MEASURING A NATION’S INCOME

 Microeconomics: the study of how individuals and

how firms make decisions and how they interact in
markets

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MEASURING A NATION’S INCOME

 Macroeconomics: the study of economy-wide

phenomena, including inflation, unemployment, and
economic growth

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MEASURING A NATION’S INCOME
 Gross domestic product
(GDP): measures the total
income of a nation; the most
closely watched economic
statistic because it is the best
measure of a society’s

Thinkstock
economic well-being

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THE ECONOMY’S INCOME
AND EXPENDITURE

For an economy as a whole,

income must equal expenditure.

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The 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)
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QuickQuiz

What two things does gross domestic product measure?

How can you measure two things at once?

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 THE MEASUREMENT OF
GROSS DOMESTIC PRODUCT

GDP: the market value of all final goods and services

produced within a country in a given period of time

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 “GDP Is the Market Value . . .”

 GDP adds together many different kinds of products

into a single measure of the value
of economic activity.

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 “. . . Of All . . .”

 It includes all items produced in the economy and

sold legally in markets.
 GDP also includes the market value of the housing
services provided by the economy’s stock of housing.
 There are some products, however, that GDP
excludes because measuring them is so difficult.

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 “. . . Final . . .”

 GDP includes only the value of final goods.

 The reason is that the value of intermediate goods is
already included in the prices of the final goods.
 An important exception to this principle arises when
an intermediate good is produced and is added to a
firm’s inventory of goods to be used or sold at a later
date.
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 “. . . Goods and Services . . .”

 GDP includes both tangible goods (food, clothing,

cars) and intangible services
(haircuts, housecleaning, dentist visits).

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 “. . . Produced . . .”

 GDP includes goods and services currently

produced.

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 “. . . Within a Country . . .”

 GDP measures the value of production within the

geographic confines of a country.

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 “. . . In a Given Period of Time”

 GDP measures the value of production that takes

place within a specific interval of time.
 Usually that interval is a year or a quarter.
 GDP measures the economy’s flow of income and
expenditure during that interval.

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FYI:
Other Measures of Income

Gross national product …. the total value of goods produced and services provided by a country during one year, equal to the gross domestic
product plus the net income from foreign investments. The formula to calculate the components of GNP is Y = C + I + G + X + Z. That stands for GNP = Consumption + Investment + Government + X (net
exports) + Z (net income earned by domestic residents from overseas investments minus net income earned by foreign residents from domestic investments).

Net national product…. the total value of goods produced and services provided in a country
during one year, after depreciation of capital goods has been allowed for. The Formula to calculate market value of all finished goods +
the market value of all finished services - the depreciation of those goods and services = net national product. The gross national
product - depreciation = net national product.

 National income
• Personal income
• Disposable personal income

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QuickQuiz

Which contributes more to the GDP: the production

of a kilogram of hamburger or
the production of a kilogram of caviar?
Why?

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Active Learning
GDP and Its Components

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.
B. Sarah spends $1800 on a new laptop to use in her publishing
business.
C. Jane spends $1200 on a computer to use in her editing 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.

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Active Learning
Answers

A. Debbie spends $200 to buy her husband dinner at the finest

restaurant in Toronto.
Consumption and GDP rise by $200.
B. Sarah spends $1800 on a new laptop to use in her publishing
business. The laptop was built in China.
Investment rises by $1800, net exports fall by $1800,
GDP is unchanged.

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Active Learning
Answers
C. Jane spends $1200 on a computer to use in her editing business. She
got last year’s model on sale for a great price from a local
manufacturer.
Current GDP and investment do not change because the computer
was built last year.
D. General Motors builds $500 million worth of cars, but consumers only
buy $470 million of them.
Consumption rises by $470 million, inventory investment rises by
$30 million, and GDP rises by $500 million.

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 The Components of GDP

 Recall: GDP is total spending.

 Four components:
 Consumption (C)
 Investment (I)
 Government Purchases (G)
 Net Exports (NX)
 These components add up to GDP (denoted Y):

Y
Y =
= C
C +
+ II +
+ G
G +
+ NX
NX
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Consumption
 Consumption: spending by households in goods and
services, with the exception of purchases of new housing
 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.
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 Investment (I)
 is total spending on goods that will be used in the future to
produce more goods.
 includes spending on
 capital equipment (e.g., machines, tools)
 structures (factories, office buildings, houses)
 inventories (goods produced but not yet sold)

Note:
Note: “Investment”
“Investment” does
does not
not
mean
mean the
the purchase
purchase of
of financial
financial
assets
assets like
like stocks
stocks and
and bonds.
bonds. 22
 Government Purchases (G)

is all spending on the g&s purchased by govt at the

federal, state, and local levels.
G excludes transfer payments, such as
Social Security or unemployment insurance
benefits.
They are not purchases of g&s.

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Net Exports

 Net exports: the value of

a nation’s exports minus
the value of its imports;
(imports are the
portions of C, I, and G
that are spent on g&s

Stuart Miles/Shutterstock
produced abroad) also
called the trade balance
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QuickQuiz

What are the four components of expenditure?

What does it mean when net exports have a negative

value?

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 REAL VERSUS NOMINAL GDP

 If total spending rises from one year to the next, one of two
things must be true:
1. The economy is producing a larger output of goods
and services.
2. Goods and services are being sold at higher prices.
 When studying changes in the economy over time,
economists want to separate these two effects.

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 Real versus Nominal GDP

 Inflation can distort economic variables like GDP, so we have

two versions of GDP:
One is corrected for inflation, the other is not.
 Nominal GDP values output using current prices. It is not
corrected for inflation.
 Real GDP values output using the prices of
a base year. Real GDP is corrected for inflation.
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 A Numerical Example

 Table 5.3 shows some data for an economy that produces

only two goods:
 Hot dogs
 Hamburgers
 The table shows the quantities of the two goods produced
and their prices in the years 2010, 2011, and 2012.

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 TABLE 5.3:
Real and Nominal GDP

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 Nominal and Real GDP in the U.S.,
1965-2007

Billions
$12,000

$10,000 Real GDP

$8,000
(base year
2000)
$6,000

$4,000 Nominal
$2,000 GDP

$0
1965 1970 1975 1980 1985 1990 1995 2000 2005
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 The GDP Deflator

 GDP deflator: a measure of the price level calculated as the

ratio of nominal GDP to real GDP times 100
 The GDP deflator is a measure of the overall level of prices.
 One way to measure the economy’s inflation rate is to
compute the percentage increase in the GDP deflator from
one year to the next.
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The GDP Deflator

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QuickQuiz

Define real and nominal GDP.

Which is a better measure of economic well-being?
Why?

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 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:

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GDP AND ECONOMIC WELL-BEING

“GDP 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 wit
nor our courage; neither our wisdom nor our learning; neither our
compassion nor our devotion to our country; it measures everything, in
short, except that which makes life worthwhile. And it tells us everything
about America except why we are proud that we are Americans.”
Robert Kennedy (1968)

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 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

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 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…

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Case Study:
International Differences in GDP and the Quality of Life
 Table 5.4:
GDP, Life Expectancy, and Literacy

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Classroom Activity
GDP and Economic Well-Being
1. If GDP is a good measure of economic well-
being, why is Switzerland’s gross domestic
product so much lower than India’s GDP or
China’s GDP?
2. What measures would be better to compare the
well-being of different countries?
3. How do you expect these direct measures to
correlate with per capita GDP?
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 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. 40 5-40