Chapter 5

Macroeconomics
Third Edition
Chapter 5
The Wealth of Nations:

Defining and Measuring
Macroeconomic
Aggregates
Copyright © 2022, 2018, 2014 Pearson Education, Inc. All Rights Reserved
Macroeconomic Questions (1 of 10)
The Big Picture:
In this first chapter in Macroeconomics, we will examine
the economy from a bird’s-eye view without focusing too
much on how households and businesses make their
decisions.
We will measure the economy’s entire production (GDP),
and look into methods used to calculate inflation.
Learning Objectives
5.1 Macroeconomic Questions
5.2 National Income Accounts: Production = Expenditure =
Income
EBE: In the United States, what is the total market value of
annual economic production?
5.3 What Isn’t Measured by GDP?
5.4 Real v s Nominal
ersu
Key Ideas (1 of 2)
1. Macroeconomics is the study of aggregate economic
activity.
2. National income accounting is a framework for
calculating gross domestic product (GDP), which is a
measure of aggregate economic output.
3. GDP can be measured in three different ways, and in
principle these three methods should all yield the same
answer: Production = Expenditure = Income.
Key Ideas (2 of 2)
4. GDP has limitations as a measure of economic activity
and as a measure of economic well-being.
5. Economists use price indexes to measure the rate of
inflation and to distinguish nominal GDP from real GDP
(which holds prices fixed)
Macroeconomics is the study of economic aggregates and
economy-wide phenomena like the annual growth rate of a
country’s total economic output or the annual percentage
increase in the total cost of living.
In particular, macroeconomics asks the following
questions:
• What is income per capita?
• How do we measure differences in income per capita?
• How large are differences in income per capita?
• What causes differences in income per capita?
• How long will differences in income per capita persist?
Income per capita
The average income per person.
Income per capita
Calculated by dividing a nation’s aggregate (or total)
income by the number of people in that country.
Income per capita in the United States is more than four
times the level in China, and almost 100 times the level in
Zimbabwe!
Why does economic growth sometimes slow down or even
turn negative?
In the short run, economic growth slows down or even
becomes negative when aggregate spending decreases.
What is a recession?
A recession is defined as two straight quarters in which
aggregate income falls.
What is the unemployment
rate, and why does it rise
during recessions?
Why were the Great
Recession of 2007–2009
and the Great Depression
of 1929–1932 so severe?
• The COVID-19 pandemic created a global economic
recession that started in 1st quarter of 2020.
• In the U.S., output fell by 10.2% in the 1st and 2nd quarter
of 2020. The unemployment rate skyrocketed from 3.5%
in February 2020 to 14.7% in just two months.
• The stock market fell by about 30% in March 2020, but
rebounded quickly after that.
The unemployment rate is defined as the ratio of workers
without a job who are actively seeking one, divided by the
labor force.
There are a multitude of reasons behind the severity of the
Great Depression and the Great Recession that we will
examine later.
National income accounts
A measure of the level of aggregate economic activity in a
country.
National Income and Product Accounts (NIPA)
The system of national income accounts used in the United
States.
National Income Accounts: Production =
Expenditure = Income (1 of 9)
Aggregate economic activity in a country can be measured

in three different ways:
• The production approach
• The expenditure approach
• The income approach
The Production Approach in Penville (1 of 2)
Penville is a small country with one employer, Bic Pen,

which produces 10 million pens a year. The market price of
a pen is $2.
Penville has 100,000 citizens, and they all work in the Bic
Pen factory.
Bic Pen owns the inputs and its own machines so only
needs to hire workers.
The Production Approach in Penville (2 of 2)
To determine the market value of production, we multiply

the quantity of pens produced by the market price of each
pen:
Production  (10 million pens)  ($2.00 / pen)  $20 million
The Expenditure Approach in Penville
We add up the sales of pens to households, firms,

government, and the foreign sector, including unsold
inventories:
Expenditure  (10 million pens)  ($2.00 / pen)  $20 million
The Income Approach in Penville
We add up payments to labor and payments to capital:
Bic Pen generates $20 million in revenue, pays $X to its
workers, and keeps ($20 million  $X) for its owners. So,
total income for its workers and owners is:
Income  $X  ($20 million  $X)  $20 million
Aggregate Accounting Identity for
Penville
From previous calculations, we see how in Bic Pen:

