Economic Policy and the

Global Environment
Business eLearning

Lecturer: Rodney Sim

Email: rodney.sim@kaplan.com

Brief Introduction on the Subject

of Economics

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Understanding Our Changing World

You are studying economics at a time of
enormous change.
Much of the change is for the better - the
information age and all the benefits that it
brings.
But some of the change is for the worse terrorism, natural disasters, and recession that
have devastated many of our lives.
This economics course will help you to
understand the powerful forces that are
shaping and changing our world.

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Definition of Economics
All economic questions arise because we want
more than we can get.
Our inability to satisfy all our wants is called
scarcity.
Because we face scarcity, we must make
choices.
The choices we make depend on the incentives
we face.
An incentive is a reward that encourages an
action or a penalty that discourages an action.
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Definition of Economics
Economics is the social science that studies the
choices that individuals, businesses,
governments, and entire societies make as they
cope with scarcity and the incentives that
influence and reconcile those choices.

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Definition of Economics
Microeconomics

Microeconomics is the study of choices

that individuals and businesses make, the
way those choices interact in markets,
and the influence of governments.
Macroeconomics

Macroeconomics is the study of the

performance of the national and global
economies.
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Graphing Relationships Among More Than

Two Variables
When a relationship involves more than two variables,
we can plot the relationship between two of the
variables by holding other variables constantby
using ceteris paribus.
Here we plot the relationships among three variables.

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Measuring GDP & Economic

Growth

Textbook:

Chapter 21

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After studying this chapter you will be able to,

Define GDP and use the circular flow model to
explain why GDP equals aggregate expenditure and
aggregate income.
Explain the two typical methods used by
Governments to measure GDP.
Explain how Governments measure real GDP and
the GDP deflator to separate economic growth from
inflation.
Explain the uses and limitations of real GDP.
Appreciate the source of long-term economic
growth.

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Outline of Lesson

Definition of GDP
Circular Flow of Expenditure and Income
Measurement of GDP
Real GDP and Nominal GDP
GDP Growth and GDP Per capita
Limitations of GDP measurement
Sources of Economic Growth

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An Economic Barometer
What exactly is GDP?
How do we use GDP to tell us whether our
economy is in a recession or how rapidly our
economy is expanding?
How do we take the effects of inflation out of GDP
to reveal the rate of growth of our economic wellbeing?
And how to we compare economic well-being
across countries?

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Gross Domestic Product (GDP)

GDP is the market value of all final
goods and services produced in a
country in a given time period.
This definition has four parts:

Market value
Final goods and services
Produced within a country
In a given time period
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Gross Domestic Product

A final good (or service) is an item bought by
its final user during a specified time period.
A final good contrasts with an intermediate
good, which is an item that is produced by one
firm, bought by another firm, and used as a
component of a final good or service.
Excluding intermediate goods and services
avoids double counting.

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Gross Domestic Product

Tires taken from that pile and

mounted on the wheels of the
new car before it is sold are
considered intermediate goods to
the auto producer.

If, in calculating GDP, we included

the value of the tires (an
intermediate good) on new cars
and the value of new cars
(including the tires), we would be
double counting.

Tires from that pile to replace tires

on your old car are considered
final goods.
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Outline of Lesson

Definition of GDP
Circular Flow of Expenditure and Income
Measurement of GDP
Real GDP and Nominal GDP
GDP Growth and GDP Per capita
Limitations of GDP measurement
Sources of Economic Growth

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Circular Flow of Expenditure

and Income
GDP measures the value of production, which
also equals total expenditure on final goods
and total income.
The circular flow diagram illustrates the
equality of income, expenditure, and the value
of production.

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Circular Flow of Expenditure

and Income
The circular flow diagram shows the transactions among
households, firms, governments, and the rest of the world. world.

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Circular Flow of
Expenditure and Income
These transactions take place in factor markets,
goods markets, and financial markets.

