C h a p t e r

4 MEASURING GDP AND

ECONOMIC GROWTH*

Key Concepts ♦ Net exports (NXNX ) — exports (X, sales of U.S.

goods and services abroad) minus imports (M, pur-
chases of foreign good and services).
„ Gross Domestic Product Aggregate expenditure, C + I + G + NX, equals aggre-
Gross domestic product, GDP, GDP is the market value of gate production, GDP, and also equals aggregate in-
all the final goods and services produced within in a come, Y. This equality is the basis for measuring GDP.
country in a given time period. ♦ National saving equals saving by households and
♦ A final good or service is an item that is bought by businesses plus government saving: S + (T − G ).
its final user during a specified time period. In con- ♦ Borrowing from the rest of the world equals M − X.
trast, an intermediate good is an item produced by Investment is financed by national saving plus bor-
one firm, bought by another and used as a compo- rowing from the rest of world, I = S + (T − G ) + M − X.
nent of a final good or service. Intermediate goods
A flow is a quantity over a unit of time. A stock is a
are not directly included in real GDP.
quantity that exists at a moment in time. Wealth and
The circular flow of income and expenditure shows real capital are stocks; saving and investment are flows.
and monetary flows in the economy. The circular flow
involves: ♦ Wealth, the value of things that people own, is a
stock; income, what people earn, is a flow.
♦ Four economic sectors — households, firms, gov-
ernments, and the rest of the world. ♦ Saving is the amount of income remaining after
spending on consumption. Saving is a flow that
♦ Three major markets — factor markets, goods mar- adds to wealth.
kets, and financial markets.
♦ Capital, the amount of plant, equipment, and in-
In these markets people make their economic decisions
ventories used to produce other goods, is a stock.
by choosing the amounts of key economic variables:
♦ Depreciation is the decrease in the capital stock
♦ Consumption expenditures (C C ) — total house-
because of wear and tear and obsolescence. Gross
hold spending on consumption goods and services.
investment is the total amount of investment. Net
♦ Investment (I ) — firms’ purchase of plants, investment is gross investment minus depreciation.
equipment, buildings, and additions to inventories. Net investment is the flow that is the amount by
♦ Government purchases (G G ) — government which the capital stock changes.
spending on goods and services. Net taxes (T T ) are Gross domestic product includes depreciation and so
taxes paid to the government minus transfer pay- on the income side includes firms’ gross profit (before
ments received from governments and minus inter- subtracting depreciation) and on the expenditure side
est payments on the government’s debt. includes gross investment. Net national product ex-
cludes (subtracts) depreciation so it includes firms’ net
profits and net investment.
* This is Chapter 19 in Economics.

67
68 CHAPTER 4 (19)

