1The idea in one paragraph

An economy's activity is measured by adding up everything it produces in a year. Because every good produced is sold to somebody, and every marc spent becomes somebody's income, you can add it up three different ways and get the same total. That total is national income. The rest of the subtopic is two jobs: making the number comparable, by stripping out inflation, then population, then the difference in what money buys in different countries; and being honest about what the number never sees, which is most of what makes a life good.

2The circular flow of income

National income accounting is the system a country uses to measure the value of what it produces. The picture behind it is the circular flow of income: households own the factors of production and sell them to firms; firms use them to produce goods and services and sell those back to households. Money goes round one way, goods and factors go round the other.

Figure 1 has five decision makers in it, and the guide expects you to name them: households, firms, the government, the financial sector (banks and other lenders), and the foreign sector (the rest of the world). The last three are there because the inner circle is not closed. Money escapes from it and money is added to it.

• Leakages (also called withdrawals) are income that is not spent on domestic output: savings (S) go to the financial sector, taxes (T) go to the government, imports (M) go abroad.
• Injections are spending on domestic output that does not come from household income: investment (I) by firms, government spending (G), and exports (X) bought by foreigners.

Put those together and you have the condition for the flow to hold steady:

S + T + M = I + G + X

When injections are larger than leakages, more is being spent on domestic output than is draining away, so national income rises. When leakages are larger, national income falls. That single sentence is the seed of the whole of 3.2, where the same idea is drawn as an aggregate demand curve instead of a loop.

This diagram is also where the key concept of interdependence earns its marks. A household's decision to save is a firm's lost sale. A foreign recession is a fall in our exports. Nothing in the loop moves alone.

3One loaf of bread, counted three ways

The equivalence of the three approaches is a fact about the circular flow, not a coincidence.

• The output approach adds up the value of everything produced.
• The income approach adds up the wages, rent, interest and profit paid to the owners of the factors.
• The expenditure approach adds up what everybody spent on final goods and services.

Figure 2 follows one loaf. A farmer grows wheat and sells flour worth 40 marcs; the baker turns it into a loaf sold for 100. Count the output as 40 + 100 and you have counted the flour twice, which is why the output approach adds value added — what each firm adds to the value of what it bought in — so 40 from the farmer and 60 from the baker, giving 100. The same 100 is paid out as 75 in wages and 25 in profit. And the same 100 is what the household handed over at the till. Output = income = expenditure, every time, because they are three views of one transaction.

Two rules follow from the loaf and they are both examined.

Count final goods only, or count value added. Never both, and never intermediate goods on their own.

Leave out transfers. A pension or an unemployment benefit moves money from one person to another without anything being produced, so it is not part of G and not part of national income. The recipient's spending of it is counted, once, when they buy something.

4GDP and GNI, and the difference examiners test

Gross domestic product (GDP) is the total value of all final goods and services produced within a country's borders over a period of time, usually a year. Domestic is the word doing the work: it does not matter who owns the factory, only where it stands.

The expenditure approach turns that definition into a formula:

GDP = C + I + G + (X − M)

where C is household consumption, I is investment (spending by firms on capital goods), G is government spending on goods and services, X is exports and M is imports. Imports are subtracted because they were already inside C, I and G — a Marovian household buying a foreign phone adds to C but adds nothing to Marovian output — so taking M out leaves only what was produced here.

Here is Marovia's data for 2025, in billions of marcs.

nominal GDP = 640 + 190 + 245 + (150 − 175) = 1,050 billion marcs

Gross national income (GNI) is the total income earned by a country's residents, wherever in the world they earned it. National is the word doing the work here: it does not matter where the factory stands, only who owns the factors.

GNI = GDP + net property income from abroad

Net property income from abroad is the income our residents earn abroad — profits, dividends, interest and the wages of people working overseas — minus the income foreigners earn here and send home.

