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Feb 27

Lope Gallego

Net exports

Net exports (also known as balance of trade or commercial balance), are one of the components of the gross domestic product. Net exports of a country are the difference between that country’s exports and imports of goods and services. Exports are defined as the merchandise produced domestically and sold in the rest of the world, whereas imports is merchandise produced overseas and sold domestically:

Net exports = exports – imports

An equivalent denomination for net exports is the trade balance, a term that allows us to determine situations of surplus, deficit or equilibrium in a country’s relations with the rest of the world. When exports are greater than imports, there is an excess of exports and we talk about a trade surplus. In contrast, when imports are greater than exports, the country is said to run a trade deficit. In the case that the country’s exports and imports are identical, net exports are zero, and the country has a balanced trade.

Some of the factors that influence the trade balance are: the tastes and incomes of domestic and foreign consumers, the prices of the products in the country and abroad, the exchange rates, the associated costs to trade (e.g. transport costs), government policies, or international agreements.

Feb 18

Lope Gallego

Government spending

Government spending, or government expenditure, is one of the components of a country’s gross domestic product. It includes all the spending on goods and services made by the government at all levels: local, regional, federal, national, etc. This component corresponds to the sum of government consumption and government gross investment.

Government consumption corresponds to the amount the government spends, subtracting the government’s revenue. On the one hand, government spending includes transfer payments made to households, such as unemployment benefits. On the other hand, government revenue includes taxes, which account for most of it.

As for investment, government spending has a multiplier effect. The reason is that government spending includes government investment. The multiplier effect makes that any amount spent in the present generates more than that amount in the future.

The level of government spending is one of the tools used in fiscal policy. An increase of public spending can be used to boost the economy, because the GDP increases as public spending does. On the other hand, a reduction of the public spending slows down the pace of GDP growing. The weight of government spending as a percentage of the GDP is considered as a measure of the importance of the public sector in a country.

Feb 14

Lope Gallego

Investment

Investment is one of the four components of a country’s gross domestic product. It is the use of money in order to accumulate capital, which will be used by other entities. For this reason, it is called productive investment, because it is an expense made with the aim of producing new goods. Investment can be made by households or by firms, always by private entities, since public investment is considered when analysing government spending. In the case of households, usually, their main investment is in the form of buying a new house, whereas in the case of firms investment is very diverse: capital equipment, machinery, vehicles, or inventories. Gross private spending can be divided into three categories: residential investment, which basically consists of buildings and houses; non-residential investment, such as machinery or tools; and change in inventories of firms.

Investment has an outcome called multiplier effect. This effect consists on the fact that any amount of money spent today in investment result in more than that amount in the future. Consequently, an increase of investment results in a higher increase of future rent, leading to higher economic growth and living standards. Countries with an elevated degree of investment have a better development projection in the long run. John Maynard Keynes made this concept popular in his “The General Theory of Employment, Interest and Money”, 1936, even though the idea came from one of his students, Richard Kahn, who developed it in his paper “The Relation of Home Investment to Unemployment”, 1931.

When analysing business cycles, we must note that investment is highly procyclical: during expansion, investment usually increases, firms have more funds and reinvest them or they have easier access to borrowing. By contrast, during recessions, investment is one of GDP’s components that more quickly decline, which makes more difficult the recovery.

Feb 11

Lope Gallego

Consumption

Consumption is one of the components of a country’s gross domestic product. It can be defined as the spending on goods and services made by households. Consumption includes only the expenses for final use, not with the intention of generate another product.

Household or private consumption is mainly determined by disposable income (Y_D), which is the money they have earned from wages and other retributions from the firms’ use of factors of production, after government intervention (subtracting taxes from unemployment benefits and other transfers). At the same time, the disposable income is influenced by the marginal propensity to consume (c₁) of households, which is between 0 and 1. However, there is a minimum level of consumption (c₀), also called autonomous consumption, which households make, independently of their disposable income. Therefore, we have:

C = c₀ + c₁ Y_D

Looking at this formula, we can see that households’ consumption may be higher than their disposable income. For example, when the disposable income is zero, the consumption is equal to c₀, a figure different from zero. This is possible because households can borrow money or reduce their savings. Savings are the part of the disposable income that households do not spend, the money they keep, for example, in a bank account. Past savings may allow households to consume during a period more than their disposable income.