„ Measuring U.S. GDP „ Measuring Economic Growth

In 2001, U.S. GDP equaled $10,208 billion. The economic growth rate is the percentage change in
♦ The expenditure approach measures GDP by adding the quantity of goods and services produced from one
final expenditures, C + I + G + NX. Of these expen- year to the next. It equals the growth rate of real GDP.
ditures, personal consumption expenditure is the Real GDP is used for economic welfare comparisons,
largest, at about 69 percent. Gross private invest- for making international comparisons of output, and
ment is about 16 percent, government purchases of for business cycle forecasting.
goods and services is about 18 percent, and net ex- Economic welfare is a comprehensive measure of gen-
ports is about –3 percent. eral economic well being. Real GDP is an imperfect
♦ The incomes approach adds the compensation of measure of economic welfare because real GDP:
employees, net interest, rental income, corporate ♦ Over adjusts for inflation — many quality im-
profits and proprietors’ income to give net domestic provements that lead to higher prices are counted as
income at factor cost. Indirect taxes and depreciation only price hikes.
are added and subsidies subtracted to obtain GDP. ♦ Omits household production — all household pro-
duction is omitted.
„ Real GDP and the Price Level ♦ Omits the underground economy — the under-
ground economy (transactions hidden from the
Real GDP is the value of final goods and services pro-
government) is not included.
duced in a given year when valued at constant prices.
Nominal GDP is the value of the final goods and ♦ Omits health and life expectancy — neither people’s
services produced in a given year valued at the prices health nor life expectancy are indicated by real
that prevailed in that same year. GDP.
The base year prices method, which is the traditional ♦ Omits leisure time — the value of leisure time is not
method of calculating real GDP, values the quantities included.
produced in each year using the prices of the base year. ♦ Omits environmental quality — the consequences
The chain-weighted output index method, which is of adverse and beneficial environmental changes are
the new method of calculating real GDP, uses the omitted.
prices of two adjacent years to calculate the real GDP ♦ Ignores political freedom and social justice — the
growth rate. extent of political freedom or social justice within a
♦ The chain-weighted output index first calculates the nation is not measured.
value of GDP for this year and last year, using prices Making international comparisons of real GDP can be
from last year and then calculates the growth rate of tricky because the real GDP of one country must be
GDP between the two years. converted into the other nation’s currency. Using ex-
♦ Next the chain-weighted index calculates the value change rates for such conversions might understate the
of GDP for this year and last year, using prices from real GDP in less developed nations. However, use of
this year and again calculates the growth rate of purchasing power parity prices might give a more accu-
GDP between the two years. rate comparison.
♦ The two growth rates are averaged. This average is Though real GDP probably overstates the size of fluc-
used to scale up last year’s real GDP by multiplying tuations in total production and economic welfare, it is
last year’s real GDP by the average. a reasonably good indicator of the phase of the business
The price level is the average level of prices. One cycle, e.g., expansion, peak, and so on.
measure is of the price level is the GDP deflator,
which is an average of current year prices as a percent-
age of base-year prices. The GDP deflator equals Helpful Hints
Nominal GDP
×100 .
Real GDP 1. GDP, AGGREGATE EXPENDITURE, AND AG-
GREGATE INCOME : Some of the most important
results in this chapter show the equality between
 MEASURING GDP AND ECONOMIC GROWTH 69

GDP, aggregate expenditure, and aggregate in- Real GDP and the Price Level
come. A key point about these equalities is that 19. The chain-weighted output index method is how
GDP, aggregate expenditure, and aggregate income real GDP is calculated.
are linked. For instance, the production of output
(GDP) creates income (aggregate income) as firms 10. The GDP deflator is calculated as real GDP di-
pay their workers and also creates expenditure (ag- vided by nominal GDP, multiplied by 100.
gregate expenditure) as households use their in- 11. If prices rise, nominal GDP is smaller than real
comes to buy goods and services. GDP.
2. THE DIFFERENCE BETWEEN GOVERNMENT
Measuring Economic Growth
PURCHASES AND GOVERNMENT TRANSFER
PAYMENTS : Government spending on goods and 12. If two nations have the same GDP, economic wel-
services (G ) and government transfer payments are fare must be the same in each.
fundamentally different. Both involve payments by 13. Real GDP is a good measure of economic welfare
the government, but transfer payments are not in less developed nations, but is a bad measure in
payments for goods and services. Instead, they are developed nations.
simply a flow of money. Transfer payments are like
gifts; they do not buy a good or service for the gov- 14. Real GDP is a good measure of the phase of the
ernment in exchange. Transfer payments are not business cycle.
payment for a good or service, so they are not part
of the G component of aggregate expenditure, C + I „ Multiple Choice
+ G + NX, because aggregate expenditure measures
purchases of goods and services. Gross Domestic Product
11. Which of the following is NOT a final good?
a. a new computer sold to an NYU student
Questions b. a new car sold to Avis for use in their fleet of
rental cars
„ True/False and Explain c. a purse sold to a foreign visitor
d. a hot dog sold to a spectator at a Chicago Bears
Gross Domestic Product football game
11. The market value of all the goods and services pro-
duced within a country in a given time period are 12. GDP equals
included in GDP. a. aggregate expenditure.
b. aggregate income.
12. Wages paid to households for their labor is part of
c. the value of the aggregate production in a coun-
aggregate income.
try during a given time period.
13. Transfer payments are included in the government d. all of the above.
purchases component of aggregate expenditure.
13. A nation’s investment must be financed by
14. Aggregate income equals aggregate expenditure.
a. national saving only.
15. Capital is a stock; investment is a flow. b. the government’s budget deficit.
c. borrowing from the rest of the world only.
16. Gross domestic product is larger than net domestic
d. national saving plus borrowing from the rest of
product.
the world.
Measuring U.S. GDP
14. Which of the following is a flow?
17. GDP can be measured only one way.
a. GDP
18. The expenditure approach to measuring GDP adds b. Wealth
firms’ expenditures on wages, rent, interest, and c. The amount of money in a savings account
profit. d. Capital
70 CHAPTER 4 (19)

