Objectives for Chapter 8

At the end of the Chapter, you will be able to answer the

following:
1. What are the other players in the circular flow of
economic activity? Identify how each affects the flow
of the national income.
2. Differentiate Gross National Product (GNP) from
Gross Domestic Product (GDP).
3. What is the difference between real GDP and nominal
GDP? How do we deflate the GDP?
4. Identify the three ways of measuring the national
income and briefly explain each.
5. Define and explain the following:
a. Transfer Payment
b. Imports
c. Exports

Chapter 8
Measuring and Understanding the National
Economy

The best way to help the poor is not to be one of them.

-Mang Pandoy

Imagine yourself sick. As a non-doctor, it will be difficult for

you to know what you have to do exactly to defeat the
illness, and even if you go to the doctor, the doctor would
still have to ask you to go into a number of laboratory test
that would indicate what your illness is, such as blood

pressure rate, complete blood count, urinalysis, and so on.

We call these as health indicators. Without them, we
cannot resolve your health problem.
This is also the case in our economy, as ordinary citizens,
the problem of the economy may be so obvious and
noticeable, however, given that we know that there is a
problem, it is not that easy to identify, what is/are cause/s
of the problem, thus we cannot exactly prescribe solutions
that easily. This is the reason why it is important for us to
look for economic indicators, which can specify what our
economic problem are, and what we can do as individuals
and as a nation for us to be able to help solve the problem.
Some economic indicators are GDP and GNP growth rate,
inflation rate, unemployment rate, exchange rate, income
per capita, and so on. We will discuss most of them along
the chapter, but first let us further understand how an
economy works.

National Income Accounting

A term used in economics to refer to the bookkeeping
system that a national government uses to measure the
level of the country's economic activity in a given time
period. National income accounting records the level of
activity in accounts such as total revenues earned by
domestic
corporations,
Figure 1. The Circular Flow Diagram With
wages paid to
the Government, Financial and
International Sectors.
foreign
and
domestic
workers,
and
the
amount
spent on sales
and
income
taxes
by
corporations
and individuals
residing in the
country.
National
income

accounting provides economists and statisticians with

detailed information that can be used to track the health of
an economy and to forecast future growth and
development. Although national income accounting is not
an exact science, it provides useful insight into how well an
economy is functioning, and where monies are being
generated and spent.
The New Circular Flow Diagram
The circular flow model that we used in an earlier chapter
simplifies the economy into two players only, the buyers
and the sellers. However, that view is very limited precisely
because it is unrealistic to assume that every peso of
income earned is consumed on goods and services.
The simple circular flow diagram also, does not consider
the important transactions that happen between the
government and the rest of the world with the local
households and firms. We will particularly give attention to
those other sectors in Figure 1 which shows a more
detailed illustration of how the economy operates.
The Financial Sector
In the simple circular flow model, we assumed that all of
the income earned was spent on consumer goods. This is
not likely to be the case.
Although Americans are
notorious for saving very little, we do indeed save. So, let
us consider this change that makes our circular flow model
more realistic.
Examine the circular flow model below. Again, let us start
with the households. The 200 workers provide their labor to
businesses.
Each worker receives a wage of 1000.
Therefore, workers receive 200,000 in income (200 x
1000), called the National Income. They receive this
income because they produced 10,000 units of product A.
What do these people do with their income? In this case,
let us assume that they spend 180,000 of it, buying 9,000
units of product A at 20 each. The other 20,000 is
saved.

As you saw, there are many forms of saving. Let us

assume here that all of the savings are placed in a financial
institution (such as a bank or credit union), perhaps in a
savings account. What does the financial institution do
with the savings? The answer is that they lend it out.
(Financial institutions are indeed interesting institutions.
After all, you put your money into the financial institution.
They lend it out. However, it is still there.) Some of the
lending of the financial institutions will be to other
households to spend on consumer goods. So your savings
may be loaned to me to buy my new car. But some of the
lending is to a private business for business investment
spending.
As you know, business investment spending means that
private businesses are buying capital goods. Capital goods
include machines, tools, buildings, and so forth. Many of
these capital goods are too expensive to be paid-for out of
current earnings. So the businesses borrow from the
financial institutions and use the increased earnings
resulting from the new capital goods to pay off the loans.
In the circular flow model above, it is assumed that the
private businesses borrow the 20,000 that the households
chose to save. They use this money to buy the other 1,000
units of product A at the price of 20 each (remember that
we assumed that there is only one product produced). The

