2.1. Microeconomics - The level of overall economic activity
Economic activity
→ Describe, using a diagram, the circular flow of income between households and firms in a closed economy with no government.
• Two sector model: constitutes of the households
and the firms in a closed economy
→ Identify the four factors of production and their
respective payments (rent, wages, interest and profit) and
explain that these constitute the income flow in the model.
• Flow from household to firms
▪ Resources (factor of production): land,
labour, capital, entrepreneur
▪ Expenditure: consumption expenditure
(demand)
• Flow from firms to household
▪ Income (respective payments): rent,
wages, interest and profits
▪ Output: goods and services (supply)
→ Outline that the income flow is numerically equivalent to the expenditure flow and the value of output flow.
• The income flow is numerically equivalent to the expenditure flow and output flow. (Y=E=O)
▪ Income flow: factor income from firms to household
▪ Expenditure flow: consumer expenditure from household to firms
▪ Value of output flow: value of goods and services (output) flowing from firms to household
▪ In theory, these should have the same value; but in reality is it not always so
→ Describe, using a diagram, the circular flow of income in an open economy with government and financial markets, referring to
leakages/ withdrawals (savings, taxes and import expenditure) and injections (investment, government expenditure and export
revenue).
• In the five sector model, additional sectors are present to illustrate leakages and injections in the economy
▪ Injection: introduction of income to the flow
▪ Leakage: removal of income from the flow
• Government sector
▪ Injection: government spending (G)
▪ Leakage: taxation (T)
• Financial sector
▪ Injection: investment (I)
▪ Leakage: savings (S)
• International sector
▪ Injection: exports (E)
▪ Leakage: imports (I)
→ Explain how the size of the circular flow will change depending on the relative size of injections and leakages.
• The size of the circular flow can change depending on the level of injections and leakages.
▪ Injection > leakage: size of circular flow increases
▪ Injection < leakage: size of circular flow decreases
▪ Injection = leakage: equilibrium level of national income
→ Distinguish between GDP and GNP/GNI as measures of economic activity.
• Gross domestic products (GDP): total value of all goods and services produced in an economy at a given time period
▪ GDP = government expenditure (G) + investment (I) + consumption (C) + net income from abroad (X-M)
▪ Measurement of economic activity: more accurately determines how the country’s economy is performing overall
within the border; takes into account how benefits are directly made from domestic sectors (e.g. tax and employment)
• Gross national income (GNI): total value of all goods and services produced by a nation’s factor of production at a given time
▪ GNI = GDP + (income earned from assets abroad – income paid to foreign assets)
▪ Measurement of economic activity: better assessment of a countries wealth as in a global economy the wealth of a
country as income often flows back from host to home country
,→ Distinguish between the nominal value of GDP and GNP/GNI and the real value of GDP and GNP/GNI.
• Nominal value of GDP and GNI: numerical GDP/GNI figures obtained that are not adjusted for inflation
• Real value of GDP and GNI: numerical GDP/GNI figures obtained that are adjusted for inflation
▪ Advantage: real GDP/GNI can be used as a comparison of economic activity between different years
▪ If nominal, the value of GDP/GNP will show an increase even if there is no real increase if not adjusted for inflation
→ Distinguish between total GDP and GNP/GNI and per capita GDP and GNP/GNI.
• Total GDP: the total value of all goods and services produced in an economy at a given time period
• GDP per capita: total GDP divided by size of the nation’s population
• Total GNP: total value of all goods and services produced by a nation’s factor of production at a given time
• GNP per capita: total GNP divided by size of the nation’s population
• Per capita values often are used to compare wealth of nations as it reflects average wealth and standard of living in a country
• For example, GDP of China is around twice of that of Canada, but GDP per capita of Canada is 27 times higher than China’s
→ Examine the output approach, the income approach and the expenditure approach when measuring national income.
• Output method: calculated by summing the total value of goods and serviced produced by firms in an economy
• Income method: calculated by measuring the total value of all the incomes earned (rent, wages, interest, profit) in an economy
• Expenditure method: calculated by measuring the total value of all spending on goods and services in the economy
→ Evaluate the use of national income statistics, including their use for making comparisons over time, their use for making
comparisons between countries and their use for making conclusions about standards of living.
• Use of national income statistics
▪ Comparison over time: income can be compared over time to analyse growth trends and development of policies
▪ Comparison between countries: shows the success or failure of the associated government action
▪ Making conclusions about standard of living: assist understanding the standard of living of a country and impact of
policies
• Problems with national income statistics in making conclusions
▪ Transfer payments: social welfare payments are not calculated in GDP as there is no evident output
▪ Inaccuracies: tax claims, sales data et cetera my not be accurately recorded
▪ Composition of output: if more output does not benefit people (e.g. weapons) it does not raise living standards
▪ Unrecorded or under recorded economic activity: presence of subsistence farming, unrecorded illicit activities
▪ Potentially inaccuracy in quality of life: higher working hours increases GDP but doesn’t raise the standard of living
→ Explain the meaning and significance of “green GDP”, a measure of GDP that accounts for environmental destruction.
