(1) National Income Accounting Improved

Question 1

1) What is the equation and definition of Gross National Product (GNP)?

Answer 1

Equation: GNP= C+ I+ G

Definition: The value of all final goods and services produced by the country’s factors of production and sold on the market in a given time period.

Question 2

2) What are the factors of production?

Answer 2

1. Land
2. Labour
3. Capital

Question 3

3) What two things are not calculated in Gross National Product (GNP) ?

Answer 3

1. Intermediate Products are not included in the calculation of GNP , only calculate final goods to avoid double counting.

Intermediate Products are products used as inputs in the production of other goods including final goods eg an intermediate product is flour in the production of a Domino’s pizza, flour is not counted however Dominos pizza is counted in GNP as this the final product.

2. Used Products are not calculated in GNP, as these have already been counted in GNP when first sold.

Question 4

What is the definition of Consumption ?

Answer 4

Definition: The amount consumed by the private sector to fulfill current wants.

Question 5

What component does Consumption make of US GNP?

Answer 5

Tends to be the biggest component of GNP, for the last 70 years in the US consumption has fluctuated between 62 to 70 %.

Question 6

What is the definition of Investment?

Answer 6

Definition: The amount put aside by private firms to build new plant and equipment for future production/output e.g factories, inventory stock.

Investment can be firms purchases of inventories which is another way for firms to transfer output from current use to future use.

Question 7

What does NOT count as Investment by an economic definition?

Answer 7

Investments are NOT stocks, bonds or real estate by an economic definition.

Question 8

How does Investment differ to other GNP components and what component does Investment make of US GNP?

Answer 8

Investment is more volatile than consumption and fluctuates between 11-22% of US GNP.

Question 9

What is the definition of Government Purchases?

Answer 9

Definition: The amount used by the Government for consumption and investment purposes.

Question 10

What component does Government make of US GNP?

Answer 10

Around 20% of US GNP, which has not changed since 1950s.

Question 11

What is not included in Government Purchases?

Answer 11

Transfer payments such as benefits are not included in Government Purchases, as recipient of transfers payments do not provide goods and services back to the Government, as money is given to people who will use it for consumption, and it is counted there.

Question 12

What is the definition of Current Account Balance?

Answer 12

Definition: The amount of net exports of goods and services to foreigners.

Question 13

What is the 3 important things of the Fourfold Classification of GNP?

Answer 13

1. Knowing how the major categories of spending have changed may help make clear the cause of a recession or boom.
2. Thus understanding helps provide sound policy response.
3. Explains why some countries have a high level of GNP relative to population size ( rich ) whilst others are poor.

Question 14

What is the definition and equation of GDP?

Answer 14

Definition: Total value of output produced within a country’s borders.

Equation:
GDP= GNP- net receipts of factor income from the rest of the world

Question 15

How do GNP and GDP differ?

Answer 15

1. GDP does not correct for citizenship of ownership (whether domestic or foreign ownership) of the factor of production.

However, GNP does correct for citizenship of ownership of factors of production.

For example: A French factory producing in the UK , would add to the UK GDP but would not add to the UK GNP. It would add to the French GNP but not the French GDP.

Question 16

What is the equation of Net Receipts from the rest of the world ?

Answer 16

Net Receipts are primarily :

The income domestic residents earn on wealth they hold in other countries

MINUS (-)

the payments domestic residents maker to foreign owners of wealth that is located in the domestic country.

Question 17

What type of economy

Small Open Economy
or
Big Closed Economy

is GNP more of an important measure ?

Answer 17

In bigger economies such as the US tend to be closed economies and trade is less important to overall production hence GNP is a more important measure although , GNP and GDP are similar.

Question 18

What type of economy

Small Open Economy
or
Big Closed Economy

is GDP more of an important measure ?

Answer 18

Smaller economies tend to be more open ,and have more Foreign Direct Investment therefore high levels of foreign owned factors of production. Output from Foreign Owned Factors of Production would add to GDP but not GNP .

Therefore, for smaller economies focus on GDP is more important. However, in smaller open economies, GDP and GNP difference can be significant .

Question 19

What is the definition and equation of National Income?

Answer 19

Definition: The income earned in that period by its factors of production.