Production = Expenditure = Income
$20 million = $20 million = $20 million
Exhibit 5.1: Circular Flow Diagram
Each of these approaches is used to measure gross

domestic product, or GDP.
GDP
The market value of the final goods and services produced
within the borders of a country during a particular time
period.
Production Approach
Production-based accounting sums up each firm’s value
added, which is the firm’s sales revenue minus the firm’s
purchases of intermediate products from other firms.
Example on Value-Added
Starbucks purchases its intermediate goods (such as
coffee beans, paper cups, lids, holders, etc.) for $0.25 per
cup. It sells a cup of coffee to customers for $2.00 per cup.
Therefore,
Value-added  $2.00  $0.25  $1.75 per cup
Expenditure Approach
Expenditure-based accounting sums up the purchases of
goods and services by different groups or categories.
There are five main categories.
1. Consumption goods and consumption services bought

by domestic households (C)
2. New physical capital (investment) bought by domestic
households and domestic firms (I)
3. Government expenditures on goods and services (G)
4. Exports of goods and services produced domestically
and sold abroad (X)
5. Imports of goods and services produced abroad and
sold domestically (M)
Income Approach
Income-based accounting sums up payments (or income)
received by labor and the owners of physical or financial
capital.
Aggregate Accounting Identity

Y  GDP PROD  GDP EXP  GDP INCOME
National Income Accounting Identity
Y  C I G  X M
The Wealth of Nations: Defining and
Measuring Macroeconomic Aggregates (1 of 8)
Evidence-Based Economics Example:

Question: In the United States, what is the total market
value of annual economic production?
Answer: The Bureau of Economic Analysis estimated in
2019 that U.S. GDP was $21.4 trillion, or $65,204 per
resident (based on population of 328.2 million in 2019).
Question: In 2019, how was GDP divided into the

expenditure components?
blank
Trillion of Dollars Share of GDP

blank
Gross Domestic Product $21.4

blank
Consumption $14.6
blank
+ Investment $3.7
blank
+ Government Exp. $3.8

blank
+ Exports $2.5
 Imports
Negative imports blank
$3.1
Answer:
blank
Trillion of Dollars Share of GDP

Gross Domestic Product $21.4 100%
Consumption $14.6 68.0%
+ Investment $3.7 17.5%
+ Government Exp. $3.8 17.5%
+ Exports $2.5 11.7%
 Imports
Negative imports
$3.1 14.6%
Negative 14.6 %
Evidence-Based Economics Example:

Question: Have U.S. expenditure shares fluctuated or
remained constant over time?
Answer: The U.S. expenditure shares have been relatively
constant over time.
Exhibit 5.4: U.S. GDP Shares (1929–2019)
Question: What fraction of income is paid to labor, and

what fraction is paid to capital?
Answer: In the United States, labor receives about two-
thirds of total income, and capital receives about one-third
of total income.
The national income accounting is useful to identify the
relationship between saving and investment in a country.
Y  C I G  X M
Saving  Y  C  G
Saving  (C  I  G  X  M )  C  G
Saving  I  X  M
In many economies, X  M is very close to 0 (exactly = 0 in
a closed economy)
Therefore: Saving = Investment
Or:
Saving / GDP  Investment / GDP
Exhibit 5.5: The Relationship Between the Saving Rate

and the Investment Rate(1929–2019)
What Isn’t Measured by GDP? (1 of 7)
GDP and national income accounting is a useful system for
taking the temperature of the economy. However, it is not
perfect, and it necessarily leaves out a lot of details.
• GDP omits depreciation of the physical capital stock and
resources.
• GDP excludes home production of cleaning, cooking,
and child care done in the household.
• GDP does not capture transactions conducted in the
underground economy.
• GDP does not count negative externalities such as
pollution, noise, and crime.
• GDP does not record leisure.
• GDP does not include production by U.S. workers and
U.S. capital abroad.
Gross domestic product, or GDP, records production in the
United States regardless of whose labor and capital
(domestic or foreign) is used.
Gross national product, or GNP, records production of
domestically owned labor and capital in the United States
and abroad.
What is the difference between GDP and GNP in the U.S.?
blank
2017 2018 2019

