Chapter 1: Basic Concepts and National Income Accounting

Introduction

Contrary to microeconomics, in macroeconomics we consider, not only the supply of and demand for a good or service in a particular market, but the supply of and demand for all goods and services produced in the economy; not only the price of a good or service but the average price of all products in the economy; not only the consumption of a single person or family, but the overall consumption of all the people or families in the economy; not only the investment of a single automobile factory, but investments of all businesses in the economy as a whole. Macroeconomics is not only interested in the determinants of these large scale variables, but also mutual relationships among them and the meaning of changes they display in time. In other words, macroeconomic analysis deals with how macro variables of a national economy affect each other and how they are determined when the economy tends to achieve equilibrium.

Birth of Macroeconomics and Its Field of Interest

Economists started to discuss the topics about macroeconomics as a result of economic events during Great Depression in 1930s. Great Depression is the period started in 1929 and lasted through 1930s in which a huge economic contraction and very high level of unemployment were experienced. During 10 years of Great Depression, unemployment levels were extremely high and the inadequacy of classical models to explain that much lasting unemployment period led to the development of macroeconomics.

Keynes has developed an economic theory for explaining complex economic events by using the information about markets and behaviors in these markets. Therefore, the origins of macroeconomics are widely based on Keynes’ book and theoretical breakthrough attributed to him is often called as the Keynesian Revvolution. Keynes’ approach can be summarized that the state needs to interfere in economy by means of supporting to prevent the decrease of production and employment in a period of inadequacy of special sector demands.

There are three basic indicators related to health of an economy, thus within the field of macroeconomics: Unemployment rate, inflation rate and output growth rate. Each government should watch these indicators carefully.

Employment is being hired the people deciding to work and earn income in order to benefit their labor services. Unemployed is used for the person who is willing and able to work, but not finding a job even accepting the current wage rate. Unemployment can partly be temporary. Types of unemployment can be categorized as, for example, partial and prevalent, temporary and permanent. Most typical temporary but widespread unemployment types are cyclical and seasonal unemployment. Cyclical unemployment is the unemployment caused by the recessions occasionally occurred in economic life. In agricultural countries, most common type is seasonal unemployment. Structural problems and long lasting recessions cause both widespread and permanent types of unemployment. In periods when the economy with its whole sectors stays in a stagnation permanently, the structural unemployment occurs.

Inflation is the general increase in all prices in the economy. However, it is necessary to separate the increase of a single good’s price from the increase of all good’s prices (general price level). General price level is the index value of weighted average of goods’ prices in a specified period of time. Inflation is the continuous increases experienced in general price level. Hyperinflation is the very rapid increase in overall prices.

One of the basic indicators used in assessing the performance of an economy and the general economic conditions in a country is the country’s total production, more correctly the rate of change of this quantity according to the previous period. Total production is the total quantity of goods and services produced in an economy in a specified period of time. The rise in the capacity of economy to produce goods and services is called as economic growth. All countries face with short term performance fluctuations in the economy instead of realizing steady and rapid growth rates. In other words, while production capacity rises sometimes, at other times it decreases. These fluctuations in the form of rises and decreases in production are known as business cycle. Contraction is the period in which total production decreases. Recovery is the period in which total production increases.

Government and Macro Economy

There are mainly three tools for the government to affect the macro economy: Fiscal policy, monetary policy and supply-side policies.

One of the government’s tools to affect the economy is to collect taxes and to make expenditures. Fiscal policy is the decisions related to taxes that government collects and expenditures that government makes. A government collects taxes from households and businesses and uses these funds in a changing scale from producing weapons to building parks, from paying pensions to building highways. The scale and composition of these taxes and expenditures have a significant effect on the economy.

Taxes and government spending are not the only tools that the government can conduct; in addition to these tools, a government can affect the quantity of money in the economy via the central bank. Monetary policy is the measures that the central bank takes to control the quantity of money in the economy.

According to these economists, government should concentrate on policies which increase production and accelerate economic growth. Supply side policies are the policies to increase production instead of increasing aggregate demand.

Basic Components of Macroeconomics

Macroeconomics focuses on behaviors of four groups in an economy: Households and businesses (private sector), government (public sector) and other countries (international sector). These four groups are in mutual relations with each other in various ways. Many of these relations include or at least are related with obtaining income and making expenditure. The easiest way to see these mutual economic relations among four units in macroeconomics is to prepare a circular flow diagram showing earnings and expenditures of these units. Circular flow diagram is the diagram which shows expenditures made and earnings obtained by each sector of the economy.

Households work for businesses and government, and in turn, earn wages. These wages are not the only revenue which households can earn from businesses and government. In addition to wages, households can earn interest, dividend and rent income from businesses as well. On the other hand, households can earn income in the form of interest and transfer payment from government. Households spend their earnings for goods and services produced by businesses and pay taxes. Businesses obtain income by selling goods and services to households and government and spend their income by paying wage, interest and dividend to households and taxes to government. Similarly, government obtains income by collecting taxes from businesses and households and spends it by purchasing goods and services from businesses, making wage, interest and transfer payments to households. Finally, while households spend their earnings partially to buy goods and services produced by other countries (import expenditures), households of other countries buy goods and services produced by domestic businesses (export income). An important point should be highlighted in the simple circular flow diagram above: In an economy, spending of someone should always be the income of another one.

