Measure activity
Explain the expenditure, income and output approaches to measuring GDP and why they should give the same total in principle.
National income
National income statistics provide a way to measure economic activity across an entire economy. This chapter explains GDP and related measures, how to distinguish nominal from real values, and how income, output and expenditure circulate between households, firms, government and the rest of the world.
GDP & GNIReal vs nominalNational accountsCircular flowInjections & leakages
What this chapter prepares you to do
Use national accounts
Distinguish GDP, GNI and NNI, and move correctly between basic and market prices and between gross and net values.
Handle real data
Separate nominal changes from real changes and use a price index to convert current-price GDP into constant-price GDP.
Analyse the circular flow
Identify injections and leakages and explain macroeconomic equilibrium when planned injections equal planned leakages.
High-grade habit: define the measure first, then show the exact adjustment. In calculation questions, write the relationship before inserting the figures.
Chapter sections
6.1
National income statistics
What is national income?
An economy produces many different goods and services, measured in different physical units. To combine them into one total, economists use their money value. A central measure is gross domestic product (GDP).
Gross domestic product (GDP)The total value of goods and services produced within an economy during a given period.
GDP is a measure of economic activity taking place within the country's territory. It is not the same as the income ultimately available to the country's residents, because income can flow between countries.
Three approaches to measuring GDP
Expenditure approach
Add spending on domestically produced output: household consumption, firms' investment, government spending and net exports.
Income approach
Add factor incomes generated by production, including wages and salaries, profits, rent and interest.
Output approach
Add the value of output produced, using value added at each stage so that intermediate production is not double counted.
GDP by expenditure=C + I + G + (X − M)
In principle, the expenditure, income and output approaches should produce the same total because the value of output produced creates an equal flow of income and an equal amount of expenditure. In practice, statistical measurement is not perfectly exact.
Why the approaches are useful: expenditure data reveal how resources are used; income data show how factor owners are rewarded; output data show the structure of production across sectors such as primary, secondary and tertiary activity.
Nominal and real measurements
Nominal value
Measured using prices current at the time. A rise can therefore reflect higher output, higher prices, or both.
Real value
Adjusted for changes in the price level, allowing changes in the actual volume of production to be compared over time.
Nominal GDPGDP measured at current prices.
Real GDPGDP measured at constant prices after allowing for changes in the price level.
When prices rise, nominal GDP can grow even if the quantity of output changes very little. Real GDP is therefore the appropriate measure when the aim is to compare production over time.
Price index=(Nominal GDP ÷ Real GDP) × 100
Worked example: nominal GDP is $315 billion and the price index is 123.9. Real GDP = 100 × 315 ÷ 123.9 = approximately $254.2 billion.
Exam warning: do not describe an increase in nominal GDP automatically as economic growth. If prices have increased, part or all of the nominal rise may simply be inflation.
Easy book example — ice cream and inflation: If the same tub of ice cream costs $2.00 last year and $2.20 this year after 10% inflation, your nominal spending has risen but your real consumption has not. This is why changes in real GDP, not nominal GDP alone, are used to compare output through time.
GDP and gross national income (GNI)
Gross national income (GNI)GDP plus net income from abroad.
GNI=GDP + net income from abroad
GDP focuses on production taking place inside the economy. GNI adjusts this for income flows between residents and the rest of the world. For example, income earned abroad by residents adds to GNI, while income generated domestically but flowing to non-residents works in the opposite direction.
Easy book example — income from abroad: GDP records production inside the country. GNI adjusts this by adding net income from abroad. The book notes that income sent home by nationals working overseas can make this difference important; for Pakistan in 2018/19, net factor income from abroad was about 6% of GNI.
Market prices and basic prices
When the output approach is used, value added is naturally measured at basic prices. These exclude taxes on products but include subsidies. Expenditure is valued at the prices actually paid in markets, so GDP by expenditure is measured at market prices.
Basic prices
Used for valuing gross value added; they exclude taxes on products and include subsidies.
Market prices
The prices paid in markets; they include taxes on products net of subsidies.
GDP at market prices=Gross value added at basic prices + taxes on products − subsidies on products
Worked example: if gross value added at basic prices is $1,275m, taxes on products are $91m and subsidies are $9m, GDP at market prices = 1,275 + 91 − 9 = $1,357m. If net income from abroad is $86m, GNI = 1,357 + 86 = $1,443m.
