Lecture 1

Measuring Domestic Output and National

Income
 Lecture Outline

1 Gross Domestic Product Measures Total Production

2 Does GDP Measure What We Want It to Measure?

3 Real GDP versus Nominal GDP

4 Other Measures of Total Production and Total Income

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 Microeconomics The study of how households and firms make choices,
how they interact in markets, and how the government attempts to influence
their choices.

Macroeconomics The study of the economy as a whole, including topics

such as inflation, unemployment, and economic growth.

Business cycle Alternating periods of economic expansion and economic

recession.

Expansion The period of a business cycle during which total production and
total employment are increasing.

Recession The period of a business cycle during which total production and
total employment are decreasing.

Economic growth The ability of an economy to produce increasing

quantities of goods and services.

Inflation rate The percentage increase in the price level from one year to
the next.
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 Gross Domestic Product Measures Total Production

1 LEARNING OBJECTIVE

Explain how total production is measured.

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 Measuring Total Production: Gross Domestic Product

Gross domestic product (GDP) The market value of all final goods and
services produced in a country during a period of time, typically one year.

GDP Is Measured Using Market Values, Not Quantities We measure

production by taking the value, in dollar terms, of all the goods and services
produced.

GDP Includes Only the Market Value of Final Goods

Final good or service A good or service purchased by a final user.

Intermediate good or service A good or service that is an input into another

good or service, such as a tire on a truck.

To avoid double counting, we do not include the value of intermediate goods or

services in calculating GDP.

GDP Includes Only Current Production GDP includes only production that
takes place during the indicated time period.
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 Calculating GDP
Production and Price Statistics for 2013
Suppose that a very simple economy (3)
produces only four goods and services: (1) (2) Price per
eye examinations, pizzas, textbooks, Product Quantity Unit
and paper. Eye examinations 100 $50.00
Assume that all the paper in this economy Pizzas 80 10.00
is used in the production of textbooks.
Textbooks 20 100.00
Use the information in the following table
to compute GDP for the year 2013: Paper 2,000 0.10

Solving the Problem

Step 1: Determine which goods and services listed in the table should be
included in the calculation of GDP.
GDP is the value of all final goods and services.
Therefore, we need to calculate the value of the final goods and services listed in
the table.
Eye examinations, pizzas, and textbooks are final goods.
Paper would also be a final good if, for instance, a consumer bought it to use in a
printer.
However, here we are assuming that publishers purchase all the paper to use in
manufacturing textbooks, so the paper is an intermediate good, and its value is not
included in GDP.
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 Solved Problem 19.1
Calculating GDP
Step 2: Calculate the value of Production and Price Statistics for 2013
the three final goods and services (3)
listed in the table. (1) (2) Price per
Product Quantity Unit

Value is equal to the quantity produced Eye examinations 100 $50.00

multiplied by the price per unit, Pizzas 80 10.00
so we multiply the numbers in column Textbooks 20 100.00
(1) by the numbers in column (2). Paper 2,000 0.10

(1) (2) (3)

Product Quantity Price per Unit Value
Eye examinations 100 $50 $5,000
Pizzas 80 10 800
Textbooks 20 100 2,000

Step 3: Add the value for each of the three final goods and services to find GDP.

GDP = Value of eye examinations produced + Value of pizzas produced +

Value of textbooks produced = $5,000 + $800 + $2,000 = $7,800.

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Circular-flow diagram – assumptions:
All goods and services – bought by households
Households - -spend all of their income

Households buy goods

and services from
firms, and firms use
their revenue from
sales to pay wages to
workers, rent to
landowners, and profit
to firm owners. GDP
equals the total
amount spent by
households in the
market for goods and
services. It also equals
the total wages, rent,
and profit paid by firms
in the markets for the
factors of production.
 Components of GDP

There are four major categories of expenditures:

• Consumption
• Investment
• Government purchases
• Net exports (total export - total import)

Economists use these categories to understand why GDP fluctuates and to

forecast future GDP.

Personal Consumption Expenditures, or “Consumption”

Consumption Spending by households on goods and services, not including

spending on new houses.

Consumption expenditures are made by households and are divided into

expenditures on services, such as medical care, education, and haircuts;
expenditures on nondurable goods, such as food and clothing; and
expenditures on durable goods, such as automobiles and furniture.
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 Gross Private Domestic Investment, or “Investment”
Investment Spending by firms on new factories, office buildings, machinery,
and additions to inventories, plus spending by households and firms on new
houses.
Spending on gross private domestic investment, or simply investment, is
divided into three categories:
1. Business fixed investment is spending by firms on new factories, office
buildings, and machinery used to produce other goods.
2. Residential investment is spending by households and firms on new
single-family and multi-unit houses.
3. Changes in business inventories are also included in investment.

