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EEB Project
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Components of real GDP; the circular
flow of income; the role of government

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and international trade; aggregate
demand and aggregate supply

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By:

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Robin Kapoor
Sourabh Garg
Deepak Kumar

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Sanjay Pal
Sakshi Joshi
Vikas Sharma

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Tushar Garg
Pankaj Jain
Prateek Nahar

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Nitin Raheja

Section: Finance, F12

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 EEB Project

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 and
services produced and incomes earned at constant prices.
• Real GDP = [(Nominal GDP)/ (GDP deflator)] x 100
• Real GDP for a given year is the given year's nominal GDP stated in the based-
year price level. Real GDP growth on an annual basis is the nominal and abnormal
GDP 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 the
economy.
• 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 prices
from 2000 (the base year) to 2004, real GDP is actually $170 billion. The lower
real 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 is
expenditure for one party and income for the other, and Y, capturing all these values, thus
represents 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, and
health 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 government
employees.
• 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 simple
economic model which describes the reciprocal circulation of income between producers
and consumers. In the circular flow model, the inter-dependent entities of producer and
consumer are referred to as "firms" and "households" respectively and provide each other
with factors in order to facilitate the flow of income. Firms provide consumers with goods
and services in exchange for consumer expenditure and "factors of production" from
households.

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 allows
the sale of goods and services, which in turn allows the payment of income (such as wages
and 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 same
size. If injections exceed leakages, the circular flow grows (i.e., there is economic
prosperity), while if they are less than leakages, the circular flow shrinks (i.e., there is a
recession).

Two Sector Model

In the simple two sector circular flow of income model the state of equilibrium is defined
as 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, capital
and raw materials, "transferring" their income to the factor owners. The factor owners
spend 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 of
the 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 of
money. In terms of the circular flow of income model the leakage that financial
institutions provide in the economy is the option for households to save their money. This
is a leakage because the saved money can not be spent in the economy and thus is an idle
asset that means not all output will be purchased. The injection that the financial sector
provides 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 that
consists of the economic activities of local, state and federal governments. The leakage
that 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 by
the government sector is Government spending (G) that provides collective services and
welfare payments to the community.

The final sector in the circular flow of income model is the overseas sector which
transforms the model from a closed economy to an open economy. The main leakage from
this sector are imports (M), which represent spending by residents into the rest of the
world. The main injection provided by this sector is the exports of goods and services
which 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 occurs
when the total leakages are equal to the total injections that occur in the economy. This
can 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. Efficiency
2. Regulation
3. Equity

• Economic Considerations
1. Market Failure
2. 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 cost

increases on producers. Production must be cut from Q1 to Q2.

c. Low elasticity of product demand allows producers to raise prices from P1

to P2.

Consumers bear the burden of regulation-induced cost increases.

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2. Problem of Underproduction
Utility Price Regulation
1. Unrestricted monopoly
2. Reduced dollar profit
3. Lower return on investment

• Problems in the Utility Industry

a. Pricing problems
b. Output level problems
c. Inefficiency
d. Investment level
e. Regulatory lag and political influence
f. Cost of regulation

• Price Controls

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

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The government may restrict the price from rising above a certain point by placing a price
ceiling 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 (price
minimum).
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 the
market 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 it

In this regime, we allow consumers to purchase the good on the basis of their willingness
to pay.

Rule 2. Product is allocated by the lottery method

In this regime, the government allocates the good randomly by giving consumers the right
to purchase the good if their name is selected from a lottery.

Rule 3. The good’s suppliers allocate product

When suppliers allocate the good, consumers compete against one another to acquire the
product. This competition may occur in a variety of ways, but we expect that the high
value consumers will be willing to pay extra for the good - up to the difference between
their respective reservation price and the ceiling price. There are several ways in which
they 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 last
fifty years. As trade has expanded, global incomes have grown. Open economies have
been 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 years
ago. World trade has expanded, with exports growing from $84 billion in 1953 to $6,272
billion 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 from
developing 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 country’s capacity to raise its productivity, i.e. its
capacity to find new ways of making more effective use of the resources which it has
available.

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 drives
globalisation and innovation will further increases the demand for a highly skilled
workforce with the ability to absorb and generate new ideas and adapt to changing
techniques 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 production
for the surplus production of other countries which have a different comparative
advantage.

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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 industries
and 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 are
selling in larger (i.e. export as well as domestic) markets. Where highly productive
firms expand as a result of exports, this boosts the productivity of the economy as
a whole.
• Greater competition. Trade openness exposes domestic firms to greater
competition. This helps to encourage exit from the marketplace of the least
productive 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 effectively
in world markets.
• Access to new technology. Trade can provide direct access to goods and services
that incorporate new technologies, particularly where more open trade regimes
have led to different stages of the production process being undertaken in different
countries.
• 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 developed
abroad to be applied to domestic production, enhancing competition and leading to
a 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 inputs
and to export markets may be critical in determining the viability of an investment
project. In such circumstances, countries with substantial barriers to trade may
attract 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) at
a 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 abbreviated
as 'AD'. The aggregate demand curve (AD) slopes downward (indicating that higher
outputs 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 capital
such 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 payments
in the form of social security benefits (pensions, job-seekers allowance etc.) are
not included as they are not a payment to a factor of production for output
produced. A substantial increase in government spending would be classified as an
expansionary 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 the
incomes 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 come
into 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 three
main ways:

Real money balances effect

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

Prices and interest rates

A lower price level increases the real interest rate - there will be pressure on the monetary
authorities to cut nominal interest rates as the price level falls. Lower nominal interest
rates 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 goods
and services will become more competitive. A rise in exports adds to aggregate demand
and therefore boosts national output.

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Aggregate Supply
Aggregate Supply (AS) measures the volume of goods and services produced within the
economy 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 meet
a higher level of AD. An increase in demand should lead to an expansion of aggregate
supply in the economy.

Short-run aggregate supply curve

Aggregate supply is determined by the supply side performance of the economy. It reflects
the 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 at
each price level might have been caused by improvements in technology and productivity
or 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. This
might 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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