Chapter 23 Measuring a Nation’s Income

Chapter 23

Measuring a Nation’s Income

In this chapter,
look for the answers to these questions:

• What is Gross Domestic Product (GDP)?

• How is GDP corrected for inflation?
• How is GDP related to a nation’s total income and
spending?
• What are the components of GDP?
• Does GDP measure society’s well-being?
• Is there any other measures of income (output)?

2- Measuring a Nation’s Income 2

I. Gross Domestic Product (GDP)

1.Definition
GDP is the market value of all final goods and services
produced within a country in a given period of time.

 “Market value”: measure value of economic activity via

market prices

n
GDPt   Pi Qit
i 1

1
Chapter 23 Measuring a Nation’s Income

I. Gross Domestic Product (GDP)

 Nominal GDP (GDPn): measure the value of output in a
give period in the price of that period
→ current prices
n
GDPt   Pi Qit
t

i 1

 Real GDP (GDPr): measure changes in physical output

→ constant prices => base year
n
GDPt   Pi 0Qit
i 1

EXAMPLE:
The change in nominal GDP reflects changes both prices
Pizza Coffee and quantities
year P Q P Q The change in real GDP reflects only changes in
2005 $10 400 $2.00
$2.00 1000 quantities
2006 $11 500 $2.50 1100
2007 $12 600 $3.00 1200
Compute real GDP in each year,
using 2005 as the base year: Increase:
2005: $10x400+$2x1000=6000
2006: $11x400+$2.5x1000=6900
2007 $12x600+$3x1200=10800
5

The GDP Deflator

• measures the current level of prices relative to the
level of prices in the base year  a measure of the
overall level of prices.
• Definition:
nominal GDP
GDP deflator = x 100
real GDP

2
Chapter 23 Measuring a Nation’s Income

NOW YOU TRY:

Real vs. Nominal GDP
2007 (base yr) 2008 2009
P Q P Q P Q
Good A $30 900 $31 1,000 $36 1050
Good B $100 192 $102 200 $100 205

Use the above data to solve these problems:

A. Compute nominal GDP in 2007.
B. Compute real GDP in 2008.
C. Compute the GDP deflator in 2009.
7

I. Gross Domestic Product (GDP)

• “all ”:
includes all items produced in the economy and sold
legally in markets
Excludes:
- Goods and services are not traded in the market:
produced and consumed at home (vegetable,
housework, taking care of your baby,…)
- Items are produced and sold illegal: drugs,
underground economy

I. Gross Domestic Product (GDP)

• “final goods and services ”:
A good or service that is consume by the end user and is
not used as an input in the production process of some
other goods.

Intermediate goods: used as components or ingredients in

the production of other goods
GDP only includes final goods – they already embody the
value of the intermediate goods used in their production
→ no double-count

2- Measuring a Nation’s Income 9

3
Chapter 23 Measuring a Nation’s Income

I. Gross Domestic Product (GDP)

•“produced”:
includes goods and services currently produced
used goods and inventory of previous years are not part of
GDP
•“within a country”:
value of production within the geographic confines of a
country
• “period of time”:
measures the economy’s flow of income and expenditure
during an interval ( a year or a quarter).

10

I. Gross Domestic Product (GDP)

2. Component of GDP by expenditure

• Circular - Flow Diagram

→ Flow of products and Flow of money

- a simple depiction of the macroeconomy

- illustrates GDP as spending, revenue, factor payments,

and income

11

• Circular - Flow Diagram

Revenue (=GDP) Spending (=GDP)
Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income (=GDP)
profit (=GDP)
12

4
Chapter 23 Measuring a Nation’s Income

What This Diagram Omits

• The government
– collects taxes, buys g&s
• The financial system
– matches savers’ supply of funds with borrowers’
demand for loans
• The foreign sector
– trades g&s, financial assets, and currencies with
the country’s residents

13

Income and Expenditure

• Gross Domestic Product (GDP) measures

total income of everyone in the economy.
• GDP also measures total expenditure on the
economy’s output of g&s.

For the economy as a whole,

income equals expenditure
because every unit of money a buyer spends
is a unit of income for the seller.

2- Measuring a Nation’s Income

Equivalent Definitions of GDP

• GDP is a flow of…

- Expenditures

- Incomes

- Production
- These must be equivalent since they are akin to the
3 sides of any transaction
Product
Buyer Seller

Expenditure Income
15

5
Chapter 23 Measuring a Nation’s Income

-Consumption (C):
spending by households on goods and services
+ Nondurable goods: food, clothing,…
(that last a short time)
+ Durable goods: car, TV, washing-machine,…
+ Services : haircuts, doctor visits, massage,…

16

Consumption (C)

• Note on housing costs:

– For renters,
consumption includes rent payments.
– For homeowners,
consumption includes the imputed rental value of
the house, but not the purchase price or mortgage
payments.

