The new topic is the production-income-spending circular flow. The assigned readings are pp. 161-165 about business cycles, pp. 183-197 about National Income Accounting, and pp. 199-205.

The business cycle refers to the ebb and flow of economic activity over time. When jobs are plentiful and consumers have confidence, they buy lots of goods and services. This induces business firms to increase production, which in turn leads to more employment and household income, which leads to more spending, etc. Clearly, the economy is moving up the business cycle toward a peak of economic activity.

In other situations, consumers become insecure about their jobs and cut back on spending. This leads business firms to cut their production of goods and services, which in turn leads to production cuts, job losses, and a reduction in household income. Spending falls as the economy moves down the business cycle to a trough. Very significant downturns result in recessions, which are sometimes defined as two consecutive quarters of negative GDP growth. When the economy is performing well and is at full employment, the economy is at the top of the business cycle.

We want to be able to measure macroeconomic activity and that is what national income accounting is designed to do. It was invented back in the 1930s due to a paucity of macroeconomic data that some believe exacerbated the depression of that time. We never really got out of the economic doldrums until WWII came along, and that would not be everybody’s first choice as a way of moving up the business cycle. Today’s macroeconomic data is quite good, although forecasting the future is never easy.

In a macroeconomy, output and income are, by definition, equal. That is, Gross Domestic Product (GDP), the total market value of all final goods and services produced in the economy, is equal to Gross Domestic Income (GDI). This is confirmed by considering a primitive economy in which the only item produced is something like strawberries picked from a strawberry patch. To keep this economy simple, assume there is no cash or checking account money and there are no credit cards. The total production in this economy consists of all the strawberries picked by the pickers. The total income to this macroeconomy is ... all the strawberries picked by the pickers. Output and income in a macroeconomy are equal.

The basic measure of economic activity is Gross Domestic Product. As stated above, it is the total market value of all final goods and services produced. Conceptually, it is price x quantity for each and every good or service produced for final usage or consumption. It may be also be thought of as a flow rate of production. Sometimes the economy at a peak of economic activity in the business cycle. When this occurs, the flow of new production is strong. At other times, the economy slides down the business cycle toward a trough of activity. In this situation, the production of goods or services is much slower.

The federal government measures GDP on a quarterly and annual basis. The quarterly growth numbers are converted to an annual basis for ease of comparison. Typical GDP growth rates are 2%, 3%, 4%, or even 5%, although 5% is higher than normal. A 2% GDP growth rate is on the weak side. Economists and business firms anxiously await the GDP statistic. Since the calculations are tedious, the government as a matter of routine reports the number and then offers a first revision and then a second revision after more data and calculations are made. This allows the government to get the initial figures out quickly and then follow up with more accurate information later.

Note that only commercial market transactions are included in GDP. If you eat at a restaurant, then the entire transaction is part of GDP, but if you prepare your own meals at home, your labor doesn’t count toward GDP(although your grocery bill does). If you buy your clothes at a department store, the entire transaction is included, but if you make your own clothing, then the value of your labor doesn’t count. Of course, the cost of fabric and other materials does count since that was a market transaction. Since a greater percentage of our consumption needs are market activities today compared to one hundred years ago, the GDP to this extent is artificially larger than it was years ago, although the production of goods and services has increased tremendously even without this factor.

Only new production is counted, that is, used items are excluded. However, if a used product is purchased from a dealer, then there is an addition to GDP based on the marketing/distribution function provided by the dealer. The dealer or his employees are performing a service in order to complete the sale, so there has to be an addition to GDP for this activity.

Another part of the economy that is not counted is the so called underground economy. Certain transactions, such as illegal drug deals and illegal gambling, are not included in the GDP because accurate data is unavailable. Private sector estimates of illegal economic activity vary widely and it would do little good to include unreliable data in the GDP figure.

Part of the underground economy consists of activities that are legal to perform, but which are unreported. Examples include baby-sitting and free lance yard work paid for in cash. Again, the government has no good data source available to determine the amount of economic activity associated with these transactions.

GDP may be subdivided into two types, nominal GDP and real GDP. To figure the nominal GDP, simply take the current final output of goods and services and multiply by current prices. That is, no adjustment (subtraction) is made for inflation. For real GDP, the increases in the price level is subtracted out so that actual increases in production are measured. To do this, the current production level is multiplied by "old" prices, that is, prices from a base year. Currently, 1992 is the base year normally used for deflating the nominal GDP into real GDP. Look at the following table:

Assume that Year 1 is the base year. Multiply $1 x 500 = $500 for bread and $5 x 700 = $3500 for beer and we have the nominal GDP of $4000. Since this is the base year, no adjustment of nominal GDP is needed and the real GDP is also $4000.