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Circular Flow of Expenditure

and Income
Firms hire factors of production from households. The blue
flow, Y, shows total income paid by firms to households.

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Circular Flow of
Expenditure and Income
Households buy consumer goods and services.
The red flow, C, shows consumption expenditure.

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Circular Flow of
Expenditure and Income
Households save, S, and pay net taxes, T. Firms borrow
some of what households save to finance their investment.

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Circular Flow of
Expenditure and Income
Firms buy capital goods from other firms. The red
flow I represents this investment by firms.

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Circular Flow of
Expenditure and Income
Governments buy goods and services, G, and borrow or
repay debt if spending exceeds or is less than net taxes.

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Circular Flow of
Expenditure and Income
The rest of the world buys goods and services from us, X,
and sells us goods and services, M. Net exports are X M.

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Circular Flow of Expenditure

and Income
And the rest of the world borrows from us or lends to us
depending on whether net exports are positive or negative.

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Circular Flow of
Expenditure and Income
The blue and red flows are the circular flow of expenditure
and income. The green flows are financial flows.

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Circular Flow of Expenditure

and Income
The sum of the red flows equals the blue flow.

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Circular Flow of
Expenditure and Income
That is: Y = C + I + G + X M

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Outline of Lesson

Definition of GDP
Circular Flow of Expenditure and Income
Measurement of GDP
Real GDP and Nominal GDP
GDP Growth and GDP Per capita
Limitations of GDP measurement
Sources of Economic Growth

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Measurement of GDP
Aggregate expenditure
Total expenditure on final goods and services,
equals the value of output of final goods and
services, which is GDP.
Total expenditure = C + I + G + (X M).

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The Expenditure Approach

Personal Consumption Expenditures (C)
The spending by households on goods and services,
with the exception of purchases of new housing.
There are three main categories of consumer
expenditures,
Durable goods: Goods that last a relatively long time,
such as cars and household appliances.
Non-durable goods: Goods that are used up fairly
quickly, such as food and clothing.
Services: The things we buy that do not involve the
production of physical things, such as transport and
medical services and education.
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The Expenditure Approach

Gross Private Domestic Investment (I)
Total investment in capital, that is, the purchase of
new housing, plants, equipment, and change in
inventories by the private sector.
Non residential investment: Expenditures by firms
for machines, tools, plants and so on.
Residential investment: Expenditures by households
and firms on new houses and apartment buildings.
Change in business inventories: The amount by
which firms inventories change during a period.
Inventories are the goods that firms produce now but
intend to sell later.
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Change in Inventories

Changes in Business Inventories

We count the change in firms

inventories as part of investment in
measuring GDP.

Why?

When goods are produced but not sold

during the year, they end up in some
firms inventory stocks.
Will provide services in the future,
when they are finally sold and used.
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The Expenditure Approach

Government Consumption and Gross Investment (G)
Expenditures by government for final goods and
services.
Does not include transfer payments because they are
not made in exchange for currently produced goods
or services.
Net Exports (EX - IM)

The difference between exports (sales to

foreigners of Singapore - produced goods and
services) and imports (Singapore purchases of goods
and services from abroad). The figure can be
positive or negative.
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 Business eLearning

Measuring U.S. GDP

The National Income and Expenditure
Accounts divide incomes into five
categories:
1.
2.
3.
4.
5.

Compensation of employees
Net interest
Rental income
Corporate profits
Proprietors income

These five income components sum to

net domestic income at factor cost.

Business eLearning

Measuring U.S. GDP

Two adjustments must be made to
get GDP:
1. Indirect taxes minus subsidies are
added to get from factor cost to
market prices.
2. Depreciation (or capital
consumption) is added to get from
net domestic product to gross
domestic product.
Business eLearning

 Business eLearning

Outline of Lesson

Definition of GDP
Circular Flow of Expenditure and Income
Measurement of GDP
Real GDP and Nominal GDP
GDP Growth and GDP Per capita
Limitations of GDP measurement
Sources of Economic Growth

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Real GDP and Nominal GDP

Real GDP is the value of final goods
and services produced in a given
year when valued at constant prices.
Nominal GDP is the value of goods
and services produced during a given
year valued at the prices that
prevailed in that same year.