total spending by both groups of spenders (called

aggregate demand) is now 200,000. This is composed of
180,000 of consumption and 20,000 of business
investment spending. This exactly equals the Potential
Real GDP of 200,000.
People are buying everything that can be produced. We
are at full employment. However, it may be that the
businesses do not borrow the exact amount that savers
wish to save. The acts of saving and of buying capital
goods are done by different people for different reasons.
Therefore, it is very possible that they will not be equal.
Let us see what happens if they are not equal.
The Government or the Public Sector
Now examine the circular flow model below. Again, let us
start with the households. The 200 workers provide their
labor to businesses. Each worker receives a wage of
1000. Therefore, workers receive 200,000 in income
(200 x 1000), called the National Income. They receive
this income because they produced 10,000 units of product
A. However, of this income, let us say that 60,000 of it
goes to the government as taxes and does not get to the
households. Of the 60,000 that the government taxes,
however, 20,000 will come back as transfers.
Transfers means that the
government takes income from
some households and transfers it
to other households, who may
spend or save it. The government
does not spend this money itself.
The largest transfer for the
government is for Social Security.
Here, income is transferred from
taxpayers to those
retired
or
disabled.
Other
transfers
are
welfare,
scholarships, and
so forth.
If the households
earn
200,000,

Transfer payments
are transactions
wherein one party is
not obliged to
deliver a good or
service in return for
the payment.
Examples:
retirement benefits,
unemployment

have 60,000 taken away as taxes, but have 20,000 of

this returned as transfers, the households will receive
160,000. This is called their disposable income. So,
disposable income equals National Income minus Taxes
plus Transfers. Households may dispose of this disposable
income in two ways: they may spend it or save it. Assume
that they choose to save 20,000 of their disposable
income and to spend the remaining 140,000.
Follow the circular flow model below. The savings are
placed in a financial institution. Assume for now that
businesses desire to borrow the 20,000 for business
investment spending. Total spending (aggregate demand)
is 160,000 --- 140,000 from consumers and 20,000
from business investment spending. Where is the other
40,000? The answer is that the government has it. This
is the tax money that has not been sent back to a
household as a transfer. What does the government do
with this money? The answer is that the government
spends the money on government purchases.
Assume the government spends the entire 40,000. Total
spending (aggregate demand) is now composed of the
spending of three groups --- consumers, business
investment
spending,
and
government
purchases.
Together, these add to 200,000 (140,000 from the
consumers, 20,000 on business investment spending, and
40,000 on government purchases). Since Potential Real
GDP is 200,000, total spending is just right. All 10,000
units of product A will be bought. All 200 workers will be
employed.
The International Sector or the Rest of the World
(ROTW)
The circular flow model below brings in the rest of the
world. With this addition, the model is now complete. It
describes many important factors that affect the Philippine
economy and shows the relation between them.
We have seen that our goal is to have total spending be
just right (that is, equal to Potential Real GDP). Of the
national income, there were two reasons that households
might not spend all of their income. First, they might save