GDP (in $billions) 19.54 20.61 21.43
Plus: income receipts from the rest of the world 1.03 1.14 1.17
Minus: income payments to the rest of the world 0.74 0.86 0.90
Equals GNP 19.83 20.89 21.70
Do all these limitations mean that GDP is a poor measure
of well-being of an economy?
Why don’t we ask people how happy or satisfied they are
and compare these responses to GDP?
Exhibit 5.6: GDP per Capita and Life Satisfaction
Real v s Nominal (1 of 17)
ersu
An increase in GDP will record both increases in actual

production (and income) and increases in prices of those
goods and services.
We therefore need to distinguish between nominal GDP
and real GDP.
ersu
Nominal GDP
The total value of production using current market prices
to determine the value of each unit that is produced.
Real GDP
The total value of production using market prices from a
specific base year to determine the value of each unit that
is produced.
ersu
Nominal GDP for 2009:

09
Papples  Qapples
09
 Pbig
09
mac  Q 09
big mac  ...  P 09
zucchini  Q 09
zucchini

13
Papples  Qapples
13
 Pbig
13
mac  Q 13
big mac  ...  P 13
zucchini  Q 13
zucchini
ersu
Real GDP for 2009 (base year 2009) =

09 09 09 09 09 09
Papples ×Qapples + Pbig mac ×Qbig mac + ...+ Pzucchini ×Qzucchini
= Nominal GDP for 2009
Real GDP for 2013 (base year 2009)=

09 13 09 13 09 13
Papples ×Qapples + Pbig mac ×Qbig mac + ...+ Pzucchini ×Qzucchini
Example: The Nation of Barney
Calculate nominal GDP for 2012 and 2013.
Calculate real GDP for 2012 and 2013.
Peanut Butter Peanut
Year Quantity Butter Price Jelly Quantity Jelly Price
2012 20 $4.00 50 $2.00
2013 30 $5.00 100 $2.00
The Nation of Barney (1 of 2)
12
Ppb  Qpb
12
 Pjelly
12
 Q12
jelly  $4.00  20  $2.00  50
Nominal GDP for 2013:  $80  $100  $180

13
Ppb  Qpb
13
 Pjelly
13
 Q13
jelly  $5.00  30  $2.00  100
 $150  $200  $350
The Nation of Barney (2 of 2)
Real GDP for 2012:
12
Ppb  Qpb
12
 Pjelly
12
 Q12
jelly  $4.00  20  $2.00  50
 $80  $100  $180

Real GDP for 2013:
12
Ppb  Qpb
13
 Pjelly
12
 Q13
jelly  $4.00  30  $2.00  100
 $120  $200  $320
ersu
Growth in Nominal GDP:
($350  $180) / $180  0.94(or 94%)
Growth in Real GDP:
($320  $180) / $180  0.78(or 78%)
ersu
Two price indexes used to measure overall changes in the

price level and inflation
GDP Deflator: the ratio of nominal GDP to real GDP. It is a
measure of how prices of goods and services produced in
a country have risen since the base year.
Consumer Price Index: the cost of buying a basket of
goods and services in the current year divided by the cost
of the same basket in the base year.
ersu
GDP deflator
The ratio of nominal GDP to real GDP:
Nominal GDP
GDP deflator  ×100
Real GDP
In the Nation of Barney:
350
GDP deflator   100  109.4
320
ersu
Exhibit 5:8: The value of the U.S. GDP Deflator from 1929
to 2019 (using 2012 as the base year)
Consumer Price Index (CPI)
The price level of a particular basket of consumer goods
and services:
cost of consumer basket in current year

CPI   100
cost of consumer basket in base year
ersu
To calculate the CPI in the Nation of Barney, let’s assume

that a typical household buys 2 units of peanut butter, and
2 units of jelly.
Peanut Peanut Cost of
Blank Blank
Butter Butter Jelly jelly Basket
Blank
YEAR Quantity Price Exp. Price Exp.
2012 2 $4.00 $8.00 $2.00 $4.00 $12.00
2013 2 $5.00 $10.00 $2.00 $4.00 $14.00
CPI  ($14.00 / $12.00)100  116.7
ersu
The GDP deflator and the CPI formula look nearly

identical.
Question: What are the differences?
Hint: Think about what is in each “basket” of goods and
services.
ersu
1. The GDP deflator includes things not purchased by

households, like trains, subways, and submarines.
2. The CPI includes imports like Chinese laptops.
3. Housing-related expenditures like shelter and utility bills
have a large weight in the CPI.
ersu
Inflation rate
The percentage change in a price index.
Inflation rate in 2013 =
(Price index in 2013)  (Price index in 2012)

