Chapter 20

Measuring Economic Activity

Dr. Radwa Abdelghaffar
Assistant professor, CU

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 Gross Domestic Product (GDP)

• The gross domestic product (GDP) is the

most comprehensive measure of a nation’s
total output of goods and services.

• It is the sum of the dollar values of

consumption (C), gross investment (I),
government purchases of goods and
services (G), and net exports (X) produced
within a nation during a gin year.
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 GDP: 4 Keywords
Market Value

• Since we have thousands of goods we

need to convert them all to their money
value, i.e. by multiplying price of each
good times its quantity, then summing
up all the market values together.

• Primarily, goods and services that pass

through the market are included in
GDP.
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 GDP: 4 Keywords
Final Goods and Services
• Only final goods and services are included:
Goods and services produced for final use and
purchased by the ultimate user.
• Intermediate goods: Goods that are produced by
one firm for further processing or for resale by
another firm.
• Intermediate goods are not included in GDP
because they go into the production of another
good, the value of the final good will include
within it the value of the intermediate good. That
is, we don’t include intermediate goods to avoid
double counting. 4
 GDP: 4 Keywords
Final Goods and Services
• To produce a final good, a firm uses some
intermediate goods from other firms and with the
efforts of its factors of production it transforms
the intermediate good into something else. i.e. it
adds value to the intermediate good .

• Thus, the value of the final good is actually the

sum of value added at the different stages of
production.

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 The Value Added
• Value Added: The difference between the value of goods
a firm produced and the cost of the intermediate goods
used (i.e. the cost of the goods as they entered that stage
of production).
• In calculating GDP, we either take the value of the final
good at the last stage of production only, OR we sum up
the value added at each stage of production.
• BUT, we do not use the value of total sales in an
economy to measure how much output has been
produced. Because this will give an exaggerated false
figure (double counting).

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 GDP: 4 Keywords
Within the Geographic Boundaries
of the Country

• GDP is the value of output produced by factors

of production located within a country.
• Output produced by foreigners working in Egypt
is counted as part of Egyptian GDP.
• However, we exclude from GDP the value of
output produced abroad by domestically owned
factors of production.

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 GDP: 4 Keywords
During a Certain Period of Time, Usually a Year

• Only new, or current production is included in GDP. Old

output is not counted in current GDP because it was
already counted when it was produced. e.g. a car produced
in 2010 will not be counted in GDP of 2015.
• i.e. we exclude the resale of used goods, like used cars,
but if the used car is sold through a car agency, we will
include the car dealer’s commission in GDP.
• We also exclude any financial transaction like purchase
or sale of stocks and bonds because this does not involve
the exchange of newly produced goods or services. It is
just a change in the owner of the asset.
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 2 Equivalent Approaches to
Measuring GDP

• The Goods Flow or Earnings Flow:

– The Goods Flow: the Goods Approach
(Expenditure) or (Spending) or Product
Approach.

– The Earnings Approach or the Income or

Cost Approach.

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 The Goods Flow
or The Flow of Product Approach
or The Expenditure Approach

• By summing up spending on all final goods

and services by the different sectors we get
GDP.

• GDP = C+ I + G + (EX - IM)

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 The Product or Expenditure Approach
(Cont’d)
• There are four main categories of expenditure:
– Personal consumption expenditures (C):
household spending on consumer goods.
– Gross private domestic investment (I):
spending by firms and households on new
capital.
– Government consumption and gross
investment (G)
– Net exports (EX – IM): net spending by the rest
of the world, or exports (EX) minus imports (IM)
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 Personal Consumption Expenditures (C)

Personal Consumption Expenditures (C): largest

component of GDP (over 60% of GDP)

• Spending by consumers on:

– Durable goods: Goods that last a relatively long time, such as
cars and household appliances.
– Nondurable goods: Goods that are used up fairly quickly, such
as food and clothing.
– Services: The things we buy that do not involve the production
of physical things, such as legal and medical services and
education, meals eaten away from home, etc.

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 Gross Private Domestic Investment (I)
Gross Private Domestic Investment (I): most volatile
component of GDP, i.e. investors are sensitive to changes in
the economy.
• Gross private domestic investment (I): spending on new
capital. I has three categories:
1. Nonresidential Investment: Expenditures by firms on
new machines, new tools, new plants, and so on.
2. Residential Investment: Expenditures by households and
firms on new houses and apartment buildings.
3. Change in Business Inventories: The amount by which
firms’ inventories change during a period (either +ve or –
ve).
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 Gross Private Domestic Investment (I)
(cont’d)

• Inventories are the goods that firms intend to sell later.

