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Q# 1 a.

Define the following terms: i) Gross National Product (GNP) ii) Gross Domestic Product (GDP) iii) Net Domestic Product (NDP) iv) National Income (NI) v) Personal Income (PI) vi) Disposable Personal Income (DPI) b. Distinguish between GNP and GDP. C. Show how calculate from GDP to Disposable Personal Income (DPI) with an example. 1. Gross Domestic Product Gross domestic product (GDP) is the market value of all final goods and services domestically-produced over a given period of time (usually one year) 2. Gross National Product Gross national product (GNP) is the market value of all final goods and services produced by domestically-owned factors of production over a given period of time (usually one year) 3. Net Domestic Product - NDP Net Domestic Product - NDP is an annual measure of the economic output of a nation that is adjusted to account for depreciation, calculated by subtracting depreciation from the gross domestic product (GDP). NDP is GDP minus depreciation of the capital worn out in producing output 4. National Income NI is the total earned by resource owners, including wages, rents, interest, and profits 5. Personal Income PI is the total income received by households that is available for consumption, saving, and payment of personal taxes 6. Disposable Personal Income DPI is the amount of income that households have to spend or save after payment of personal taxes

Difference between GNP and GDP


GNP or gross national product and GDP or gross domestic product are both measures of economic development. When you calculate the estimated value that defines the worth of any countrys services provided and production carried out over a whole year, then you refer to it as that countrys GDP. On the other hand, GNP refers to the GDP added to the total amount of capital gain from all investments made abroad with the amount of income that has been earned by foreign nationals in that country subtracted from the total. Meanwhile, the formula to calculate GDP is addition of consumption, investment, government spending, exports with imports subtracted from the total. Both terms are used in the sectors of finance, business and forecasting of economic trends. But while, GDP captures an image of the domestic economic strength of a country, GNP captures an image of how the nationals of a particular country are faring financially. GNP ignores the production area but focuses totally on the nationals of a particular country and businesses and industries owned by them irrespective of where they are located.

Further, GDP is also taken into account on the basis of the current prices in the period being studied. It includes three variants which are: 1. Nominal GDP: is the production of services and goods that are valued at the current price prevalent in the market. 2. Real GDP: is the production of goods and services that are valued at constant prices and are not affected by market fluctuations. This calculation helps economists to figure out if production in a country has improved or not without any reference to how the purchasing power of the countrys currency has changed. In countries where there is very high foreign investment, the GDP is always much higher than the GNP. This is the reason the difference between the two is very trivial when it comes to America. But, is extremely high when it comes to countries like Saudi Arabia.

Topic
Stands for: Definition:

GDP
Gross Domestic Product An estimated value of the total worth of a countrys production and services, within its boundary, by its nationals and foreigners, calculated over the course on one year. GDP = consumption + investment + (government spending) + (exports imports).

GNP
Gross National Product An estimated value of the total worth of production and services, by citizens of a country, on its land or on foreign land, calculated over the course on one year. GNP = GDP + NR (Net income inflow from assets abroad or Net Income Receipts) - NP (Net payment outflow to foreign assets). Business, Economic Forecasting. To see how the nationals of a country are doing economically.

Formula for Calculation:

Uses: Application (Context in which these terms are used): Layman Usage:

Business, Economic Forecasting. To see the strength of a countrys local economy.

Total value of products & Services produced within the territorial boundary of a country. GDP focuses on domestic production.

Focus

Total value of Goods and Services produced by all nationals of a country (whether within or outside the country). GNP however focuses on the production by nationals.

From GDP to Disposable Personal Income


Measuring National Output and National... An important distinction is the difference between gross national product (GNP) and GDP. Many people grew up with GNP as the primary measure of the output of the economy. Now, however, GDP is more commonly used. Let us take a brief look at the difference. Conceptually, GNP measures the output of all domestically owned factors of production, while GDP measures the output of factors of production located within the domestic economy. How do these differences translate into the real world? Consider, for example, a Honda automobile assembled in Tennessee. If the car is sold in the United States, it will be counted in GDP because the factory is located within the United States. It would not be counted in GNP, however, because a foreign company owns the factory. Conversely, consider a Chevrolet factory located in Mexico. Because it