15. Which of the following is a stock? 10. How much is aggregate income?
a. Income a. $440 billion
b. Depreciation b. $330 billion
c. Investment c. $300 billion
d. Capital d. $270 billion

Measuring U.S. GDP 11. How much are net exports?

16. Gross private domestic investment is a component a. $20 billion
of which approach to measuring GDP? b. $10 billion
a. Incomes approach c. $0
b. Expenditure approach d. −$10 billion
c. Linking approach
d. Output approach 12. How much is household saving?
a. $300 billion
17. Which of the following is NOT a component of the b. $200 billion
incomes approach to GDP? c. $100 billion
a. Net exports d. $50 billion
b. Wages and salaries
c. Corporate profits 13. How much is government saving?
d. Proprietors’ income a. $60 billion
b. $50 billion
Use Table 6.1 for the next eight questions. Assume there c. $0
are no indirect taxes, subsidies, or depreciation. d. −$10 billion
TABLE 6.1 14. How much is national saving?
Multiple Choice Questions 8–15 a. $200 billion
Consumption expenditure $200 billion b. $50 billion
Government purchases 60 billion
c. $40 billion
Net taxes 50 billion
d. −$10 billion
Investment 50 billion
15. How much is the borrowing from the rest of the
Corporate profits 30 billion world?
Imports 20 billion
a. $20 billion
Exports 10 billion b. $10 billion
c. $0
18. How much is aggregate expenditure? d. −$10 billion
a. $440 billion
b. $330 billion Real GDP and the Price Level
c. $300 billion 16. Currently, real GDP is calculated using
d. $270 billion a. the quantities only method.
b. base year prices method.
19. How much is GDP? c. current year prices method.
a. $440 billion d. chain-weighted output index method.
b. $330 billion
c. $300 billion
d. $270 billion
 MEASURING GDP AND ECONOMIC GROWTH 71

17. Real GDP in 2002 is $100. Between 2002 and 21. Which of the following is NOT a reason that real
2003, using 2002 prices GDP grew 8 percent and GDP is a poor measure of a nation’s economic wel-
using 2003 prices real GDP grew 4 percent. What fare?
does real GDP in 2003 equal? a. Real GDP omits measures of political freedom.
a. $104 b. Real GDP does not take into account the value
b. $106 of people’s leisure time.
c. $108 c. Real GDP does not include the underground
d. None of the above answers is correct. economy.
d. Real GDP overvalues household production.
Use Table 6.2 for the next two questions.
22. Which of the following statements about the com-
TABLE 6.2 parison between GDP in China and in the U.S. is
Multiple Choice Questions 18 and 19 correct?
a. Using the exchange rate to value China’s GDP
Nominal GDP Real GDP
in dollars shows that China’s GDP per person
Year (billions of (billions of GDP
dollars) 1996 dollars) deflator exceeds the GDP per person in the United
2001 $4,500 ____ 150
States.
b. Using purchasing power parity prices to value
2002 ____ $3,100 156
China’s GDP in dollars shows that China’s GDP
18. What is real GDP in 2001? per person exceeds the GDP per person in the
United States.
a. $675,000 billion
c. China’s GDP per person is higher using pur-
b. $4,500 billion
chasing power parity prices rather than the ex-
c. $3,100 billion
change rate when valuing China’s GDP in dol-
d. $3,000 billion
lars.
19. What is nominal GDP in 2002? d. None of the above answers are correct because
they are all false statements.
a. $4,836 billion
b. $3,100 billion
c. $3,000 billion „ Short Answer Problems
d. $1,987 billion 11. Robert buys 100 shares of stock in Microsoft and
pays a total of $10,000. Is his expenditure of
Measuring Economic Growth
$10,000 part of GDP? Explain your answer.
20. Pollution is a by-product of some production proc- 12. How can we measure gross domestic product,
esses, so real GDP as measured GDP, with either the expenditure or the incomes
a. is adjusted downward to take into account the approach, when neither of these approaches actu-
pollution. ally measures production?
b. is adjusted upward to take into account the ex- 13. Betty receives a Social Security check for $1,500
penditures that will be made in the future to from the government. Is her check part of the gov-
clean up the pollution. ernment purchases component of GDP? Explain
c. tends to overstate economic welfare. your answer.
d. tends to understate economic welfare.
14. How is a nation’s investment financed? Define
national saving and borrowing from the rest of
world in your answer.
72 CHAPTER 4 (19)