Firms keep inventories because they are not sure of the
exact amount that will be demanded and they want to
avoid run outs. Inventories are considered capital
because they provide value in the future.
• Adding the change in inventories is the first step we do
to ensure that total spending will be equal to total
production of final goods and services.

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 Example on the change in
inventories
• A shoe factory relies on their economist’s forecast to
decide how many pairs of shoes to produce next year. The
economist forecasts sales of 1,000 pairs of shoes, so that’s
what the firm produces. At the end of the year they find
that they sold only 600 pairs of shoes. The difference is the
net change in their inventory, 400 pairs of shoes.
• Total sales of shoes are 600 pairs.
• Total sales + change in inventories = (600 + 400 = 1,000)
= total production
• GDP = sales of final goods + change in business
inventories
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 Example on the change in
inventories
• Suppose that another factory predicted the sales to be
1000 pairs in 2018, accordingly they produced 1000 pairs
in 2018, but they had from 2017, 300 pairs of unsold shoes
in their inventories. In 2018, the actual sales they got were
1200 pairs. So, the factory sold the 1000 pairs and drew
another 200 from its inventories. To calculate the change
in inventories in the end of 2018 (inventories at the end of
2018 – inventories at the beginning of 2018) (100 - 300)= -
200
• Total production = 1000
• Total sales + the change in inventories (1200 - 200 = 1000)
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 Why do we include the change in
inventories in the expenditure approach?

• By adding the change in inventories to

the total expenditures, we guarantee that
we take into consideration total
production of this year, a positive change
in inventories means some output was
produced, but not sold so to account for
it, we include it as part of investment
spending as if the investor bought it from
himself. 18
 Government Spending (G)
Government Consumption and Gross Investment (G)
• Expenditures by the government for final goods and
services.
• These could be:
1. consumption goods like food for the military and pencils.
2. investment goods like, equipment, roads, bridges.
3. services like salaries for government employees.

• N.B.: G does not include transfer payments or

Interest payments on Government debt, as these are
not payments for current production.

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 Net Exports (EX – IM)
• Net exports (EX – IM): The difference between exports
(sales to foreigners of domestically produced goods and
services) and imports (the purchases of goods and
services from abroad). The figure can be positive or
negative.
• X = Exports – Imports
• Adding X is the final step we make to ensure that total
spending on final goods/s will give us GDP. Why?
• Because when we add C + I + G these include spending
on foreign goods, which do not reflect domestic
production, so we must subtract imports, similarly some
production is sold to foreigners abroad so we need to add
exports. 20
The Difference between Gross Investment
and Net Investment
• Gross Investment: includes all the spending on new
capital during a given period. (new plant, equipment,
housing, and the change in inventory).
• But it doesn’t take into account that during the process
of production, some of the capital produced in previous
years wears out.
• Depreciation: The amount of capital that is used up
during a year.
• GDP includes gross investment, that is all the newly
produced capital, it does not account for the fact that
some of the new capital will simply replace worn out
capital. So, GDP does not account for depreciation.
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 Net Investment

• If you want a measure for the increase in society’s

capital, gross investment is not the right measure to
use.

• Net investment: Gross investment minus depreciation.

• If net investment is positive, then capital stock

increased.

• If net investment is negative then capital stock

decreased.
Capitalend of period = Capitalbeginning of period + net investment
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 The Earnings or Income or Cost
Approach to Measure GDP

• An equivalent way to measure GDP is the

earnings or cost Approach: which simply adds
up all of the earnings of all of the factors of
production that have participated in the
production process (wages, salaries, rent,
interest and profits in addition to taxes and
depreciation).

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 The Earnings or Income or Cost
Approach to Measure GDP

• Value of output of any firm is used to cover all the

production costs including profits, taxes,
depreciation and intermediate goods.
• Value of firm’s output = cost of intermediate
goods + Taxes + depreciation + (w/s + r + i + π)
• Value of firm’s output - cost of intermediate
goods = Taxes + depreciation + (w/s + r + i + π)
• Value Added (VA) by a firm = Taxes +
depreciation + earnings of factors of production
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 The Earnings or Income or Cost
Approach to Measure GDP
• Summation of VA by all firms = Summation
of earnings of factors of production by all
firms + Depreciation + Taxes = value of the
final goods = GDP
• Thus, by summing up all of the earnings of
all of the factors of production, we also get
GDP.