In Year 2, we notice that prices stayed the same (i.e., no inflation) and that nominal GDP is larger only because of the production increase. No adjustment is needed here since the nominal GDP amount does not include any inflation. Real GDP also is $5100.

In Year 3, the situation is reversed and we find that nominal GDP went up only due to price increases. These have to be subtracted out in order to have a valid comparison to the base year (Year 1). Since the actual production amount in Year 3 was exactly the same as in Year 1, then the real GDP figure should also be the same. The 10% from Year 1 to Year 3 must be taken out and the 4400 nominal GDP is reduced to 4000 real GDP.

In Year 4, we have a combination of production and price increase compared to the base year. For nominal GDP, multiply the new prices of $1.05 x 575 plus $5.25 x 825. Combine the two and nominal GDP = $4935. For real GDP, take the old prices from the base year and multiply by the current production amounts. We have $1 x 575 = $575 plus $5 x 825 = $4125. Combine the two and the real GDP = $4700. This makes sense because there were production increases compared to the base year so real GDP should be higher. But there also was inflation, so the real GDP should be lower than nominal GDP.

Using GDP as a starting point, we start making deductions in order to arrive at the other national income accounts:

- depreciation (a/k/a capital consumption allowance)

- indirect business taxes (e.g., sales and excise taxes)

- social insurance taxes (e.g., social security)

- corporate profits taxes

- retained earnings (part of business savings)

+ transfer payments (welfare + social insurance)

- personal income taxes (federal & state)

To arrive at Net Domestic Product from GDP, depreciation is subtracted from the GDP figure. Depreciation (sometimes called the capital consumption allowance) refers to the wearing out process that occurs with respect to equipment, tools, machinery, etc. In a macroeconomy, depreciation also includes the wearing out of roads, bridges, sewer and water systems, and so on. In other words, the public stock of capital goods is part of the depreciation process just as the private sector stock of capital is subject to wearing out.

The total amount of investment in the economy each year is referred to as gross investment. This includes business investment (tools, machinery, etc.) as well as new residential investment. This latter classification includes the construction of new single and multi-family dwelling units. Some of this gross investment is used to replace capital goods that are wearing out. Once this replacement occurs, then any investment remaining is called net investment. We want net investment to be positive. It is what is needed in order to allow the economy to grow on a long-term basis. Gross investment is what is included in GDP, while net investment is used for NDP.

As shown above, National Income = NDP minus indirect business taxes. These taxes are collected from business firms but consumers actually pay the tax. The gas tax, liquor taxes, and sales taxes are all examples of indirect business taxes. National Income may also be though of as representing all income earned by currently utilized factors of production. Each of the factors has an associated return that it earns, as shown in the following table:

(1) Wages + Interest + Rent + Profit = National Income

(2) GDP - depreciation - indirect business taxes = National Income

Since depreciation under method (2) is difficult to estimate for a macroeconomy, method (1) above provides an alternative method and a check so that an accurate figure for national income can be calculated.

Here are a few observations about the above table. The term wages, when used to refer to returns earned by labor, includes salary, commissions, piecework compensation, etc. Regarding interest, the return to capital, we usually think of interest as something we pay on a car or home loan. We also think of interest as something we earn on a savings account or a bond. In the factor markets studied in economics (especially in microeconomics), interest is defined as the rate of return earned by a business firm on a capital investment in new tools, computers, equipment, or machinery.

Normally rent is considered what we pay to live in an apartment or what we pay for a rental car while on vacation. In economics, rent is the return associated with unimproved land or natural resources. Note that improvements to the land, such as permanently attached buildings or other structures, are considered capital goods and are subject to depreciation.

As a return to entrepreneurship, there are two types of profits. One type is known as normal profit and is the amount an entrepreneur must have in order to continue operating the business. Without a normal profit, the business would close and the entrepreneur would find another job, either as an employee or possibly a new and different entrepreneurial venture.

Any profit that is earned above and beyond a normal profit is known as economic profit. This is the reward for truly successful entrepreneurship. Entrepreneurs hope they can achieve this by introducing a new, useful, and desired product to the marketplace or by figuring out a new, more efficient, better way to provide a good or service that was introduced by another firm.

