Economic Growth 2.3 AS90796

What is Economic Growth?




Definition

A positive change in the level of production of goods and services by a country over a certain period of time. Nominal growth is defined as economic growth including inflation, while real growth is nominal growth minus inflation. Economic growth is usually brought about by technological innovation and positive external forces.

The simplest definition of economic growth is an increase in real gross domestic product (GDP) (that is, GDP adjusted for inflation). The growth rate of real GDP is the percentage change in real GDP from one year to the next.

Economic growth - what is it and what contributes to it?

Economies tend to grow in cycles - consistently high growth is rare. The cycle of growth is called the business cycle or the trade cycle and is shown in the diagram below.
external image Business_Cycle.jpg



The macroeconomy grows or contracts over time by a series of repetitive expansions (booms) and contractions (recessions), or business cycles. A business cycle is a single complete episode of expansion of above-average economic growth, followed by a peak, followed by a contraction of below-average economic growth, followed by a trough or low-point. A new business cycle, beginning with a new period of expansion, follows each trough or low-point. Business cycles are recurrent but not periodic (they do not recur at regular intervals). Each business cycle is unique in many ways, such as length, depth of trough, and height of peak.

external image Biot604PhotoA.bmp
Diagram showing the relationship of business cycles to overall economic growth. Note the variability of individual cycles, e.g., depth of trough, height of peak. Source: http://therottenlittlegirls.files.wordpress.com/20...; accessed March 25, 2009.

At the peak of the cycle (boom period), growth is high, unemployment low but inflation may be starting to rise as high growth in demand starts to cause demand-pull inflation. The emergence of inflation may cause deflationary policies to be put in place and growth may start to fall (the downturn). It may even slow down to the extent that there is a recession. This is defined as two successive quarters of negative growth.

Measuring growth

Economic growth is growth in the level of national income. There are various measures of national income, but the most commonly used one is gross domestic product (GDP). We measure growth as the percentage change in GDP. However, it is very important that we only take the percentage change in real GDP. This means the change in GDP after inflation has been taken into account.

Causes of growth

Governments are obviously keen to encourage economic growth and to do that they need to be sure about the main contributory factors. The main sources of growth are:
  • Natural resources - if an economy has a plentiful supply of natural resources it may help it to expand. However, natural resources on their own are not enough. There also have to be the skilled people to exploit the opportunities. This means that education and training become critical factors contributing to growth.
  • Capital - more capital generally means more production, and more production means more growth. To get capital, countries have to invest and so the level of investment may be a big determinant of future growth. The quality of the capital is important as well. It's no good investing in out of date equipment!
  • Rate of savings - to have more tomorrow you often have to have less today (jam tomorrow!). This is true with savings as well. To provide funds for investment there needs to be a good level of savings. This should in turn mean more growth in the future.
  • Technological progress - this is perhaps the most widely accepted (and easiest to understand) source of economic growth. This is because technology makes it possible to produce more from the same quantity of resources (or factors of production). This boosts the potential level of output of the economy. The pace of technological change will depend on:
    • the scientific skills of the country
    • the quality of education
    • the amount of GDP devoted to research and development

Measures of Economic Performance

Economic Measures:

  • Inflation

  • Unemployment Growth

  • Gross Domestic Product (GDP)

  • Balance of Payments

  • Exchange Rate

Non-Economic Measures:

  • Quality of Life
  • life –
  • Environment
  • Health
  • Education
  • life expectancy
  • standard of living


net economic welfare

The concept of a broader measure of economic welfare than income per head. This could include in addition to ordinary measures of income items such as the following: the cost of effort; the value of household production, including services such as child-care and looking after the sick


New Zealand GDP Growth Rate

The Gross Domestic Product (GDP) in New Zealand expanded at an annual rate of 0.60 percent in the last quarter. New Zealand Gross Domestic Product is worth 130 billion dollars or 0.21% of the world economy, according to the World Bank. Over the past 20 years the government has transformed New Zealand from an agrarian economy dependent on concessionary British market access to a more industrialized, free market economy that can compete globally. This dynamic growth has boosted real incomes - but left behind some at the bottom of the ladder - and broadened and deepened the technological capabilities of the industrial sector.


Country
Interest Rate
Growth Rate
Inflation Rate
Jobless Rate
Current Account
Exchange Rate
New Zealand
2.75%
0.60%
2.00%
6.00%
0
0.7108




external image nz-gdp-growth.jpg?w=614&h=306






















link on NZ latest figures:
http://www.dol.govt.nz/lmr/lmr-economic-growth.asp



Economic Growth (GDP)

Gross Domestic Product: The value of output of goods and services produced in NZ during one year Primary, secondary and tertiary sectors Real versus nominal output Can be viewed as being national income, national output or aggregate demand (AD) GDP per capita – GDP divided by the population (GDP per head)


Why is GDP important?


The gross domestic product (GDP) is one the primary indicators used to gauge the health of a country's economy. It represents the total dollar value of all goods and services produced over a specific time period - you can think of it as the size of the economy. Usually, GDP is expressed as a comparison to the previous quarter or year. For example, if the year-to-year GDP is up 3%, this is thought to mean that the economy has grown by 3% over the last year.

Measuring GDP is complicated (which is why we leave it to the economists), but at its most basic, the calculation can be done in one of two ways: either by adding up what everyone earned in a year (income approach), or by adding up what everyone spent (expenditure method). Logically, both measures should arrive at roughly the same total.