National Income Accounting

Measuring the activities forming the income in a country is called as national income accounting. In an economy, from lemon cake to helicopter, from book to house, from haircut to pizza delivery, there are millions of various types of goods and services. How we can collect these various types of data? The government collects the required and detailed information about this matter within a specific scheme and announces the results to the public by combining and summarizing these data. These announced results include highly detailed information and show the conclusion of economic activities occurred in that country and in that period. For instance, the public institution authorized for this task in Turkey is Turkish Statistical Institute (TUIK) .

There are millions of types of goods and services produced in a country and national income accounts might be used to measure the production level of that country. Here we have a problem: How can we collect the amounts of that much goods and services produced in various units such as tons, pieces, hours, cubic meters? The only answer is to use their prices as a common measure referencing the values of these goods and services. Indeed, each good and service produced and supplied to the market for selling has a price and that price has a function as a measure in determining the total production value. Total market value of finished (final) goods and services produced in a period of time in an economy is called the gross domestic product (GDP) and this is the most widely used concept to evaluate the country’s general economic performance. Gross domestic product is the total value of all final (finished) goods and services produced and expressed with market prices in a specific period of time.

In GDP definition provided above, some features and technical terms should be clarified. First of all, we must avoid double counting so that the same product should not be included twice in calculation of GDP. Some goods and services, called as intermediate goods, are used to produce other goods and services in the economy. If this kind of goods and services are included into GDP, we count them twice. If all production phases of a product from manufacturing to finished product are included into national income accounts, the final total of GDP will be higher than the actual one. Therefore, it is required to find and sum up the net value added to GDP as a result of production of each businesses. This value is called the value added and calculated by subtracting the value of intermediate goods from the value of production of related business. The second feature of GDP is that it includes all final goods and services produced in the economy. The problem here is that some goods and services cannot be sold via markets and it is difficult to determine their values. Third, it is useful to exclude some final goods and services from GDP for some practical reasons. Especially, some goods and services not being marketed (such as services provided by housewives) are not included into GDP. Fourth, the transactions which are completely financial are not included into GDP. This kind of financial transactions consist of transfer payments of public and private sectors, as well as buying/ selling transactions of securities. Fifth, second hand sales of goods are not taken into account in GDP calculation. The reason of that is obvious. When a product is produced, the value of this product is added to GDP. If its value is added to GDP when it is sold in the second hand market, then it is counted twice and GDP is calculated higher than the actual. Finally, GDP indicates the production realized within the borders of a country, but does not refer to the value of production realized by production factors belonging to citizens of the country.

There are three appearances of gross domestic product as income created, earned and spent. These different approaches to GDP are like looking at the same object from different sides; however, eventually defined object is the same. As we mentioned in previous topic, while GDP indicates the monetary value of all goods and services produced in a period of time, it also indicates the total of wage, interest, profit and rent earnings paid for production factors participated to production of these goods and services. On the other hand, considering the earned income is somehow spent, total expenditures in an economy should be equal to the value of created production. According to summarized three different aspects of GDP, it can be calculated in three different ways:

• In terms of the total value of goods and services produced,
• In terms of the income obtained in return for producing goods and services,
• In terms of the expenditures made for goods and services produced.

In explanations we made so far, firstly we defined the production value realized in a country, then we reviewed various methods that can be used to calculate this concept. Within our explanations on this matter, we mentioned that gross domestic product (GDP) can be used as a measure of wealth level in the country. By adding net international factor income, we had a new income magnitude named as gross national product (GNP). However, both of these concepts have an important drawback at this point.

While discussing inflation, we mentioned that general price level changes in time. As GDP evaluates goods and services with their current market prices, changes in GDP will reflect both price changes and changes in production amount. If all prices would be doubled tomorrow, GDP would be doubled as well. This GDP value calculated with current prices in markets is called GDP at current prices or nominal GDP. Nominal GDP is the value of production with current market prices.

GDP value calculated using fixed prices are called the real GDP or GDP at constant prices . Real GDP value is the GDP value after eliminating the effect of price changes as explained above. Namely, while nominal GDP expressed with current prices reflects the effect of price changes, real GDP expressed with fixed prices doesn’t reflect the price changes as its expressed with the prices of base year.

Finding an indicator that represents price changes in the economy is very useful to transform nominal values to real ones. We can get this type of indicator by dividing the value of a group of goods and services at current prices to the value of the same group at base year’s prices. The ratio of the value for a group of goods and services at current prices to the value of the same group of goods and services at constant prices is called the price index.

To compare the people’s wealth levels living in various countries, per capita national income figures are used. Per capita national income is calculated by dividing the Dollar value of national income to population and used as a wealth indicator.

Understanding that there are some limits in usage of GDP and the concepts based on it is crucial for national income analysis. Although they are very useful measures, these concepts are not the best measures related to economic wealth.

There are at least 6 points unfavorable with these figures should always be kept in mind.

• GDP and other income concepts based on it do not make sense if the population of the country in question is unknown.
• GDP and other income concepts exclude the most valuable activity for an individual: leisure.
• GDP and other income concepts do not take the quality changes of produced goods into account.
• GDP and other income concepts don’t provide detailed information about the combination and distribution of income created in the country.
• GDP and other income concepts do not reflect some social costs originated from production of goods and services.
• There are many activities need to be added to GDP in principle but not included actually. For example, illegal activities are not included into GDP calculations unless they are ‘acquitted’ by being introduced into legal system.