some of their income. Second, they pay taxes on their

income. In order for total spending (aggregate demand) to
be just right, the amount of their incomes that
households do not spend must be spent by others. These
others include private businesses (for business investment
spending)
and
the government
(for
government
purchases). Bringing the rest of the world into the model
does not change this thinking. All it does is add another
reason households might not spend all of their income and
an additional spender. The other reason that households
might not spend all of their income is imports. Remember
that Real GDP is the value (in 1996 pesos) of all goods and
services produced in the United States in a year. Importing
goods or services involves spending that does not come
back to American businesses. On the other hand, the
additional spending is from exports. Foreigners may also
buy goods and services produced in the United States.
Examine the circular
flow model below.
Again, start with the
households. The 200
workers
provide
their
labor
to
businesses.
Each
worker receives a
wage
of
1000.
Therefore, workers
receive 200,000 in
income
(2000
x
1000), called the
National
Income.
They receive this
income
because
they produced 10,000 units of Product A. However, of this
income, let us say that 60,000 of it goes to the
government as taxes and does not get to the households.
Of the 60,000 that the government taxes, however,
20,000 will come back as transfers. The government has
the other 40,000. Of the 160,000 that households have
after paying their taxes, assume that they choose to save
20,000 in financial institutions.
Also, assume that
10,000 of their spending goes out of the country as
imports. This means that households spend $130,000
buying goods and services produced in the Philippines.

This is consumption. Assume that businesses borrow the

20,000 of saving and spend it on business investment
spending. Assume also that the government spends the
40,000 it has after collecting the taxes and paying out the
transfers. And finally, assume that foreigners spend all
10,000 that they received from imports buying goods and
services produced in the Philippines (exports).
How much total spending (aggregate demand) is there?
The answer is 200,000 (130,000 by consumers, 20,000
by businesses, 40,000 by the government, and 10,000
by foreigners). Total spending (aggregate demand) is just
right. By now you should be able to explain what will
result if the amount people wish to save plus the amount
they pay in taxes (net of transfers) plus the amount they
spend on imports is greater than (or less than) the amount
of business investment spending plus the amount of
government purchases plus the amount of exports.
Let us summarize. Total spending (aggregate demand) is
now broken into four groups of spenders: consumers,
businesses (for business investment spending), the
government, and foreigners (net exports = exports minus
imports). If the sum of the spending of these four groups is
less than the Potential Real GDP, we could have deflation.
But it is more likely that we would have recession.
If the sum of the spending of these four groups is greater
than the Potential Real GDP, we would have inflation. Our
goal is to have the sum of the spending from each of these
groups just equal the Potential Real GDP.

Gross Domestic Product (GDP)

Macroeconomists are interested in total production in the
economy, so it is essential that we create a measure of
total output. This measure is called GDP. GDP is the total
market value of all final goods and services produced in a
country in a given year. Three things to note about this
definition of GDP:

Total market value. We add up the dollar value of all

the stuff produced in the United States. This is
because producing a car is way different that
producing a haircut or a can of soup, but by
converting everything to its dollar value we have a
uniform measure.

Final goods and services. We only count final

products ready to be consumed, NOT products used
to make other products. So a car will be counted in
the GDP but the steel used to make the car is not
counted separately. Why? Because the value of the
car already reflects the value of the steel, rubber,
plastic,etc. that goes into it.

Produced in a country. The Philippines GDP counts

only those goods and services produced in the
physical borders of the Philippines. So Toshiba made
in Laguna are counted, even though Toyota is a
Japanese company.

Example. Suppose our imaginary economy produces 3

goods: apples, computers, pizza. The table below shows
production and prices for 2012:
year

2012

apples
price quant
ity
5
500

computers
price quant
ity
10,0
100
00

pizza
price quant
ity
90
400

To calculate GDP, we simple multiply the price and quantity

of each good to get the dollar value, and then add up all
three values:
GDP =
of pizza

value of apples + value of computers + value

GDP =
2500 +

(5)(500) + (10,000)(100) + (90)(400) =

1,000,000 + 36,000 = 1,038,500

With millions of goods and services in the Philippines, the

process is a bit more complicated, but the principle is the

same.
The measurement of GDP and its components is known as
national income accounting. The Philippines National
Statistic Coordination Board is in charge of measuring U.S.
GDP and measures it quarterly, or 4 times per year.
Nominal GDP vs. Real GDP
In measuring GDP, we use prices to measure the value of
goods and services produced. Using the current prices to
value current production is known as nominal GDP. The
problem with nominal GDP is that a change in nominal GDP
can be due to either (1) a change in the production of
goods and services, or (2) a change in the prices of those
goods and services. So an increase in prices will cause
nominal GDP to rise, even if production has not changed at
all. This gives a misleading picture of how well our
economy is doing. It also makes it difficult to compare
production from year to year, since prices change every
year.
To address the price problem, we also construct a measure
of GDP that takes price changes into account. Real
GDP values goods and services in any given year by using
the prices of a set base period. By holding prices constant,
real GDP measures only the changes in production from
year to year. Changes in real GDP are used to measure
economic growth.
Example. Lets continue our example above. The table
below has the prices and production of apples, computers
and pizza for three years:
year

