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CHAPTER 11
Measuring the size of the economy
Allan Layton, Tim Robinson, Tommy Tang, Dinusha Dharmaratna and Irvin B. Tucker, Economics for Today, 7th Asia–Pacific Edition. © 2022 Cengage Australia
Pty Ltd. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
LEARNING OBJECTIVES
• Understand the concept of gross domestic product.
• Understand how gross domestic product is measured.
• Appreciate the shortcomings in using gross domestic product as a
measure of the economic welfare of a country.
• Learn the difference between nominal and real gross domestic product.
• Develop an understanding of the nature of the national saving and
investment relationship in an open economy.
GROSS DOMESTIC PRODUCT (GDP)
• GDP measures the market value of all final goods and services
produced within a nation’s geographic borders during a period of
time.
• It is a measure of a nation’s economic performance.
• There is an emphasis on GDP because it is the measure that is more
relevant to the level of domestic economic activity and generation of
domestic jobs.
WHAT DOES GDP INCLUDE?
1. GDP counts only new domestic production. It excludes:
• second-hand transactions
• ‘non-productive’ financial transactions.
2. GDP counts only final goods and excludes:
• intermediate products.
CONCEPT OF VALUE-ADDED
• GDP also can be used to measure how much value each stage of
production adds to the overall price of the final good or service.
• Exhibit 11.1 shows how a $420 sale price of a woollen suit is split up
over its stages of production.
MEASURING GDP
• GDP counts the value of production in all markets for products,
resources, consumers, workers and businesses.
• The circular flow model, shown in Exhibit 11.2 on the next slide,
shows how we can think of all the economy’s sectors in one ‘whole’.
THE CIRCULAR FLOW MODEL
FLOW VERSUS STOCK
• Flow is a rate of change in a quantity during a given time period:
• For example: weekly consumption spending.
• Stock is a quantity measured at one point in time:
• For example: the amount of money in a bank account.
• All measurements in the circular flow model are flows.
A FOUR-SECTOR CIRCULAR
FLOW MODEL
• Most household income is spent on domestic goods. However:
• part of household income is saved
• part of household income is taxed
• part is spent on goods from overseas (imports).
• These parts are called leakages from the main flow.
THE CIRCULAR
FLOW MODEL
OF AN OPEN
ECONOMY
APPROACHES TO
MEASURING GDP
• Expenditure approach: adds all spending for final goods during a
period of time:
GDP = C + I + G + (X – M)
• Income approach: adds the incomes of all factors of production:
GDP = Wages + Rent + Interest + Profits
• Output approach (production-based): sum of all value added.
THE EXPENDITURE APPROACH
HOUSEHOLD CONSUMPTION
EXPENDITURES (C)
• These are the most significant component of GDP.
• They are made up of spending on:
• services (e.g. education, medical visits, haircuts, etc.)
• durable goods (e.g. cars, appliances, furniture)
• non-durable goods (e.g. food, clothing, petrol).
GROSS PRIVATE DOMESTIC
INVESTMENT (I)
• This is spending that maintains or increases the stock of capital
equipment in the economy.
• It is made up of:
• fixed investment for newly produced capital goods
• changes in business inventories (unsold finished goods and raw
materials).
GOVERNMENT CONSUMPTION AND
GROSS PUBLIC INVESTMENT
EXPENDITURES (G)
• This includes:
• the value of all goods and services that the government purchases
• spending on investment-type goods, such as highways, buildings
and bridges.
• G does not include transfer payments from one level of government
to another.
NET EXPORTS (X – M)
• Exports (X) are expenditures by foreigners on domestically produced
goods and services.
• Imports (M) are the dollar amount of a nation’s purchases from
producers in other countries.
A FORMULA FOR GDP
GDP = C + I + G + (X – M)
GDP IN OTHER COUNTRIES
OTHER NATIONAL ACCOUNTS
• Net domestic product (NDP): GDP minus depreciation of the capital
worn out in producing output
• Gross national income (GNI): Income accruing to a country’s residents
from the production of all final goods and services, no matter where
the goods and services are produced in the world
• Gross disposable income (GDI): GNI minus net transfers overseas
OTHER NATIONAL ACCOUNTS (CONT.)
GDP SHORTCOMINGS AS A MEASURE
OF ECONOMIC WELFARE
• GDP is seen as not being able to fully measure issues of economic
welfare; e.g.:
• non-market transactions
• distribution, kind and quality of products
• neglect of leisure time
• the underground economy
• economic ‘bads’.
NOMINAL GDP AND REAL GDP
• Nominal GDP is the value of all final goods and services produced
during a given time period based on the prices existing during the
time period of production.
• Nominal GDP is also referred to as current-dollar GDP.
• Real GDP is the value of all final goods and services produced during a
given time period based on the prices existing in a selected reference
year.
• Real GDP is also referred to as constant-dollar GDP.
THE CHAIN VOLUME MEASURE
OF GDP
• The chain volume measure of GDP provides a measure of all final
goods and services produced during a given period using a set of
relevant prices prevailing in some selected reference year.
• This measure is used by the Australian Bureau of Statistics.
CHANGING NOMINAL GDP TO
REAL GDP
• To get a clearer picture of an economy’s growth, it is necessary to
adjust nominal GDP to real GDP so that it reflects only changes in
output and not changes in prices.
• Nominal GDP is converted to real GDP using the following conversion
equation:
NOMINAL GDP AND REAL GDP
RELATIONSHIP BETWEEN NATIONAL
SAVING AND INVESTMENT
• In a simple economy, saving is by definition its investment (S = I).
• National saving = Total income – consumption
• National investment = Total spending on capital goods by private sector
and government
• If national investment exceeds national saving, the additional
investment must be financed by net foreign investment flowing into the
country:
National investment – national saving = net foreign investment
DECISION HEURISTICS
• Decision heuristic is a mental short-cut or rule of thumb to make a
quick decision of form a judgment when dealing with a complex or
obscure task
• the tendency to use the first or most recognisable piece of
Anchoring heuristic information to make decision or judgment when faced with
uncertainty or lack of any information
• the tendency to overestimate (or underestimate) the frequency of

Availability heuristic an event or phenomenon if the examples of the event are familiar
(or unfamiliar)
• the tendency to make a choice by following others on the belief

Herding heuristic that the decision by the group should be right

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CHAPTER 11

Measuring the size of the economy

• the tendency to overestimate (or underestimate) the frequency of

• the tendency to make a choice by following others on the belief

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