Lilongwe University of Agriculture and Natural Resources

Faculty of Development Studies

Department of Agricultural and Applied Economics

Agricultural Economics II (AAE 221)

Year 2

By
Sensei: MAONGA, B.B (PhD)
 Topic 2
NATIONAL OUTPUT
2. Introduction
• Economists study massive amounts of output using
national income accounting – a system of statistics and
accounts that keeps track of production, consumption,
savings, and investment in the economy.
• This topic covers national output (income) concepts,
contribution of agricultural sector to national output,
uses and limitations of national income accounts,
nominal and real gross domestic product (GDP),
measuring national output (national output accounting),
and determination of equilibrium national income
2
National Income Equilibrium and the General
Price Levels
Aggregate demand (AD) - total demand for all final goods
and services in an economy over a period of time.

Consists of the sum of all the demand from

consumers, firms, the government and foreign trade
which consumers are willing and able to purchase at
each possible value of the price level.

Aggregate demand curve shows the quantity of

domestic product that is demanded at each possible
value of the price level.
3
Aggregate Supply (AS)

Aggregate Supply - total supply of all fixed goods and

services in an economy over a period of time.

Consists of the sum of supply of producers, firms and

industries which suppliers are willing and able to
offer for sale at each possible value of the price level.

Aggregate supply curve shows the quantity of

domestic product that is supplied at each possible
value of the price level.
4
National income equilibrium
The equilibrium level of national income and level
of general prices will occur where aggregate
demand is equal to aggregate supply (point E in
Figure 2.1)
P AS

P0

AD
0 Q0 Q
Figure 2.1 National income equilibrium
5
Gross National Product (GNP)
• GNP is the value of all final goods and services
produced in the economy in a given time period (e.g.
quarter or year).
• GNP is the basic measure of economic activity and it
comprises all the income that flows to a country’s
supplied resources, whether inside the country or
abroad.
• Malawi’s GNP includes the value of final goods and
services that flows to Malawian supplied resources
(whether here or abroad).

6
Gross Domestic Product (GDP)
GDP is the sum of the money values of all final goods
and services produced in the domestic economy during
a specified period of time, usually a year.
GDP differs from GNP by the fact that GDP includes all
goods and services produced by either citizen-supplied
or foreign-supplied resources within the country.
GNP, on the other hand excludes the value of foreign
supplied resources.
For example, Malawi’s GDP includes the market value
of Tambala Peanut Butter produced by Press
Corporations Limited in Blantyre and the market value
of fertilizer produced by Chinese factory at Kanengo .
7
 Classification of goods and services
Final Goods and Services - Final goods and services are
those that are purchased by their ultimate users for
final use, not for resale or for further processing or
manufacturing.

Intermediate Goods - Intermediate goods are goods

purchased for resale or for use in producing another
good.
 
Value added - Value added is the market value of a
firm’s output less (minus) the value of the inputs that
the firm bought from others. 8
Measuring Domestic Output, National Income,
and the Price Level
Assessing the Economy’s Performance: National Income
Accounting
National income accounting measures the economy’s
overall performance periodically (quarterly or yearly).
 Significance of National Income Accounting
It enables economists and policymakers to:
Assess the health of the economy by comparing levels
of production at regular intervals.
Track the long-run course of the economy to see
whether it has grown, been constant, or declined.
Formulate policies to safeguard and improve the
economy’s health. 9
Measuring Domestic Output, National Income,
and the Price Level
• Analysis of GDP
– As already mentioned the primary measure of the
economy’s performance is its total output of goods
and services or, as it is called, its aggregate output.
– Note that GDP is a monetary measure: mere
production of vast amounts of units means
nothing to GDP accounting until a price tag is
attached to the products to indicate how
society evaluates their relative worth.

10
Measuring Domestic Output, National Income,
and the Price Level
Analysis of GDP
• Avoiding Multiple Counting
– In order to measure output accurately, all goods and
services produced in a particular year must be
counted once and only once.
– Because most goods go through a series of production
stages before they reach the market, some of their
components are bought and sold many times.
Therefore, to avoid counting those components each
time, GDP includes only the market value of final
goods and ignores intermediate goods altogether.
11
Measuring Domestic Output, National Income, and
the Price Level
Analysis of GDP
Why GDP includes only the value of final goods
The reason why only the value of final goods is included
in GDP is because the value of the final goods already
includes the value of all the intermediate goods that
were used in producing them.
 Including the value of intermediate goods would
amount to multiple counting and, thus distorting GDP
value.
Alternatively, we could avoid multiple counting by
measuring and cumulating only the value added at each
stage of production (Table 2.1). 12
Table 2.1: Value Added in a Five-Stage Production
Process
• By calculating and summing up the value added to all the
goods produced by all firms, we could get economy’s GDP.
Sales (Market) Value
Stage of Production of resources or Value Added
Product
Open land (Before purchase) $0 -
Firm A, Sheep Ranch $120 $120 = (120 - 0)
Firm B, Wool Processor $180 $60 = (180 – 120)
Firm C, Suit Manufacturer $220 $40 = (220 – 180)
Firm D, Clothing Wholesaler $270 $50 = (270 - 220)
Firm E, Retail Clothier $350 $80 = (350 – 270)
Total Sales Values $1140
Value Added (Total Income) $350 13
GDP Excludes Non-production Transactions

• Although many monetary transactions in the economy

involve final goods and services, many others do not.
– Those non-production transactions must be excluded
from GDP because they have nothing to do with the
generation of final goods.

