Birks – Mankiw Chapter 23: Measuring a Nation’s Income
Mankiw, N. G. (2015) Principles of macroeconomics (7th ed.) Ch.10
Principles of economics (7th ed.) Ch.23
Mason, OH: South-Western Cengage Learning.
Chapter 23: Measuring a Nation’s Income
When reading the chapter, here are some aspects to consider:
- There are some terms which are worth noting:
Variables in models can be divided into those which are exogenous and those which are endogenous.
– Exogenous: Values are given from elsewhere, outside the model. They are not explained by the model. Policy variables may be included among these because they can be set by policy decisions.
– Endogenous: Values are determined within the model
This distinction is an aspect of the analysis, not of the real world. Models can be expanded by changing a variable from exogenous to endogenous. Some determinants of the variable then have to be specified, along with the nature of the relationship.
Mesoeconomics: this relates to situations where smaller scale (microeconomic) changes can affect an economy as a whole (macroeconomic). For example, Fonterra is large enough for its activities to have a macroeconomic impact. Microeconomics assumes that any such impacts can be ignored. We do not cover mesoeconomics in this course, but it is worth noting.
Aggregation: Macroeconomics relied heavily on variables which are aggregates, i.e. many things are grouped together to be represented by one measure. Hence we have GDP, aggregate consumption, the price level, the labour force, a country’s imports and its exports, for example. For there to be no loss of information through the use of aggregates, we need the components of an aggregate to be homogeneous. The term means “the same”, and really we are just concerned with the components being the same with respect to the relationships under consideration. If we are looking at consumption out of income, all the individuals are assumed to have the same relationship between consumption and income, but they can differ in height and hair colour, for example. This means that the validity of an aggregate is context-specific. If items are not homogeneous, they are heterogeneous, or different.
- The circular flow diagram (Figure 1) involves four arrows indicating money flows (going anti-clockwise).
We can group them as follows:
The top 2 arrows:
1. Expenditure (HH spending, out from HHs) becomes
2. Revenue (Firms receipts, in to firms)
The bottom 2 arrows:
3. Income (HHs receipts, in to HHs)
4. Factor payments (value added, firms spending, out from firms)
These indicate four ways to measure GDP (a more complex diagram would include additional components as in point 3). As the data would be obtained from different sources, the numbers may not match exactly, although they should. The difference is commonly labeled as a “statistical discrepancy”.
- The basic circular flow diagram is commonly said to omit three flows of withdrawals and injections.
Households may have savings (S), in which case they will not spend (“pass on” all their income). This is a withdrawal from the circular flow. The financial system can take these savings, lending them to investors for investment (I) in goods and services, an injection into the circular flow.
The government (1) collects taxes (T), a withdrawal, and (2) buys goods and services, described as government expenditure (G), an injection.
The foreign sector involves imports (spending on goods and services produced outside the country), a withdrawal, and exports (spending by others on goods and services produced within the country), an injection. We sometimes use a variable, net exports (NX), which is exports minus imports.
At equilibrium, the flow around the circle is at a constant rate, and this occurs when flows out are balanced by flows in, or injections = withdrawals. The equality does not have to hold for each individual pair, S and I, T and G, imports and exports. It just has to hold overall.
An alternative representation of the circular flow could use the analogy of a tyre, with air leaking from the tyre (withdrawals) and being pumped in (injections). The tyre pressure stays constant when the two flows are equal.
- Note the distinction between intermediate and final goods. This was mentioned in point 8 of the notes to Chapter 2, discussing the difference between income, Y, and transactions, T. Adding up Intermediate goods involves double counting. Consider the following chain(s).
- A farmer grows wheat
- A miller mills the wheat into flour, some is sold to a supermarket, some is sold to a baker
- A baker uses the wheat to bake bread bake
- A supermarket buys bags of flour from the miller and bread from the baker
- A consumer buys flour and bread from the supermarket
The price of the wheat used for bread is included in the initial price of the wheat to the miller, and in the price of the flour to the baker, and in the price of the bread to the supermarket, and in the supermarket’s mark-up price to the consumer, who consumes the final good. If we include the intermediate transactions, the then wheat is being counted four times.
Note that when the consumer buys flour from the supermarket, that is also a final good. It is not the item itself which determines whether a transaction is intermediate or final. It is the stage in the chain of production to final purchaser of the good or service (for consumption, investment, government expenditure or export, C, I, G or export).
Instead of adding up the values of final goods and services, we could add up the value added at each stage, the difference between the cost of inputs (wheat for the miller or flour for the baker, for example) and the value of output at each stage (in this example flour for the miller or bread for the baker).
- The identity Y = C + I + G + NX is an identity because it refers to actual, or realised, C, I, G and NX. Some models also refer to planned C, I, G and NX. Planned expenditure need not equal realised expenditure. If they are not equal, then some people’s plans are not realised and there is an incentive for change. In other words, when plans are not realised, the macroeconomy is not at equilibrium.
Conversely, when plans are realised, then not only will realised expenditure equal income, but so also will planned expenditure. This gives us an equilibrium condition, our simple model will be at equilibrium when planned expenditure equals income. This is also the situation where withdrawals equal injections, the circular flow is at a constant level, or the tyre is at constant pressure.
This interpretation of the concept of equilibrium is important in mainstream economics. Note the importance of expectations, and whether plans are realised. This indicates that behavioural aspects are important. People’s decisions can be influenced by their perceptions, and revised according to their experiences. To take this a step further, we might not expect people to always react in the same way when faced with identical circumstances. Static analysis places great importance on equilibrium. Other approaches might be more concerned about constant change and paths through time. Different framing of the issue will result in alternative emphases and the identification of different concerns.
- Here is a link to a Statistics New Zealand report on measurement of GDP.
It mentions one difficulty with the measurement of financial services (see section on FISIM). The cost of the services is sometimes incorporated into the interest charge, and so not easy to identify.
It also refers to imputed rent from owner occupied dwellings. It refers to the rent which owner-occupiers “pay” themselves to live in their homes. Unlike the US treatment of housing, imputed rent is included in consumption. (Note also that, unlike actual rent payments, it is not included in income received, and so is not subject to tax. However, rates, insurance, repairs and maintenance, and mortgage interest payments are not tax deductible expenses either.)
Commentary by Stuart Birks, 28 August 2014