To move from National Income to Personal Income, several adjustments are needed. The general concept of Personal Income is that it is the income to the family or household before the payment of personal income taxes (although, confusingly, after the payment of certain other taxes, such as Social Security and Medicare payroll taxes). Some of the income generated by the factors of production that is included in National Income does not make it through to become part of Personal Income. If you recheck the chart above that shows the progression through the various accounts, you will notice two types of taxes that are diverted at this stage:

1. corporate profits taxes
2. social insurance taxes

Clearly these amounts are removed from the progression through the national income accounts. They go to the government tax collection offices. We also notice that corporate retained earnings are separated from the flow. This amount is withheld from dividend payments, employee raises, etc. It is a funding source for business investment projects such as new retail outlets for a discount retailer or new planes for an airline.

There is one addition after the three subtractions are made as discussed above. This addition consists of transfer payments such as Supplemental Security Income (SSI), Temporary Assistance to Needy Families (TANF), Social Security benefits, and Unemployment Compensation. Transfers must be factored in because they are Personal Income to various households. Note that transfers could not be included in the National Income because, by definition, a transfer is a payment by government for which nothing is received in return at the time of the payment. National Income is specifically limited to income earned by currently utilized factors of production.

Once Personal Income has been calculated, only one subtraction is needed to arrive at Household Disposable Income. Personal income taxes are deducted, including federal, state, and, where applicable, local income taxes.

Once Disposable Income has been determined, the consumer has only two choices: Spend it on consumer goods or services (consumption spending) or save it. Consumption spending far exceeds savings. Typically, 95% to 100% of disposable income goes to consumption. Very little is allocated for savings. Note that savings can be positive or negative. Positive savings are just traditional savings accounts whereas negative savings occur when your total spending exceeds your disposable income. Negative savings involve the use of credit cards with an ongoing balance or otherwise borrowing money or selling off assets.

Based on the previous paragraph, C + S = DI. This statement can be modified to DI – C = S and this is how the savings amount is calculated, as a leftover, since a direct calculation of savings would be too difficult considering all of the various savings and personal financial investment vehicles available today.

Now we can work in reverse. As noted above, the bulk of disposable income is allocated for spending on consumer goods and services, while only a small portion of disposable income goes toward savings. Consumption spending is the major driving force behind the GDP, accounting for about two-thirds of it. It could also be said that two-thirds of the GDP is for household consumption.

There are different types of consumption spending, including durables, non-durables, and services. Consumer durables are defined as goods that are built to last three years or more, such as cars, boats, and appliances. Non-durables include expenditures for food and clothing, while the service category is wide-ranging and includes doctor visits, cable TV, and airline tickets. In fact, services today account for well over half of the GDP, although some transactions are combinations of goods and services, such as buying a product and a maintenance contract along with it.

As we worked through the various accounts from GDP down to DI, we noticed that business firms might have retained earnings, which are a component of business savings. These retained earnings are a funding source for capital goods installations (investment). Another source of funding for investment is personal savings, that is, the portion of disposable income not spent on consumption by households. These savings will typically go through a financial institution as an intermediary before a loan is made to help fund a capital goods project.

When business firms make expenditures for investment, they are contributing to demand in the macroeconomy and this is another major force in the determination of GDP. A significant percentage of GDP is allocated to investment.

In going through the national income accounts, we also noticed that a number of taxes were subtracted at various stages. These taxes go into the government’s coffers. Some of these taxes, such as Social Security, Medicare, and unemployment compensation, are for the type of transfer payments known as social insurance. Other taxes are used for Supplemental Security Income, TANF, and Medicaid. These transfers are classified as public assistance, or welfare.

After government makes all the transfer payments, the money that remains is mostly spent on government purchases. Examples of government purchases include salaries for military personnel, military hardware such as tanks and planes, and pencils and computers for government bureaucrats. Government purchases require the usage of current factors of production to produce the desired item or provide the current service. These purchases are yet another factor that determines the level of GDP.

There is also a certain amount of demand from foreign business firms and consumers for American products. It’s also true that U.S. firms and consumers demand goods and services from other countries. This contribution to GDP is figured on a net basis, that is, the value of Exports minus the value of Imports. This number has been negative for many years and so is a deduction from the total aggregate demand that consists of consumption + investment + government purchases. Some economists believe this minus number is quite bad while others find it to be of limited significance.

The components of GDP look something like this:

You are now ready to work on the Problems and Exercises for Unit Three, Assignment One.