• Green GDP: measure of GDP that accounts for cost associated with environmental destructions
▪ Calculation: Green GDP = GDP – environmental cost
▪ Significance: may reflect a more accurate GDP as there may be a higher GDP from environmental destruction (e.g.
cleaning oil spills) that is not considered when calculating GDP values
→ HL content: Calculate nominal GDP from sets of national income data, using the expenditure approach.
• Nominal GDP = government expenditure (G) + investment (I) + consumption (C) + net income from abroad (X-M)
▪ Expenditure method: calculated by measuring the total value of all spending on goods and services in the economy
▪ These values are not adjusted for inflation (non-real figures) and are not fit for comparison over time
→ HL content: Calculate GNP/GNI from data
• GNP/GNI = GDP + (income earned from assets abroad – income paid to foreign assets)
→ HL content: Calculate real GDP, using a price deflator.
• Calculation of real GDP
▪ Real GDP = (nominal GDP) ÷ (GDP deflator) x 100
▪ Price deflator = (nominal GDP) ÷ (real GDP) x 100
Business cycle
→ Explain, using a business cycle diagram, that economies typically tend to go through a cyclical pattern characterized by the
phases of the business cycle.
• Business cycle: periodic fluctuations in real national output around the productive potential (long term trend) of the economy
▪ Stages of a business cycle: trough, recovery/boom, peak, recession
▪ Potential growth curve: the potential growth curve (trend) cuts through the curve in an increasing trend
, Characteristics Trough Peak
Employment Low High
Income Low High
Consumption Low High
Investment Low High
Demand for imports Low High
Tax revenues Low High
Transfer payment High Low
Budget Deficient Surplus
→ Explain the long-term growth trend in the business cycle diagram as the potential output of the economy.
• Long term growth trend: in the long run, economies tend to go through a general upward trend in economic growth
▪ In the long run, quantity and quality of factor of production increases (e.g. growth of labour, productivity, technology)
▪ Subsequently, there is an outward shift of PPC and hence an increase in economic potential
▪ This is seen as the long-run linear trend in the business cycle as the increasing potential output of the economy
▪ Long term growth is promoted following the increase in economic potential
• When the potential real GDP is compared with the actual GDP, there is an output gap
▪ Inflationary gap: positive output gap = potential real GDP < actual GDP
▪ Deflationary gap: negative output gap = potential real GDP > actual GDP
→ Distinguish between a decrease in GDP and a decrease in GDP growth.
• Decrease in GDP growth rate: decrease in the percentage increase in real GDP from earlier measurement cycle
• Decrease in GDP: the actual fall of real GDP from the earlier measurement cycle
Economic activity
→ Describe, using a diagram, the circular flow of income between households and firms in a closed economy with no government.
• Two sector model: constitutes of the households
and the firms in a closed economy
→ Identify the four factors of production and their
respective payments (rent, wages, interest and profit) and
explain that these constitute the income flow in the model.
• Flow from household to firms
▪ Resources (factor of production): land,
labour, capital, entrepreneur
▪ Expenditure: consumption expenditure
(demand)
• Flow from firms to household
▪ Income (respective payments): rent,
wages, interest and profits
▪ Output: goods and services (supply)
→ Outline that the income flow is numerically equivalent to the expenditure flow and the value of output flow.
• The income flow is numerically equivalent to the expenditure flow and output flow. (Y=E=O)
▪ Income flow: factor income from firms to household
▪ Expenditure flow: consumer expenditure from household to firms
▪ Value of output flow: value of goods and services (output) flowing from firms to household
▪ In theory, these should have the same value; but in reality is it not always so
→ Describe, using a diagram, the circular flow of income in an open economy with government and financial markets, referring to
leakages/ withdrawals (savings, taxes and import expenditure) and injections (investment, government expenditure and export
revenue).
• In the five sector model, additional sectors are present to illustrate leakages and injections in the economy
▪ Injection: introduction of income to the flow
▪ Leakage: removal of income from the flow
• Government sector
▪ Injection: government spending (G)
▪ Leakage: taxation (T)
• Financial sector
▪ Injection: investment (I)
▪ Leakage: savings (S)
• International sector
▪ Injection: exports (E)
▪ Leakage: imports (I)
→ Explain how the size of the circular flow will change depending on the relative size of injections and leakages.
• The size of the circular flow can change depending on the level of injections and leakages.
▪ Injection > leakage: size of circular flow increases
▪ Injection < leakage: size of circular flow decreases
▪ Injection = leakage: equilibrium level of national income
→ Distinguish between GDP and GNP/GNI as measures of economic activity.
• Gross domestic products (GDP): total value of all goods and services produced in an economy at a given time period
▪ GDP = government expenditure (G) + investment (I) + consumption (C) + net income from abroad (X-M)
▪ Measurement of economic activity: more accurately determines how the country’s economy is performing overall
within the border; takes into account how benefits are directly made from domestic sectors (e.g. tax and employment)
• Gross national income (GNI): total value of all goods and services produced by a nation’s factor of production at a given time
▪ GNI = GDP + (income earned from assets abroad – income paid to foreign assets)
▪ Measurement of economic activity: better assessment of a countries wealth as in a global economy the wealth of a
country as income often flows back from host to home country
,→ Distinguish between the nominal value of GDP and GNP/GNI and the real value of GDP and GNP/GNI.