is owned by a United States corporation, the value of the cars produced there would be counted in GNP. Since the cars are not produced within the United States, the value of these cars would not be included in GDP. REALITY CHECK: To get a firmer grasp of the idea, think of a country like Saudi Arabia. Which is larger, GNP or GDP? On the one hand, there are many foreign workers employed in Saudi Arabia. The output of these foreign workers is part of Saudi GDP, but not GNP. On the other hand, Saudi Arabians own businesses, real estate, and other assets in other countries. The income derived from these assets is included in Saudi GNP, but not GDP, because the production takes place abroad. In theory, either answer could be correct, but in fact, Saudi earnings from foreign assets are so large that they dominate the foreign worker effect. Saudi Arabias GNP is significantly larger than its GDP. The concept of GNP leads directly to the economic measure of national income, discussed above, and to the measures of per-capita income, such as personal income and disposable personal income. The following table shows the path from GDP to the other measures of economic output:

We start with GDP and add receipts of factor income from the rest of the world, then subtract payments of factor income to the rest of the world. That gives us GNP. We then subtract depreciation and have net national product, or NNP. NNP less indirect taxes minus subsidies (note, thats the difference between indirect taxes and subsidies) and plus other gives us national income. National income was all the income earned; personal income is the income received. So to get from national income to personal income, we subtract all the income that was earned but not received: corporate profits minus dividends, and social insurance payments. Then we add the income that was received but not earned: personal interest income and transfer payments. REALITY CHECK: If you work, you should be familiar with the idea that you dont take home all of the money you earned. Even if we dont consider income taxes, there are still those FICA deductions that represent payments into Social Security, etc. Thats what is meant by social insurance payments in the table above. Finally, we subtract personal taxes and we have disposable personal income, the income that households can either spend or save.

Q# 2 a. Explain the value added method of GDP measurement. b. What is the expenditure approach of GDP measurement? Explain the expenditure components of GDP. c. What is the income approach of GDP? Explain the income components of GDP. GDP is the nations expenditures on all FINAL goods and services produced during the year at market prices. Here, two things have to Avoid when compiling GDP a) Multiple counting Only expenditures on final products what consumers, businesses, and government units buy for their own use belong in GDP Intermediate goods are not counted Used goods are not counted b) Transfer payments Transfer payments are not payments for currently produced goods and services When they are spent for final goods and services they will go into GDP as consumer spending Financial transactions dont go into GDP Why only Final Goods Counting the sale of final goods and intermediate products would result in double and triple counting. Confusing! The tires that come with the car is not counted as a final good However if you get a flat and buy the same tire it is counted as a final good

------ To correct these problems economist have created the Value Added approach.
Production (Valued-added) approach Measures the total market value of all final goods and services It is difficult to distinguish between intermediate goods and final goods. To avoid double counting, valued-added method is used. GDP= sum of value-added of RPUs 1. Farmers value-added = $2 (Wheat) 0 (Cost) = $2 2. Flour-making factory = $3.5 (Flour) - $2 (Wheat) = $1.5 3. Bakery Shop = $6 (Bread) - $3.5 (Flour) = $2.5 Example: The small economy of Pizzania produces three goods (bread, cheese, and pizza), each produced by a separate company. The bread and cheese companies do not buy inputs. The pizza company uses the bread and cheese from the other companies to produce pizza. All three companies use capital and labor to produce output, and the dierence between the value of the goods sold and total costs is rm prot.

There are three official methods to measure GDP 1. Output Method 2. Income Method 3. Expenditure Method - Output of goods and services leads to income for those who are producing, as well as expenditure for those who are consuming the items. Hence, the value of GDP measured by any of the three methods is exactly the same. (However, this is not always the case due to discrepancies, errors and omissions in counting)

Expenditures Approach to Calculating GDP

In this approach GDP is calculated as the sum of four categories of expenditures on output. These are: Gross Private Consumption Expenditures(C) Gross Private Investment (I) Government Purchases (G) Net Exports (X - M) GDP = C + I + G + (X- M) Or GDP = C + I + G +NX C = Private consumption expenditure I = Investment Expenditure G= Government Consumption Expenditure X = Value of Exports M = Value of Imports

Private Consumption Expenditures (C): This consists of all goods and service purchased by households. This is broken down even farther into services, nondurable goods, and durable goods.

As interest rates increase, people begin to save more and consume less in relation to their spending/saving habits with lower interest rates, so C decreases. When taxes go down, people tend to have more income, so C increases. When income increases, C increases.