17

(1) Component of GDP by expenditure

- Investment (I): total spending on goods that will be used in
the future to produce more goods
+ Business fixed investment: purchase new plant and
equipment by firms
+ Residential fixed investment: purchase new housing by
households
+ Inventory investment: goods produced but not yet sold
(the increase in firms’ inventories of goods)

18

6
Chapter 23 Measuring a Nation’s Income

Investment (I)

Note:
- “Investment” does not mean the purchase of financial
assets like stocks and bonds.
- Net investment = I - depreciation = change in capital >< 0
=> capital increase => good for economic growth

19

(1) Component of GDP by expenditure

- Government Purchases(G): total spending on goods and
services by local and central government: salary, public
goods, military equipment.

Note: G excludes transfer payments, such as Social

Security or unemployment insurance benefits.
They are not purchases of g&s.

20

(1) Component of GDP by expenditure

- Net Exports (NX):

• NX = exports – imports
• Exports: foreign spending on the economy’s g&s.
• Imports: spending on foreign goods & services by
domestic residents  one part of C, I, and G
are spent on g&s produced abroad.
• Adding up all the components of GDP gives:
GDP = C + I + G + NX
Total spending on new goods & services. Excludes resales
2- Measuring a Nation’s Income 21

7
Chapter 23 Measuring a Nation’s Income

NOW YOU TRY:

Components of GDP by Expenditure
In each of the following cases, determine how much GDP
and each of its components is affected (if at all).
A. Debbie spends $200 to buy her husband dinner
at the finest restaurant in Boston. increase
B. Sarah spends $1800 on a new laptop to use in her increase investment --> import increase --> GDP unchanged
publishing business. The laptop was built in China.
C. Jane spends $1200 on a computer to use in her editing cannot calculate (last year)
business. She got last year’s model on sale for a great
price from a local manufacturer.
D. General Motors builds $500 million worth of cars,
but consumers only buy $470 million worth of them. 22GDP changed --> consumption increased 470 --> increase inventory 30

3. GDP and Economic Well-Being

• Real GDP per capita is the main indicator of the

average person’s standard of living.
• But GDP is not a perfect measure of well-being.
• Robert Kennedy issued a very eloquent yet harsh
criticism of GDP:

23

Gross Domestic Product…

“… does not allow for the health of our
children, the quality of their education,
or the joy of their play. It does not
include the beauty of our poetry or
the strength of our marriages, the
intelligence of our public debate or
the integrity of our public officials.
It measures neither our courage, nor our wisdom,
nor our devotion to our country. It measures everything,
in short, except that which makes life worthwhile, and it
can tell us everything about America except why we are
proud that we are Americans.”
- Senator Robert Kennedy, 1968 24

8
Chapter 23 Measuring a Nation’s Income

3. GDP and Economic Well-Being

GDP Does Not Value:

• the quality of the environment
• leisure time
• non-market activity, such as the child care a parent
provides his or her child at home
• an equitable distribution of income

25

3. GDP and Economic Well-Being

Then Why Do We Care About GDP?

• Having a large GDP enables a country to afford better
schools, a cleaner environment, health care, etc.
• Many indicators of the quality of life are positively
correlated with GDP. For example…

 GDP is the main indicator of a country’s economic

well-being, even though it is not perfect.
26

II. Other Measures of Output

1. Gross National Product (GNP)

GNP is the total income earned by a nation’s permanent
resident

GDP GNP

Income that Income that Income that

foreigner earn citizens earn at citizens earn
at the economy the economy abroad

27

9
Chapter 23 Measuring a Nation’s Income

II. Other Measures of Output

1. Gross National Product (GNP)

GNP is the total income earned by a nation’s permanent
resident

GNP = GDP + factor payment from abroad

– factor payment to abroad
= GDP + net factor payment from abroad (NFA
or NIA)

28

2. Net National Product (NNP)

NNP = GNP – De
3. National Income (NI)
NI =Y= NNP – Ti
4. Personal Income (PI): income that households and non-
corporate businesses receive
PI = NI – Pr – social insurance + dividends +
government transfer to individual + interest income
from holding government debt
5. Disposable Income (Yd)
Yd = PI – net personal taxes = PI - T

29

CHAPTER SUMMARY
• Gross Domestic Product (GDP) measures a country’s
total income and expenditure.
• The four spending components of GDP include:
Consumption, Investment, Government Purchases, and
Net Exports.
• Nominal GDP is measured using current prices. Real
GDP is measured using the prices of a constant base
year and is corrected for inflation.
• GDP is the main indicator of a country’s economic well-
being, even though it is not perfect.
• GNP is more appropriate to measure total income of
citizens 30

10