TABLE 6.3
16. Use the data and your answers from problem 6 to
show how Mallville’s investment of $80 billion is
Data From Mallville financed.
Consumption expenditure $400 billion 17. Igor has been hired to use the chain-weighted out-
Government purchases 120 billion put index method for calculating real GDP for
Net taxes 100 billion Transylvania’s real GDP in 2003. Igor likes chains,
Investment 80 billion so he thought he would be good at his new job, but
Corporate profits 50 billion he needs help. Real GDP in 2002 was $500. Igor
Imports 50 billion
calculates that GDP using 2002 prices is $1,000 in
2002 and $1,100 in 2003. He also calculates that
Exports 60 billion
GDP using 2003 prices is $1,200 in 2002 and
$1,440 in 2003. Help Igor avoid chains himself by
15. Table 6.3 shows data for the nation of Mallville.
calculating real GDP in 2003.
Depreciation in Mallville is zero. Using these data,
what is the value of Mallville’s
a. GDP? „ You’re the Teacher
b. aggregate expenditure? 1. “Even though I studied this chapter a lot, just like
c. net exports? our teacher told us to, I don’t understand why I
d. aggregate income? had to study it so much. What’s the big deal? Do
e. household saving? you know why?” Your friend probably didn’t study
this chapter quite enough. Because you did, you
f. government saving?
can help your friend by explaining why this chapter
g. national saving? is worthy of study.
h. borrowing from the rest of world?
.
 MEASURING GDP AND ECONOMIC GROWTH 73

Answers 13. F In developed nations real GDP is not a perfect

measure of economic welfare and is an even
poorer measure in less developed nations.
„ True/False Answers 14. T Real GDP generally is a reliable indicator of
Gross Domestic Product business cycle phases.
11. F The market value of only final goods and serv-
ices is included in GDP; the market value of in-
termediate goods is not included. „ Multiple Choice Answers
12. T Compensation of employees (wages) is the single Gross Domestic Product
largest component of aggregate income. 11. b The new car sold to Avis is an intermediate
13. F The government purchases part of aggregate good.
expenditure is the goods and services the gov- 12. d The equality of these three measures of GDP is a
ernment buys. Transfer payments buy no good key result developed in this chapter.
or service and so they are not part of government 13. d A nation’s investment can be financed through
purchases. borrowing from foreigners and/or saving by do-
14. T Aggregate income equals aggregate expenditure mestic citizens.
and both equal GDP. 14. a GDP is the flow of production during a year.
15. T Investment is the flow that adds to the stock of 15. d Capital is the total amount of plant, equipment,
capital. and inventories that exists at a moment in time.
16. T Gross domestic product includes depreciation.
Measuring U.S. GDP
Measuring U.S. GDP 16. a The expenditures approach adds the expendi-
17. F Because of the equality between aggregate ex- tures made on all final goods and services.
penditure, aggregate income, and GDP, GDP 17. a Net exports is a component of the expenditure
can be measured using the expenditure approach approach to measuring GDP.
or using the income approach.
18. c Aggregate expenditure equals the sum of con-
18. F The expenditure approach to measuring GDP sumption expenditure ($200 billion) plus gross
adds consumption expenditure, investment, gov- investment ($50 billion) plus government pur-
ernment purchases, and net exports. chases ($60 billion) plus net exports (–$10 bil-
lion, exports minus imports).
Real GDP and the Price Level
19. c GDP equals aggregate expenditure.
19. T The chain-weighted output index method is the
new method used to calculate real GDP. The 10. c Aggregate income equals GDP.
base year prices method is the older method that 11. d Net exports equals exports ($10 billion) minus
is no longer in use. imports ($20 billion).
10. F The GDP price deflator is defined as 12. d Household saving equals aggregate income
Nominal GDP ($300 billion) minus consumption expenditure
×100 . ($200 billion) and net taxes ($50 billion), so
Real GDP
household saving is $50 billion.
11. F When prices rise, nominal GDP is larger than
13. d Government saving equals net taxes ($50 bil-
real GDP and must be deflated to equal real
lion) minus government purchases ($60 billion)
GDP.
so government saving is –$10 billion.
Measuring Economic Growth 14. c National saving equals the sum of household
12. F Economic welfare depends on more than just saving plus government saving. From question
real GDP, so even if the nations’ real GDPs are 13, household saving is $50 billion. From ques-
equal, their economic welfare can be different. tion 14, government saving is –$10 billion. So,
national saving is $40 billion.
74 CHAPTER 4 (19)