The income approach, which is sometimes referred to as GDP(I), is calculated by adding up total compensation to employees, gross profits for incorporated and non incorporated firms, and taxes less any subsidies. The expenditure method is the more common approach and is calculated by adding total consumption, investment, government spending and net exports.

As one can imagine, economic production and growth, what GDP represents, has a large impact on nearly everyone within that economy. For example, when the economy is healthy, you will typically see low unemployment and wage increases as businesses demand labor to meet the growing economy. A significant change in GDP, whether up or down, usually has a significant effect on the stock market. It's not hard to understand why: a bad economy usually means lower profits for companies, which in turn means lower stock prices. Investors really worry about negative GDP growth, which is one of the factors economists use to determine whether an economy is in a recession.
Potential Growth – the overall capacity of the economy (i.e. what the economy could produce if it used all its resources), represented by the straight line on the business cycle diagram.
Actual Growth – the annual percentage increase in output
Nominal Growth – the growth in output not including any adjustment for price changes expressed as ‘current prices’ (the price reigning at the time of the measurement, with the inflation component)
Real Growth – growth in GDP adjusted to take account of changes in the price level (inflation) – expressed as ‘constant prices’

How is GDP calculated?

GDP can be determined in three ways, all of which should in principle give the same result. They are the
  1. product (or output) approach,
  2. the income approach, and
  3. the expenditure approach.
The most direct of the three is the product approach, which sums the outputs of every class of enterprise to arrive at the total.
The expenditure approach works on the principle that all of the product must be bought by somebody, therefore the value of the total product must be equal to people's total expenditures in buying things.
The income approach works on the principle that the incomes of the productive factors ("producers," colloquially) must be equal to the value of their product, and determines GDP by finding the sum of all producers' incomes.
Example: the expenditure method:
GDP = private consumption + gross investment + government spending + (exportsimports), or
mathrm{GDP} = C + mathrm{Inv} + G + left (mathrm{eX} - i right )
mathrm{GDP} = C + mathrm{Inv} + G + left (mathrm{eX} - i right )

In the name "Gross Domestic Product":
"Gross" means that GDP measures production regardless of the various uses to which that production can be put. Production can be used for immediate consumption, for investment in new fixed assets or inventories, or for replacing depreciated fixed assets. If depreciation of fixed assets is subtracted from GDP, the result is called the Net domestic product; it is a measure of how much product is available for consumption or adding to the nation's wealth.
"Domestic" means that GDP measures production that takes place within the country's borders. In the expenditure-method equation given above, the exports-minus-imports term is necessary in order to null out expenditures on things not produced in the country (imports) and add in things produced but not sold in the country (exports).
Economists (since Keynes) have preferred to split the general consumption term into two parts; private consumption, and public sector (or government) spending. Two advantages of dividing total consumption this way in theoretical macroeconomics are:
  • Private consumption is a central concern of welfare economics. The private investment and trade portions of the economy are ultimately directed (in mainstream economic models) to increases in long-term private consumption.
  • If separated from endogenous private consumption, government consumption can be treated as exogenous,[citation needed] so that different government spending levels can be considered within a meaningful macroeconomic framework.
Gross domestic product comes under the heading of national accounts, which is a subject in macroeconomics. Economic measurement is called econometrics.

Production approach

Usually in this approach the producer units (corporated and unincorporated enterprises which together form the business sector, "pure" households, governments and non-profit institutions serving households) of an economy are classified into classes of industries: agriculture, construction, manufacturing, etc. Their outputs are estimated largely on the basis of surveys which businesses fill out, but also the services from dwellings owned by households are counted towards production. To avoid "double-counting" in cases where the output of a producer unit is not a final good or service, but serves as intermediate input (intermediate consumption) into another producer unit, either only final goods and services outputs must be counted, or a "value added" approach must be taken, where what is counted is not the total value output of a producer unit, but its value added: the difference between the value of its gross output and the value of its intermediate consumption. Value added is obtained as a balancing item in the production account of the national accounts.
For market producer sales is usually the largest part of output. But producer units may also produce output for own final use (own final consumption or own gross fixed capital formation) or add their output of goods to their inventories.
Depending on how gross value added has been calculated, it may be necessary to make an adjustment to it before it can be considered equal to GDP. This is because GDP is the market value of goods and services – the price paid by the customer – but the price received by the producer may be different than this if the government taxes or subsidises the product. For example, if there is a sales tax:
Producer's price + sales tax = market price
*Productive capacity is a term used to define maximum possible output of an economy.

Expenditure approach

In contemporary economies, most things produced are produced for sale, and sold. Therefore, measuring the total expenditure of money used to buy things is a way of measuring production. This is known as the expenditure method of calculating GDP. Note that if you knit yourself a sweater, it is production but does not get counted as GDP because it is never sold. Sweater-knitting is a small part of the economy, but if one counts some major activities such as child-rearing (generally unpaid) as production, GDP ceases to be an accurate indicator of production. Similarly, if there is a long term shift from non-market provision of services (for example cooking, cleaning, child rearing, do-it yourself repairs) to market provision of services, then this trend toward increased market provision of services may mask a dramatic decrease in actual domestic production, resulting in overly optimistic and inflated reported GDP. This is particularly a problem for economies which have shifted from production economies to service economies.