– Non-production transactions are of two types:

• (1) Purely financial transactions and
• (2) Secondhand sales.

14
GDP Excludes (1) Purely Financial transactions such as:
• Public transfer payments
 These are social security payments, welfare payments and
veterans’ payments that the government makes directly to
households.
 The recipients contribute nothing to current production in
return; therefore, to include such payments in GDP would
be to overstate the year’s output.
• Private transfer payments
 The money that parents or guardians give to their children
or wards falls under private transfer payments.
 The exercise involves simply transfer of funds from one
private individual to another. No production is involved
and consequently do not get recognized in GDP
accounting. 15
GDP Excludes (1) Financial transactions (cont’d)
• Stock market transactions
The buying and selling of stocks and bonds is just
a matter of swapping bits of paper
Stock market transactions create nothing in the
way of current production
 However, payments (wages) for the services of a
security broker are included in GDP, because
those services do contribute to current output.

16
GDP Excludes (2) Secondhand sales
Secondhand sales contribute nothing to current
production and for that reason are excluded from GDP.
Example:
Suppose Jane sells her 2012 Scientific Calculator to a
friend; that transaction would be ignored in
reckoning this year’s GDP because it generates no
current production.
 The same would be true if Jane sold a brand-new
snicker to a roommate a week after she purchased
it.

17
1.3.3 Two Ways of Determining GDP: Spending
and Income Approaches
(1) Output approach or expenditure approach. We can
look at GDP as the sum of all the money spent in buying
the goods and services.

(2) Earnings or allocations approach, or the income

approach. We can also view GDP in terms of income
derived or created in the production process.

– Figure 2.1 illustrates these two approaches.

18
 Figure 2.1: Approaches to the determination of GDP
Expenditures, or output Income, or
approach allocations approach

Consumption expenditures by Wages

households +
+ Rents
Investment expenditures by +
businesses Interest
+ = GDP = +
Government purchases of goods Profits
and services +
+ Statistical
Expenditures by foreigners adjustments
19
The expenditures and income approaches to GDP
• As illustrated in Figure 2.1, on the expenditure side of
GDP all final goods produced by the economy are
bought either by three domestic sectors (households,
businesses, and government) or by foreign buyers.

• On the income side, (once certain statistical

adjustments are made), the total receipts acquired from
the sale of that total output are allocated to the
suppliers of resources as wages, rent, interest, and
profit income.

20
(1) The Expenditures Approach (Explained)
•  To determine GDP using the expenditures approach, we
add up all the spending on final goods and services that
has taken place throughout the year.
National income accountants (economists) use
precise terms for the types of spending listed under
expenditures approach given in Figure 2.1.

The following are the terms used in the GDP

determination under expenditures approach.

21
 Terms used in expenditures approach to GDP
• Personal Consumption Expenditures (C)
The term personal consumption expenditures
refers to what has been called “consumption
expenditures by households”.
This term covers all expenditures by households on
durable consumer goods (such as automobiles,
refrigerators, video recorders), non-durable
consumer goods (such as bread, nsima, ugari, milk,
pencils, toothpaste) and consumer expenditures for
services (of lawyers, medical doctors, mechanics,
barbers).
This component of GDP is designated C.
22
Gross Private Domestic Investment (Ig)
Investment refers to the creation of new capital
assets – assets that create jobs and income in the
production process.
The words “Private” and “domestic” mean spending
by private businesses, and that the investment is
taking place inside the country, not abroad.
Items under gross private domestic investment:
o All final purchases of machinery, equipment, and
tools by business enterprises.
o All construction (residences, factories,
warehouses, stores, etc).
o Changes in inventories.
23
Why do we regard residential construction as
investment rather than consumption?
Because, residential houses, like factories and stores,
earn income when they are rented or leased.

Owner-occupied houses are treated as investment

goods because they could be rented to bring in an
income return (opportunity cost of own house).

24
Why do we regard increases in inventories as
investments?
Increases in inventories (unsold goods) are an
investment because they represent, in effect,
unconsumed output.

And as we know from production possibilities

analysis, such inventories are precisely what
investment is – they could be used to expand the
production possibilities frontier.

