Chapter 20: The Measurement of National Income

National Output and Value Added

Production occurs in stages: Some firms produce outputs that are used as inputs by other firms,
and these other firms, in turn, produce outputs that are used as inputs by yet other firms.
If we added up all the market values of all outputs of all firms, we would obtain a total greatly
in excess of the value of the economys actual output - double counting.
2 types of output
1) Intermediate Goods: All outputs that are used as inputs by other producers in a further
stage of production
2) Final Goods: Goods that are not used as inputs by other firms but are produced to be
sold for consumption, investment, government, or export during the period under
consideration (an item bought by its final user)
It is extremely difficult, if not impossible to successfully distinguish final from intermediate
goods.
To avoid double counting, economists use the concept of value added.
Value Added: The value of a firms output minus the value of the inputs that it purchases from
other firms. (net value of its output)
Value Added = Sales Revenue - Cost of Intermediate Goods
Since the firms revenue must be fully exhausted by the cost of intermediate goods plus all
payments to factors of production, value added = payments owed to the firms factors of
production.
Value added is the correct measure of each firms contribution to total output (GDP) - the
amount of market value that is produced by that firm.
The sum of all values added in an economy is a measure of the economys total output.
National Income Accounting: The Basics
The value of domestic output is equal to the value of the expenditure on that output and is also
equal to the total income claims generated by producing that output.
3 Methods of Calculating GDP
1) Add up the value of all goods and services produced in the economy (value added)

2) Add up total expenditure for each of the main components of final output
3) Add up all the income claims generated by the act of production
The conventions of double-entry bookkeeping require that the value of all production must be
accounted for by a claim that someone has to that value. Thus, the values calculated from the
income and the expenditure sides are identical conceptually and differ in practical
measurements only because of errors of measurement. Any discrepancy arising from such
errors is then reconciled so that one common total is given as the measure of GDP.
GDP from the Expenditure Side
Add up the expenditures needed to purchase the final output produced in that year
GDP, Y (total expenditure on final output) is measured as a sum of
1) Consumption Expenditure, C
- Expenditure on all goods and services sold to their final users during the
year
- Includes services such as haircuts and dental care, non-durable goods
such as vegetables and clothing, and durable goods such as cars and TVs
2) Investment Expenditure, I
- Expenditure on goods not for present consumption
- 4 broad categories of expenditure
Inventories
Stocks of goods made but not yet sold and inputs
purchased, but not yet used in production
New Plant and Equipment
Creating new capital goods
Capital Stock: The economys total quantity of capital
goods
New Residential Housing
A house/apartment is a durable asset that yields its utility
over a long period of time
The building of a new house
Gross and Net Investment
Gross Investment: The total investment that occurs in the
economy
Gross Investment = Inventories + New Plants and
Equipment + New Residential Housing
Gross investment is divided into 2 parts: replacement and
net investment
Replacement Investment: The amount of investment
required to replace capital stock that loses its value
Depreciation: The amount by which the capital stock is
depleted through the production process
Net Investment = Gross Investment - Depreciation

3) Government Purchases, G
- All government expenditure on currently produced goods and services,
exclusive of government transfer payments
- Ex. street-cleaning and firefighting
- Government output is typically valued at cost rather than at market value
4) Net Exports, (NX)
- Imports: The value of all domestically produces goods and services,
purchased from firms, households, or governments in other countries
- Exports: The value of all goods and services sold to firms, households, and
governments in other countries
- Net Exports (NX) = Total Exports (X) - Total Imports (M)
Y = C + I + G + (X - M)
GDP from the Income Side
Add up factor incomes and other claims until all of that value is accounted for
1) Factor Incomes
- Wages and Salaries: All pre-tax labor earnings
- Interest: Interest that is earned on deposits, loans, or investments
- Business Profits: Dividends and retained earnings are part of the GDP
calculation
2) Non-Factor Payments
- Indirect Taxes and Subsidies: Taxes on the production/sale of goods and
services (Ex. provincial sales taxes, GST)
- Depreciation: Part of gross profits, but because it is needed to
compensate for capital used up in the process of production, it is not part
of net profits, not earned by any factor of production
Y = Factor Incomes (Wages and Salaries + Interest + Business Profits) + Indirect Taxes
(Net of Subsidies) + Depreciation
20.3 National Income Accounting: Some Further Issues
GDP and GNP
Gross National Product (GNP): The value of total incomes earned by domestic residents
GDP measures the value of all production located in Canada, no matter who receives
the income from that production
GNP measures the income received by Canadian residents, no matter where the
production occurred to generate that income
Income produced versus income received
In Canada, GNP is slightly lower than GDP
GDP is a better measure of the economic activity in a country, whereas GNP is a better
measure of the income of a countrys residents
Disposable Personal Income: The part of national income that is available to households
to spend or save

Real and Nominal GDP

Nominal GDP: Total GDP valued at current prices
Real GDP: GDP valued at base-period prices
The GDP Deflator
GDP Deflator: An index number derived by dividing nominal GDP by real GDP, whose
change measures the average change in price of all the items in the GDP

Changes in the GDP deflator and Consumer Price Index (CPI) similarly reflect overall
inflationary trends, but changes in relative prices may lead the 2 price indices to move in
different ways
Omissions from GDP
GDP and related measures of national income must be interpreted with their limitations
in mind
GDP excludes production resulting from illegal activities, that take place in the
underground economy, or that do not pass through markers
GDP and Living Standards
Changes in real per capita income are a good measure of average material living
standards, but material living standards are only part of what most people consider
their overall well-being (religious and political freedom, ability to treat and prevent
illness)