Marovians earned 40 billion abroad. Foreign owners earned 85 billion inside Marovia and took it home. So net property income from abroad is 40 − 85 = −45, and:

nominal GNI = 1,050 + 40 − 85 = 1,005 billion marcs

Read that back, because reading it back is where the marks are. Marovia's GNI is below its GDP, which tells you Marovia hosts more foreign-owned production than it owns abroad. A country in that position — many foreign-owned factories, mines or hotels — produces more than its residents actually receive. A country whose people own assets abroad or work abroad is the mirror image: its GNI is above its GDP.

Which one should a question use? If you want to know how much was produced in a place, GDP. If you want to know how much income the people who live there have, GNI. For a small economy with a lot of foreign ownership, the gap between them is the difference between a boom on paper and a boom in people's pockets.

5Making the numbers comparable: real, per person, at PPP

A national income figure straight out of the accounts is nominal, meaning it is measured at the prices of the year it was collected. That makes it useless for comparison, because it rises when output rises and it rises when prices rise, and you cannot tell which happened.

Real GDP is GDP measured at the prices of a chosen base year, so that any change in it is a change in output alone. The tool that converts one to the other is a price deflator: an index number, set at 100 in the base year, showing what has happened to the average price of everything the economy produces.

real GDP = (nominal GDP ÷ price deflator) × 100

Marovia's deflator in 2025 is 125, with 2020 as the base year, so prices are 25% above their 2020 level.

real GDP (2025) = (1,050 ÷ 125) × 100 = 840 billion marcs, at 2020 prices

real GNI (2025) = (1,005 ÷ 125) × 100 = 804 billion marcs, at 2020 prices

Figure 4 shows why this matters. Marovia's nominal GDP went from 800 billion in 2020 to 1,050 billion in 2025, a rise of 31.25%. Its real GDP went from 800 to 840, a rise of 5%. A politician quoting the first number is quoting mostly inflation.

Now the second correction. A country with more people needs more output to be as well off, so divide by the population.

real GDP per capita = real GDP ÷ population

Marovia's population was 32 million in 2020 and 35 million in 2025.

real GDP per capita (2020) = 800,000 million ÷ 32 million = 25,000 marcs

real GDP per capita (2025) = 840,000 million ÷ 35 million = 24,000 marcs

Real output grew by 5%, and output per person fell by 4%, because the population grew by 9.4%. That reversal is the single most useful thing per capita figures do, and it is why a question about living standards always wants the per capita number.

The same division works on GNI:

real GNI per capita (2025) = 804,000 million ÷ 35 million = 22,971 marcs

Then the third correction, which only matters when you compare two countries. Converting Marovia's figure into dollars at the market exchange rate of 2.5 marcs to the dollar gives 24,000 ÷ 2.5 = $9,600. But market exchange rates are set by traded goods and by flows of money looking for a return, not by the price of a haircut, a bus ride or a room. Things that cannot be traded are usually cheaper in poorer countries, so converting at the market rate makes their people look poorer than they live.

Purchasing power parity (PPP) fixes this by converting at the rate that makes a given basket of goods cost the same in both countries. If it takes 1.6 marcs to buy in Marovia what one dollar buys in the reference country, then:

real GDP per capita at PPP = 24,000 ÷ 1.6 = $15,000

The same Marovian, on the same income, counted at $9,600 one way and $15,000 the other. Nothing about their life changed; only the conversion did. For any comparison between countries, PPP is the one to use, and saying so is worth a mark on its own.

Real strips out prices. Per capita strips out population. PPP strips out the difference in what money buys.

Figure 5 is the decision in five seconds. One country over time: real, and per capita if the population moved. Two countries in the same year: real per capita at PPP. Neither tells you whether life is better, which is section 7.

6The business cycle

Real GDP does not grow smoothly. It swings above and below a rising trend, and that pattern is the business cycle: the short-term fluctuations of real output around the long-term growth trend.

The wave in Figure 6 has four phases, and each has a set of symptoms you can be asked to describe.