Components of GDP by expenditure


external image magnify-clip.png Components of GDP
GDP (Y) is a sum of Consumption (C), Investment (I), Government Spending (G) and Net Exports (X - M).
Y = C + I + G + (X − M)
Here is a description of each GDP component:
  • C (consumption) is normally the largest GDP component in the economy, consisting of private (household final consumption expenditure) in the economy. These personal expenditures fall under one of the following categories: durable goods, non-durable goods, and services. Examples include food, rent, jewelry, gasoline, and medical expenses but does not include the purchase of new housing.
  • I (investment) includes business investment in equipments for example and does not include exchanges of existing assets. Examples include construction of a new mine, purchase of software, or purchase of machinery and equipment for a factory. Spending by households (not government) on new houses is also included in Investment. In contrast to its colloquial meaning, 'Investment' in GDP does not mean purchases of financial products. Buying financial products is classed as 'saving', as opposed to investment. This avoids double-counting: if one buys shares in a company, and the company uses the money received to buy plant, equipment, etc., the amount will be counted toward GDP when the company spends the money on those things; to also count it when one gives it to the company would be to count two times an amount that only corresponds to one group of products. Buying bonds or stocks is a swapping of deeds, a transfer of claims on future production, not directly an expenditure on products.
  • G (government spending) is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. It does not include any transfer payments, such as social security or unemployment benefits.
  • X (exports) represents gross exports. GDP captures the amount a country produces, including goods and services produced for other nations' consumption, therefore exports are added.
  • M (imports) represents gross imports. Imports are subtracted since imported goods will be included in the terms G, I, or C, and must be deducted to avoid counting foreign supply as domestic.



Income approach

Another way of measuring GDP is to measure total income. If GDP is calculated this way it is sometimes called Gross Domestic Income (GDI), or GDP(I). GDI should provide the same amount as the expenditure method described above.
Total income can be subdivided according to various schemes, leading to various formulae for GDP measured by the income approach. A common one is:
GDP = compensation of employees + gross operating surplus + gross mixed income + taxes less subsidies on production and importsGDP = COE + GOS + GMI + TP & M - SP & M
  • Compensation of employees (COE) measures the total remuneration to employees for work done. It includes wages and salaries, as well as employer contributions to social security and other such programs.
  • Gross operating surplus (GOS) is the surplus due to owners of incorporated businesses. Often called profits, although only a subset of total costs are subtracted from gross output to calculate GOS.
  • Gross mixed income (GMI) is the same measure as GOS, but for unincorporated businesses. This often includes most small businesses.
The sum of COE, GOS and GMI is called total factor income; it is the income of all of the factors of production in society. It measures the value of GDP at factor (basic) prices. The difference between basic prices and final prices (those used in the expenditure calculation) is the total taxes and subsidies that the government has levied or paid on that production. So adding taxes less subsidies on production and imports converts GDP at factor cost to GDP(I).
Total factor income is also sometimes expressed as:
Total factor income = Employee compensation + Corporate profits + Proprieter's income + Rental income + Net interest[7]
Yet another formula for GDP by the income method is:[citation needed]
GDP = R + I + P + SA + W
where R : rents
I : interests
P : profits
SA : statistical adjustments (corporate income taxes, dividends, undistributed corporate profits)
W : wages
Note the mnemonic, "ripsaw".
A "production boundary" that delimits what will be counted as GDP.

"One of the fundamental questions that must be addressed in preparing the national economic accounts is how to define the production boundary – that is, what parts of the myriad human activities are to be included in or excluded from the measure of the economic production."[8]

All output for market is at least in theory included within the boundary. Market output is defined as that which is sold for "economically significant" prices; economically significant prices are "prices which have a significant influence on the amounts producers are willing to supply and purchasers wish to buy."[9] An exception is that illegal goods and services are often excluded even if they are sold at economically significant prices (Australia and the United States exclude them).
This leaves non-market output. It is partly excluded and partly included. First, "natural processes without human involvement or direction" are excluded.[10] Also, there must be a person or institution that owns or is entitled to compensation for the product. An example of what is included and excluded by these criteria is given by the United States' national accounts agency: "the growth of trees in an uncultivated forest is not included in production, but the harvesting of the trees from that forest is included.

The Business Cycle

Over a period of time, there are changes in the level of economic activity in an economy. In some years economic growth might be quite slow and in other years growth rates tend to be stronger. There is a tendency for patterns of economic growth to occur. This is called the Business Cycle. (Do not get this confused with the Product Life Cycle!)
There may be a period where economic growth is quite strong. When this happens we might see the number of people being employed rising and the number of people unemployed falling. This makes sense if you refer back to our definition of economic activity. If there is more buying and selling going on then businesses need to employ people to produce the goods and services that people want to buy.
Strong economic growth is not going to last forever. When business activity slows down economic growth also slows. The economy might still be growing - for example a 1% growth rate is still growth it is just not as fast a rate of growth as 2.5%.

Recession

In some cases, economic growth can actually be negative. If there is negative economic growth for two successive quarters this is given a special name - a recession.
A manshowing the insides of his trouser pockets
A manshowing the insides of his trouser pockets

The amount we choose to buy and sell might depend on our income. If people lose their jobs, they have less income and so might not be able to buy as much as they might like. If this happens a lot in the economy then it can cause GDP to be negative. Copyright: David Playford, from stock.xchng.
The business cycle is often expressed as a diagram like the one below:
Diagramshowing how the business goes in cycles of 'boom' and 'bust'
Diagramshowing how the business goes in cycles of 'boom' and 'bust'