This is the largest category and accounts for about two-thirds of the GDP

Investment (I): Total Investment (I) = Fixed Investment + Inventory Investment + Residential Investment Eventually all capital begins to wear out because of use or may even become technologically obsolete. This process is called depreciation which is the decrease in the capital's value. Net private investment is gross private investment minus depreciation. Net private investment is important because it gives economists a clue to a possible increase to a certain capacity that a country can produce. There are two types of investment: fixed investment and inventory investment. Fixed investment is the purchase of capital goods such as robots, machines, and factories. Raw materials (intermediate goods) are NOT included in investment. Inventory Investment is the change in inventories such as goods awaiting sale on store shelves, or raw materials which have yet to be assembled into final form or sold.

Positive inventory means that inventory is rising, while negative inventory means that inventory is falling. Residential Investment is the purchase of new residential homes by the household sector. Government Purchases (G): This accounts for the total expenditures on new goods and services by the local, state, and federal government. Transfer payments are not included in government purchases, but rather find their way to consumption or investment. These payments include the spending of the government on welfare projects. These are programs and benefits that are awarded to individuals who do not need to work for it. Net Exports (NX = X - M): The value of a country's total exports minus its total imports X = foreign country's spending on the country's goods M = Country's spending on foreign goods If (X - M) is positive, then X > M resulting in a trade surplus If (X - M) is negative, then X < M resulting in a trade deficit If (X - M) is zero, then X=M results in a trade balance

GDP and NDP Net Domestic Product (NDP) is GDP minus depreciation. Since depreciation is sometimes hard to account for, GDP is often used when calculating national income. NDP = GDP - total capital depreciation

Examples of Calculating GDP Here, we will show you the two different ways of calculating GDP using the information from different factors given in Table 1. Using the Expenditures Approach Table 1: Expenditures Transfer Payments Interest Income Depreciation Wages Business Profits Indirect Business Taxes Rental Income Net Exports (X-M) Net Foreign Factor Income $54 $150 $36 $67 $200 $74 $75 $18 $12

Gross Private Investment (I) $124

Government Purchases (G) $156 Household Consumption (C) $304

By using the data in Table 1 we can calculate the GDP using the expenditures approach. As you can see, the table contains more data than is necessary so you have to look for the parts which make up the expenditures approach to calculating GDP. The necessary data is highlighted within the table. Remember: GDP = C + G + I + (X - M) In this case the C is represented by Household Consumption which is $304. The G refers to Government Spending which is $156. I is gross private investment and is $124. (X - M) is the net exports and in the table is shown to be $18. Therefore: GDP = $304 + $156 + $124 + $18 GDP = $602

Income Approach to Calculating GDP

This approach calculates National Income, NI. NI is the sum of the following components: Labor Income (W) Rental Income (R) Interest Income (i) Profits (PR) NI = W + R + i + PR Labor Income (W): Salaries, wages, and fringe benefits such as health or retirement. This also includes unemployment insurance and government taxes for Social Security. Rental Income (R): This is income received from property received by households. Royalties from patents, copyrights and assets as well as imputed rent are included. Interest Income (i): Income received by households through the lending of their money to corporations and business firms. Government and household interest payments are not included in the national income. Profits (PR): The amount firms have left after paying their rent, interest on debt, and employee compensation. GDP calculation involves accounting profit and not economic profit.

Examples of Calculating GDP Using the Income Approach Table 1 also contains the data necessary to calculate GDP using the income approach. Table 1: Income Transfer Payments Interest Income (i) Depreciation Wages (W) Gross Private Investment Business Profits (PR) Indirect Business Taxes Rental Income (R) Net Exports Government Purchases Household Consumption $54 $150 $36 $67 $124 $200 $74 $75 $18 $156 $304

Net Foreign Factor Income $12

In this case we use the formula: NI = W + R + i + PR W is the wages that are represented by $67 in the table. Rental income is the R and is $75. Interest income is i and is $150. PR are business profits and are $200. Therefore: NI = $67 + $75 + $150 + $200 NI = $492 GDP = NI + Indirect Business Taxes + Depreciation GDP = $492 + $74 + $36 GDP = $602

As you can see, in this case, both approaches to calculating GDP will give the same estimate. This is not always what happens and sometimes GDP will differ slightly when the different approaches are used.

