Economists measure economic activity using several approaches, namely income, expenditure, and output. All three will produce an equal number.
How do all three approaches produce an equal number? Economists use circular flow diagrams (also known as circular flows of income) to explain them. The model tells us how economic actors are interconnected, where their relationship involves the flow of money, goods, and services.
Economists divide economic actors into three sectors:
There is one more, namely the external or the foreign sector, which also consists of the three abovementioned sectors.
Circular flows of income under an open economy and a closed economy
Under a closed economy, economic activity does not involve the external sector. Thus, the circular flow diagram only depicts the relationship between the domestic, business, and government sectors in the country.
In contrast, the circular flow model includes the external sector under an open economy. Relations with the external sector involve exports and imports. Exports represent the sale of domestic goods and services to economic actors abroad. In contrast, imports represent foreign goods and services purchased by domestic economic actors.
Exports represent an injection into the domestic economy as it flows money from external economic actors to the domestic. On the other hand, imports represent leakage because they attract money from the domestic economy to foreign countries.
Simple circular flow of income
The simplest model only uses the business and household sectors. The two interact in the product market and the factor market.
The household sector acts as a consumer in the goods and services market. But, in factor markets, they act as suppliers or sellers. Meanwhile, businesses play opposite roles in both markets, acting as suppliers in the goods and services market (product market) and buyers in the factor market.
In this simple model, economists show us how spending on output by households becomes income for businesses and vice versa. In the product market, households spend their money on goods and services, which in turn become income for the business. The business then uses the income to purchase factors of production, such as labor, in the factor market.
Thus, spending by households becomes income for businesses. And conversely, spending by businesses becomes income for households. This simple way of working explains how we will get an equal number when measuring economic activity using the output, expenditure, and income approach.
What are the indicators to measure economic activity?
Economists introduce gross domestic product (GDP) and gross national product (GNP) measures for economic activity. GDP represents the output produced in a country, regardless of who produces it. Meanwhile, GNP represents the output produced by citizens, regardless of where they produce it.
For example, Indonesia’s GDP only calculates output produced domestically, perhaps by Indonesians or foreigners. Meanwhile, Indonesia’s GNP only considers the output produced by Indonesians, regardless of where they produce it, whether domestic or abroad.
Since the output is equal to income, we can also say GDP and GNP as measures of the total income earned by the providers of factors of production. GDP represents the total income earned by Indonesians and foreigners who produce in Indonesia. Meanwhile, GNP represents the total income earned by Indonesians working in the country and abroad.
So, if your brother works abroad, his income is included when calculating GNI but not in GDP. Meanwhile, your income, because you are working domestically, is calculated in GDP but not GNP. Likewise, your foreign friends’ income is also calculated in GDP because they work and produce domestically.
There is another measure related to GDP, namely green GDP. It is GDP after adjusting for environmental costs, such as natural resource depletion and environmental degradation. It is used to measure continuity.
Calculating GDP with three approaches
As noted earlier, economists use three approaches to calculate GDP to measure economic activity. The three approaches are output, expenditure, and income.
Output approach. Economists calculate GDP by adding the value of all final goods and services produced in the economy in a year. The key word is final goods and services. Thus intermediates are excluded from the calculation under this approach.
The final value method can also be approached using a value-added method. It is calculated by subtracting the output value from the input value for products along the production chain, including considering intermediate goods.
Expenditure approach. GDP is equal to the total expenditure by the four sectors of the economy. They are household spending, business investment, government spending, and net exports. The last is the difference between exports and imports.
- GDP = Household spending + Business investment + Government spending + Net exports
Income approach. Economists add up the income received by the providers of the factors of production: land, capital, labor, and entrepreneurship. The income includes rent, interest, wages, and profits.
GNP equals GDP after adjusting for net factor payments (also known as net factor income). GNP with gross national income (GNI) is the equivalent. Like the GDP calculation, GNP and GNI are different names even though they both measure the same. GNP uses the output approach, while GNI uses the income approach.
The formula for GNP/GNI is:
- GNP = GDP + Net factor payments = GDP + Factor payments from abroad – Factor payments abroad
Factor payments abroad refer to the income earned by foreigners and foreign companies domestically. Meanwhile, the factor payments from abroad refer to the income earned by citizens or domestic companies in other countries.
What is the difference between nominal value and real value?
We may come across the terms nominal and real GDP when reading GDP figures. Other terms we might come across are GDP at current prices and GDP at constant prices. So what’s the difference between them?
Nominal GDP is another name for GDP at current prices. While real GDP is another name for constant price GDP.
As the name suggests, nominal GDP is calculated using current prices. So, for example, let’s say we are calculating nominal GDP in 2020. So we use prices for that year to calculate the final value of goods and services. Likewise, when we calculated nominal GDP in 2021, we used prices in 2021.
- Nominal GDP 2020 = Final output quantity in 2020 x Prices in 2020
- Nominal GDP 2021 = Quantity of final output in 2021 x Price in 2021
- Real GDP 2020 = Quantity of final output in 2020 x Prices in 2020
- Real GDP 2021 = Quantity of final output in 2021 x Prices in 2020
In contrast, real GDP uses constant prices. Let’s say 2020 is the base year for calculations. So, when calculating real GDP in 2021, we used prices in 2020. And real GDP in 2020 uses prices in 2020. Then, in 2022, we will continue to use prices 2022 when calculating the final value of goods and services.
When to use nominal and real values?
Changes in nominal GDP from year to year occur due to two factors:
- Price changes
- Output quantity change
Meanwhile, changes in real GDP represent changes in output because prices do not change, i.e., they are the same as prices in the base year. For this reason, real GDP is widely used to measure economic growth, which shows us the growth in economic activity, as measured by the output produced.
Meanwhile, nominal GDP is used as an economic size. For example, how big is the United States economy in 2021? We can answer it by looking at nominal GDP. This approach makes more sense than real GDP because we use prices in 2021. On the other hand, using real GDP is probably unrealistic because it uses prices in the base year, which were probably prices ten years ago and have changed significantly compared to 2021.
Apart from being an economic size, for example, we can also use nominal figures to measure how much household spending or business investment contributes to the economy in a given year.
Long story short, real GDP is useful for time series comparisons. Meanwhile, nominal GDP is useful for comparison at a certain point in time (cross-section).
What is a per capita figure?
Per capita means per head. GDP per capita means nominal GDP divided by the total population. It shows the output produced by each person. As mentioned above, nominal GDP per capita is more appropriate for cross-section comparisons. Meanwhile, real GDP per capita is more appropriate for time series comparisons.
For instance, economists usually focus on changes in real GDP per capita from year to year when evaluating trends in a country’s standard of living. Its increase over time significantly impacts improving the standard of living. Higher real GDP per capita indicates the country is more productive because it produces more output. That ultimately drives an increase in income and positively impacts several aspects, such as better health and education.