Average growth is the level of expected growth of an economy. It can be seen as the overall capacity of the economy - what it is capable of producing given its resources of land, labour and capital. Actual growth is what actually happens. It can be seen as the level of demand in an economy at any one time.
You can see that sometimes actual growth is above average growth. In times like this, the level of demand is higher than the ability of the economy to supply goods and services.
When this happens, there might be what are called 'bottlenecks' in production. Business might be trying to meet the level of demand but might be having difficulties getting hold of the right resources to carry out production. Prices might be rising as a result.
Buildingsite next to a tall building
Buildingsite next to a tall building

Economic activity all depends on the level of buying and selling - it is highly interdependent. There is no point building new offices if businesses are not wanting to move into them. Copyright: Elvis Santana, from stock.xchng.
Some firms might be trying to recruit new staff, for example, but not being able to get the right people with the right qualifications and skills to do the job. Most of the 'good' people in this field might be already employed. One way to attract labour to move from one job to another would be to offer a higher salary. This might get you your employee but increases costs which you might then try and pass on to your customers in the form of higher prices.
In other times the rate of economic growth might be slowing down and if things get really bad we might slip into recession. At times like this, businesses will be having difficulties selling and stock levels may be rising. They might decide there is no point continuing to produce at the same rate if sales are slow and decide to cut back production.
If they do this, there is a risk that some people might lose their jobs and suppliers might also notice a slowdown in orders. They then get affected in the same way and so the process continues.
When looking at the diagram above, we must remember that the shape of these cycles may not be anything like as regular as the diagram. The important thing to remember is that there can be changes in economic conditions and that there can be a pattern. Equally, it is important to remember the terminology being used - growth, slowdown, recession, upturn.

PPF and Economic Growth


The Production Possibilities Frontier (PPF) shows the maximal combinations of two goods that can be produced during a specific time period given fixed resources and technology and making full and efficiency use of available factor resources. A PPF is normally drawn as concave to the origin because the extra output resulting from allocating more resources to one particular good may fall. This is known as the law of diminishing returns and can occur because factor resources are not perfectly mobile between different uses, for example, re-allocating capital and labour resources from one industry to another may require re-training, added to a cost in terms of time and also the financial cost of moving resources to their new use.
external image ppf_1.gif

An example of a conventional PPF is shown in the diagram above which shows potential output of DVD players and MP3 players from a given stock of labour and capital. Combinations of the two goods that lie within the PPF are feasible but show an output that under-utilises existing resources or where resources are being used inefficiently. Combinations of the two goods that lie on the PPF are feasible and can be produced using all available factor inputs efficiently. In the PPF diagram above, the combination of output shown by point E is unattainable given current resources and the productivity of the available factor inputs
Shifts in the PPF
The production possibility frontier will shift when:
(a) There are improvements in productivity and efficiency (perhaps because of the introduction of new technology or advances in the techniques of production)
(b) More factor resources are exploited (perhaps due to an increase in the available workforce or a rise in the amount of capital equipment available for businesses to use)
In our example illustrated in the second diagram below we see the effects of a change in the state of technology in supplying MP3 players which causes an outward shift in the PPF. With the same resources allocated to DVD players, a greater output of MP3 players is possible. The real cost of MP3 players will fall – there has been a change in the opportunity cost
external image ppf_2.gif

The PPF and Economic Efficiency
An efficient production point represents the maximum combination of outputs given resources and technology – clearly the PPF is a useful way of illustrating this idea
Allocative efficiency
An economy achieves allocative efficiency if it manages to produce the combination of goods and services that people actually want. For allocative efficiency to be achieved we need to be on the PPF - because at points which lie within the frontier, it is possible to raise output of both goods and improve total economic welfare. The definition of Pareto Efficiency is an allocation of output where it is impossible to make one group of consumers better off without making another group at least as worse off.
Productive Efficiency
Productive efficiency is defined as the absence of waste in the production process. When the production of the two goods lies on the frontier, anywhere on the frontier is deemed to be production efficient and production inside frontier is inefficient. Productive efficiency requires minimizing the opportunity cost for a given value of output. When there is an outward shift of the PPF perhaps due to improvements in productivity or advances in the state of technology, then the opportunity cost of production falls and society can now produce more from given resources.
Distributive efficiency
We achieve distributive efficiency if we get the goods and services produced to those who actually want or need them. Where we are on the production possibility frontier has little real bearing on distributive efficiency, we tend to use the concept to make comment on allocative and productive efficiency. But when an economy achieves economic growth leading to an outward shift in the PPF, economists have concerns over the distribution of gains in output and whether or not an improvement in average living standards has benefited the majority of consumers or whether there has been an increase in inequality and relative poverty

Production Possibility Frontier (PPF)

Under the field of macroeconomics, the production possibility frontier (PPF) represents the point at which an economy is most efficiently producing its goods and services, and therefore allocating its resources in the best way possible. If the economy is not producing quantities indicated by the PPF, resources are being managed inefficiently, and the production of society will dwindle. The production possibility frontier shows there are limits to production, so an economy, to achieve efficiency, must decide what combination of goods and services can be produced.

Let's turn to the chart below. Imagine an economy that can produce only wine and cotton. According to the PPF, points A, B and C—all appearing on the curve—represent the most efficient use of resources by the economy. Point X represents an inefficient use of resources, while point Y represents goals that the economy cannot attain with its present levels of resources.

external image economics1.gif

As we can see, in order for this economy to produce more wine, it must give up some of its resources used to produce cotton (point A). If the economy started producing more cotton (represented by points B and C), it would have to divert resources from making wine and consequently produce less wine than it is at point A. As you can see, by moving production from point A to B, the economy will have to decrease wine production a small amount in comparison to the increase in cotton output. However, if the economy moved from B to C, wine output would be significantly reduced while the increase in cotton would not be that much of a move. Keep in mind that A, B, and C all represent the most efficient uses of resources for the economy, and the nation must decide how to achieve the PPF and which combination to use. If more wine is in demand, the cost of increasing its output is proportional to the cost of decreasing cotton production.

