The circular flow diagram of income and expenditure:

The blue and red flows are the circular flow of expenditure and income. The
green flows are borrowing and lending.
 How Investment Is Financed
Investment is financed from three sources:
Private saving, S
Government budget surplus, (T – G)
Borrowing from the rest of the world (M – X).
 We can see these three sources of investment finance by using the
fact that aggregate expenditure equals aggregate income.
 Start with
Y = C + S + T = C + I + G + (X – M).
Then rearrange to obtain
I = S + (T – G) + (M – X)
Private saving S plus government saving (T – G) is called national
saving.
  GNP (Gross National Product): total income earned by a country’s
permanent residents.
 NNP (Net National Product): = GNP – depreciation (consumption of fixed
capital)
 National Income: = NNP – indirect business taxes + business subsidies
 The GDP deflator is a measure of the overall level of prices.
 Definition: GDP deflator=(nominal GDP/Real GDP)*100
the GDP deflator from one year to the next.

Use the above data to solve these problems:

A. Compute nominal GDP in 2007.
B. Compute real GDP in 2008.
C. Compute the GDP deflator in 2009.
  To calculate the economic growth of a country, find the percent change
in RGDP using the basic percentage change formula:
(new − old)/old*100. Remember since RGDP reflects changing levels of
OUTPUT, this % change shows how the productivity of a country
changes.

Find the growth rate between 2008 and 2009?

2008RGDP=50000
2009RGDP=52000
GROWTH RATE FROM 2008 TO 2009=[52000-50000]/50000*100=4%
Suppose the economy is growing at 4%. If the current RGDP is 67,000, what
will be the RGDP for next year?[67,000*1.04=69680]
=67000+.04*67000
=67000[1+.04]=67000[1.04]

TWO METHODS OF MEASURING CHANGING PRICE LEVELS

 To measure changes in price level (inflation/deflation) in an economy,
two statistics can be used: the GDP deflator or the consumer price index
(CPI). In both cases, a year of interest is compared to the base year to
see how price levels have changed.
(1) GDP Deflator
The GDP Deflator is an index number that compares the nominal GDP to real
GDP for a given year. It is more comprehensive than CPI since it includes all
domestically produced goods and services in a country. Changes in consumer
preference and the arrival of new goods/services in the market are also
reflected in the GDP deflator.
𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 =(𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃/𝑅𝑒𝑎𝑙 𝐺𝐷𝑃)× 100
If the GDP deflator for 2010 is 105.1 and the base year is 2005, this means that
the price level has risen 5.1% since 2005. Another way to say it is that the 2005
dollar could buy 5.1% more than the 2010 dollar.
(2) Consumer Price Index (CPI)
The CPI is another index number calculated using a specific set, or basket, of
600 retail goods and services. Each good in the basket is weighted according to
the proportion of average household expenditure accounted for by that good.
The CPI indicates the change in prices of the basket from the base year (which
is normalized to 100) to the given year: a CPI of 98 indicates that price levels
have decreased 2% from the base year.
To calculate CPI, take the ratio of the cost of the CPI basket at current prices to
the CPI basket at base year prices.
CPI =(CPI Basket Cost @ Current Prices/CPI Basket Cost @ Base Prices) × 100
CPI has some drawbacks in analyzing price level changes.
 First, CPI is calculated using a specific set and percentage of CONSUMER
goods. It is a fixed basket not often adjusted to reflect changes in goods
available or consumer preferences.
 Also, things like machinery and medical equipment are not included.
 CPI also does not reflect the change in the quality of goods, only the
prices of goods. Although a laptop costs less today than 3 years ago, the
quality has improved significantly.
Calculating CPI:
For a simple economy that consumes only oranges and haircuts, we can
calculate the CPI.
The CPI basket is 10 oranges and 5 haircuts.
Item Quantity Price Cost of CPI basket
Oranges 10 $1.00 $10
Haircuts 5 $8.00 $40
Cost of CPI basket at base period prices $50
 This table shows the prices in the current period. The cost of the CPI
basket in the current period is $70.
Item Quantity Price Cost of CPI basket
Oranges 10 $2.00 $20
Haircuts 5 $10.00 $50
Cost of CPI basket at current period prices $70
 The CPI is calculated using the formula:
CPI = (Cost of basket in current period/Cost of basket in base period)* 100.
Using the numbers for the simple example, the CPI is
CPI = ($70/$50) *100 = 140.
The CPI is 40 percent higher in the current period than in the base period.

Inflation rate:

Inflation
Inflation is an increase in the general level of prices of goods and services.
Deflation is a decrease in the general level of prices of goods and services.
From both an individual and government’s point of view, inflation is a huge
concern.
The CPI and GDP deflator tell us how high prices are relative to a base year, but
the rate of inflation can be used to express the change in price level between 2
years when neither is the base year.
The rate of inflation is calculated by using the basic percentage change formula
with either two CPI numbers or two GDP deflator numbers: (new − old)/old ×
100.
***If the CPI last year was 121 and the CPI this year is 125, the rate of inflation
is:
𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 =(125 – 121)/121× 100 = 3.3%
If the current CPI is 125 and the inflation rate is 4%, how much was the CPI in last year?
[125-x]/x*100=4
125*100-x*100=4x
12500=4x+100x
104x=12500
X=12500/104=120.19

 Disinflation
 Core inflation
 What items are not included in GDP
Used items
Stocks shares and bonds
 Low, steady, and anticipated inflation or deflation isn’t a problem, but an
unexpected burst of inflation or period of deflation brings big problems and costs. An
unexpected inflation or deflation:
■ Redistributes income
■ Redistributes wealth
■ Lowers real GDP and employment
■ Diverts resources from production
 Inflation sometimes becomes hyperinflation—an inflation rate of 50 percent a
month or higher that grinds the economy to a halt and causes a society to collapse.
Hyperinflation is rare, but Zimbabwe in recent years and several European and Latin
American countries have experienced it.
 The core CPI inflation rate is the CPI inflation rate excluding volatile elements[prices
of foods and fuel].The core CPI inflation rate is calculated as the percentage change
in the CPI (or other price index) excluding food and fuel. The prices of these two
items are among the most volatile. While the core CPI inflation rate removes the
volatile elements in inflation, it can give a misleading view of the true underlying
inflation rate. If the relative prices of the excluded items are changing, the core CPI
inflation rate will give a biased measure of the true underlying inflation rate.
 The full employment unemployment rate is also referred to as “natural”
unemployment. In an effort to avoid this normative connotation, James Tobin
introduced the term “Non-Accelerating Inflation Rate of Unemployment” also known
as the NAIRU. It corresponds to the level of unemployment when real GDP equals
potential output. The NAIRU has been called the “inflation threshold. ” The NAIRU
states the inflation does not rise or fall when unemployment equals the natural rate.