2010

apples
price quant
ity
4.50
475

2011

4.80

510

2012

500

computers
price quant
ity
11,0
70
00
10,5
85
00
10,0
100
00

pizza
price quant
ity
70
380
80

390

90

400

First, let's calcuate nominal GDP for each year. This means
we take the price for that year times the quantity for that
year.
nominal GDP 2010
(70)(380)

(4.5)(475) + (11000)(70) +
=
798,737.50

nominal GDP 2011

(80)(390)

(4.8)(510) + (10500)(85) +
=
926,148.00

nominal GDP 2012

(90)(400)
=

(5)(500) + (10,000)(100) +

1,038,500.00

From 2010 to 2012 nominal GDP has increased by

1,035,800
798,737.50
798,737.50
but this increase includes changes in BOTH price and
production.
Now let's calculate real GDP, using 1998 as the base year.
This means for each year we will value output using 1998
prices.
real GDP 2010
(80)(380)

(4.8)(475) + (10,500)(70) +
=
767,860.00

real GDP 2011

(80)(390)

(4.8)(510) + (10,500)(85) +
=
926,148.00

real GDP 2012

(80)(400)

(4.8)(500) + (10,500)(100) +

1,084,400.00

From 2010 to 2012 real GDP has increased by

1,084,400
767,860

767,860

but this increase includes ONLY changes in production,

because prices are held constant at their 2011 levels. Note
how the real GDP increase is greater. This is because in
calculating nominal GDP, computer prices are falling over

time even though computer production is increasing.

Note that real GDP = nominal GDP in the base year, since
both measures use the same prices and same production.
When the Philippines National Statistics Coordination
Board calculates real GDP they use an average of prices in
previous years, not just the prices of a single year. This is
known as a chain-weighted price adjustment.
The Philippine Economy as of the 4th quarter of 2012
With the robust growth of the Services sector led by Trade
and Real Estate, Renting & Business Activities, accentuated
by the sturdy performances of Manufacturing and
Construction, the countrys Gross Domestic Product (GDP)
grew by 6.8 percent in the fourth quarter of 2012, paving
the way for the annual GDP to post a broad-based growth
of 6.6 percent.
On the demand side, Household Final Consumption
Expenditure (HFCE) together with government spending,
the recovery of capital formation and the remarkable
performance of our external trade contributed to the
healthy growth of the economy in the fourth quarter and
the year 2012.
Table 1. Growth Rates of Gross National Income and Gross
Domestic Product
by Industrial Origin
4th Quarter 2011 and 2012 and Annual 2011-2012
(at constant 2000 prices)
4th Quarter Annual
INDUSTRY

2010 2011- 2010- 2011-11

12
11
12

1. AGRI., HUNTING, FORESTRY AND

-2.5
FISHING

4.7

2.7

2.7

a. Agriculture and forestry

-2.0

5.1

4.5

3.5

b. Fishing

-4.8

3.3

-4.1

-0.7

3.4

7.5

2.3

6.5

a. Mining & Quarrying

-16.3

9.6

7.0

-3.7

b. Manufacturing

3.3

5.6

4.7

5.4

c. Construction

8.1

18.4

-7.3

14.4

2. INDUSTRY SECTOR

d. Electricity, Gas and Water Supply

2.9

3.7

0.6

5.1

5.9

6.9

5.1

7.4

4.1

8.1

4.3

9.1

b. Trade and Repair of Motor Vehicles,

Motorcycles, Personal and Household 3.4
Goods

6.4

3.3

7.5

7.2

5.2

7.8

d. R. Estate, Renting & Business

13.6
Activities

7.7

9.3

7.9

e. Public Administration & Defense;