Point X means that the country's resources are not being used efficiently, or, more specifically, given the potential of its resources, the country is not producing enough cotton or wine. Point Y, as we mentioned above, represents an output level that is currently unreachable by this economy. However, if there were a change in technology while the level of land, labor, and capital remained the same, the time required to pick cotton and grapes would be reduced. Output would increase, and the PPF would be pushed outwards. A new curve, on which Y would appear, would represent the new efficient allocation of resources:

external image economics2.gif

When the PPF shifts out, we know there is growth in an economy. Alternatively, when the PPF shifts inwards, it indicates that the economy is shrinking as a result of a decline in its most efficient allocation of resources and optimal production capability. A shrinking economy could be a result of a decrease in supplies or a deficiency in technology.

An economy can be producing on the PPF curve only in theory. In reality economies constantly struggle to reach an optimal production capacity. And because scarcity forces an economy to forgo one choice for another, the slope of the PPF will always be negative: if production in product A increases, production in product B will have to decrease accordingly.


Review: What do we already know about Economic Growth?



external image 5esgrowth.gif
Economic Growth is one of the ways for a society to reduce scarcity.
Let's define Economic Growth as an increase in the ABILITY to produce goods and services.
This means we are ABLE to produce more, but it doesn't necessarily mean we do produce more.
This type of Economic Growth is caused by:


a) more resources
b) better resources
c) better technology

If we only had more resources we could produce more goods and services and satisfy more of our wants. This will reduce scarcity and give us more satisfaction (more good and services). All societies therefore try to achieve economic growth.
From Production Possibilities lesson - Economic Growth
In Macroeconomics we study three main issues:
  1. Unemployment (UE)
  2. Inflation (IN), and
  3. Economic Growth (EG)
We can use the production possibilities model to demonstrate how economic growth can reduce scarcity.
Our multimedia lesson use several definitions of economic growth. let me review them here.
Three Definitions of Economic Growth
(1) Increasing our POTENTIAL OUTPUT

I like to call this increasing our ABILITY to Produce. this is the definition we used in the 5Es lesson. This is the most fundamental definition of economic growth. It is the type of economic growth used on out 5Es diagram. external image 5esgrowth.gif
We can increase our ABILITY to produce goods and services (or increase our POTENTIAL GDP) if we get:
  1. more resources
  2. better resources, and
  3. better technology
Since this increase maximum output that we are able to produce it shifts the PPF outward. On the graph below, economic growth would cause the PPF to move from PP1 to PP2.
external image ppcgrow2.gif
This doesn't necessarily mean that the economy IS producing more, just that it CAN produce more. To achieve our new potential levels of output we also need full employment and productive efficiency. It could be possible to have this type of economic growth so that we CAN produce the quantities represented by point E, but if there is unemployment and productive inefficiency we would be at a point beneath this new curve (maybe point C). So we may get new resources or new technology so we CAN produce more (point E on PP2), but if we don't use the new resources (i.e. we have unemployment) or if we don't use the new technology (i.e. we have productive inefficiency) , we may remain on PP1 (point C).

(2) Increasing Output (or ACHIEVING our potential output)
The most commonly used definition of economic growth is simply producing more. (Later we will call this INCREASING REAL GDP.)When an economy increases its output it is often said to have achieved economic growth. But if by producing more we are simply ACHIEVING OUR POTENTIAL, then we could also say that it is REDUCING UNEMPLOYMENT or ACHIEVING PRODUCTIVE EFFICIENCY. On our graph this would be represented by moving from point D to a point on the curve: A, B, or C).
external image ppcgrow1.gif

(3) Increasing Real GDP per capita
The definition of economic growth used in our multimedia lesson on economic growth (Macro_015.les) is an increase in GDP per capita. This means increasing output per person. GDP per capita is calculated by dividing output by the population.
From the AS - AD Lesson:
Economic Growth

What about economic growth? In an earlier lesson we discussed three definitions of economic growth
  1. Increasing our POTENTIAL OUTPUT
  2. Increasing Output, and
  3. Increasing Real GDP per capita
(1) Increasing our POTENTIAL OUTPUT

I like to call this increasing our ABILITY to produce. This is the most fundamental definition of economic growth. It is the type of economic growth used in the diagram. external image 5esgrowth.gif
We can increase our ABILITY to produce goods and services (or increase our POTENTIAL GDP) if we get:
  1. more resources
  2. better resources, and
  3. better technology
Since this increases maximum output that we are able to produce it shifts the PPF outward. On the graph below, economic growth would cause the PPF to move from PP1 to PP2.
external image ppcgrow2.gif
This doesn't necessarily mean that the economy IS producing more, just that it CAN produce more. To achieve our new potential levels of output we also need full employment and productive efficiency. It could be possible to have this type of economic growth so that we CAN produce the quantities represented by point E, but if there is unemployment and productive inefficiency we would be at a point beneath this new curve (maybe point C). So we may get new resources or new technology so we CAN produce more (point E on PP2), but if we don't use the new resources (i.e. we have unemployment) or if we don't use the new technology (i.e. we have productive inefficiency) , we may remain on PP1 (point C).
In the AS-AD model INCREASING OUR POTENTIAL OUTPUT is represented by in increase in AS.
external image asincfe.gif
Notice that when AS increases, the full employment level of output increase from RDO-FE1 to RDO-FE2. this is an increase in our potential level of output.
In the 5 Es lecture we said that economic growth is caused by:
  1. more resources
  2. better resources, or
  3. better technology
An increase in the production possibilities curve is caused by having more resources, better resources, or better technology.
An increase in AS is caused by:
  1. a decrease in the price of resources
  2. an increase in productivity
  3. lower business taxes and government red tape
These are all really the same thing.