Equation:
National Income= GNP - depreciation + net unilateral transfers of Income

Question 20

What is the definition of Depreciation?

Answer 20

Definition: Economic loss due to the tendency of machinery and structures to wear out as they used , reduces income of capital owner.

GNP-depreciation = Net National Product (NNP)

Question 21

What is the definition of Unilateral Transfers of Income?

Answer 21

Definition: Gifts from residents of foreign countries e.g reparations, foreign aid. It is part of a country’s income but not part of its product.

Unilateral transfers of Income are part of a country’s income but not part of its product, so must be added in.

Question 22

Describe what is neglected to be able to assume National Income= GNP?

Answer 22

The difference between GNP and National Income is by no means an insignificant amount.

However in macroeconomics, there is little to say about the difference and it is of little importance for macroeconomic analysis.

Therefore, for purposes of the text,

National Income= GNP and will be used interchangeably.

( But technically it is an identity (National Income ≡ GNP) and not an equality)

Therefore,

1. GNP a country generates over some time period must equal its national income.
2. The reason for equality is that money spent to purchase goods or services automatically ends up in someones pocket.

For example if a doctors visit cost $75 ( raises GNP by $75) but the $75 dollars paid by a doctor raises his or her income (raises national income by $75)

Question 23

What is the National Income Identity in a Closed Economy?

Answer 23

Equation : Y= C+I+ G

Y=GNP
C=Consumption
I=Investment G=Government Purchases

It is assumed that all final goods or services are consumed or invested or purchased by its government.

Question 24

What is the National Income Identity in an Open Economy?

Answer 24

Equation :

Y= C+I+ G+ EX - IM

OR

Y= C+I+ G+ CA

OR

Y= A+ CA

Y=GNP
C=Consumption
I=Investment G=Government Purchases
EX= Exports
IM= Imports
CA= EX-IM
A= Domestic Absorption== C+I+G

In an open economy, goods and services can flow across national borders, so the GNP identity for open economies shows how the national income a country earns is divided between sales to domestic residents and sales to foreign residents. The value of imports must be subtracted from total domestic spending, while the value of exports must be added to it.

Question 25

What is the equation of Net Exports?

Answer 25

Equation: Net Exports= EX-IM

Question 26

Is the Currency Account and Net Exports exactly equal?

Answer 26

Net Exports and Current Account balance are not exactly equal ( it is an identity in technicality). However net exports is the most important component of the Current Account Balance.

Question 27

What is the definition and equation of Domestic Absorption?

Answer 27

Definition: Total Expenditure by domestic residents on goods and services. Equation: A =C+I +G A=Domestic Absorption

Question 28

What are the 4 main implications when a country is running a Current Account Deficit?

Answer 28

1. Imports > Export, Import spending> Export earnings 2. Domestic Absorption > Output ( C+I+G >Y) hence why importing more is required. Only in an open economy, if a country is able to borrow from foreign countries can domestic expenditure exceed what is produced within the country. For example a country total value of its consumption, investment and government purchases can be 110 g of Wheat , however its output is only 100 g of Wheat. Therefore, under an open economy, it can borrow the difference from a foreign country to be able to do so. 3. A country can only finance their current account deficit by borrowing from foreign countries. 4. A country with a current account deficit must be increasing its net foreign debts by the amount of the deficit. Therefore, the net foreign asset position deteriorate.

Question 29

What are the 4 main implications when a country is running a Current Account Surplus?

Answer 29

1. Exports> Imports, Export earnings > Imports spending. 2. Output> Domestic Absorption ( Y> C+I+G) , therefore why importing is required less. 3. A country finances the current account deficit of its trading partners by lending to them, foreign countries pay for imports not covered by export earnings by issuing IOUs which they will eventually have to redeem. 4. A country with a current account surplus must be increasing its net foreign wealth by the amount of the surplus. Therefore, the net foreign asset position improves.

Question 30

What is the equation and definition of National Saving in a Closed Economy?

Answer 30

1. Equation: S=Y-C-G S= National Savings Y= Output C=Consumption G= Government Purchases 2. Definition: Savings are the portion of output not devoted to private sector consumption and government purchases.

Question 31

What is relationship between Investment and Savings in a Closed Economy?