This function was first introduced by John Maynard Keynes in his “The General Theory of Employment, Interest and Money”, 1936. Thanks to his work, he is considered as the father of macroeconomics.

Feb 6

Lope Gallego

Gross domestic product

Gross domestic product (GDP) is the market value of all final goods and services produced within an economy in a given period of time. This means that we take into account the market value of products of a given country, including nationals and foreigners working in that country. This is the main difference with the gross national product, which considers goods produced only by nationals of a country, without considering their residence.

Note that GDP is calculated over a given period of time, which makes it easy to compare it with other periods or the GDP of other countries. It has also two important implications: goods resold are not considered in the GDP; and goods finalised but not sold are considered as inventory.

We can estimate it using one of three methods. The income approach considers all wages, interests paid, rent and other sources of income to estimate GDP. The production approach estimates gross value and then subtracts intermediate consumption, considered as goods and services used in the making of final goods and services. Finally, there is the expenditure approach, which looks at the demand side.

The expenditure approach considers total expenditure, considering everyone in the economy, such as households, firms and government. GDP (also denoted as Y, production) can be disaggregated into four big components that classify the nature of the expenditure. These components are consumption (C), investment (I), government spending (G) and net exports (NX). With all these variables we can define the following identity:

Y = C + I + G + NX

Any amount of money spent in an economy can be classify into one of the four components of the identity, taking into account the nature of the product, the buyer and the purpose of the spending.

The evolution during the years of a country’s GDP shows the performance of its economy. When GDP is bigger year after year, we can consider it as a sign of a growing economy. Inflation must be considered when analysing gross domestic product, in order to differentiate nominal and real GDP. Nominal GDP considers only current prices, while real GDP is calculated using prices of a base year, in order of eliminate the effects of inflation

Additionally, if we look at the GDP per capita, dividing the GDP between that country’s total population, we can compare the living standards among countries. However, this measures does not completely represent the welfare of a country’s population, since other things must be taken into consideration.

Feb 4

Lope Gallego

Circular-flow diagram

The circular-flow diagram (or circular-flow model) is a graphical representation of the flows of goods and money between two distinct parts of the economy:

-market for goods and services, where households purchase goods and services from firms in exchange for money;

-market for factors of production (such as labour or capital), where firms purchase factors of production from households in exchange for money.

The market for goods and services is the place where households spend their money buying goods and services produced by firms. In other words, is the place where firms sell the goods and services they have produced, receiving a revenue paid by households.

This market represents the place where money and goods are exchanged. In this case, the flow of money (green arrow in the diagram below) goes from households to firms, in exchange for finished products, which flow from firms to households (red arrow).

The market for factors of production is the place where households offer their labour, capital and other factors such as land, receiving an income for their use. Firms use these factors in their production.

In this case, money flows from firms to households (green arrow in the diagram below) in the form of wages in exchange for labour, interests for capital and rent for the use of land. Factors of production flow form households (red arrow) to firms, so they can produce more goods and services.

When we combine both diagrams, we get the circular-flow diagram, as shown below. The exchanges made in the economy imply a redistribution of rent according to the diagram, and the creation of value makes the economy grow.

It’s worth mentioning that, as usually, diagrams do not shown how the economy actually works. There are a few things that are not showed in this diagram that must be taken into account to really understand how the economy of a country works. For instance, take government intervention. Things such as government spending (in the form of unemployment benefits, for example) or government income (taxes) are not shown in the diagram.

However, this diagram introduces a clear view of how the economy works. The way of measuring all these flows of money is the gross domestic product (GDP). It can be estimated using one of three methods: looking at total expenditure, at total income or using the production approach.