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 Why are the two approaches equivalent?
• Because the earnings approach includes an item
called “profits”; and profits are the residuals, i.e.
what remains from firm’s revenues after the firm
has paid all other costs.
• So by including profits in the earnings approach
we will be certain that adding all the earnings in
the economy (including profits) will be equal to
the total value added in the economy, which is
equal to the value of all final goods and services
produced.

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Nominal GDP versus Real GDP

• Nominal GDP or GDP at current prices: using the

actual prices of the year, includes the effect of prices.
• But because prices change from year to year, nominal
GDP may be misleading. Because it may increase
because of higher prices or because of higher output.

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 Example
• Suppose an economy produces 1000 bushels of corn in year
1 and 1010 bushels of corn in year 2, P of a bushel in year 1
is1$ and P of a bushel in year 2.
• Nominal GDP in Year 1 = 1$ x 1000 =1000
• Nominal GDP in year 2 = 2$ x 1010 = 2020
• Rate of Change of nominal GDP = [(2020-1000)/ 1000 ]x 100
= 102%
• But, growth rate of actual output = [(1010-1000)/ 1000]x 100
= 1%

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 Nominal GDP versus Real GDP
• Real GDP or GDP at constant prices: it is the GDP
adjusted for inflation, that is it is calculated after
removing the influence of price changes. It is calculated
using the prices of some base year.

• Therefore, when we calculate the economic growth rate,

which measure should be used (real or nominal)?

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 The Price Index
• The Price Index: is a measure of the overall price level, it
is a weighted average of the prices of the different
goods and services, e.g. CPI, GDP deflator and the PPI.

• Normally the price index, they set it to be 1 in the base

year or 100 and we mseaure the price of the same
basket in different years relative to price of the base
year

• For example if 2005 is our base year, we let the P in 2005

be 1 and then inflation rate was 15% in 2006, the price
index in 2006 will be 1.15. That is, if we used to pay 1$ to
a buy a certain basket of goods in 2005, in 2006 we
would pay 1.15 for the same basket.
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 Using the Price index to convert
Nominal GDP into Real GDP
Nominal GDP Price index Real GDP
(current dollars, 1929 =1 (constant
billion) dollars)
1929 104 1 104/1=104
1933 56 0.74 56/0.74 =76

1- We notice that output declined sharply

Nominal during the great depression but also prices
GDP declined, so after we corrected for that, the
decline in output is less than if we looked at
nominal GDP.
Real Price
GDP Index 2- Nominal and Real GDP are the same in the
base year.

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Note on Calculating Real GDP
• Sometimes the price index is expressed
in 100s rather than 1s, i.e. instead of
assuming the P index or GDP deflator to
be 1 in 1929, they assume it to be 100
so The price index in 1930 would be
instead 74.
• Now to calculate Real GDP
Real GDP =100* (Nominal / Price
Index)
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 The Different Measures
of National Income and Product Accounts
from GDP to Disposable Personal Income
• We can derive different measures from GDP by
following some accounting rules:
– Difference between Gross and Net (GDP and NDP)
– Difference between Domestic and National (GDP and
GNP)
– Difference between GDP at Market Prices and GDP at
Factor Costs.

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First: The Difference between Gross
and Net
• As in Gross Investment and Net Investment,
Net = Gross - depreciation

• Gross Domestic Product (GDP) and Net

domestic Product (NDP),
NDP = GDP – Depreciation

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 Second: The Difference between
Domestic and National
• Gross Domestic Product (GDP) and Gross
National Product (GNP)
• Domestic: includes production that took place
inside the country, no matter whether the factors
of production are foreign or national
• National: includes production by national factors
of production even if they work abroad
GNP = GDP + Net factor payments from abroad
Where Net Factor payments from abroad = factor income
received from abroad– income paid to foreign factors 38
 Third: The Difference between Market
Price and Factor Cost
• Market price: price at which the good is sold in the
market, it could be higher than the original price
suggested by the producer if there are indirect taxes like
value added taxes. Also, it could be lower than the original
price suggested by the producer if it is subsidized.
• To get Factor Cost (the original price suggested by
producers) we must subtract the indirect taxes and add the
subsidies.
• GDP at Factor Cost = GDP at Market price – Indirect
taxes + Subsidies
• i.e. Factor cost = Market Price – Net Indirect Taxes
• Where net indirect taxes = (Indirect Taxes – Subsidies)
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 Now, We can calculate National
Income from GDP

• National Income is the total incomes received

by labor, capital and land. It is equivalent to
Net National Product at Factor Cost.

GDP at market price – depreciation =

NDP at market price + Net Factor Payments =
NNP at market price – net indirect taxes =
NNP at factor cost = NI
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