National Income
Topic Twenty

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Economics and the Macroeconomic Goals and Objectives of the Government

While microeconomics deals with economic decisions of individual economic agents such as individuals and companies, macroeconomics deals with the economic decisions with respect to the entire economy in aggregate which results in the country’s national income. The main issues that are dealt with in macroeconomics include: unemployment, inflation, business cycle, economic growth and development and; trade.

The five main macroeconomic goals or objectives of the government are:

Economic Growth - economic growth is the increase in goods and services produced in an economy within a given period usually a year. This usually results from an increase in the income of a country.

Full Employment or the Alleviation of Unemployment – when there is unemployment or when the economy is at less than full employment, this means that there are unused resources. Unemployment can lead to social problems so it is critical that governments have as many resources employed as possible including human resources which is labour.

Price Stability (Containment of Inflation and Deflation) – government will want to contain inflation which is the rise in the general level of prices in the economy. When there is inflation, money loses its value meaning that citizens will be able to purchase less with their existing income levels. This can result in a decrease in the living standards of people in the country.

Favourable External Position/Improvement in Trade – a country’s external position can be measured by viewing its balance of payments position. The balance of payments is the set of records which a country keeps all of its exports (the amount of goods and services which it sells to other countries) and its imports (the amount of goods and services which it buys from other countries). Ideally, governments will want a surplus in their balance of payments position.

Exchange Rate Stability - instability in the exchange rate can result in outflow of foreign reserves. Therefore, a stable exchange rate plays a key role in international trade. A stable exchange rate is very important to achieve a favourable external trade position of a country.

Tools for Achieving the Macroeconomic Objectives

A policy instrument or tool is an economic variable under the control of the government that can affect one or more of the macroeconomic goals. The main macroeconomic policy tools or instruments for the achievement of the five main macroeconomic goals are:

  • Monetary policy – this determines the money supply as well as interest rates in order to achieve desired economic objectives. Monetary policy is really the manipulation of the money supply in order to achieve the government’s economic goals.
  • Fiscal policy - is the creation of economic activity by changing expenditures and taxation to foster economic growth, price stability, the creation of employment and hence the reduction of unemployment.
  • Interventionist or direct policies - are government attempts to moderate inflation by direct steps (legislated wage or price controls).
  • Trade policies - consist of tariffs, quotas and other devices that restrict or encourage imports and exports. Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the prices of imports will increase by the extent of the tariff. The increased prices will reduce the demand for imported goods. With a quota system, the government may fix the maximum quantity or value of a commodity to be imported during a given period. By restricting imports through tariffs and a quota system, the trade deficit will be reduced and the balance of payments position will improved.
  • Exchange rate policy - exchange rate represents the price of one currency in terms of the currency of other nations. There are different ways or methods to regulate a foreign exchange market. One of the methods is a depreciation/devaluation of the local currency which refers to a fall in the value of a country’s currency on the foreign exchange market. This makes the value of imports more expensive and exports more feasible thereby improving the balance of payments position.

National Income and Measures of National Income

National income is the total value a country’s final output produced in one year. In other words, the spending or earnings of private individuals (consumers), companies (investors), the government (governmental ministries and agencies) and foreigners who purchase our products (difference between exports and imports) are summed to arrive at the national income of a country.

The following are some measures of national income:

Gross domestic product (GDP) is the market value of all final goods and services produced within a country in a given period of time;

Gross national product (GNP) is the market value of all final goods and services produced by permanent residents of a nation within a given period of time; this is GDP plus net income earned by our citizens living abroad.

NNP is the total market value of all final goods and services produced by citizens of an economy during a given period of time; it is Gross National Product or GNP minus depreciation.

NNI is the Net National Product (NNP) minus indirect taxes.

Per capita GDP is total GDP divided by the population.

Current GDP is GDP expressed in the current prices of the period being measured.

Nominal GDP growth is GDP growth in nominal prices (unadjusted for price changes).

Real GDP growth is GDP growth adjusted for price changes or inflation. Calculating real prices allows economists to determine if production increased or decreased, regardless of changes in the purchasing power of the currency.

Approaches to Measuring National Income

There are three main methods of calculating national output which are: the expenditure approach, the income approach which sums all incomes and the output approach which sums all outputs. It is important to note that the values from all three of these approaches must equal because what is spent by some are the income of others.

The expenditure approach:

The GDP of a country is defined as the total market value of all final goods and services produced within a country in a given period of time (usually a calendar year). It is also considered the sum of value added at every stage of production (the intermediate stages) of all final goods and services produced within a country in a given period of time. This expenditure approach can be depicted as follows:

GDP = consumption + investment + government spending + exports − imports, or, GDP = C + I + G + (X-M)

  • C is private consumption in the economy which includes most personal expenditures of households such as food, rent and medical expenses but does not include new housing.
  • I is defined as business investments in capital. Examples of investment by a business include construction of a factory, purchase of software, or purchase of machinery and equipment for a factory. Spending by households on new houses is also included in Investment. Unlike general meaning, Investment in GDP is meant very specifically as non-financial product purchases.
  • G is the sum of government expenditures on final goods and services. It includes salaries of public servants and any investment expenditure by a government. It does not include any transfer payments such as social security or unemployment benefits.
  • X is gross exports; GDP captures the amount a country produces, including goods and services produced, for overseas consumption, therefore exports are added.
  • M is gross imports which are subtracted since imported goods represent an outflow of money from the country..

Converting GDP from Market Prices to Factor Cost

Converting gross domestic product from market prices to gross domestic product at factor cost requires subtracting indirect taxes and adding back subsidies.