(2) Increasing Output (or ACHIEVING out potential)
The most commonly used definition of economic growth is simply producing more. (Later we will call this INCREASING REAL GDP.)When an economy increases its output it is often said to have achieved economic growth. But if by producing more we are simply ACHIEVING OUR POTENTIAL, then we could also say that it is REDUCING UNEMPLOYMENT or ACHIEVING PRODUCTIVE EFFICIENCY. On our graph this would be represented by moving from point D to a point on the curve: A, B, or C).
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On our AD-AS model we could illustrate this type of growth (producing more) by an increase in AD.
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Notice that output increase from RDO-EQUIL to RDO', but the full employment level of output, which is our potential level of output, does not change (RDO-FE).
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If Ad increase so that equilibrium is at the full employment level of output, it is analogous to going from a point inside the production possibilities curve to a point on the curve.
(3) Increasing Real GDP per capita

The definition of economic growth used in our multimedia lesson on economic growth (Macro_015.les) is an increase in GDP per capita. This means increasing output per person. GDP per capita is calculated by dividing output by the population.


Circular FLow Diagram

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Two Sector Model

In the simple two sector circular flow of income model the state of equilibrium is defined as a situation in which there is no tendency for the levels of income (Y), expenditure (E) and output (O) to change, that is:
Y = E = O
This means that the expenditure of buyers (households) becomes income for sellers (firms). The firms then spend this income on factors of production such as labour, capital and raw materials, "transferring" their income to the factor owners. The factor owners spend this income on goods which leads to a circular flow of income.
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Five sector model


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The five sector model of the circular flow of income is a more realistic representation of the economy. Unlike the two sector model where there are six assumptions the five sector circular flow relaxes all six assumptions. Since the first assumption is relaxed there are three more sectors introduced. The first is the Financial Sector that consists of banks and non-bank intermediaries who engage in the borrowing (savings from households) and lending of money. In terms of the circular flow of income model the leakage that financial institutions provide in the economy is the option for households to save their money. This is a leakage because the saved money can not be spent in the economy and thus is an idle asset that means not all output will be purchased. The injection that the financial sector provides into the economy is investment (I) into the business/firms sector. An example of a group in the finance sector includes banks such as Westpac or financial institutions such as Suncorp.
The next sector introduced into the circular flow of income is the Government Sector that consists of the economic activities of local, state and federal governments. The leakage that the Government sector provides is through the collection of revenue through Taxes (T) that is provided by households and firms to the government. For this reason they are a leakage because it is a leakage out of the current income thus reducing the expenditure on current goods and services. The injection provided by the government sector is Government spending (G) that provides collective services and welfare payments to the community. An example of a tax collected by the government as a leakage is income tax and an injection into the economy can be when the government redistributes this income in the form of welfare payments, that is a form of government spending back into the economy.
The final sector in the circular flow of income model is the overseas sector which transforms the model from a closed economy to an open economy. The main leakage from this sector are imports (M), which represent spending by residents into the rest of the world. The main injection provided by this sector is the exports of goods and services which generate income for the exporters from overseas residents. An example of the use of the overseas sector is Australia exporting wool to China, China pays the exporter of the wool (the farmer) therefore more money enters the economy thus making it an injection. Another example is China processing the wool into items such as coats and Australia importing the product by paying the Chinese exporter; since the money paying for the coat leaves the economy it is a leakage.
In terms of the five sector circular flow of income model the state of equilibrium occurs when the total leakages are equal to the total injections that occur in the economy. This can be shown as:
Savings + Taxes + Imports = Investment + Government Spending + Exports
OR
S + T + M = I + G + X.
This can be further illustrated through the fictitious economy of Noka where:
S + T + M = I + G + X
$100 + $150 + $50 = $50 + $100 + $150
$300 = $300
Therefore since the leakages are equal to the injections the economy is in a stable state of equilibrium. This state can be contrasted to the state of disequilibrium where unlike that of equilibrium the sum of total leakages does not equal the sum of total injections. By giving values to the leakages and injections the circular flow of income can be used to show the state of disequilibrium. Disequilibrium can be shown as:
S + T + M ≠ I + G + X
Therefore it can be shown as one of the below equations where:
Total leakages > Total injections
$150 (S) + $250 (T) + $150 (M) > $75 (I) + $200 (G) + 150 (X)
Or
Total Leakages < Total injections
$50 (S) + $200 (T) + $125 (M) < $75 (I) + $200 (G) + 150 (X)
The effects of disequilibrium vary according to which of the above equations they belong to.
If S + T + M > I + G + X the levels of income, output, expenditure and employment will fall causing a recession or contraction in the overall economic activity. But if S + T + M < I + G + X the levels of income, output, expenditure and employment will rise causing a boom or expansion in economic activity.
To manage this problem, if disequilibrium were to occur in the five sector circular flow of income model, changes in expenditure and output will lead to equilibrium being regained. An example of this is if:
S + T + M > I + G + X the levels of income, expenditure and output will fall causing a contraction or recession in the overall economic activity. As the income falls (Figure 4) households will cut down on all leakages such as saving, they will also pay less in taxation and with a lower income they will spend less on imports. This will lead to a fall in the leakages until they equal the injections and a lower level of equilibrium will be the result.
The other equation of disequilibrium, if S + T + M < I + G + X in the five sector model the levels of income, expenditure and output will greatly rise causing a boom in economic activity. As the households income increases there will be a higher opportunity to save therefore saving in the financial sector will increase, taxation for the higher threshold will increase and they will be able to spend more on imports. In this case when the leakages increase they will continue to rise until they are equal to the level injections. The end result of this disequilibrium situation will be a higher level of equilibrium.