• Expansion (recovery). Real GDP is rising. Firms hire, so unemployment falls. Confidence and investment rise. Tax revenue rises without any change in tax rates. As spare capacity is used up, prices start to rise.
• Peak (boom). Output is at or above the trend. Unemployment is low and skilled workers are hard to find. Wages and prices rise faster. This is the top of the wave, not a permanent state.
• Contraction. Real GDP is falling. Firms cut hours and jobs, so unemployment rises. Households and firms postpone spending, which makes the fall worse. A contraction lasting two consecutive quarters is usually called a recession.
• Trough (slump). Output is at its lowest. Unemployment is high, factories stand idle, and business failures peak. From here the cycle turns again.

The straight line through the middle is the long-term growth trend, and it is also called potential output: what the economy could produce if its factors of production were fully employed. It slopes upward because the quantity and quality of those factors grow over time — more workers, better trained, with more and better machines and better technology. 3.2 draws that trend as a vertical long-run aggregate supply curve, and 3.3 Macroeconomic objectives calls a rise in it potential economic growth.

The distance between the wave and the trend is the part that does the explaining. Above the trend, the economy is producing more than it comfortably can, and prices are pulled up. Below the trend, factors sit unused and people are out of work. 3.2 gives that distance a diagram and two names, the inflationary gap and the deflationary gap. Learn the picture here and you get those free.

One warning about the vertical axis. It is real GDP. A cycle drawn with nominal GDP is not a business cycle, because an economy can post rising nominal output all the way through a recession.

7What the number does not see

The guide asks you to judge the appropriateness of GDP and GNI statistics as a measure of economic well-being. That is an AO3 line, so a list of limitations is not enough; you have to weigh them.

Start with what GDP is built to count, in Figure 7: market transactions, in final goods and services, produced inside the borders, in one period, at the prices actually paid. Everything outside that definition is invisible to it, and some of what is invisible is enormous.

• Unpaid work. Care for children and the elderly, housework, subsistence farming, volunteering. If a family pays for childcare, GDP rises; if a grandparent does the same work, it does not. The output is identical.
• The informal economy. Cash work, unregistered trade, smuggling. In some countries this is a third of activity, and the official figure simply misses it.
• Income distribution. GDP per capita is an average. It is the same whether everyone earns 24,000 marcs or ten people earn everything. 3.4 is the subtopic that measures this.
• Externalities and depletion. Output that poisons a river counts in full; the poisoned river counts not at all. A country that cuts down its forest records the timber as income and the lost forest as nothing. This is where the key concept of sustainability enters the argument.
• What is produced, and at what cost in time. Weapons and vaccines count the same. Leisure counts for nothing, so a country that works longer hours for the same output looks more successful.
• Spending that repairs damage. A flood clean-up raises GDP. Nobody is better off.

Now the two comparisons the guide names.

Comparisons over time, for one country. Use real GDP, and real GDP per capita if the question is about living standards. Even then, be careful: the composition of output changes, and services are harder to measure than goods; quality improves in ways prices do not capture; the share of activity that is informal changes; hours worked change; and statistical methods are revised, so an old number and a new number were not made the same way.

Comparisons between countries. Use real GNI or GDP per capita at PPP. Even then: the informal and subsistence economy is much larger in some countries, so their output is understated; income distribution differs, so the same average hides very different lives; data quality differs, and some governments have reason to flatter the figure; and GDP will differ from GNI wherever there is a lot of foreign ownership.

The balanced position, which is what a part (b) is marked on: national income statistics are the best single indicator of an economy's capacity to give people what they need, and they are a poor description of whether life is good. They are strongly associated with health, education and life expectancy at low incomes, and much more weakly associated with them once a country is rich. Say both, then say which matters more for the question in front of you.

8Alternative measures of well-being

The guide names three. Know what each adds and what each still misses.

Used well in an exam, these are not a list to recite. They are the evidence for a judgement: GDP measures one thing accurately, these measure other things roughly, and a government that watches only the first will make decisions that the other three would have warned it about.