 100
(Price index in 2012)
ersu
Exhibit 5.9: The Annual U.S. Inflation Rate (1930–2019)
ersu
We can use a price index to make meaningful

comparisons across time:
In 1909, then U.S. President William Howard Taft was
paid $75,000.
In 2016, former U.S. President Barack Obama was paid
$400,000.
ersu
We can convert Taft’s salary to 2016 dollars by applying

this formula:
Value in 2016 dollars  Price index in 2016  / Price index in 1909 
 Value on 1909 dollar.
 239.5 / 9  $75,000
 $1.99 million
President Taft earned almost 5 times more income in real

terms than President Obama ($1.9 million/$400,000)
ersu
Question: The table below shows minimum wage in

different years. In which year did a worker on minimum
wage earn the most in real terms? (hint, it’s not 2016)
Year Minimum Wage

1956 $1.00
1967 $1.40
1975 $2.10
1981 $3.35
1996 $4.75
2007 $5.85
2019 $7.25
ersu
Answer: We must convert each year’s minimum wage to a constant

year’s dollars (say 2019). Example,
Value of 1981 min. wage in 2019 dollars =
Min. wage in 1981 (CPI 2019 / CPI 1981) 
$3.35(254.4 / 90.9)  $8.83
Year Minimum Wage CPI Value in 2016 dollars
1956 $1.00 27.2 $9.35
1967 $1.40 33.4 $10.66
1975 $2.10 53.8 $9.93
1981 $3.35 90.9 $9.37
1996 $4.75 156.9 $7.70
2007 $5.85 207.3 $7.18
2019 $7.25 254.4 $7.25
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Macroeconomics

The Wealth of Nations:

Aggregate economic activity in a country can be measured

Penville is a small country with one employer, Bic Pen,

To determine the market value of production, we multiply

We add up the sales of pens to households, firms,

From previous calculations, we see how in Bic Pen:

Exhibit 5.1: Circular Flow Diagram

Each of these approaches is used to measure gross

1. Consumption goods and consumption services bought

Aggregate Accounting Identity

Evidence-Based Economics Example:

Question: In 2019, how was GDP divided into the

Trillion of Dollars Share of GDP

Gross Domestic Product $21.4

+ Government Exp. $3.8

Trillion of Dollars Share of GDP

Evidence-Based Economics Example:

Exhibit 5.4: U.S. GDP Shares (1929–2019)

Question: What fraction of income is paid to labor, and

Exhibit 5.5: The Relationship Between the Saving Rate

2017 2018 2019

An increase in GDP will record both increases in actual

Nominal GDP for 2009:

Nominal GDP for 2013:

Real GDP for 2009 (base year 2009) =

= Nominal GDP for 2009

Real GDP for 2013 (base year 2009)=

Nominal GDP for 2013:  $80  $100  $180

 $150  $200  $350

 $80  $100  $180

 $120  $200  $320

Growth in Nominal GDP:

($350  $180) / $180  0.94(or 94%)

Growth in Real GDP:

($320  $180) / $180  0.78(or 78%)

Two price indexes used to measure overall changes in the

In the Nation of Barney:

cost of consumer basket in current year

To calculate the CPI in the Nation of Barney, let’s assume

YEAR Quantity Price Exp. Price Exp.

2012 2 $4.00 $8.00 $2.00 $4.00 $12.00

2013 2 $5.00 $10.00 $2.00 $4.00 $14.00

CPI  ($14.00 / $12.00)100  116.7

The GDP deflator and the CPI formula look nearly

1. The GDP deflator includes things not purchased by

Inflation rate in 2013 =

(Price index in 2013)  (Price index in 2012)

Exhibit 5.9: The Annual U.S. Inflation Rate (1930–2019)

We can use a price index to make meaningful

We can convert Taft’s salary to 2016 dollars by applying

President Taft earned almost 5 times more income in real

Question: The table below shows minimum wage in

Year Minimum Wage

Answer: We must convert each year’s minimum wage to a constant

This work is protected by United States copyright laws and is

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