(A) Illustrate the circular flow of income diagram and explain why different methods of measuring Gross Domestic Product should, in principle, always give the same result. (7%)
(B) Explain the difference between nominal and real GDP. (3%)
Gross domestic product (GDP) also known as national income is defined as the monetary value of all the finished goods and services produced within a country in a specific time period. GDP can be defined by the following four areas, Market Value, Final goods and services, Produced within a company and In a given time period. GDP is a market value where goods and services are valued at their market prices. We add the market value so that we have the total value of output in pounds. The market value of an asset is determined by fluctuations in supply and demand. It should be noted that market value represents what someone is willing to pay for an asset. [Parkin, et al. (2012)]. GDP is also the total values of the final goods and services produced. A final good is a good purchased by its final user. For example if we bought a new car tyre to replace an old flat tyre then this would be an example of a final good, however if a car manufacturer bought a new tyre, for example when Mercedes buy tyres to put on their new cars then this is an example of an intermediate good. We exclude intermediate goods from the definition of GDP to avoid double counting; we do this because the value of the intermediate good is previously included in the value of the final good. We can explain this by the concept of ‘Value Added’. Value added=Value of product-cost of intermediate products. The follow table explains the concept of Value added. Figure 1
Stage of Production
Raw Material Cost
This above table shows the stages in making bread where bread is the final product. We can see the value added for bread is 500 as the raw material cost is 500 and the value of the bread is 1000, the raw material cost of flour is 200 and the value of flour is 500 which means there is 300 value added and for wheat the raw material cost is zero and the value of wheat is 200 leaving the value added of 200. The total value added ad all stages is 1000. We can see that the income for workers and owner equals 500 for bread. The GDP can be defined then as GDP= sum of the values in final products and this is equal to sum of value added in all products including final and intermediate products. This suggests that we are not really excluding intermediate products in the GDP calculation. There are two different types of Final goods and services. One is consumption goods which are those that provide us satisfaction directly, for example Bread or a tyre in the example above. The other final good is known as Investment goods sometimes referred to as capital goods. This type of good provides us with satisfaction indirectly by producing other goods that give us satisfaction directly. Examples of investment goods are Machinery or Houses. The final two definitions in GDP are Produced within a Country, this is a measure for production within the company and In a given time period, where GDP measures production within a specific time frame. This might be within a year or quarter year. There are three faces of GDP, namely, Production, Income and Expenditure. Since we have already discussed that GDP measures final goods and services we will now review that GDP also equals total expenditure on final goods and services produced and total income earned by the population. We can explain and understand the three faces of GDP by studying the Circular Flow of Income diagram. Below is a picture of the basic Circular Flow Diagram. Figure 2
One of the most beneficial ways of demonstrating the macroeconomic environment and the relationships among producers and consumers is the...
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