Q# 3 a. What is circular flow model? Illustrate the circular model of an open economy. b. Compare the expenditure and income approach of GDP measurement. The Circular Flow Model Every economy is a dynamic system. The economy is ''moving'', constantly operating. The economy has a ''velocity''; households are consuming, firms are producing - we're moving towards the future. But like a rider on a bicycle, our economy gets the ''wobbles'' from time to time. Our economy is constantly changing, and reacting to change. And some of this changes include unemployment and inflation; problems that are difficult to solve. To begin to understand how we can improve our economy, we must analyse the components and flows that make up the economy. Economists have developed a model of how an economy works: the Circular Flow Model. In economics, the terms circular flow of income or circular flow refer 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. More complete and realistic circular flow models are more complex. They would explicitly include the roles of government and financial markets, along with imports and exports.

Two Sector Model Simply put, 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 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 labour, 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.

Three Sector Model It includes household sector, producing sector and government sector. It will study a circular flow income in these sectors excluding rest of the world i.e. closed economy income. Here flows from household sector and producing sector to government sector are in the form of taxes. The income received from the government sector flows to producing and household sector in the form of payments for government purchases of goods and services as well as payment of subsides and transfer payments. Every payment has a receipt in response of it by which aggregate expenditure of an economy becomes identical to aggregate income and makes this circular flow unending. Four Sector Model A modern monetary economy comprises a network of four sector economy these are1.Household sector 2.Firms or Producing sector 3.Government sector 4.Rest of the world sector. Each of the above sectors receives some payments from the other in lieu of goods and services which makes a regular flow of goods and physical services. Money facilitates such an exchange smoothly. A residual of each market comes in capital market as saving which inturn is invested in firms and government sector. Technically speaking, so long as lending is equal to the borrowing i.e. leakage is equal to injections, the circular flow will continue indefinitely. However this job is done by financial institutions in the economy.

Circular Flow of Income in a Four Sector Economy Take the inflows and outflows of the household, business and government sectors in relation to the foreign sector. The household sector buys goods imported from overseas and makes payment for them which is leakage from the circular flow. The households may receive transfer payments from the foreign sector for the services rendered by them in foreign countries. Conversely, the business sector exports goods to foreign countries and its receipts are an injection in the circular flow. Likewise, there are many services rendered by business firms to foreign countries such as shipping, insurance, banking etc. for which they receive payments from overseas. These are the leakages from the circular flow. Like the business sector modern governments also export and import goods and services and lend to and borrow from foreign countries. For all the exports of goods, the government receives payments from abroad. Similarly, the government receives payments from foreigners when they visit the country as tourists and for receiving education etc. and also when the government provides shipping, insurance and banking services to foreigners through the state owned agencies. It also receives royalties, interest, dividends etc. for investments made abroad. These are injections into the circular flow. Conversely, the leakages are payments made for the purchase of goods and services to foreigners. In the in the below diagram, the circular flow of the four sector open economy with saving, taxes and imports shown as leakages from the circular flow on the right hand side of the diagram and investment, government purchases and exports as injections into the circular flow on the left side of the figure. Further, imports, exports and transfer payments have been shown to arise from the three domestic sectors the household, the business and the government. These outflows and inflows pass through the foreign sector which is also called the balance of payments sector.

If exports exceed imports, the economy has a surplus in the balance of payments. And if imports exceed exports, it has a deficit in the balance payments. But in the long run, exports of an economy must balance its imports. This is achieved by the foreign trade policies adopted by the economy. The whole analysis can be shown in simple equations: Y = C+I+G Equation (1)

Where Y represents the production of goods and services, C for consumption expenditure, I for investment level in the economy and G for Government expenditure respectively. Now we introduce taxation in the model to equate the government expenditure. Therefore Y = C + S + T Where S is saving T is taxation. By equating (1) and (2), we get, C + I + G = C + S + T Therefore, I + G = S+T .Equation (2)

With the introduction of foreign sector, we divide investment into domestic investment (Id) and foreign investment (If) and get Id + If + G = S + T But If = X M, where X is exports and M is imports. Id + (X M) + G = S + T Id + (X M) = S + (T G) The equation shows the equilibrium condition in the circular flow of income and expenditure.

Compare the expenditure and income approach of GDP measurement.