Government Consumption and Gross Investment, or “Government

Purchases”

Government purchases Spending by federal, state, and local governments on

goods and services.
However, this does not include the Transfer Payments

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 Net Exports of Goods and Services, or “Net Exports”

Net exports Exports minus imports. ( X – M)

Exports
Spending on domestically produced goods by foreigners
Imports
Spending on foreign goods by domestic residents

We add exports to expenditures to include all spending on new goods and

services domestically produced and we subtract imports from total expenditures
to exclude spending that does not result in this production.

An Equation for GDP and Some Actual Values

A simple equation sums up the components of GDP:

Y C  I  G  NX
The equation tells us that GDP (denoted as Y) equals consumption (C) plus
investment (I) plus government purchases (G) plus net exports (NX).

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The Components of GDP
Example
 Measuring GDP Using the Value-Added Method

Value added The market value a firm adds to a product.

Table 19.1 Calculating Value Added

Firm Value of Product Value Added

Cotton farmer Value of raw cotton = $1 Value added by cotton farmer = 1
Textile mill Value of raw cotton woven Value added by cotton textile = 2
into cotton fabric = $3 mill = ($3 − $1)
Shirt company Value of cotton fabric made Value added by shirt = 12
into a shirt = $15 manufacturer = ($15 − $3)
L.L.Bean Value of shirt for sale on Value added by L.L.Bean = 20
L.L.Bean’s Web site = $35 = ($35 − $15)
Total Value Added = $35

The price of the shirt on L.L.Bean’s Web site is exactly equal to the sum of the
value added by each firm involved in the production of the shirt.

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 Does GDP Measure What We Want It to Measure?

2 LEARNING OBJECTIVE

Discuss whether GDP is a good measure of well-being.

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 Shortcomings in GDP as a Measure of Total Production

When the GDP is calculated, it does not include two types of productions:

• Production in the home

• Production in the underground economy

Household production refers to goods and services people produce for

themselves that are not bought and sold in markets.

Underground economy Buying and selling of goods and services that is

concealed from the government to avoid taxes or regulations or because the
goods and services are illegal.

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 Shortcomings of GDP as a Measure of Well-Being

GDP per capita is calculated by dividing the value of GDP for a country by the
country’s population.

The Value of Leisure Is Not Included in GDP If Americans still worked 60-
hour weeks as they typically did in 1890, GDP would be much higher than it is,
but the well-being of the typical person would be lower because less time would
be available for leisure activities.

GDP Is Not Adjusted for Pollution or Other Negative Effects of

Production Although GDP does not take into account negative effects of
production, countries are known to devote more resources to reducing these
effects as GDP increases.

GDP Is Not Adjusted for Changes in Crime and Other Social Problems
An increase in crime reduces well-being but may actually increase GDP if it
leads to greater spending on police, security guards, and alarm systems.

GDP Measures the Size of the Pie but Not How the Pie Is Divided Up
GDP may not provide good information about the goods and services
consumed by the typical person.
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 Real GDP versus Nominal GDP

3 LEARNING OBJECTIVE

Discuss the difference between real GDP and nominal GDP.

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 Calculating Real GDP

Nominal GDP The value of final goods and services evaluated at

current-year prices. ( P change Q change)

Real GDP The value of final goods and services evaluated at base-
year prices. ( P constant Q change)
Or
Production of goods and services Valued at constant prices

One drawback to calculating real GDP using base-year prices is that,

over time, prices may change relative to each other, distorting real GDP
estimates more the further away the current year is from the base year.

