In this chapter, look for the answers to

these questions:
• What is Gross Domestic Product (GDP)?
• How is GDP related to a nation’s total income
and spending?
• What are the components of GDP?
5 • How is GDP corrected for inflation?
• Does GDP measure society’s well-being?

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Measuring a Nation’s Income THE ECONOMY’S INCOME AND

Microeconomics is the study of how individual households and
EXPENDITURE
firms make decisions and how they interact with one another in • When judging whether the economy is doing
markets.
Macroeconomics is the study of the economy as a whole. Its goal
well or poorly, it is natural to look at the total
is to explain the economic changes that affect many income that everyone in the economy is
households, firms, and markets at once. earning.
Macroeconomics answers questions like the following: • For an economy as a whole, income must
▪ Why is average income high in some countries and low in
others? equal expenditure because:
▪ Why do prices rise rapidly in some time periods while they – Every transaction has a buyer and a seller.
are more stable in others? – Every dollar of spending by some buyer is a dollar
▪ Why do production and employment expand in some years of income for some seller.
and contract in others?
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Figure 1 The Circular-Flow Diagram

THE MEASUREMENT OF GROSS
Revenue
MARKETS
FOR
GOODS AND SERVICES
Spending DOMESTIC PRODUCT
• Firms sell

• Gross domestic product (GDP) is a measure of

Goods Goods and
• Households buy
and services services
sold bought

the income and expenditures of an economy.

FIRMS
• Produceand sell
goods and services
HOUSEHOLDS
• Buy and consume
goods and services
• GDP is the total market value of all final goods
• Hire
and use factors
of production
• Own and sell factors
of production and services produced within a country in a
given period of time.
Factors of
production
MARKETS
FOR
FACTORS OF PRODUCTION
Labor, land,
and capital • The equality of income and expenditure can be
Wages, rent,
and profit
• Households
• Firms buy
sell Income
illustrated with the circular-flow diagram.
= Flow of inputs
and outputs
= Flow of dollars

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1
THE MEASUREMENT OF GROSS THE MEASUREMENT OF GROSS
DOMESTIC PRODUCT DOMESTIC PRODUCT
• “GDP is the Market Value . . .” • “. . . Produced . . .”
– Output is valued at market prices. – It includes goods and services currently produced, not
• “. . . Of All. . .” transactions involving goods produced in the past.
– Includes all items produced in the economy and legally • “ . . . Within a Country . . .”
sold in markets
– It measures the value of production within the geographic
• “. . . Final . . .” confines of a country.
– It records only the value of final goods, not intermediate
goods (the value is counted only once). • “. . . In a Given Period of Time.”
– It measures the value of production that takes place within
• “. . . Goods and Services . . .” a specific interval of time, usually a year or a quarter (three
– It includes both tangible goods (food, clothing, cars) and months).
intangible services (haircuts, housecleaning, doctor visits).
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THE COMPONENTS OF GDP THE COMPONENTS OF GDP

• GDP includes all items produced in the GDP (Y) is the sum of the following:
economy and sold legally in markets. ▪ Consumption (C)
• What Is Not Counted in GDP? ▪ Investment (I)
– GDP excludes most items that are produced and ▪ Government Purchases (G)
consumed at home and that never enter the ▪ Net Exports (NX)
marketplace.
– It excludes items produced and sold illicitly, such
as illegal drugs. Y = C + I + G + NX

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THE COMPONENTS OF GDP THE COMPONENTS OF GDP

• Consumption (C):
• The spending by households on goods and services, with the exception of • Government Purchases (G)
purchases of new housing. – The spending on goods and services by local, state, and
– For renters, consumption includes rent payments. federal governments.
– For homeowners, consumption includes – Does not include transfer payments, such as social security
the imputed rental value of the house, or unemployment insurance, because they are not made in
but not the purchase price or mortgage payments. exchange for currently produced goods or services.
• Investment (I):
• The spending on capital equipment, inventories, and structures, including new
• Net Exports (NX):
housing. – Exports minus imports.
• includes spending on
• capital equipment (e.g., machines, tools) – Exports represent foreign spending on the
• structures (factories, office buildings, houses) economy’s g&s.
• inventories (goods produced but not yet sold)
Note: “Investment” does not mean the purchase of financial assets like stocks – Imports are the portions of C, I, and G
and bonds. that are spent on g&s produced abroad.
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 Table 1 GDP and Its Components
THE COMPONENTS OF GDP

Adding up all the components of GDP gives:

Y = C + I + G + NX

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GDP and its components

GDP and Its Components (2004)
In each of the following cases, determine how much GDP
Government Purchases and each of its components is affected (if at all).
15% A. Debbie spends $200 to buy her husband dinner
Investment Net Exports at the finest restaurant in Boston.
16% -5 % Consumption and GDP rise by $200.
B. Sarah spends $1800 on a new laptop to use in her
publishing business. The laptop was built in China.