25
 Non-investment Transactions
Investment does not include the transfer of paper
assets (stocks, bonds) or the resale of tangible assets
(houses, jewelry, boats).
Such transactions merely transfer the ownership of
existing assets.

26
 Gross Investment (GI) versus Net Investment
(NI)
• Gross private domestic investment
 Gross private domestic investment comprises all investment
goods – both those that replace machinery, equipment, and
buildings that were used up (worn out or made obsolete) in
producing the current year’s output and any net additions
to the economy’s stock of capital.

 Gross investment includes investment in replacement capital

and in added capital.

27
 Gross Investment (GI) versus Net Investment
(NI)
• Net private domestic investment
Net private domestic investment includes only
investment in the form of added capital.
o The amount of capital that is used up over the
course of a year is called Depreciation.

So, Net investment = Gross Investment minus

Depreciation
o NI = GI – D

28
Gross investment, depreciation, net investment,
and the stock of capital
• When Gross Investment = Depreciation, Net
Investment is zero (NI = 0);
This implies that there is no change in the size of
capital stock.

• When Gross Investment < Depreciation, Net

Investment is Negative (- NI);
This implies that the economy is disinvesting;
This means that the economy is using up more capital
than it is producing; and consequently, the stock of
capital shrinks.
29
Government Purchases (G)
Government purchases are officially labeled
“government consumption expenditures.” These
expenditures have two components:
(1) Expenditures for goods and services that
government consumes in providing public
services,
(2) Expenditures for social capital such as schools
and highways, which have long life-times.
Government purchases include all government
expenditures on final goods and all direct purchases
of resources, including labour. It does not include
government transfer payments.
30
Net Exports (Xn)
• International trade transactions are a significant item in
national income accounting.
• GDP records all spending on goods and services
produced in the country (Malawi), including spending
on the country’s output by people abroad (exports).
So we must include the value of exports when using
the expenditures approach to determine GDP.
• At the same time, we know that Malawians spend a
great deal of money on goods and services produced
abroad (imports, labeled M) .

31
Exports versus Imports in GDP Determination
• Spending on imports shows up in the other nations’
GDP (as export value).
 Thus, we (the importing nation) must subtract the
value of imports from Malawi’s spending to avoid
overstating total production in Malawi.

• Therefore, Net Exports (Xn) = Exports (X) – Imports

(M)
o Xn = X - M

32
GDP as viewed from the expenditures approach
• Putting all the expenditure components of GDP gives us
the following:
GDP = C + Ig + G + Xn or (X – M)
Alternatively, GDP = C + Ig + G + (X – M)
• The above equation is the commonest way of
presenting GDP.
• Note that
When X > M, there is positive balance of trade: the
economy is exporting more than it is importing.
When X < M, there is negative trade balance (trade
deficit): the economy is exporting less than it is
importing or it is importing more than it is exporting.
33
 GDP Summary
• From the expenditures approach to GDP analysis it is clear
that GDP comprises four major Economic Sectors, namely:
(1) Consumer Sector (C):
• Its basic unit is the household. The consumer sector (C)
receives its income in the form of disposable personal
income.
• The consumer sector receives the income that is left over
after all the payments such as depreciation, taxes and others
are made, plus the income that is received in transfer
payments that are added back in.

34
GDP Summary (cont’d)
(2) Investment Sector (I):
• Is made up of proprietorships, partnerships, and corporations.
• Investment sector is the productive sector responsible for
bringing the factors of production together to produce output.
• The income to the investment sector, labelled I is the
depreciation, retained earnings, and personal savings borrowed
from consumers through financial systems (banks, thrifts, etc).
• Depreciation is considered a form of income because businesses
are allowed to treat it as an expense and subtract it from their
profits before they pay taxes.
– Because depreciation never leaves the firm, it is a form of
income to that sector (Investment sector).

35
GDP Summary (cont’d)
(3) Government Sector (G):
• Includes the local, and state government aggregated
together.
• The government sector receives its income from indirect
business taxes, corporate income taxes, Social Security
contributions, and personal income taxes from the consumer
or household sector.

36
GDP Summary (cont’d)
(4) Foreign Sector (F) OR (Xn):
• The foreign sector identified as F includes all consumers
and producers outside the country e.g. Malawi.
• This sector does not have a source of income specific to
it.
– Instead, the sector represents the difference between
the money value of goods sent abroad (Export value),
and the money value of goods purchased from abroad
(Imports).
• If the two (exports and imports) are reasonably close,
foreign sector appears to be fairly small, even when there
are a large number of goods and services being traded in
both directions. 37
Table 2.2: Accounting statement for the US Economy, 2000 ($ bn)
Receipts: Expenditures Approach Allocations: Income Approach
Item Amount ($) Item Amount ($)
Personal consumption 6759 Compensation of employees 5639
expenditures (C)
Gross domestic investment (Ig) 1834 Rents 140
Government purchases (G) 1743 Interest 571
Net exports (Xn) -370 Proprietors’ net income 711
Corporate income taxes 286
Dividends 397
Undistributed corporate profits 274
National income 8018
Indirect business taxes 682
Consumption of fixed capital 1257
Net foreign factor income 9
earned in the U.S.
Gross Domestic Product (GDP) 9966 Gross Domestic Product (GDP) 9966
38
 (2) The Income Approach
• The expenditures approach shows the amount of national
income that allocated as income to those responsible for
producing the output.
• It would be simple if we could say that the entire amount
flowed back to them in the form of wages, rent, interest, and
profit.
• However, we have to make a few adjustments to balance the
expenditures and income sides of the account.
• Let’s look at the items that make up the national income,
and then turn to the adjustments.