Income Approach:

Another method of measuring GDP is to measure the total income (gross domestic income is GDI) payable in the GDP income accounts. This should provide the same figure as the expenditure method described above. By definition, GDI=GDP.

The formula for GDP using the income approach

GDP = W + R + I + P, where:

W - wages

R - rents

I - interests

P - profits

The Output Approach

This method of compiling GDP leads to counting the production by sector of activity. One major drawback of this method is the difficulty to differentiate between intermediate and final goods. This problem can lead to double counting or the overstating of national output and income. This can be overcome be using only the added value at the intermediate stage of production.

For example, assume that a company is manufacturing a lawn mower from the very beginning. Company A provides the metal at a cost of $120 so this firm has added $120 to the manufacture of the lawn mower. Firm B bends the metal into the shape to make the lawn mower at a cost of $180 (Firm B therefore adds $60 ($180-$120) towards the manufacture of the lawn mower). Firm C provides the motor for the lawn mower at a cost of $400 and adds $220 to the value of the making of the lawn mower ($400-$180). When all of these are assembled to form the lawn mower, the manufacturer sells the lawn mower for $800 thereby adding $400 to the cost of making the lawn mower. This $400 is his profits. If we sum up all of the added values through the intermediary stages, we will get $800 which is the final value of the lawn mower. However, if we add up all of the total cost of the parts that make up the lawn mower at each stage we will get $1,500 which is double counting. Note the huge difference in cost. We are supposed to be using $800 towards the calculation of GDP which is the real value of the manufacture of the lawn mower and not the $1,500 which includes the costs of all of the parts which will lead us to an inflated or over-valued figure for the manufacture lawn mower.

Limitations of the Use GDP and GNP as a Measure of Economic Well-Being

Even though GDP has been used in many countries and by various international agencies as a measure of the size of an economy and economic well-being, it does have some challenges as such a measure. The following are some of the challenges of using GDP as a measure of economic well-being:

Non-Marketable Activities – GDP only counts goods and services that pass through markets. Production that is not bought or sold does not generally get counted. For example, a mother raising a child is an important activity. However, this is not something that is paid for or provided on the market. This can therefore lead to an understating of GDP and economic well-being of a country.

Leisure - GDP only takes the market value of output, therefore, leisure which includes paid vacation and holidays which increases well-being and satisfaction, are excluded from the GDP. This will mean that GDP as a measure on economic well-being will be understated.

Forced Government Expenses - perhaps the most significant shortcoming of GDP as a measure of economic growth is its inclusion of government spending alongside other voluntary or forced market transactions. For example, higher crime rates may lead to increased expenditures on police which shows up as an increase in GDP. In other words, even though GDP or per capita GDP may be stated as being high, it may be so due to forced government expenses as a result of tensions and problems in society.

Externalities – GDP also can be misleading due to the exclusion of negative externalities that can result from the production of goods. We may have a situation where there is growth and expansion in the manufacturing sector. However, this can also cause pollution through the emission of chemicals into the atmosphere and oils into the seas and rivers which can result in health problems and damage to the environment.

Underground economy – the underground economy is excluded from the calculation of GDP. This category includes activities that are illegal such as drugs. Incomes in these activities are not included in GDP and therefore GDP is understated.

Business Cycle

The business cycle refers to the different trends or cycles in the economy. An economy does not remain in the same state year after year. Most economies experience periods of economic boom or prosperity, or modest growth or recession or depression.

There are five stages in the business cycle which are growth (expansion), peak, recession (contraction), trough and recovery as can be seen in the graph below.

Figure 1

  1. The letter A represents a decline which is called a recession. During a decline, consumer spending decreases as consumers and investors become cautious about the future.
  2. The letter B represents the lowest point of the recession. This is a period of high unemployment, idle capacity and resources and low prices.
  3. The letter C represents a boom, sometimes called prosperity; in this phase, there is high employment as well as high prices.
  4. The letter D represents a depression. A depression is a very big decline whereas a recession is a small decline.
  5. The letter E represents a recovery. During a recovery.

Recession

In a recession, workers are laid off and the unemployment rate increases. Factories and machinery are idled and capacity utilization falls significantly. This causes a decline in wages as workers will be willing to obtain employment at a lower wage rate. This is so due to the oversupply of workers relative to the demand for labour by firms. Recessions also result in a fall in exports and even a fall imports at times. When this happens, the revenues of the country fall and the response from countries is usually a devaluation or depreciation of the country’s currency. This can have the effect of making its exports attractive again on the global market and it may also reduce imports because imports are now more expensive.

Circular Flow of Income

Goods and services and resources flow around the economy in one direction, while money flows around the economy in the opposite direction. This is because money is normally exchanged for goods and services or resources.

Figure 2

Households or people in the circular flow own all the labour, land and capital. In the markets for factors of production, households sell the services of labour, land and capital to firms in exchange for wages, rent and interest. The sale of factors by individuals, the purchase of these factors and the production of output by firms take place in the factor market – the market for factors of production. On the other hand, the sale of products by firms and the purchase of products by individuals take place in the product market.

Households (people) have two functions in the economy. Firstly, they sell their labour, land and capital to firms in order to make income. Secondly, they spend their income on the goods and services that firms produce. Firms also have two functions in the economy. Firstly, they purchase the services of labour, land and capital. Secondly, they use labour, land and capital to produce goods and services, which they sell to households. In the graph above, the red line represents the flow of goods and services and the brown line represents the flow of income.

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