Investment rises by $1800, net exports fall

Consumption
by $1800, GDP is unchanged.
70%

© 2007 Thomson South-Western 15

© 2007 Tho mso n Sout h-We ster n

GDP and its components

C. Jane spends $1200 on a computer to use in her
editing business. She got last year’s model on sale
for a great price from a local manufacturer.
Current GDP and investment do not change,
because the computer was built last year.
D. General Motors builds $500 million worth of cars,
but consumers only buy $470 million worth of them.
Consumption rises by $470 million,
inventory investment rises by $30 million,
and GDP rises by $500 million.
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REAL VERSUS NOMINAL GDP
• Inflation can distort economic variables like GDP,
so we have two versions of GDP:
One is corrected for inflation, the other is not.
• Nominal GDP values the production of goods and
services at current prices. It is not corrected for
inflation
• Real GDP values the production of goods and
services at constant prices. It is corrected for
inflation.
• An accurate view of the economy requires adjusting
nominal to real GDP by using the GDP deflator.
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 The GDP Deflator
Table 2 Real and Nominal GDP

• The GDP deflator is a measure of the price level

calculated as the ratio of nominal GDP to real GDP
times 100.
• It tells us what portion of the rise in nominal GDP that
is attributable to a rise in prices rather than a rise in the
quantities produced.
• The GDP deflator is calculated as follows:
Nominal GDP
GDP deflator =  100
Real GDP
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The GDP Deflator

Table 2 Real and Nominal GDP

• Nominal GDP is converted to real GDP as

follows:

Nominal GDP20XX
Real GDP20XX   100
GDP deflator20XX

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Computing GDP Computing GDP

2004 (base yr) 2005 2006 2004 (base yr) 2005 2006
P Q P Q P Q P Q P Q P Q
good 1,00 good 1,00
$30 900 $31 $36 1050 $30 900 $31 $36 1050
A 0 A 0
good $10 good $10
$100 192 200 $100 205 $100 192 200 $100 205
B 2 B 2
Use the above data to solve these problems: A. Compute nominal GDP in 2004.
A. Compute nominal GDP in 2004.
$30 x 900 + $100 x 192 = $46,200
B. Compute real GDP in 2005.
C. Compute the GDP deflator in 2006. B. Compute real GDP in 2005.
$30 x 1000 + $100 x 200 = $50,000
22 23
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Computing GDP Figure 2 Real GDP in the United States
Billions of
2004 (base yr) 2005 2006 2000 Dollars

P Q P Q P Q $10,000
9,000
good 1,00
$30 900 $31 $36 1050 8,000
A 0 7,000

good $10 6,000

$100 192 200 $100 205 5,000
B 2
4,000
C. Compute the GDP deflator in 2006. 3,000

Nom GDP = $36 x 1050 + $100 x 205 = $58,300 2,000

Real GDP = $30 x 1050 + $100 x 205 = $52,000

GDP deflator = 100 x (Nom GDP)/(Real GDP) 1970 1975 1980 1985 1990 1995 2000 2005

= 100 x ($58,300)/($52,000) = 112.1 24 © 2007 Thomson South-Western

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IS GDP A GOOD MEASURE OF Gross Domestic Product…

“… does not allow for the health of our
ECONOMIC WELL-BEING? children, the quality of their education, or
the joy of their play. It does not include
• GDP is the best single measure of the the beauty of our poetry or the strength of
economic well-being of a society. our marriages, the intelligence of our
• GDP per person tells us the income and public debate or the integrity of our public
officials. It measures neither our courage,
expenditure of the average person in the nor our wisdom, nor our devotion to our
economy. country. It measures everything, in short,
• Higher GDP per person indicates a higher except that which makes life worthwhile,
and it can tell us everything about
standard of living. America except why we are proud that we
• GDP is not a perfect measure of the happiness are Americans.”
- Senator Robert Kennedy, 1968
or quality of life, however.
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GDP AND ECONOMIC

Then Why Do We Care About GDP?
WELL-BEING
• Some things that contribute to well-being are • Having a large GDP enables a country to
not included in GDP. afford better schools, a cleaner environment,
– The value of leisure. health care, etc.
– The value of a clean environment.
– The value of almost all activity that takes place • Many indicators of the quality of life are
outside of markets, such as the value of the time positively correlated with GDP. For
parents spend with their children and the value of example…
volunteer work.

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