Compulsory
5.2
Social Security

6.1

0.3

3.3

7.5

6.0

6.6

7.2

4.0

6.8

3.9

6.6

GROSS NATIONAL INCOME

4.5
Source: National Statistical Coordination Board

5.4

3.2

5.8

3. SERVICE SECTOR
a.
Transport,
Communication

Storage

&

c. Financial Intermediation

f. Other Services
GROSS DOMESTIC PRODUCT

1.5

Table 2. Growth Rates of Gross National Income and Gross

Domestic Product
by Expenditure Shares
4th Quarter 2011 and 2012 and Annual 2011-2012
(at constant 2000 prices)
4th Quarter Annual
TYPE OF EXPENDITURE
1. Household
Expenditure

Final

2010 2011 2010- 2011-11

-12
11
12
Consumption

6.4

6.9

6.3

6.1

2. Government Final Consumption

7.6
Expenditure

9.1

1.0

11.8

3. Capital Formation*

-3.8

-1.4

8.1

-4.4

-2.4

10.6

0.2

8.7

1. Construction

3.9

19.1

-6.2

13.7

2. Durable Equipment

-7.9

4.5

5.2

5.7

3. Breeding Stock & Orchard Dev't

-2.0

0.9

-0.3

1.4

4. Intellectual Property Products

11.7

26.4

11.8

16.9

-8.2

9.1

-4.2

8.7

A. Fixed Capital

4. Exports
A. Exports of Goods

-13.0 10.2

-6.0

8.4

B. Exports of Services

13.4

5.5

4.0

9.8

-6.2

4.6

0.2

4.2

5. Less : Imports

A. Imports of Goods

-10.1 3.1

0.4

2.6

B. Imports of Services

8.9

9.5

-0.7

11.1

GROSS DOMESTIC PRODUCT

4.0

6.8

3.9

6.6

GROSS NATIONAL INCOME

4.5

5.4

3.2

5.8

* Capital formation includes fixed capital and changes in inventories

Source: National Statistical Coordination Board

Measuring GDP: The Expenditure Approach

So how does the U.S. government go about measuring
such a huge quantity? One approach is to add up
expenditures on goods and services in each sector of the
economy:

Consumption (C). This accounts for about 2/3 of GDP.

Investment (I). Plants, equipment and inventory of

businesses. This is one of the most volatile
components of GDP.

Government Spending (G): national, and local

government purchases of goods and services are
counted here. This does NOT count transfer
payments, such as welfare, since this just transfers
income and does not represent production of goods
and services.

Net Exports (X - IM). Net exports is exports minus

imports. So we add in those goods and services
produced in the Philippines and sold abroad but we
substract the good and services purchased by
consumers, businesses, and governments that were
not made in the Philippines. Since the 1970s, the
Philippines has imported more than it has exported,
so net exports are negative.

Putting all of the expenditures together we have the

identity.
GDP = C + I + G + X IM
Measuring GDP: The Income Approach

The second approach to measuring GDP is to look at

income instead of expenditures. If someone bought it, then
someone is being paid to make it. The income components
include:

Wages and salaries

Corporate profits, Proprietors income (the profits of

partnerships and solely owned businesses, like a
family restaurant)

Farm income

Rent, Interest, Sales taxes

Depreciation (the amount of capital that has worn

out during the year)

Tables 1 and 2 show the relationship between the income

and expenditure approaches. The expenditure and income
approaches should, in theory, give us the same answer. In
reality they are slightly different due to some measurement
error. But spending and income are related in a circular
flow: spending by someone becomes income for someone
else.
For example, when my family goes out to eat, the meal we
purchase represents income for the waiter, the restaurant
owner, the suppliers, and the sales tax on the meal is
income for the government. So to calculate GDP we can
either add up expenditures or add up income.
Measuring GDP: Value Added Approach
Disaggregate GDP by which industry produced the value
added associated with output. The value added is the
value of the firms output minus the value of its purchases
from other firms.
Too complex in practice. Suppose that rice is the only final
product of an economy: It goes through several (3) stages
of production.