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Real GDP and Nominal GDP

Nominal GDP
Calculations
The table provides data
for 2005 and 2006.
In 2005,
Expenditure on balls =
$100
Expenditure on bats =
$100
Nominal GDP = $200

Item

Quantity

Price

2005
Balls

100

$1.00

Bats

20

$5.00

Balls

160

$0.50

Bats

22

$22.50

2006

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Real GDP and Nominal GDP

Item

In 2006,
Expenditure on balls
= $80
Expenditure on bats
= $495
Nominal GDP = $575

Quantity

Price

2005
Balls

100

$1.00

Bats

20

$5.00

Balls

160

$0.50

Bats

22

$22.50

2006

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Real GDP and Nominal GDP

Base-Year Prices
Value of Real GDP
This method of
calculating real GDP
is to value each
years output at the
prices of a base year.
In the base year, real
GDP equals nominal
GDP.
Suppose 2005 is the
base year, then real
GDP in 2005 is $200.

Item

Quantity

Price

Balls

100

$1.00

Bats

20

$5.00

Balls

160

$0.50

Bats

22

$22.50

2005

2006

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Real GDP and Nominal GDP

To calculate real GDP in 2006:

Expenditure on balls in 2006 valued at

2005 prices is $160.
Expenditure on bats in 2006 valued at
2005 prices is $110.
So real GDP in 2006 would be recorded
as $270.

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Real GDP and Nominal GDP

The average level of prices is called the price
level.
One measure of the price level is the GDP
deflator, which is an average of the prices of
the goods and services in GDP in the current
year expressed as a percentage of the baseyear prices.
Real GDP

= Nominal GDP x 100

GDP Deflator
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Real GDP and Nominal GDP

Deflating the GDP Balloon
Nominal GDP increases because production (real
GDP) increases.

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Real GDP and Nominal GDP

Nominal GDP also increases because prices rise.

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Real GDP and Nominal GDP

We use the GDP deflator to let the inflation air out
of the nominal GDP balloon and reveal real GDP.

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Outline of Lesson

Definition of GDP
Circular Flow of Expenditure and Income
Measurement of GDP
Real GDP and Nominal GDP
GDP Growth and GDP Per capita
Limitations of GDP measurement
Sources of Economic Growth

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GDP Growth Rate

Economic growth is the sustained expansion of
production possibilities measured as the
increase in real GDP over a given period.
The economic growth rate is the annual
percentage change of real GDP.
The economic growth rate tells us how rapidly
the total economy is expanding.

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GDP Per Capita

The standard of living depends on real GDP
per person or GDP per capita.
Real GDP per person is real GDP divided by the
population.
Real GDP per person grows only if real GDP
grows faster than the population grows.

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Outline of Lesson

Definition of GDP
Circular Flow of Expenditure and Income
Measurement of GDP
Real GDP and Nominal GDP
GDP Growth and GDP Per capita
Limitations of GDP measurement
Sources of Economic Growth

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The Limitations of Real GDP

We use real GDP to calculate the economic
growth rate.
We measure economic growth so we can make

Economic welfare comparisons across

time
International comparisons across
countries
Business cycle forecasts

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The Limitations of Real GDP

Economic welfare measures the nations overall
state of economic well-being.
Real GDP is not a perfect measure of economic
welfare for seven reasons:
1. Inflation rate tends to be overestimated
because quality improvements are neglected.
2. Real GDP does not include household
production or productive activities done in and
around the house by members of the
household.

