in autonomous expenditure multiplies itself to generate a given
level of national output/income in otherward; it measures how national output changes due to a
given change in autonomous spending.

MULTIPLIERS IN A TWO SECTOR ECONOMY

In a two sector model, we have the investment multiplier. It refers to the number of times
investment expenditure multiplies itself to generate a given level of income
Illustration
Y=a+I0/1-b
Y+∆Y = a+I0 +∆I)/ 1-b
Eqn2 – Eqn1
∆Y= ∆I/1-b
Dividing thru by ∆I
∆Y/∆I = 1/1-b

Note: an investment multiplier is positive and this is because an increase in investment expenditure
leads to an increase in national income
E.g. C=200+ 0.8Y, I=250
Determine the investment multiplier
The APC and APS
The MPC and MPS
The new equilibrium level of income if investment expenditure increases to 300 units

Multipliers in a three sector Economy

There are four common measures of multipliers in a three sector model i.e. investment multiplier,
government multiplier, tax multiplier and transfer payments multiplier

Y= C+I+G
 C= a+ bYd

Yd= T0+tY

Definitions, derivation and sample questions

i) the investment multiplier:

ii) the Government Multiplier- the number of times that government expenditure
multiplies itself to generate a given level of income
iii) the Tax multiplier- number of times that tax multiplies itself to generate a
given level of income-(reduce taxes to stimulate consumption and expenditure thus
increase national income)
iv)the transfer payments multiplier

Multipliers in a four sector economy

There are five common measures of multipliers in a three sector model i.e. investment multiplier,
government multiplier, tax multiplier and transfer payments multiplier, the foreign trade multiplier

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

C=a+bYd

Yd= Y-T+TR

T=T0+Ty

M= M0+mY

Definitions, derivation and Y-T+TR