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CIRCULAR FLOW:

A model of the continuous movement of production, income, and the services of scarce resources that flow between producers and consumers. In particular, the circular flow is a model of the continuous production and consumption interaction among the four major sectors of the macroeconomy--household, business, government, and foreign--using the three macroeconomic markets--product, resource, and financial. The circular flow model provides a easy way of getting the "big picture" and of seeing how the key parts of the macroeconomy fit together.
The circular flow model is a fundamental representation of macroeconomic activity among the major players in the economy--consumers, producers, government, and the rest of the world. Different versions of the model sequentially combined the four sectors--household, business, government, and foreign--and the three markets--product, resource, and financial--into increasingly more comprehensive representations of the economy.
The basic model illustrates the interaction between the household and business sectors through the product and resource markets. However, more realistic circular flow models include saving, investment, and investment borrowing enabled by the financial markets; taxes and expenditures of the government sector; and imports and exports of the foreign sector.
The prime conclusion of the circular flow model is that the overall volume of the circular flow is largely unaffected by the path taken. In particular, household income can be used for consumption, saving, or taxes. The income diverting away from consumption and to saving or taxes does not disappear, but is used to finance investment by business sector and purchases by the government sector.

Four Sectors

The circular flow model illustrates the interaction among the four macroeconomic sectors--household, business, government, and foreign. These four sectors capture four fundamental macroeconomic functions and their expenditures are combined together to purchase the economy's total production.

  • Household sector: This includes everyone, all people, seeking to satisfy unlimited wants and needs. This sector is responsible for consumption and undertakes consumption expenditures. It also owns all productive resources.

  • Business sector: This includes the institutions (especially proprietorships, partnerships, and corporations) that undertake the task of combining resources to produce goods and services. This sector does the production. It also buys capital goods with investment expenditures.

  • Government sector: This includes the ruling bodies of the federal, state, and local governments. Regulation is the prime function of the government sector, especially passing laws, collecting taxes, and forcing the other sectors to do what they would not do voluntarily. It buys a portion of domestic product',500,400)">gross domestic product as government purchases.

  • Foreign sector: This includes everyone and everything (households, businesses, and governments) beyond the boundaries of the domestic economy. It buys exports produced by the domestic economy and produces imports purchased by the domestic economy, which are commonly combined into net exports (exports minus imports).

Three Markets

The four macroeconomic sectors interact through three macroeconomic markets--product, resource, and financial. These three markets exchange the goods, services, and resources that are used for economic activity.

  • Product Markets: The product markets exchange the production of final goods and services, or what is termed gross domestic product. The buyers of this production are the four macroeconomic sectors--household, business, government, and foreign. The seller of this production is primarily the business sector.

  • Resource Markets: The services of the four factors of production--labor, capital, land, and entrepreneurship--are traded through resource markets. Resource markets are used by the business sector to acquire the factor services needed for production. Payment for these factor services then generate the income received by the household sector, which owns the resources.

  • Financial Markets: The commodity exchanged through financial markets is legal claims. Legal claims represent ownership of physical assets (capital and other goods). Because the exchange of legal claims involves the counter flow of income, those seeking to save income buy legal claims and those wanting to borrow income sell legal claims.

The Physical Flow

The Physical Flow
Circular Flow
Circular Flow

The foundation of the circular flow is the physical movement of goods and services, what is termed the physical flow. This flow is illustrated in the exhibit to the right for the simplest circular flow model, two sectors (household and business) and two markets (product and resource). The physical flow is the movement of goods and services from the business sector to the household sector and the movement of resource services from the household sector to the business sector, usually represented as a counter-clockwise movement.
For example, suppose that Duncan Thurly buys an OmniMotors XL GT 9000 Sports Coupe. This car physically "flows" from the OmniMotors Dealership in the business sector through the product markets and ends up in the possession of a member of the household sector, which is Duncan. This is represented by the upper half of the circular flow exhibit.
In addition, the labor services of Gerald Cheverhold, an OmniMotors employee, physically "flows" from the household sector, where Gerald resides, through the factor markets, and ends up with OmniMotors in the business sector, where it is used in the production of an OmniMotors XL GT 9000 Sports Coupe. This is represented by the lower half of the circular flow exhibit.

The Payment Flow

The physical flow of goods, services, and resources is countered by the payment flow that moves in the opposite direction. The payment flow is the movement of money payments from the household to the business sector in exchange for final goods and services and from the business to the household sector in exchange for the services of resources, usually represented as a clockwise movement.
The Payment Flow
Circular Flow
Circular Flow

The basic payment flow is illustrated by the revised circular flow model to the left. The gray inner ring represents the physical flow. The green outer ring represents the payment flow moving in the opposite direction.
For example, when Duncan purchases his OmniMotors XL GT 9000 Sports Coupe, the car "flows" from the dealer to him, from the business sector to the household sector in the upper half of the diagram. However, moving in the opposite direction is the payment for this car. The payment "flows" from Duncan to the dealer, from the household sector to the business sector.
In the lower half of the diagram, the labor services of Gerald Cheverhold "flows" from the household sector to the business sector. However, moving in the opposite direction is the payment for this labor. The payment "flows" from OmniMotors to Gerald, from the business sector to the household sector.