For the base year

Nominal GDP = Real GDP

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 Real and Nominal GDP
Suppose that a very simple economy produces only the following two final goods
Prices and Quantities
Price of Quantity of Price of Quantity of
Year hot dogs hot dogs hamburgers hamburgers
2011 $1 100 $2 50
2012 $2 150 $3 100
2013 $3 200 $4 150
Calculating Nominal GDP ( P current x Q current)
2011 ($1 per hot dog × 100 hot dogs) + ($2 per hamburger × 50 hamburgers) = $200
2012 ($2 per hot dog × 150 hot dogs) + ($3 per hamburger × 100 hamburgers) = $600
2013 ($3 per hot dog × 200 hot dogs) + ($4 per hamburger × 150 hamburgers) = $1,200
Calculating Real GDP (base year 2011) (P base x Q current)
2011 ($1 per hot dog × 100 hot dogs) + ($2 per hamburger × 50 hamburgers) = $200
2012 ($1 per hot dog × 150 hot dogs) + ($2 per hamburger × 100 hamburgers) = $350
2013 ($1 per hot dog × 200 hot dogs) + ($2 per hamburger × 150 hamburgers) = $500
Calculating the GDP Deflator
2011 ($200 / $200) × 100 = 100 This table shows how to calculate real GDP, nominal
2012 ($600 / $350) × 100 = 171 GDP, and the GDP deflator for a hypothetical economy
2013 ($1,200 / $500) × 100 = 240 that produces only hot dogs and hamburgers.
 The GDP Deflator

Price level A measure of the average prices of goods and services in the
economy.

GDP deflator A measure of the price level, calculated by dividing nominal GDP
by real GDP and multiplying by 100.

Nominal GDP
GDP deflator  100
Real GDP

Nominal GDP is equal to real GDP in the base year, so the value of the GDP
price deflator will always be 100 in the base year.

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 The following table gives the values for nominal and real GDP for 2009 and 2010:
2009 2010
Nominal GDP $13,939 billion $14,527 billion
Real GDP $12,703 billion $13,088 billion

We can use the information to calculate values for the GDP price deflator for 2009 and 2010:
Formula Applied to 2009 Applied to 2010

GDP Nominal GDP  $13,939 billion   $14,527 billion 

Deflator  100   100 110   100 111
Real GDP  $12,703 billion  $13,088 billion
 
From these values for the deflator, we can calculate the increase in the Economy’s
overall price level Known as Inflation.
Inflation rate
Percentage change in some measure of the price level from one period to the next
GDP Price deflator in year 2 - GDP Price deflator in year 1
Inflation in year 2  100
GDP Price deflator in year 1
 111  110 
  100 0.9%
 110 
Here the price level increased by 0.9 percent between 2009 and 2010:
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 Other Measures of Total Production and Total Income

4 LEARNING OBJECTIVE

Understand other measures of total production and total income.

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 Gross National Product (GNP)
Gross national product (GNP) is the value of final goods and services
produced by residents of a country, even if the production takes
place outside of it.
National Income
National income is calculated as GDP minus the consumption of fixed
capital, or depreciation.
Personal Income
Personal income is income received by households.

To calculate personal income, we subtract the earnings that corporations

retain rather than pay to shareholders in the form of dividends.
We also add in the payments received by households from the
government in the form of transfer payments or interest on government
bonds.
Disposable Personal Income
Disposable personal income is equal to personal income minus personal
tax payments and is the best measure of the income households actually
have available to spend.
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Figure 19.5 The Division of Income, 2010

We can measure GDP in terms of total expenditure

or as the total income received by households.
The largest component of income received by
households is wages, which are more than three
times as large as the profits received by sole
proprietors and the profits received by corporations combined.

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 GDP calculated as the sum of income payments to households is sometimes
referred to as gross domestic income.

Wages include all compensation received by employees, including fringe benefits

such as health insurance.

Interest is net interest received by households, or the difference between the

interest received on savings accounts, government bonds, and other investments
and the interest paid on car loans, home mortgages, and other debts.

Rent is rent received by households.

Profits include the profits of sole proprietorships, which are usually small
businesses, and the profits of corporations.

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 Two Approaches to GDP
Expenditure Approach Income Approach
Consumption by
Wages

+
Households

+
Investment by Rents
Businesses G +
+ = D= Interest
Government
Purchases P +
Profits
+
Expenditures
+
Statistical
By Foreigners Adjustments
 GDP Approaches Compared
Accounting Statement for the U.S. Economy, 2005, in Billions
Receipts Allocations
Expenditures Approach Income Approach

Personal Consumption (C) $ 8746 Compensation $ 7125

Gross Private Domestic Rents 73
Investment (Ig) 2105 Interest 498
Government Purchases (G) 2363 Proprietor’s Income 939
Net Exports (Xn) -727 Corporate Profits 1352
Taxes on Production and 917
Imports
National Income $10,904

Net Foreign Factor Income -34

Statistical Discrepancy 43
Consumption of Fixed
Capital 1574
Gross Domestic Product $ 12,487 Gross Domestic Product $ 12,487