Gross and net values
DepreciationThe fall in the value of capital goods caused by wear and tear.
Gross measures include the production needed to replace worn-out capital. Net measures deduct depreciation to show the amount remaining after allowing for this loss in capital value.
Net domestic product=GDP − depreciation
Net national income (NNI)=GNI − depreciation
Quick memory rule: domestic → national means adjust for net income from abroad; gross → net means deduct depreciation.
6.2
Introduction to the circular flow of income
A simple closed economy
Begin with an economy containing only households and firms, with no government and no international trade. Households own and supply factors of production to firms. Firms use these factors to produce goods and services.
The circular flow of income
In the simple closed-economy model, households supply factors of production to firms and receive factor incomes in return. Firms supply goods and services to households, while household expenditure flows back to firms. The same activity can therefore be viewed as income, output or expenditure.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Firms pay households factor incomes such as wages, rent, interest and profits. Households spend income on goods and services produced by firms. In this simple closed system, income, output and expenditure are different ways of measuring the same circular flow.
Circular flow modelA model showing flows of goods, services and factors of production between economic agents together with the corresponding money payments.
An open economy: injections and leakages
A real economy also contains government and trades with the rest of the world. Some spending enters the circular flow from outside the household-consumption stream, while some income leaves it.
Injections
Money entering the circular flow through investment (I), government expenditure (G) and exports (X).
Leakages
Money leaving the circular flow through savings (S), taxation (T) and imports (M).
Injections=I + G + X
Leakages=S + T + M
Injections and leakages in the circular flow of income
Saving (S), taxation (T) and imports (M) are leakages because they remove spending from the domestic circular flow. Investment (I), government expenditure (G) and exports (X) are injections because they add spending. Planned macroeconomic equilibrium occurs when total injections equal total leakages.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Investment is not financial saving
In macroeconomics, investment means firms' expenditure on capital goods such as machinery, equipment and buildings that add to productive capacity. Putting money into a bank account is saving, not investment in this sense.
Common mistake: buying shares or placing money in a deposit account is not counted as investment expenditure in this model. Investment refers to expenditure on newly produced capital goods.
Equilibrium and disequilibrium in the circular flow
Macroeconomic equilibriumwhenI + G + X = S + T + M
If planned injections exceed planned leakages, total spending in the economy rises and national income tends to increase. As income increases, households are likely to save more, pay more tax and spend more on imports. These leakages rise until the circular flow moves back towards equilibrium.
If planned leakages exceed planned injections, spending and national income tend to fall. Lower income then tends to reduce saving, taxation and import expenditure, helping restore equality between injections and leakages.
Easy book example — extra government road spending: Higher government expenditure is an injection. It raises firms’ revenues and household incomes. As incomes rise, households save more, pay more tax and buy more imports, so leakages rise. The adjustment continues until planned injections again equal planned leakages.
Why investment matters beyond the current flow
Investment is an injection into current expenditure, but it also increases the economy's productive capacity by adding to the capital stock. Higher investment can therefore affect both current national income and the economy's potential for future growth. Additional investment spending may also generate further rounds of income and expenditure as firms hire workers and those workers spend part of their incomes.
Exam chain: higher planned investment → injection rises → expenditure and production rise → incomes rise → leakages rise → a new equilibrium is approached. Keep this separate from the longer-run effect of a larger capital stock on productive capacity.
Chapter 6 revision checklist
Define GDP as a measure of production within an economy.
Explain expenditure, income and output approaches to GDP.
Explain why value added prevents double counting.
Use C + I + G + (X − M) for the expenditure approach.
Distinguish nominal values from real values.
Explain why nominal GDP can overstate real growth when prices rise.
Use a price index to convert nominal GDP to real GDP.
Distinguish GDP from GNI.
Calculate GNI using net income from abroad.
Distinguish basic prices from market prices.
Convert gross value added at basic prices to GDP at market prices.
Define depreciation.
Calculate net domestic product and NNI.
Explain the basic two-sector circular flow.
Identify factor income, output and expenditure flows.
Identify I, G and X as injections.
Identify S, T and M as leakages.
Distinguish economic investment from financial saving.
State the circular-flow equilibrium condition.
Explain how disequilibrium can cause national income to adjust.
20 questions. Each answer is marked immediately with a short explanation of why it is correct or incorrect.