Stage of Production

Value of
intermediate
good

Farmer - Palay

Value of
Sales

Value-added

12,000

12,000

Rice Miller -Milled

Rice

12,000

15,000

3,000

Retailers - Rice

15,000

20,000

5,000

GDP= Total Value

Added

20,000

What does GDP NOT measure?

So GDP is an important measure of the economic power
and health of a nation. But GDP does not tell the whole
story in terms of the well-being of a nation. Here are a few
things GDP leaves out:

Other social indicators. These include crime,

illiteracy, life expectancy, infant mortality. Although
these things are related to GDP, the connection is not
perfect: The U.S. has a larger GDP per capita than
Canada or Japan, but also has a higher rate of crime,
illiteracy, and infant mortality. The Philippines has a
higher GDP compared to Cambodia and Vietnam, yet
our poverty rate is much higher than these two other
nations.

Equity. A large GDP per capita does not mean that

the wealth of a nation is shared equally. In some
nations, the GDP is distributed for the most part
among a small elite class, leaving the rest of the
nation in poverty.

Environmental issues. A high rate of production

may have disastrous environmental consequences.
Brazil may increase its GDP by cutting down rain
forests for the timber, but very few of us would say
that is a good thing.

The underground economy. The GDP actually

measured will fail to capture any goods and services
that are not reported to the government. These
include illegal activities, like
marijuana
cultivation, Three Ways of
cocaine
sales,
and
tax Measuring the
National Economy:
evasion, such as underreporting tip income, or cash- Expenditure Approach
paid
babysitting.
The (upper loop) measures
underground
economy
is GDP as the sum of
estimated to be as large as expenditures on final
13% of the measured GDP in goods and services.
the
Philippines).
The
underground
economy
in Income Approach (lower
Mexico is relatively larger loop) measures GDP as
due to drug smuggling. the sum of incomes of
factors of production
Canada's
underground
(wages, rent, interest
economy is estimated to be
and profit.
as high as 20% due to the
higher taxes there. U.S.s Value-added Approach
estimated
underground measures GDP as the
economy is 10% of their GDP.
sum of value added at

Nonmarket work. This includes transactions for

which people are not paid. When I do my family's
laundry, which is not counted in GDP. But if I paid
someone to do my laundry, it would count in GDP.
The exclusion of homemaking really understates the
services produced in the United States.

So while GDP is a crucial measure of the size and health of

an economy, keep in mind it is not the ONLY measure of
well-being.
GDP vs. Gross National Product (GNP)
Up until 1992, the Philippines used GNP as the measure of
total output. In 1992, GDP was adopted since it is easier to
calculate and it facilitates international comparisons (most
countries use GDP).

For GDP the last part of the definition changes. Within

the Philippines is replaced with by Filipino citizens and
firms (whether at home or abroad).

Summary

Business cycle is the alternating increases and

decreases in the level of business activity of varying
amplitude and length

The decline that sets in after the peak is called a

recession, which ends with a trough. Recovery
begins with the trough, but the expansion must
eventually reach the level of the previous peak.
Once a recovery definitely has set in, real GDP
moves upward until it passes the level of the
previous peak. When it enters the third phase of the
business cycle: prosperity. Prosperity is the second
part of economic expansion. Sooner or later we
reach the peak and the process starts over again
recession, recovery, and prosperity.
Generally, we consider inflation as a regular
economic phenomenon where there is a sustained
increase in the general price level of goods and
services. It is an ongoing process.

There are two generally accepted causes of

inflation. These are demand-pull inflation and cost
push inflation.

Demand-pull inflation is often summed up as too

much money chasing too few goods. Cost-Push
Inflation

There are three variants of cost-push inflation. Most

prominent is the wage-price spiral. The second
variant of cost-push inflation is the profit-push
inflation. Finally we have the supply-side cost
shocks inflation.

Questions for Review and Application

1. Why is high inflation rate bad for the economy?

2. Right now, our economy is going through what phase
in the business cycle? How do you know this?

3. Being unemployed means different things to different

people. Illustrate this by making up examples of
three different unemployed people.
4. Mang Pandoy is laid off from work. How does he
make ends meet until he finds another job?