Four Measures

Four Circulating Measures
Circular Flow
Circular Flow

The essence, the core, of the circular flow is the flow of payments between the household and business sectors through the product and resource markets. This core flow can be divided into four parts, each of which is important to the study of macroeconomics.

  • Gross domestic product, or GDP, is the upper right-hand segment of the flow. This is the revenue received by the business sector for the production of final goods and services sold to the household sector.

  • Factor payments are the lower right-hand segment of the flow. These are wage, interest, rent, and profit payments made by the business sector to hire labor, capital, land, and entrepreneurship resources from the household sector.

  • National Income is the lower left-hand segment of the flow. It is the income earned by the household sector for supplying labor, capital, land, and entrepreneurship resources to the business sector.

  • Consumption expenditures are the upper left-hand segment. These are payments made by the household sector to purchase gross domestic product from the business sector.

Four Models

The Complete Model
Circular Flow
Circular Flow

The circular flow model actually consists of four separate models, each sequentially adding sectors or markets and thus providing greater complexity and realism.

  • Two Sectors, Two Markets: The simplest circular flow model contains two sectors (household and business) and two markets (product and resource). This model highlights the core circular flow of production, income, and consumption.

  • Two Sectors, Three Markets: A second version of the circular flow model adds the financial markets. This addition illustrates how saving is diverted from the household sector to the business sector to finance investment expenditures.

  • Three Sectors, Three Markets: A third version of the model includes the government sector. This model highlights the importance of taxes, which are also diverted from household sector income and used to finance government purchases.

  • Four Sectors, Three Markets: The most comprehensive circular flow model includes the foreign sector. Adding the foreign sector highlights the role of trade with the rest of the world, especially exports and imports.
The complete circular flow model, with all four macroeconomic sectors (household, business, government and foreign) and all three macroeconomic markets (product, resource, and financial),








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circular flow of income
circular flow of income



The Circular Flow

Resource markets are a key component of the circular flow model of the economy. The circular flow captures the continuous movement of production, income, and factor payments between producers and consumers.
A basic representation of the circular flow is displayed to the right. The four components of this simple model are: household sector, business sector, product markets, and resource markets. The household sector at the far left contains the consuming population of the economy. The business sector at the far right includes all of the producers.

The resource markets at the bottom of the flow direct factor services from the household sector to the business sector in exchange for payment flowing in the opposite direction. The product markets at the top of the flow direct production from the business sector to the household sector in exchange for payment flowing in the opposite direction.

The circular flow indicates that the income used by the household sector to purchase goods through the product markets is obtained by selling factor services through the resource markets. It also indicates that the revenue used by the business sector to pay for factor services obtained through the resource markets is generated by selling goods through the product markets.

he circular flow model is a fundamental representation of macroeconomic activity among the major players in the economy--consumers, producers, government, and the rest of the world. Different versions of the model sequentially combined the four sectors--household, business, government, and foreign--and the three markets--product, resource, and financial--into increasingly more comprehensive representations of the economy. This article does not include the foreign sector. It will be discussed in a separate article

The model below illustrates the simple, basic interaction between the household and business sectors through the product and resource markets.
Two Sectors, Two Markets:
The simplest circular flow model contains two sectors (household and business) and two markets (product and factor/resource). This model highlights the core circular flow of production, income, and consumption.
Total income is income re­ceived by house­holds in payment for the production of these goods and servic­es. The value of total output is identical to total income since spending by one group is income to another. Thus income earned by households equals their spending on consumption.
Circular Flow Model Factor and Product Market
Circular Flow Model Factor and Product Market

The circular flow of goods and services is a simplified illustration of basically two flows: the flow of incomes to households from firms, and the flow of resources to firms from households. Resources flow from households to businesses, which change the resources into goods and services for consumption in the product markets. Households are rewarded for the resources they provide in the form of money. It is a circular process that flows in both directions.
Three Sectors, Three Markets:
The second version of the model includes the government sector and the financial sector. You will notice that when household savings "leak out" of the circular flow and are deposited in the financial institutions. They are "injected" back into the economy in the form of business investments. Households also receive interest and dividend income form businesses.
While taxes take a portion of the household income out of the circular flow (leaks out as did the savings), that amount comes back to the circular flow as an injection in the form of purchases of goods and services that the government buys from the product markets and pays households as social security, Medicaid, welfare, etc
The government buys goods and services from private firms and pays wages and salaries to government employees. Since many government goods are not sold in the market place we value them at their cost when estimating Gross Domestic Product (GDP) which is explained and discussed later in a later article.
Leakages and Injections Model Leakages: Household Savings and Taxes Injections: Government Purchases and Business Investments
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The prime conclusion of the circular flow model is that the overall volume of the circular flow is largely unaffected by the path taken. In particular, household income can be used for consumption, saving, or taxes






Sunrise and sunset firms
sunrise =new firms with high growth potential
sunset= firms reaching the end of their life cycle

Resources will be moved from sunset firms to sunrise firms to take advantage of the economic groeth potential. People will change jobs, move regions as well. This can result in an uneven spread of incomes, economic growth.

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