39
Items on the Income Side of the GDP
 Compensation of Employees
• By far the largest share of national income is paid as wages
and salaries by businesses and government to their
employees.
• That figure also includes wage and salary supplements, in
particular, payments by employers into social insurance,
pension schemes, health and welfare funds for workers.
 Rents
• Rents consist of income received by the households and
businesses that supply property resources. They include
monthly payments that tenants pay to landlords and the
lease payments that corporations pay for the use of office
space.
• The figure used in national accounts is net, which is gross
rental income minus depreciation of the rental property. 40
Items on the Income Side of the GDP (cont’d)
 Interest
• Interest consists of the money paid by private businesses to
the suppliers of money capital.
• It also includes such items as the interest that households
receive on savings deposits, corporate bonds, etc.
 Proprietors’ Income
• What is loosely termed profits is broken down by national
income accountants into two accounts:
(i) proprietors’ income, which consists of the net income of
sole proprietorships, partnerships, and other
unincorporated businesses, and
(ii) corporate profits. These profits that businesses
(corporate) make and the income flows to the proprietors.
41
Corporate profits Explained
• Corporate profits are the earnings of owners of corporations.
Corporate profits are subdivided into three categories:
(i) Corporate income taxes
 There are taxes levied on corporations’ net earnings and
they flow to the government.
(ii) Dividends
 These are the part of corporate profits that are paid to the
corporate stockholders and thus flow to households – the
ultimate owners of the corporations.
(iii) Undistributed corporate profits
 These are money saved by corporations to be invested
later in new plants and equipments. They are called
retained earnings.
42
Making statistical adjustments
• From National Income to GDP
•  When the above listed items (Compensation of employees,
rents, interest and proprietors' income or profit) are added
together, national income accountants get National Income:
the income that flows to a country’s supplied resources,
whether here or abroad.
• But notice that the figure for national income shown in Table
2.1 comes to $8018 billion. This is less than the GDP
presented in the expenditures approach.
• The account is balanced by adding three items to national
income.

43
Items added to balance GDP in Income Approach
(i) Indirect Business Taxes
• This includes general business taxes, excise taxes, business property
taxes, licenses fees, and customs duties.
• Why do we add indirect business taxes to national income as a way of
balancing expenditures and income?
 Assume that a firm produces a product that sells for K10,000. The
production and sale of that product create K10,000 of wages, rent,
interest, and profit income. But now the government through MRA
charges a 5% sales tax on all products sold at retail. The retailer adds the
tax` to the price of the product and shifts it to consumers and this
becomes part of consumption expenditures. But the K500 (or 5% tax) is
clearly not earned income because the government contributes nothing
to the production of the product in return for it. Only K10,000 of what
consumers pay goes out as wage, rent, interest, and profit income. So
the national income accountants need to add the K500 to the K10,000 of
national income in calculating GDP and make the same adjustment for
the entire economy.
• 44
Items added to balance GDP in Income Approach (cont’d)
(ii) Consumption of Fixed Capital
 The useful life of private capital equipment (such as bakery ovens or motor
vehicle assembly lines) extend far beyond the year in which they were produced.
To avoid understating profit and income in the year of purchase and to avoid
overstating profit and income in succeeding years, the cost of such capital must
be allocated over its lifetime. The amount allocated is an estimate of how much
of the capital is being used up each year, - that is, its depreciation value. The
depreciation allowance results in a more accurate statement of profit and
income for the economy each year. Social capital, such as courthouses and
bridges, also requires a depreciation allowance in the national income accounts.
 The huge depreciation charge made against private and social capital each year is
called consumption of fixed capital because it is the allowance for capital that
has been consumed in producing that year’s GDP. It is the portion of GDP that is
set aside to pay for the ultimate replacement of those capital goods.
 The depreciation allowance is a cost of production and thus included in the gross
value of output. But this money is not available for other purposes, and, unlike
other costs of production, it does not add to anyone’s income. For that reason, it
is not included in national income. We must therefore add it to national income
to achieve balance with the economy’s expenditures. 45
Items added to balance GDP in Income Approach (cont’d)
(iii) Net Foreign Factor Income
 Lastly, slight adjustments must be made in “national” income versus
“domestic” income. In moving from national income to GDP, we must
consider the income that nationals (such as Malawians) gain from
supplying resources abroad and the income that foreigners gain by
supplying resources to the country.
• In Table 2.2, in the year 2000, foreign-owned resources earned $9
billion more in the U.S. than American-owned resources earned
abroad. That difference is called net foreign factor income. For that
reason it is not included in the country’s national income. It must be
added to national income in determining the value of a country’s
domestic output produced within the country’s borders.
 So, Table 2.2 summarizes the expenditures approach and income
approach to GDP. The left side shows what the U.S. economy produced
in the year 2000 and what was spent to produce it. The right side shows
how those expenditures, when appropriately adjusted, were allocated as
income.
46
 Other National Accounts
 Several other national accounts provide additional useful information
about the economy’s performance. We can derive these accounts by
making various adjustments to GDP.
•  Net Domestic Product (NDP)
 As a measure of total output, GDP does not make allowances for
replacing the capital goods used up in each year’s production. As
a result, it does not tell us how much new output was available
for consumption and for additions to the stock of capital.
 To determine that, we must subtract from GDP the capital that
was consumed in producing the GDP and that had to be replaced.
That is, subtract consumption of fixed capital (depreciation) from
the GDP, you get net domestic product.
NDP = GDP – Depreciation
 Thus, NDP is simply GDP adjusted for depreciation. It measures
the total annual output that the entire economy, - households,
businesses, government and foreigners – can consume without
impairing its capacity to produce in ensuing years. 47
Other National Accounts (cont’d)
•  Deriving National Income (NI) from NDP
 Sometimes it is useful to know how much the nationals (Malawians) earned
for their contributions of land, labour, capital, and entrepreneurial talent.
 Recall that the U.S. national income (NI) - presented in Table 2.2 – includes
all income earned through the use of American-owned resources, whether
they are located at home or abroad.
 To derive NI from NDP, two adjustments must be made:

(i) Subtract net foreign factor income from NDP

 Net foreign factor income is factor (resource) income earned by foreigners in
Malawi in excess of factor income earned by Malawians abroad.
 Since foreigners earn this income, it is not included in Malawi’s national
income.

(ii) Subtract indirect business taxes from NDP

 Because government is not an economic resource, the indirect business taxes
it collects do not qualify as payments to productive resources and thus are
not included in national income. 48
Other National Accounts (cont’d)
• Personal Income (PI)
 Personal income (PI) includes all income received whether
earned or unearned.
 It is likely to differ from national income (income earned)
because some income earned such as social security taxes
(payroll taxes), corporate income taxes, and undistributed
corporate profits, is not earned by households.
Conversely, some income received, such as social security
payments, unemployment compensation payments, welfare
payments, disability and education payments to veterans,
and private pension payments, is not earned.
 These transfer payments must be added to obtain personal
income (PI).
49
Other National Accounts (cont’d)
• Disposable Income (DI)
Disposable income (DI) is personal income less (minus)
personal taxes.
 Personal taxes include personal income taxes, personal
property taxes, and inheritance taxes.

Disposable income is the amount of income that households

have left over after paying their personal taxes.

They are free to divide that income between consumption

(C) and saving (S):
Thus, DI = Consumption + Savings

50
The Relationships among GDP, NDP, NI, PI, and DI
Table 2.3 summary of relationships among GDP, NDP, NI, PI, and DI
using an example of the U.S. economy.
Item Amount ($ billions)
Gross Domestic Product (GDP) 9966
Consumption of fixed capital (Depreciation) -1257
Net Domestic Product (NDP) 8709
Net foreign factor income earned in the U.S. -9
Indirect business taxes -682
National Income (NI) 8018
Social security contributions -706
Corporate income taxes -286
Undistributed corporate profits -274
Transfer payments +1530
Personal Income (PI) 8282
Personal taxes -1292
Disposable Income (DI) 6990
51
GDP and Changes in the Price Level
• A major problem with GDP is that it is subject to distortions
because of inflation – a rise in the general price level.
 Output may appear to grow from one year to the next
without actually doing so.
• Recall that GDP is a measure of market or money value of final
goods and services produced by the economy in a given year.
• We use money or nominal (current) values as a common
denominator in order to sum that heterogeneous output into
meaningful total.
 But that creates a problem: How can we compare the market
values of GDP from year to year if the value of money itself
changes in response to inflation or deflation? After all, GDP is
determined by multiplying total output (quantity) by market
prices.
52
GDP and Changes in the Price Level (cont’d)
• Whether there is a 5% increase in output with no change in
prices, or a 5% increase in prices with no change in output,
the change in the value of GDP will be the same.
 And yet it is the quantity of goods that get produced and
distributed to households that affects our standard of
living, not the price of goods.
For instance, a standard loaf of bread that sold for K150
in 2010 yields the same satisfaction as identical bread
that is sold for K280 in 2013.

