Measuring a Nations Income

Principles of Macroeconomics: Ch 10

Second Canadian Edition

What

Overview

is GDP?
Important things to remember about GDP
Circular flow of income
Approaches to measure GDP
Rules for computing GDP
Distinguish between real and nominal GDP
Components of GDP
Other measures of national income
GDP as a measure of economic well-being.
Principles of Macroeconomics: Ch 10

Second Canadian Edition

Definition of GDP
What

is GDP?
- GDP is defined as the market
value of all officially recognized
final goods and services
produced within an economy in a
given period of time.

Principles of Macroeconomics: Ch 10

Second Canadian Edition

Important Features of GDP

Output

is valued at market-determined

prices.
Output is measured in dollar terms.
GDP records only the output of final
goods. We want to count production
only once.
Represents the amount of money one
would need to purchase a years worth
of the economys production of all final
goods.
Principles of Macroeconomics: Ch 10

Second Canadian Edition

Income, Expenditure
And the Circular Flow
There are 2 ways
of viewing GDP

Total income of everyone in the economy

Total expenditure on the economys
output of goods and services
Income $
Labor

Households

Firms
Goods
Expenditure $

For the economy as a whole, income must equal expenditure.

GDP measures the flow of dollars in this economy.
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The Circular-Flow Diagram

Product Market
$

Households

Businesses

$
Market for Factors
Principles of Macroeconomics: Ch 10
of Production

$
Second Canadian Edition

Two Approaches to
Measuring GDP
Expenditure

Sum the total expenditures by households

(from the top portion of the circular flow).

Resource

Approach:

Cost or Income Approach:

Sum the total wages and profit paid by firms

for resources (from the bottom portion of the
circular flow).

Principles of Macroeconomics: Ch 10

Second Canadian Edition

The Economys
Income and Expenditure
When

judging whether the economy is

doing well or poorly, it is natural to look at
the total income that everyone in the
economy is earning.
For an economy as a whole, income must
equal expenditure.
The forces of supply and demand
determine the market equilibrium price
and quantity that is produced and
exchanged.
Principles of Macroeconomics: Ch 10

Second Canadian Edition

1) To compute the total value of different goods and services, the

national income accounts use market prices.
Thus, if
$0.50

$1.00

GDP = (Price of apples Quantity of apples)

+ (Price of oranges Quantity of oranges)
= ($0.50 4) + ($1.00 3)
GDP = $5.00
2) Used goods are not included in the calculation of GDP.
3) The treatment of inventories depends on if the goods are stored or
if they spoil. If the goods are stored, their value is included in GDP.
If they spoil, GDP remains unchanged. When the goods are finally sold
out of inventory, they are considered used goods (and are not counted).
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4) Intermediate goods are not counted in GDP only the value of

final goods. Reason: the value of intermediate goods is already
included in the market price. Value added of a firm equals the
value of the firms output less the value of the intermediate goods
the firm purchases.
5) Some goods are not sold in the marketplace and therefore dont
have market prices. We must use their imputed value as an estimate
of their value. For example, home ownership and government services.

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value of goods and services measured at current prices is the nominal

GDP.
The value of goods and services measured at constant prices (a baseyear) is the real GDP.
Real GDP is the better measure of economic well-being
In calculating real GDP, we use a base-year price of commodities.
Because the prices are held constant, real GDP varies from year to year
only if the quantities produced vary.
Because a societys ability to provide economic satisfaction for its
members ultimately depends on the quantities of goods and services
produced, real GDP provides a better measure of economic well-being.
GDP Deflator
It is defined as the ratio of nominal GDP to real GDP:
GDP deflator: (Nominal GDP/Real GDP)100
The GDP deflator reflects whats happening to the overall level of prices
in the economy
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Lets see how real GDP is computed in our apple and

orange economy.
For example, if we wanted to compare output in 2002 and output
in 2003, we would obtain base-year prices, such as 2002 prices.
Real GDP in 2002 would be:
(2002 Price of Apples 2002 Quantity of Apples) +
(2002 Price of Oranges 2002 Quantity of Oranges).
Real GDP in 2003 would be:
(2002 Price of Apples 2003 Quantity of Apples) +
(2002 Price of Oranges 2003 Quantity of Oranges).
Real GDP in 2004 would be:
(2002 Price of Apples 2004 Quantity of Apples) +
(2002 Price of Oranges 2004 Quantity of Oranges).
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Principles of Macroeconomics: Ch 10

13

Second Canadian Edition

GDP calculation

Value added method GDP is

also the total value added of all
firms in the economy. The value
added of a firm equals the value
of the firms output minus the
value of the intermediate goods
that the firm purchases