Answer 31

National saving must equal Investment. In a closed economy, countries can finance investment only by saving. 1. If the National Income Identity (Y=C+I+G) is rearranged then (I= Y-C-G) 2. Therefore, S=I, as S=Y-C-G

Question 32

What is the equation of National Saving in an Open Economy?

Answer 32

Equation: S=I+CA

Question 33

Is it possible to raise investment and foreign borrowing without changing saving?

Answer 33

It is possible to raise investment and foreign borrowing without changing saving. You can use imports materials from a foreign country and borrow foreign funds to pay for them. The transaction raises a countries current account deficit by an amount equal to the increase in investment. Therefore savings does not have to change, despite investment rises.

Question 34

What is Net Foreign Investment?

Answer 34

Net Foreign Investment is the current account surplus obtained by saving that funds another country investment .When one country lends to another country to finance investment then part of the income generated by the investment in future years must be paid back to the lender. Domestic investment and foreign investment are two different ways a country can use current account savings to increase future income. Thus, not all current account deficits are the same. Borrowing to improve one’s future may be very useful, while borrowing for pure consumption does not lead to tangible future benefits.

Question 35

What is the equation for National Saving decomposed into Private Sector Saving and Public Sector Saving?

Answer 35

Equation: S= Sp + Sg S= National Saving Sp= Private Sector Saving Sg=Public Sector Saving

Question 36

What is the equation and definition for Private Sector Saving?

Answer 36

1. Definition: part of disposable income that is saved rather than consumed by the private sector. 2. Equation: Sp=Y-T-C ``` Y-T = Disposable income Y= National Income T= Net Taxes collected from households and firms by the government C= Consumption ```

Question 37

Who are the Private Sector?

Answer 37

The part of national economy made up of private enterprises. It includes the personal sector (households) and corporate sector (companies), and is responsible for allocating most of the resources within an economy.

Question 38

What is the equation and definition of Public Saving?

Answer 38

1. Definition: part of Net Tax Revenue that is saved rather than spent by the government. 2. Equation: Sg = T-G ``` T= Net Tax Revenue G= Government Purchase ```

Question 39

How does Public Sector and Private Sector saving objective differ? Also, state what the Public Sector objectives for saving?

Answer 39

Unlike Private Saving decisions, Government saving decisions are often made with an eye toward their effect on output and employment (macroeconomic conditions) and aim to achieve Policy objectives 1: Internal Balance and Policy objectives 2: External Balances

Question 40

What is the Internal Balance Government Objective?

Answer 40

A situation in which the consumption in an economy roughly equals production. That is, internal balance occurs when what is spent and what is produced in the economy are never too far from being even. Internal balance may be characterized by both full employment and low inflation.

Question 41

What is the External Balance Government Objective?

Answer 41

A situation of BALANCE OF PAYMENT EQUILIBRIUM that, over a number of years, results in a country spending and investing abroad no more than other countries spend and invest in it.

Question 42

Explain Supply and Demand for Financial Capital (Money) in a open economy?

Answer 42

1. S=SP + SG =I + CA 2. SP - CA= I -(T-G) OR SP - CA= I +(G-T) Shows Supply of Financial Capital = Demand for Financial Capital ``` S= National Saving Sp= Private Sector Saving Sg = Public Sector Saving I= Investment CA= Current Account Balance T= Net Taxes G=Government Spending -(T-G)/ (G-T)= Government Borrowing ``` Equations shows: Two Main Supply of Financial Capital ( Money) : 1. Sp: Saving by the Private Sector 2. -CA: Inflow of Financial Capital from Foreign Investors which is equal to the trade deficit. Two Main Demand for Financial Capital (Money) 1. I=Investment 2. =(-(T-G) OR (G-T)=Government Borrowin - Government saving preceded by a minus sign - This is a government budget deficit/ fiscal deficit However, the government and trade balance elements of the equation can move back and forth as either suppliers or demanders of financial capital, depending on whether government budgets and the trade balance are in surplus or deficit.

Question 43

What is the Government Budget Deficit?