53
GDP and Price Changes
• Inflation can distort the value of GDP from one year to the next.
Table 2.4: Estimating Gross Domestic Product
Product Quantity Price ($, each) Value ($, millions)
(mil.) 2008 2010 2008 2010
Goods Automobiles 6 16,000 17,600 96,000 105,600
Replacement Tires 10 40 44 400 440
Shoes 55 40 44 2,200 2,420
..........*
Services Haircuts 150 8 9 1,200 1,350
Income Tax Filings 30 150 165 4,500 4,950
Legal Advice 45 200 220 9,000 9,900
..........*
Structures Single Family 3 75,000 82,500 225,000 247,500
(Housing) Multifamily 5 300,000 330,000 1,500,000 1,650,000
Commercial 1 1,000,000 1,100,000 1,000,000 1,100,000
……….*
Total Gross Domestic Product = $7 trillion $7.7 trillion
54
Sorting the Problem of Price Fluctuations in GDP
Accounting
• The way around this problem is to deflate GDP when prices rise
and to inflate GDP when prices fall.
• These adjustments give us a measure of GDP for various years as if
the value of the money currency (Kwacha or Dollar) had always
been the same as it was in some reference year.
 A GDP based on the prices that prevailed when the output was
produced, and not adjusted for inflation is called Unadjusted
GDP, or Nominal GDP or Current GDP or simply GDP.
 A GDP that has been deflated or inflated to reflect changes in
the price level and thus, removing the distortions of inflation is
called Adjusted GDP or Real GDP or GDP in constant dollars (or
Kwacha).
• To avoid language confusions, we will use the terms Nominal GDP
and Real GDP in this study.
55
Constructing a Price Index
• To reduce the distortions of inflation, economists construct a price
index.
 A price index is a statistical series that can be used to measure
changes in prices over time. It can be compiled for a specific
product or for a range of products.
• Steps in constructing a price index
(1)Choose a base year. This is a particular year that serves as the basis
of comparison for all other years. The base year can vary . It is used
only in comparative sense and generally is updated as time goes by.
(2)Select a market basket of goods. These are goods representative of
the purchases that will be made over time. Although the number of
items in the basket is a matter of judgement, it must remain fixed
after the selection is made. The advantage of this market basket
concept is that it captures the overall trend in prices. change

56
Steps in Constructing a Price Index (cont’d)
(3) The price of each item in the basket is recorded and totalled.
 The total represents the prices of the market basket in the base year
and is assigned a value of 100 percent.
 The Price Index is calculated using the following formula:
Price IndexGiven Year = (Price of market basketGiven Year  Price of
same market basketBase Year)  100
 For example, given market basket of $1,792.00 for 2010,
$1,895.94 for 2011, $1,790.75 for 2012 and $2,610.94 for 2013;
the price index for each year will be as follows:
Base Second Third Period Fourth Period
Year Period (2011) (2012) (2013
(2010)
Market basket $1792.00 $1895.94 $1790.75 $2610.94
Price Index 100 105.8 99.9 145.7
57
Major Price Indices
• Price indices can be constructed for a number of different
purposes.
 Some measure changes in the price of a single item.
 Some measure the price changes of imported goods,
while others do the same for agricultural products.
• Of all these measures, three are especially important. They
are the
 consumer price index,
 the producer price index, and the
 implicit GDP price deflator.

58
Major Price Indices: (1) Consumer Price Index
 The consumer price index (CPI) reports on price changes for
the consumer items in all the categories of the economy.

 A sample of prices for the goods and services is taken from

the geographically distributed areas around the country.
Some of the items are surveyed in all the areas, while others
are sampled in only a few.

 In Malawi, the consumer price index is compiled monthly by

National Statistical Office (NSO) and is published for the
economy as a whole.

59
Major Price Indices: (2) Producer Price Index
 The producer price index, measures price changes received
by domestic producers for their output.

 Producer price index uses a sample of commodities and has

a base year that is determined by NSO. In Malawi, the
producer price index also is reported monthly by NSO.

 Although it is compiled for all commodities, it is also broken

down into subcategories that include farm products, fuels,
chemicals, rubber, pulp and paper, and processed foods.

60
Major Price Indices: (3) Implicit GDP Price Deflator
• The implicit GDP price deflator measures price change in
GDP. It has a predetermined base year and can be used to
remove the effects of inflation from GDP.

• Because GDP is a measure of the final output of goods and

services and covers thousands of items instead of hundreds,
many economists believe it is a good, long-run indicator of
the price changes that consumers face.

• The Implicit GDP Price Deflator is compiled quarterly.