Principles of Macroeconomics: Ch 10

Second Canadian Edition

14

Value added method

(Table)
Value

Added in Bread Production

Each stage of production adds value

But if we add up the total sales made at all stages of production we will
double count intermediate inputs

Value of final sales = the total value added at all stages of production
GDP sums up value added at each stage of production.
Principles of Macroeconomics: Ch 10

Second Canadian Edition

15

Value added method

The market value of a firms product
or service minus the cost of inputs
purchased from other firms
The summing of the value added by
all firms in the economy yields the
total value of final goods and
services

Principles of Macroeconomics: Ch 10

Second Canadian Edition

16

Real versus Nominal GDP

GDP

is the market value of the

economys current production, referred
to as Nominal GDP.
Real GDP measures any given years
total output in constant prices.
An accurate view of the economy
requires adjusting nominal to real GDP,
using the GDP Price Deflator.

Principles of Macroeconomics: Ch 10

Second Canadian Edition

GDP Price Deflator

The

GDP Price Deflator is a price index

that uses a bundle of all final goods and
services.

It tells us the rise in nominal GDP that is

attributable to a rise in prices.

Converting

Nominal GDP to Real GDP:

Real GDP20xx =

(Nominal GDP20xx ) (GDP deflator20xx)X100

Principles of Macroeconomics: Ch 10

Second Canadian Edition

Y
Y == CC ++ II ++ G
G ++ NX
NX
Totaldemand
demand
Total
fordomestic
domestic
for
output(GDP)
(GDP)
output

composed
isiscomposed
of
of

Investment
Investment
spendingby
by
spending
businessesand
and
businesses
households
households

Consumption
Consumption
spendingby
by
spending
households
households

Government
Government
purchasesof
ofgoods
goods
purchases
andservices
services
and

Netexports
exports
Net
ornet
netforeign
foreign
or
demand
demand

This is the called the national income accounts identity.

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The Four Components of

GDP

Consumption (C):

Is the spending by households on

goods and services
e.g. buying clothing, food, movie tickets

Investment

(I):

Is the purchases of capital

equipment and structures
e.g. factory, houses, etc.

Principles of Macroeconomics: Ch 10

Second Canadian Edition

The Four Components of

Government
GDP Purchases (G):

Includes spending on goods and services by

local, provincial and federal governments
(e.g. roads, police, etc.).
Does not include transfer payments, because
it is not made in exchange for currently
produced goods or services.

Net

Exports (NX):

Exports minus imports.

Principles of Macroeconomics: Ch 10

Second Canadian Edition

Other Measures of Income

Gross

National Product

This measures the total income earned by

nationals (residents of a nation).
Net

National Product

Total income of residents of a nation after

subtracting capital consumption allowances.
Personal

Income:

The income that households and noncorporate businesses receive.

Disposable

Personal Income:

The income that households and noncorporate businesses have left after taxes.
Principles of Macroeconomics: Ch 10

SecondEdition
Canadian Edition
First Canadian

To see how the alternative measures of income relate to one

another, we start with GDP and add or subtract various quantities.
To obtain gross national product (GNP), we add receipts of factor
income (wages, profit, and rent) from the rest of the world and
subtract payments of factor income to the rest of the world.
GNP = GDP+Factor Payments from Abroad -Factor Payments to Abroad
Whereas GDP measures the total income produced domestically, GNP
measures the total income earned by nationals (residents of a nation).
To obtain net national product (NNP), we subtract the depreciation of
capital-- the amount of the economys stock of plants, equipment, and
residential structures that wears out during the year:
NNP = GNP - Depreciation
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GDP and Economic Well-Being

GDP

Per Person tells us the income and

expenditure of the average person in the
economy.

It is a good measure of the material wellbeing of the economy as a whole.

More Real GDP means we have a higher
material standard of living by being able to
consume more goods and services.
It is NOT intended to be a measure of
happiness or quality of life.

Principles of Macroeconomics: Ch 10

Second Canadian Edition

What Is and What Is Not

Counted in GDP?
GDP

includes all items produced

in the economy and sold legally
in markets.
GDP does not include items
produced and consumed at home
that never enter the marketplace.
It does not include items
produced and sold illicitly, such
as illegal drugs.

Principles of Macroeconomics: Ch 10

Second Canadian Edition

GDP and Economic Well-Being

Some

factors and issues not in GDP that

lead to the well-being of the economy:

Factors that contribute to a good life such as

leisure.
Factors that lead to a quality environment.
The value of almost all activity that takes
place outside of the markets, e.g. volunteer
work and child-rearing.

Principles of Macroeconomics: Ch 10

Second Canadian Edition