Measuring Economic Activity - GDP, GNI and the Circular Flow (Part 1)

Measuring Economic Activity - GDP, GNI and the Circular Flow (Part 1)

Let’s say you wanted to measure how “busy” your country’s economy is. Not in terms of traffic or supermarket queues, but actual productivity - how much value the nation creates in a year. You’d need some pretty clever bookkeeping, right?

Well, national income accounting is exactly that: the economist’s way of taking the pulse of an economy.

It’s the economic equivalent of tracking your steps, calories, sleep - and then arguing about whether it actually makes you healthier.

What Is National Income Accounting?

National income accounting is how we measure economic activity within a country over a set time period. It tracks:

• The value of goods and services produced

• The incomes earned by households and businesses

• The spending on those goods and services

You may think that sounds like three different things - well: they all add up to the same number (in theory). This is captured in:

Output = Income = Expenditure

or

O = Y = E

The Three Methods of Measuring Economic Activity

1. The Income Method

Add up all the factor incomes:

• Wages (labour)

• Rent (land)

• Interest (capital)

• Profit (enterprise)

This shows how much people earnt from participating in production.

2. The Output Method

Add up the value of all final goods and services produced. Be careful not to double count intermediate goods (no one wants the bread and the flour added up).

3. The Expenditure Method

Add up all spending on domestic goods / services:

GDP = C + I + G + (X − M)

Where:

• C = Consumer spending

• I = Investment (by businesses)

• G = Government spending

• X – M = Net exports (exports minus imports)

The Circular Flow of Income

This isn’t just a theory - it’s a model of how income moves through an economy.

Imagine:

• Households provide labour → firms pay wages

• Households use those wages to buy goods and services

• Firms earn revenue, produce more, and pay more wages

That’s the core loop. But real economies have more going on…

Withdrawals (W) (Leakages):

• Savings (S) – income not spent

• Taxes (T) – income taken by the government

• Imports (M) – spending on foreign goods

Injections (J):

• Investment (I) – firms borrowing to grow

• Government spending (G) – roads, schools, NHS (health service)

• Exports (X) – foreigners buying domestic products

When Injections > Withdrawals, the economy grows.

When Withdrawals > Injections, the economy shrinks.

When J = W → national income in equilibrium

Nominal GDP and GNI

So far, we’ve looked at GDP - the total value of what’s produced within a country.

But what if your country has companies making money abroad?

That’s where GNI (Gross National Income) comes in:

GNI = GDP + net factor income from abroad

(Things like dividends from overseas, interest payments, etc.)

It includes all income earned by nationals, no matter where it’s generated.

Fun fact: Ireland’s GDP is famously inflated due to multinational companies headquartered there. GNI gives a better picture of what Irish people actually earn.

Real vs Nominal GDP (and GNI)

Nominal GDP is measured at current prices - so it includes inflation.

But if you want to compare economic performance over time, you need to strip out inflation. That’s where real GDP comes in:

Real GDP = Nominal GDP ÷ GDP deflator

The GDP deflator reflects how much prices have risen since a base year.

If the deflator is 1.10, prices have risen 10% - so nominal figures are adjusted down to show real changes in output, not just price.

Real GDP / GNI Per Capita

To compare living standards, we don’t just look at total output. We look at output per person:

Real GDP per capita = Real GDP ÷ Population

This gives a more realistic view of how much income is available to the average person.

And to be able to compare internationally? We need one more adjustment...

Purchasing Power Parity (PPP)

PPP adjusts for the cost of living between countries.

£1.50 might buy you a bottle of water in London... or a whole lunch in Bangkok. So GDP needs to be adjusted to show what money can actually buy in each country.

That’s where PPP-adjusted GDP or GNI per capita comes in. It helps:

• Compare living standards between countries

• Identify under / overvalued currencies

• Avoid misleading currency-based comparisons

Summary So Far:

• GDP = total value of goods/services produced in a year

• GNI = GDP + net income from abroad

• Income, output, and expenditure methods all theoretically give the same result

• Circular flow explains how income moves - and how injections / withdrawals affect it

• Nominal = current prices; Real = inflation-adjusted

• Per capita = more useful for comparing living standards

• PPP = adjusts for cost of living across countries

Coming up in Part 2:

• Business cycles

• The limits of GDP as a measure of well-being

• Alternative indicators like the Better Life Index, Happiness Index, and Happy Planet Index

Stay tuned - this is where macroeconomics stops counting money and starts asking what actually makes life good or above average.