When you finish studies and start looking for a full time job, your experience will, to a large extent, be shaped by prevailing economic conditions. In some years, firms throughout the economy are expanding their production of goods and services, employment is rising and jobs are easy to find. In other years, firms are cutting back production employment is declining and finding a good job takes a long time. Not surprisingly any college graduate would rather enter the labour force in a year of economic expansion than in a year of economic contraction.
Changes in economic conditions are widely reported by the media. Indeed, it is hard to pick up a newspaper without seeing some newly reported statistic about the economy. The statistic might measure the total income of everyone in the economy (GDP) the rate at which average prices are rising (inflation) the percentage of the labour force that is out of work, total spending at stores, or the imbalance of trade between the United States and the rest of the world (the trade deficit).
Economics is divided into two branches: microeconomics and macroeconomics. Microeconomics is the study of how individual households and firms make decision and how they interact with one another in markets. Macroeconomics is the study of the economy as a whole. The goal of macroeconomics is to explain the economic changes that affect many households, firms, and markets simultaneously. Macroeconomists address diverse questions: Why is average income high in some countries while it is low in others? Why do prices rise rapidly in some periods of time while they are more stable in other periods? Why do production and employment expand in some years and contract in others? What, if anything can the government do to promote rapid growth in incomes, low inflation and stable employment?
Because the economy as a whole is just a collection of many households and many firms interacting in many markets, microeconomics and macroeconomics are closely linked. The basic tools of supply and demand, for instance are as central to macroeconomic analysis as they are to microeconomic analysis. Yet studying the economy in its entirety raises some new and intriguing challenges.
If you were to judge how a person is doing economically you might first look at his or her income. A person with a high income can more easily afford life’s necessities and luxuries. It is no surprise that the people with higher incomes enjoy higher standards of living – better housing, better health care, fancier cars, more opulent vacations and so on.
The same logic applies to a nation’s overall economy. When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning. That is the task of gross domestic product (GDP).
GDP measures two things at once: the total income of everyone in the economy and the total expenditure of the economy’s output of goods and services. The reason that GDP can perform the trick of measuring both total income and total expenditure is that these two things are really the same. For an economy as a whole, income must equal expenditure.
All the transactions between households and firms are simple economy. It simplifies matters by assuming that all goods and services are bought by households and that households spend all of their income. In this economy, when households buy goods and services from firms, these expenditure flow through the markets for goods and services. When the firms in turn use the money they receive from sales to pay workers’ wages, landowner’s rent and firm owners’ profit this income flows through the markets for the factors of production. Money continuously flows from households to firms and then back to households.
GDP measures this flow of money. We can compute it for this economy in one of the two ways: by adding up the total expenditure by households or by adding up the total income (wages, rent and profit) paid by firms. Because all expenditure in the economy ends up as someone’s income, GDP is the same regardless of how we compute it.
Households do not spend all of their income; they pay some of it to the government taxes, and they save some for use in the future. In addition, households do not buy all goods and services produced in the economy; some goods and services are bought by governments and some are bought by firms that plan to use them in the future to produce their output. Regardless of whether a household, government or firm buys a good or service the transaction has a buyer and seller. Thus, for the economy as a whole, expenditure and income are always the same.