15. b Borrowing from the rest of the world equals the GDP. That measures the government’s purchases of
negative of net exports. goods and services. The government is not buying a
good or service when it gives Betty her Social Secu-
Real GDP and the Price Level rity check. Instead, the check is a transfer payment,
16. d The base year prices method is the old method that is, a transfer of income from the people who
for calculating real GDP; currently the chain- paid Social Security taxes to Betty. Transfer pay-
weighted output index is the method used to – ments are not part of the government purchases
calculate real GDP. component of GDP.
17. b The average growth rate between 2002 and 4. Investment can be financed by national saving
2003 is 6 percent, so real GDP grew at 6 percent and/or borrowing from the rest of the world. Na-
to $106. tional saving equals the sum of household saving, S,
18. d Real GDP equals nominal GDP deflated by plus government saving, T − G. Hence national
(divided by) the GDP deflator, then multiplied saving equals S + (T − G ). Borrowing from the rest
by 100. of world is M − X. So investment must equal what is
19. a Nominal GDP equals real GDP multiplied by saved in the nation plus what is borrowed from
the GDP deflator, then divided by 100. abroad, which in terms of a formula is equal to S +
(T − G ) + M − X.
Measuring Economic Growth 5. a. GDP in Mallville equals the sum of consump-
20. c Because pollution is not subtracted from real tion expenditure (C, $400 billion) plus invest-
GDP, real GDP overstates economic welfare. ment (I, $80 billion) plus government purchases
21. d Real GDP omits household production. (G, $120 billion) plus net exports (NX ), which
22. c When the exchange rate is used to value China’s equals exports (X, $60 billion) minus imports
GDP, GDP per person in the United States is (M, $50 billion). So GDP in Mallville is $610
69 times larger than China’s GDP per person. If billion.
purchasing power parity prices are used to value b. Aggregate expenditure equals GDP, so aggregate
China’s GDP, U.S. GDP per person is only 12 expenditure is $610 billion.
times that in China. c. Net exports, NX, is equal to exports ($60 bil-
lion) minus imports ($50 billion), or $10 bil-
„ Answers to Short Answer Problems lion.
d. Aggregate income, Y, equals GDP, or $610
1. No, Robert’s purchase of Microsoft stock is not part
billion.
of GDP. GDP includes the purchase of final goods
and services. So included in GDP would be, say, e. Household saving equals aggregate income
Microsoft’s purchase of a new telephone system be- ($610 billion) minus net taxes ($100 billion)
cause this is the purchase of a piece of capital. When minus consumption expenditure ($400 billion),
Robert purchased Microsoft stock, no good or serv- or $110 billion.
ice changed hands. So it is excluded from GDP be- f. Government saving is net taxes minus govern-
cause the expenditures in GDP represent the pur- ment purchases, or T − G. So government saving
chase of goods or services. equals $100 billion − $120 billion, or
2. The analysis of the circular flow showed that firms −$20 billion.
produce goods and services (what we want to meas- g. National saving equals household saving plus
ure, GDP); sell them (what the expenditure ap- government saving. From parts (e) and (f), na-
proach measures); and then use the proceeds to pay tional saving in Mallville is $90 billion.
incomes, such as rents, profits, and the like (what h. Borrowing from the rest of the world equals
the incomes approach measures). Therefore aggre- imports minus exports, M − X. Therefore
gate expenditure = aggregate income = production = Mallville’s borrowing from the rest of the world
GDP. is $50 billion − $60 billion = −$10 billion, that
3. No, Betty’s $1,500 Social Security check is not part is, Mallville’s residents loan $10 billion to the
of the government purchases (G ) component of rest of the world.
 MEASURING GDP AND ECONOMIC GROWTH 75