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The Limitations of Real GDP

3.Omits the underground economy, which is illegal
economic activity or legal economic activity that
goes unreported for tax avoidance reasons.
4.Health and life expectancy are not directly
included in real GDP.
5.Leisure time, a valuable component of an
individuals welfare, is not included in real GDP.
6.Environmental damage is not deducted from real
GDP.
7.Political freedom and social justice are not
included in real GDP.
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The Uses and Limitations of Real GDP

8. Economic Welfare Comparisons Across
Countries
Using the exchange rate to compare GDP in one country
with GDP in another country is problematic because
prices of particular products in one country may be
much less or much more than in the other country.
For example, using the market exchange rate to value
Chinese GDP in dollars leads to an estimate that in
2006, U.S. real GDP per person was 28 times Chinese
real GDP per person.

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The Uses and Limitations of Real GDP

Using the market

exchange rate and
domestic prices
leads to an
estimate that China
is very poor.
U.S. GDP per
person is 28 times
that in China.

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The Uses and Limitations

of Real GDP
Using purchasing
power parity
prices leads to an
estimate that U.S.
GDP per person is
(only) 12 times
that in China.
Purchasing Power Parity Theory states that an exchange rate should be
determined by the domestic value at purchasing power parity of the
foreign currency concern. Thus, if $15 has the same purchasing power as
10 sterling pounds, the rate of exchange used should be $1.50 = 1 pound.
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Outline of Lesson

Definition of GDP
Circular Flow of Expenditure and Income
Measurement of GDP
Real GDP and Nominal GDP
GDP Growth and GDP Per capita
Limitations of GDP measurement
Sources of Economic Growth

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The Sources of Economic Growth

The two sources of real GDP growth are,
Aggregate hours
Labor productivity

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The Sources of Economic Growth

Aggregate Hours
Aggregate hours, the total number of hours worked
by all the people employed, change as a result of:
Working-age population growth
Changes in the employment-to-population ratio
Changes in average hours per worker

Population growth increases aggregate hours and

real GDP, but to increase real GDP person, labor
must become more productive.

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The Sources of Economic Growth

Labor Productivity
Labor productivity is the quantity of real GDP produced by an hour of
labour or real GDP divided by aggregate hours.
The growth of labor productivity depends on
Physical capital growth
Human capital growth
Technological advances
Physical Capital Growth
Physical capital growth results from saving and investment decisions.
The accumulation of new capital increased capital per worker and
increased labor productivity.

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The Sources of Economic Growth

Human Capital Growth
Human capital acquired through education, on-the-job
training, and learning-by-doing is the most fundamental
source of economic growth.
It is the source of increased labor productivity and
technological advance.
Technological Advances
Technological change such as the discovery and the
application of new technologies and new goods has
contributed immensely to increasing labor productivity.

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The Sources of Economic Growth

The growth of real GDP per person

depends on real GDP growth and the
population growth rate.
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Government Policies to Achieve Economic

Growth

Encourage population growth

Import of foreign labour
Mobilising of working-age population not in the labour
force e.g. housewives, and extension of retirement age

Encourage domestic saving

Attract Foreign Direct Investments (FDIs)
Encourage Research and Development (R&Ds)
Improve the quality of education and continuous training
Promote international trade such as the signing of Free
Trade Agreements (FTAs).

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Review Questions
1. Describe the economic problem faced by all
economies.
2. Discuss the economic ways of thinking.
3. Differentiate between microeconomics and
macroeconomics.
4. Describe an economic model.
5. What do you understand by the term ceteris
paribus.

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Review Questions
1. Discuss and elaborate on the two typical methods of
measuring GDP.
2. Differentiate between real and nominal GDP. Which
GDP would you use to analyse the performance of an
economy over several years?
3. Discuss the insights which GDP, Real GDP growth rate
and GDP per capita can tell us about an economy or
several economies which you are making comparison.
4. Identify and discuss the limitations of GDP as an
indicator of the changing level of welfare in an
economy or for comparison across economies.
5. Identify and elaborate on the two sources of economic
growth.
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Have a good evening!

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