Answer 43

The Government Budget Deficit/ Fiscal Deficit is the annual amount by which government spending exceeds income from taxation of which it must finance by borrowing through the issue (sale) of new debt. A government will normally borrow money by issuing bonds or other securities. The interest rate on this debt will depend on the willingness of lenders to offer credit, the expected rate of inflation and risk of whole or partial default. A government of a country with low or worsening credit ratings may negotiate loans from institutions such as the World Bank, the IMF ( International Monetary Fund) , sovereign wealth funds or other governments/ overseas banks.

Question 44

What is a Twin Deficit?

Answer 44

Many people talk about government budget deficits and current account deficits as being twin deficits, twins as if deficits are both are born at the same time. (SP- I + (T-G)= CA) identity shows that there is a relationship between government budget deficits and current account deficits.

Question 45

What two theories show the linkage between government budget deficit and current account deficit?

Answer 45

The are two distinct theories Keynesian Theory and Ricardian Equivalence Hypothesis.

Question 46

What is the Keynesian Theory relating to Twin Deficits?

Answer 46

-> Focus Identity: Sp- I + (T-G)= CA The first theory is based on the traditional Keynesian approach, which argues that the current account deficit has a positive relationship with the budget deficit. This means that an increase in budget deficit will lead to a current account deficit, and a budget surplus will have a positive impact on the current account deficit. Keynesian theory argues that: (1) According to the Mundell–Fleming model, an increase in the government budget deficit (expansionary fiscal policy) will exert upward pressure on domestic interest rate. The increase in interest is to make it attractive for foreign investors to invest in government bonds ( or invest in domestic market). This increases in the demand for the domestic currency (capital inflows) leads to an appreciation of the domestic currency, which in turn causes imports to be cheaper for domestic consumers and exports expensive for foreign consumers. Therefore, leads to the deterioration of the Current Account Balance. (2) The Keynesian approach argues that a rise in the budget deficit will increase domestic absorption via import expansion, causing a current account deficit.

Question 47

What is the Ricardian Equivalence Hypothesis relating to Twin Deficits?

Answer 47

-> Focus Identity: Sp- I + (T-G)= CA REH disagrees with the Keynesian approach, in a setting of an open economy, that shifts between taxes and budget deficits do not affect the real interest rate, the quantity of investment or the current account balance. REH suggest that current consumption and investment depends on expected lifetime income, rather than on current income as proposed by Keynes theory Furthermore, the permanent income hypothesis developed by Milton Friedman in 1957, states that private consumption will increase only with a permanent increase in income. This means that a temporary rise in income fueled by tax cuts or deficit-financed public spending, leads to rational agents (consumers and investors) saving instead and therefore aggregate demand remaining unchanged. Rational agents foresee that the present tax cut will become a tax burden in the future/ face higher taxes later to pay off the resulting government debt in the future. Therefore, As private savings rise or investment falls, the need for a foreign capital inflow declines.

Question 48

What are the dangers of Government Budget Deficits?

Answer 48

There is a limit to what the budget deficit can rise to without being detrimental to economic activity. There is danger to economic activity when debt becomes unsustainable and government risk bankruptcy and despite the promise of higher interest rates does not attract investors due to high risk of default. Therefore, governments cannot infinitely/ indefinitely continue to borrow to finance deficits. Additionally, countries in a monetary union have no control over their monetary policy and therefore have no control to use attractiveness of high interest rates to attract investors.

Question 49

What type of economies have a high likelihood of having twin deficits ?

Answer 49

Savings are needed to finance capital investment. In many smaller low-income countries, high levels of extreme poverty make it difficult to generate sufficient savings to provide the funds needed to fund investment projects. This increases reliance on aid or borrowing from overseas. This problem is known as the savings gap. Therefore, emerging economies which require public sector investment , run large government deficits to finance public sector investment and therefore have large government deficits and also current account deficits.

Question 50

What is the definition of a Savings Gap?

Answer 50

Definition: Lack of sufficient domestic savings to be able to finance the required rate of capital investment to promote economic growth.

Question 51

Can it be fully determined the cause of current account change using the identity (Sp=I+CA+ (G-T) ?

Answer 51

Private Saving, Investment, The current Account, government deficit are jointly determined variables, we can never fully determine the cause of current account change using the identity above. Nonetheless the identity provides an essential framework for thinking about the current account and can furnish useful clues. . But with the tool of the national accounting equation, we see that there are links between the variables. To be more definite about causes and welfare implications, we need to build more theoretical tools.