 Because the GDP deflator is compiled quarterly, it is not
useful for measuring month-to-month changes in inflation.
61
Use 2011 as base year to calculate price index for
each of the Years in Table 2.5, below
• Table 2.5: Calculating Consumer Price Index (Class Exercise)
Description Quantity per Monthly Price (MK)
month
2010 2011 2012

Toothpaste (250 g) 2 tubes 1,150.00 1,560.90 1,750.00

Milk (0.5 litre) 12.5 litres 4,868.13 5,062.50 6,315.63
Bread (Standard loaf) 15 loaves 1,800.00 2,250.00 2,550.00
Margarine (250 g) 2 packs 531.00 720.00 830.00
Usipa (1 kg pack) 10packs 2,000.00 2,500.00 5,000.00
Beef (kg) 5 kg 4,375.00 4,750.00 5,500.00
Rice ( 5 kg) 1 bag 1,345.55 1,460.00 1,650.35
Light bulb (60 watt) 1 bulb 75.00 100.00 95.00
Mini bus fare (Area 18 to Town) 24 days 2,400.00 2,880.00 3,600.00
Total Cost of Market Basket 18,544.68 21,283.40 27,290.98
62
Real vs. Current GDP
• Converting GDP to Real Dollars (or Kwacha)
• Suppose unadjusted GDP for 2010 was $2,708 billion, and we
want to convert it to constant dollars. The procedure is to divide
the current or nominal GDP by the price index, and then multiply
by 100 because the index number is really a percent.
• Because we are adjusting GDP for inflation, we use the implicit
GDP price deflator for that year:
Example:
Real GDP2011 = [Nominal GDP  implicit GDP Price deflator]  100
Given implicit GDP price deflator of 71.71 for 2010, real GDP would
be computed as:
[$2,708 billion  71.71]  100 = $3776.3 billion
• The real GDP for 2010 is $3,776.3 billion in terms of the base year
price . 63
Comparing GDP in Different Years
• Now suppose we want to know if there was any real increase in
GDP between 2011 and 2012. Suppose, the unadjusted data for
those years were: GDP in 2011 = $5,522.2 billion; GDP in 2012 =
$5677.5 billion.
• The best way to answer the question is to convert both GDP
figures to real dollars, and then make the comparisons. If the
implicit GDP price deflator for 2011 was 113.22, and if the deflator
for 2012 was 117.77, the computations would appear as follows:
2011: ($5,522.2 billion ÷ 113.22)× 100 = $4,877.4 billion
2012: ($5,677.5 billion ÷ 117.77) × 100 = $4820.8 billion
• Real GDP, then, actually dropped between 2011 and 2012. The
increase in nominal GDP from $5,522.2 billion to $5,677.5 billion
was caused by inflation.
• Removing the inflation by deflating with a price index enables us to
see the real, underlying trend. Thus, 2012 GDP has been deflated.
64
Advantage of Real GDP
 The advantage of real GDP is that it allows comparisons over
time.
 When GDP is not adjusted for inflation, it appears as if
GDP simply increases every year.
 When we take out the inflation, however, we get a much
better look at the performance of real GDP.

 Today, the impact of inflation cannot be ignored. For this

and other reasons, almost all modern statistics are
reported in both current and real terms.
 To have an understanding of one without the other
would be to understand only part of the picture.

65
Compute real GDP and implicit GDP price deflator
in the blank spaces
Table 2.6: Nominal GDP, real GDP, and implicit GDP deflator for selected years
(1) (2) (3) (4)
Year Nominal GDP Real GDP Implicit GDP price
($ billions) ($ billions) deflator
1975 1635.2 4,084.4 ……….
1980 2,795.6 .......... 57.05
1985 .......... 5,717.1 73.69
1990 5,803.2 6,707.9 ……….
1995 7,400.5 ………. 98.10
1996 7,813.2 ………. 100.00
1999 9,299.2 8,875.8 ……….

• Determine the missing values in the table above and indicate,

which years’ GDP values were inflated or deflated. 66
Limitations of the GDP: What GDP is not
• GDP is a reasonably accurate and extremely useful measure
of how well or how poorly the economy is performing.

• But it has several shortcomings (limitations) as a measure of

both total output and well-being (total utility).
 While GDP is the primary measure of the economy’s
performance, it is not a measure of a nation’s economic
well-being.
• Reasons why GDP does not measure economic well-
being
•  The GDP is not intended to measure economic well-
being, and does not do so for several reasons:
67
Reasons why GDP does not measure economic well-being
 Some of the shortfalls of GDP as an economic measure include:

(1)GDP only includes market activity/transactions

 Certain production transactions do not take place in any
market. A great deal of work done in the home contributes to
well-being but is not measured in the GDP because it has no
price tag.
 This implies that a fraction of economic activity goes
unnoticeable in the GDP analysis.
 Another implication is that GDP statistics take no account of
the so-called “underground economy”. Underground economy
includes not just criminal activities, but a great deal of
legitimate business activity that is conducted in cash or by
barter to escape the tax collector. For instance, storekeepers
may report only a portion of their sales receipts.
68
Shortfalls of GDP as an economic measure (cont’d)
(2) GDP places no value on leisure
 As a country gets richer, its citizens normally take more and
more leisure time.
 The increase in leisure time has positive effects on overall
well-being.
 If that were true, a better measure of national well-being that
includes the value of leisure time would display faster growth
than conventionally measured GDP.
 Thus, growth in GDP may underestimate or overestimate the
growth in national well-being.
 GDP accounting also does not accommodate the satisfaction;
i.e. the unquantifiable “psychic income” – that many people
derive from their work.
69
Shortfalls of GDP as an economic measure (cont’d)
(3) “Bad” as well as “good” things get counted in GDP
  Suppose that there is a natural disaster – such as floods or
earthquakes; surely the well-being of a country would
diminish by the catastrophe as people get killed and injured;
and many homes and business get destroyed.
 Yet the disaster may likely raise the GDP as consumers spend
more to clean up and replace lost homes and possessions.
 Businesses spend more to rebuild and repair damaged
stores and plants.
 The government spends more for disaster relief and
cleanup.
 And yet no one would think such a country was better off for
its higher GDP.
70
Shortfalls of GDP as an economic measure (cont’d)
(4) GDP excludes improved product quality
 Because GDP is a quantitative measure rather than a
qualitative measure, it fails to take into account the value of
improvements in product quality.
 There is a very real difference (in quality, speed, storage
capacity, multimedia capabilities), between a K150,000 pc
purchased today and a computer that cost the same amount
just five years ago.
 Obviously quality improvement has a greater effect on
economic well-being, as does the quantity of goods
produced. But again, GDP ignores that effect entirely.

71
Shortfalls of GDP as an economic measure (cont’d)
(5) Ecological costs are not netted out of the GDP
 Many production activities in modern industrial economy have
undesirable side effects on the environment.
 Automobiles provide enjoyment and a means of transportation,
but they also despoil the atmosphere. Factories pollute rivers and
lakes while manufacturing valuable commodities.
 Almost everything seems to produce garbage, which creates a
serious disposal problem. However, none of these ecological costs
are deducted from the GDP in an effort to give us a truer measure
of the net increase in economic welfare that our economy
produces.
 Nevertheless, most developed nations are now engaged in a huge
effort to estimate the “green GDP” – that is, GDP adjusted for
environmental damage and for depletion of resources.
72
Shortfalls of GDP as an economic measure (cont’d)
(6) GDP excludes accounting of the composition and distribution
of output
The composition of output is undoubtedly important for
well-being. But GDP does not tell us whether the mix of
goods and services is enriching or potentially detrimental to
society.
GDP assigns equal weight to an assault rifle and a set of
encyclopedias, as long as both sell for the same price.
Moreover, GDP reveals nothing about the way output is
distributed.
 For example, does 90% of output goes to 10% of the
households, or is the output more evenly distributed?
The distribution of output may make a big difference for
society’s overall well-being.
73
Shortfalls of GDP as an economic measure (cont’d)
(7) GDP excludes per capita output
 For many purposes, the most meaningful measure of economic
performance is per capita output, which is found by dividing
real GDP by population.
 Because GDP measures only the magnitude of total output, it
conceals changes in the standard of living of the people.
 If GDP and population rise simultaneously, the per capita
standard of living may be constant or even declining. That is the
plight of some low-income developing countries.
 For example, Malawi’s GDP grew at a rate of 2.3% per year
from 1980 to 1990 and 0.7% per year from 1990 to 1995;
but over the same periods its annual population growth was
3.3% and 2.7%, respectively (World Bank, 1997).
 This resulted in a decline in per capita output of 1% per year
in 1980 – 1990, and 2% per year for the period 1990 – 1995.
74
Shortfalls of GDP as an economic measure (cont’d)
(8) GDP excludes non-economic sources of well-being
 Finally, the connection between GDP and well-being is problematic
for another reason. Just as the household’s income does not
measure its total happiness, a nation’s GDP does not measure its
total well-being.
 There are many things that could make a society better off without
necessarily raising GDP such as:
 a reduction of crime and violence,
 peaceful relations with other countries,
 people’s greater civility toward one another,
 better understanding between parents and children, and
 a reduction of drug and alcohol abuse.

75
References
 Clayton, Gary E. (1995). Economics. Principles and Practices.
Glencoe/McGraw-Hill. New York, U.S.A.

 McConnell, R.C. and Stanley L. Brue (2002). Economics: Principles,

Problems, and Policies, 15th Edition, New York, USA, McGraw-Hill
Companies Inc. Chapters 13.

 World Bank (1997). World Development Report 1997: The State in

a changing World, New York, United States, Oxford University
Press.

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