GDP is generally understood to represent the health of a nations economy, and most people realize that if GDP is growing, things are going well, while if its falling things have turned sour in the economy. There are two ways of measuring GDP, the expenditure approach and the income approach. The income approach: measures the total incomes earned by households in a nation in a year. The expenditure approach: measures the total amount spent on the goods produced by a country in a year. Measuring GDP: the expenditure and income approaches : There are two ways of measuring GDP, the expenditure approach and the income approach. The expenditure approach is to add up the market value of all domestic expenditures made on final goods and services in a single year. Final goods and services are goods and services that have been purchased for final use or goods and services that will not be resold or used in production within the year. Intermediate goods and services, which are used in the production of final goods and services, are not included in the expenditure approach to GDP because expenditures on intermediate goods and services are included in the market value of expenditures made on final goods and services. Including expenditures on both intermediate and final goods and services would lead to double counting and an exaggeration of the true market value of GDP. Total expenditure on final goods and services is broken down into four large expenditure categories, according to the type of good or service purchased. The sum total of these four expenditure categories equals GDP. These four expenditure categories are Consumption expenditures: Personal consumption expenditures on goods and services comprise the largest share of total expenditure. Consumption good expenditures include purchases of nondurable goods, such as food and clothing, and purchases of durable goods, such as appliances and automobiles. Consumption service expenditures include purchases of all kinds of personal services, including those provided by barbers, doctors, lawyers, and mechanics. 2. Investment expenditures: Investment expenditures can be divided into two categories: expenditures on fixed investment goods and inventory investment. Fixed investment goods are those that are useful over a long period of time. Expenditures on fixed investment goods include purchases of new equipment, factories, and other nonresidential housing as well as purchases of new residential housing. Also included in fixed investment expenditures is the cost of replacing existing investment goods that have become worn out or obsolete. The market value of all investment goods that must be replaced in a single year is referred to as the depreciation for that year. Inventory goods are final goods waiting to be sold that firms have on hand at the end of the year. The yeartoyear change in the market value of firms' inventory goods is considered investment expenditure because these inventory goods will eventually yield a flow of consumption or production services. 3. Government expenditures: Government expenditures on consumption and investment goods and services are treated as a separate category in the expenditure approach to GDP. Examples of government expenditures include the hiring of civil servants and military personnel and the construction of roads and public buildings. Social security, welfare, and other transfer payments are not included in government expenditures. Recipients of transfer payments do not provide any current goods or services in exchanges for these payments. Hence, government expenditures on transfer payments do not involve the purchase of any new goods or services and are therefore excluded from the calculation of government expenditures. 4. Net exports: Exports are goods and services produced domestically but sold to foreigners, while imports are goods and services produced by foreigners but sold domestically. In the expenditure approach to GDP, expenditures on exports are added to total expenditures, while expenditures on imports are subtracted from total expenditures. Alternatively, one can calculate net exports, which is defined as expenditures on exports minus expenditures on imports, and add the value of net exports to the nation's total expenditures. The income approach to measuring GDP is to add up all the income earned by households and firms in a single year. The rationale behind the income approach is that total expenditures on final goods and services are eventually received by households and firms in the form of wage, profit, rent, and interest income. Therefore, by adding together wage, profit, rent, and interest income, one should obtain the same value of GDP as is obtained using the expenditure approach. There are two types of expenditures, however, that are included in the expenditure approach to GDP measurement but do not provide households or firms with any form of income: depreciation expenditures and indirect business taxes. Depreciation expenditures, made to replace existing but deteriorated investment goods, do increase the incomes of those providing the replacement goods, but they also decrease the profit incomes of those purchasing the replacement goods. The result is that aggregate income remains unchanged. Indirect business taxes consist of sales taxes and other excise taxes that firms collect but that are not regarded as a part of firms' incomes. Consequently, indirect business taxes are not included in the expenditure approach to determining GDP; rather it is included in the income approach. The difference between the expenditure and income approaches to GDP measurement is illustrated in Figure1.

Q# 5 a. What does indicate aggregate demand (AD) and aggregate supply (AS)? b. Suppose a two sector closed economy, the consumption and investment functions are given as follows: C = 1000 + 0.80 Y and I = 2000 i. From the consumption function, find the autonomous consumption and marginal propensity consume (MPC) and interpret the MPC. ii. Find the level of equilibrium income and the value of the multiplier. iii. Find out the saving function and Marginal Propensity to Save (MPS). iv. What will be the effect on equilibrium level of income if I increase by 1000 units? v. Draw a diagram indicating the equilibrium points.

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