• Nominal value of GDP and GNI: numerical GDP/GNI figures obtained that are not adjusted for inflation
• Real value of GDP and GNI: numerical GDP/GNI figures obtained that are adjusted for inflation
▪ Advantage: real GDP/GNI can be used as a comparison of economic activity between different years
▪ If nominal, the value of GDP/GNP will show an increase even if there is no real increase if not adjusted for inflation
→ Distinguish between total GDP and GNP/GNI and per capita GDP and GNP/GNI.
• Total GDP: the total value of all goods and services produced in an economy at a given time period
• GDP per capita: total GDP divided by size of the nation’s population
• Total GNP: total value of all goods and services produced by a nation’s factor of production at a given time
• GNP per capita: total GNP divided by size of the nation’s population
• Per capita values often are used to compare wealth of nations as it reflects average wealth and standard of living in a country
• For example, GDP of China is around twice of that of Canada, but GDP per capita of Canada is 27 times higher than China’s
→ Examine the output approach, the income approach and the expenditure approach when measuring national income.
• Output method: calculated by summing the total value of goods and serviced produced by firms in an economy
• Income method: calculated by measuring the total value of all the incomes earned (rent, wages, interest, profit) in an economy
• Expenditure method: calculated by measuring the total value of all spending on goods and services in the economy
→ Evaluate the use of national income statistics, including their use for making comparisons over time, their use for making
comparisons between countries and their use for making conclusions about standards of living.
• Use of national income statistics
▪ Comparison over time: income can be compared over time to analyse growth trends and development of policies
▪ Comparison between countries: shows the success or failure of the associated government action
▪ Making conclusions about standard of living: assist understanding the standard of living of a country and impact of
policies
• Problems with national income statistics in making conclusions
▪ Transfer payments: social welfare payments are not calculated in GDP as there is no evident output
▪ Inaccuracies: tax claims, sales data et cetera my not be accurately recorded
▪ Composition of output: if more output does not benefit people (e.g. weapons) it does not raise living standards
▪ Unrecorded or under recorded economic activity: presence of subsistence farming, unrecorded illicit activities
▪ Potentially inaccuracy in quality of life: higher working hours increases GDP but doesn’t raise the standard of living
→ Explain the meaning and significance of “green GDP”, a measure of GDP that accounts for environmental destruction.
• Green GDP: measure of GDP that accounts for cost associated with environmental destructions
▪ Calculation: Green GDP = GDP – environmental cost
▪ Significance: may reflect a more accurate GDP as there may be a higher GDP from environmental destruction (e.g.
cleaning oil spills) that is not considered when calculating GDP values
→ HL content: Calculate nominal GDP from sets of national income data, using the expenditure approach.
• Nominal GDP = government expenditure (G) + investment (I) + consumption (C) + net income from abroad (X-M)
▪ Expenditure method: calculated by measuring the total value of all spending on goods and services in the economy
▪ These values are not adjusted for inflation (non-real figures) and are not fit for comparison over time
→ HL content: Calculate GNP/GNI from data
• GNP/GNI = GDP + (income earned from assets abroad – income paid to foreign assets)
→ HL content: Calculate real GDP, using a price deflator.
• Calculation of real GDP
▪ Real GDP = (nominal GDP) ÷ (GDP deflator) x 100
▪ Price deflator = (nominal GDP) ÷ (real GDP) x 100
Business cycle
→ Explain, using a business cycle diagram, that economies typically tend to go through a cyclical pattern characterized by the
phases of the business cycle.
• Business cycle: periodic fluctuations in real national output around the productive potential (long term trend) of the economy
▪ Stages of a business cycle: trough, recovery/boom, peak, recession
▪ Potential growth curve: the potential growth curve (trend) cuts through the curve in an increasing trend
, Characteristics Trough Peak
Employment Low High
Income Low High
Consumption Low High
Investment Low High
Demand for imports Low High
Tax revenues Low High
Transfer payment High Low
Budget Deficient Surplus
→ Explain the long-term growth trend in the business cycle diagram as the potential output of the economy.
• Long term growth trend: in the long run, economies tend to go through a general upward trend in economic growth
▪ In the long run, quantity and quality of factor of production increases (e.g. growth of labour, productivity, technology)
▪ Subsequently, there is an outward shift of PPC and hence an increase in economic potential
▪ This is seen as the long-run linear trend in the business cycle as the increasing potential output of the economy
▪ Long term growth is promoted following the increase in economic potential
• When the potential real GDP is compared with the actual GDP, there is an output gap
▪ Inflationary gap: positive output gap = potential real GDP < actual GDP
▪ Deflationary gap: negative output gap = potential real GDP > actual GDP
→ Distinguish between a decrease in GDP and a decrease in GDP growth.
• Decrease in GDP growth rate: decrease in the percentage increase in real GDP from earlier measurement cycle
• Decrease in GDP: the actual fall of real GDP from the earlier measurement cycle