6. Investment is financed by national saving and bor- gregate economy in order to discover what makes
rowing from the rest of the world. In Mallville’s our economy grow more or less rapidly and what
case, gross investment is $80 billion. That equals causes business cycles and other stuff. Look, these
the sum of national saving, $90 billion plus bor- are important issues! I don’t know about you, but I
rowing from the rest of world, −$10 billion. Basi- sure hope the economy’s not in a recession when we
cally, Mallville has national saving of $90 billion, graduate and have to look for jobs. At least I sure
but only $80 billion of investment. Hence the dif- hope there’s no recession going on when I have to
ference, $10 billion, is loaned to the rest of the look for a job! And once we get jobs, I sure hope
world. that the economy grows rapidly so that our incomes
7. Using 2002 prices, Transylvania’s GDP grew from grow rapidly along with it.
$1,000 in 2002 to $1,100 in 2003, so the percent- “Anyway, we have to know what GDP is in order to
$1,100 − $1,000 understand growth and business cycles. After all,
age increase is 10 percent, × 100. how would we measure these things if we didn’t
$1,000
Using 2003 prices, GDP increased from $1,200 in know what the GDP is? So, we’re going to be
2002 to $1,440 in 2003, for a 20 percent increase. studying what makes GDP grow faster and what
The average percent increase is 15 percent. As a re- makes it fluctuate. And, when we do, a lot of the
sult, real GDP is calculated as growing 15 percent stuff we learned in this chapter will be important,
between 2002 and 2003, so real GDP in 2003 is like the idea that aggregate expenditure equals ag-
(15 percent) × ($500) = $575. gregate income and both equal GDP. So, I’m glad
you studied this stuff, because if you’d blown it off,
I’d be alone, without any friends, in the last half of
„ You’re the Teacher the class.”
1. “Yes, I have an idea why this chapter is important.
Basically, it is a lot of the foundation for the next 12
or so chapters!
“That statement sure got your attention! Now, lis-
ten: We’re trying to learn what factors affect the ag-
76 CHAPTER 4 (19)

Chapter Quiz 16. Which component of GDP has been negative in

recent years?
11. Which of the following is an example of a flow a. Consumption expenditure.
variable? b. Investment.
a. Capital. c. Government purchases of goods and services.
b. GDP. d. Net exports.
c. Inventories.
d. The money in your wallet. 17. Gross investment equals
a. depreciation minus net investment.
12. Two factors that both directly change the amount of b. net investment plus depreciation.
capital are c. net investment minus depreciation.
a. consumption and government expenditure. d. saving.
b. exports and net exports.
c. depreciation and investment. 18. As a measure of economic welfare, real GDP takes
d. investment and government expenditure. account of
a. household production.
13. In the national income accounts, government pur- b. the value of leisure time.
chases of goods and services exclude c. the underground economy.
a. transfer payments. d. None of the above answers is correct because real
b. state and local government spending. GDP does not take account of any of them.
c. spending on national defense.
d. local government spending, though it does in- 19. Which of the following is correct?
clude state government spending. a. Aggregate production, GDP, equals aggregate
expenditure.
14. A government budget surplus equals b. Aggregate production, GDP, equals aggregate
a. net taxes minus government spending on goods income.
and services. c. Investment can be financed by national saving or
b. government spending on goods and services mi- borrowing from the rest of the world.
nus investment. d. All of the above answers are correct.
c. consumption expenditure minus net taxes.
d. None of the above. 10. GDP equals
a C + I – S – T.
15. Real GDP
b. C + S – NX.
a. measures only real things, such as goods but not c. C + I + G + NX.
services. d. C + S + G.
b. is the value of final goods and services using cur-
rent prices.
c. measures the change in production.
d. is always larger than nominal GDP.

The answers for this Chapter Quiz are on page 309