Measuring a Nation’s Income

November 29, 2021

BSE 1204: Introduction to Macroeconomics

BSA 1202: Macroeconomics for Actuarial Science

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Economy’s Income & Expenditure

Gross Domestic Product (GDP)

Measures the total income of everyone in the economy.
Measures the total expenditure on the economy’s output of
goods and services.
For an economy as a whole
Income must equal expenditure. Every dollar spent by a buyer of
a good or service becomes a dollar of income to the seller of
that good or service.

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Economy’s Income & Expenditure

Circular-flow diagram – assumptions:

Markets
Goods and services
Factors of production
Households
Spend all of their income
Buy all goods and services
Firms
Pay wages, rent, interest, profit to resource owners

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The circular flow of income

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The circular flow of income

Withdrawals (W)
Only part of the income received by households will be spent
on the goods and services of domestic firms & only part of the
incomes generated by firms will be paid to households. The re-
mainder will also be withdrawn.
i) Net saving (S): income that households choose not to spend
but to put aside for the future - any borrowing or drawing on past
savings.
ii) Net taxes (T): total taxes - benefits.
iii) Import expenditure (M): Spending on imported goods and ser-
vices, or on goods and services using imported components.

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The circular flow of income

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Injections

Only part of the demand for firms’ output arises from consumers’
expenditure.
i) Investment (I): Money that firms spend after obtaining it from
financial institutions (savings or loans), or through a new issue of
shares.
ii) Government purchases (G): Government spending on goods
and services.
iii) Export expenditure (X): When residents abroad buy our goods
and services

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Economy’s Income & Expenditure

Gross domestic product (GDP)

Market value of all final goods and services produced within a
country in a given period of time.
“GDP is the market value. . . ”
Market prices - reflect the value of the goods.
“. . . of all. . . ”
All items produced in the economy and sold legally in markets.
Excludes most items produced and sold illicitly; produced and
consumed at home.

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Economy’s Income & Expenditure
“. . . final. . . ”
Value of intermediate goods is already included in the prices of
the final goods. Intermediate good?
“. . . goods and services. . . ”
Tangible goods & intangible services.
“. . . produced. . . ”
Goods and services currently produced.
“. . . within a country. . . ”
Goods and services produced domestically regardless of the
nationality of the producer.
“. . . in a given period of time”
A year or a quarter.
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Expenditure approach

Components of GDP

Y = C + I + G + NX
Identity
Y = GDP
C = consumption
I = investment
G = government purchases
NX = net exports

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Components of GDP

Consumption, C
Spending by households on goods and services.
Exception: purchases of new housing; second-hand items.

Investment, I
Investment is the purchase of goods (called capital goods) that will
be used in the future to produce more goods and services.

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Components of GDP

Consumption, C
Spending by households on goods and services
Exception: purchases of new housing
Investment, I
Investment is the purchase of goods (called capital goods) that will
be used in the future to produce more goods and services.
Spending on capital equipment, inventories, structures,
intellectual property products- business capital.
Household purchases of new housing - residential capital.
Inventory accumulation- whether of raw materials, semi-finished
goods or finished goods.

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Components of GDP

Government purchases, G ??

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Components of GDP

Government purchases, (G) or Government consumption

expenditure and gross investment
Spending on goods and services by the government.
It includes the salaries of government workers as well as
expenditures on public works.
Does not include transfer payments i.e. payment of money for
which no good, or service is received in exchange. Example of a
transfer payment?
From a macroeconomic standpoint, transfer payments are like
negative taxes.

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Components of GDP

Net exports, NX = Exports - Imports.

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

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Calculating GDP

Discuss the product/ value added method of measuring GDP.

Explain using an example.

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Calculating GDP

The product/value added method of measuring GDP

Add up the “value added” of each industry - simply involves
adding up the value of everything produced in the country
during the year.
This avoids “double counting” of intermediate products.

plus taxes on products

less subsidies on products
=Total GDP at market prices.

Subsidy = Payment by the government to a producer or

consumer. It is the opposite of a tax.

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The product/value added method of measuring
GDP

E.g. If a manufacturer sells a television to a retailer for $600 and

the retailer sells it to the consumer for $800, how much has this
television contributed to GDP?

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The product/value added method of measuring
GDP

E.g. If a manufacturer sells a television to a retailer for $600 and

the retailer sells it to the consumer for $800, how much has this
television contributed to GDP?
We do not add the $600 received by the manufacturer to the
$800 received by the retailer: that would be double counting.
We either just count the final value ($800) or the value added at
each stage ($600 by the manufacturer + $200 by the retailer).

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The income method of measuring GDP

Income Method
Add up the incomes earned before taxes, i.e. wages, interest,
rent and profit.
Do not include transfer payments.

plus taxes on products

less subsidies on products
=GDP at market prices
Focuses on the incomes generated from the production of goods
and services.

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Real versus Nominal GDP

Total spending rises from one year to the next

Economy - producing a larger output of goods and services
And/or goods and services are being sold at higher prices

Nominal GDP
Production of goods and services
Valued at current prices

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Real versus Nominal GDP

Real GDP
Production of goods and services valued at constant prices
Designate one year as base year
Not affected by changes in prices
For the base year
Nominal GDP = Real GDP

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Real versus Nominal GDP

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Real versus Nominal GDP

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GDP deflator

The GDP deflator = Nominal GDP

Real GDP
× 100
Nominal GDP and real GDP must be the same in the base year,
∴ the GDP deflator for the base year always equals 100.
Measures the current level of prices relative to the level of prices
in the base year.
Can be used to take inflation out of nominal GDP (“deflate”
nominal GDP for the rise that is due to increases in prices).

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GDP deflator

Inflation
Economy’s overall price level is rising.
Inflation rate
Percentage change in some measure of the price level from one
period to the next.
Inflation in year 2 = GDP deflatorGDP
in year 2−GDP deflator in year 1
deflator in year 1
× 100

GDP deflator is one measure that economists use to monitor the

average level of prices in the economy.

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Other measures of Income

Gross National Income (GNY): See page 488 - Sloman, J.,

Garrat, D., & Guest, J. (2018). Economics for Business (10th ed.).
GNY at market prices = GDP at market prices + Net income
(inflows minus outflows), from abroad.
GDP focuses on the value of domestic production, whereas GNY
focuses on the value of incomes (wages, interest, profit and rent)
earned by domestic residents.
Value of income earned by the nation’s resources.

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Other measures of Income

Each year some of the country’s capital equipment wears out or be-
comes obsolete - capital depreciation.
Net National Income:
Allowing for depreciation (i.e. the decline in the value of capital
equipment due to age or wear and tear),
NNY at market prices = GNY at market prices - depreciation

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Taking account of population: the use of per
capita measures

We are often more interested in output or income per head.

Why?

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Taking account of population: the use of per
capita measures

E.g. Luxembourg has a lower total national income than the

UK, but it has a higher GDP per head.
Other per capita measures may be useful: Measuring GDP per
head of the employed population allows us to compare how
much the average worker produces.
A country may have a relatively high GDP per head of
population, but also have a large proportion of people at work.
Its output per worker will therefore not be so high.

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Taking account of exchange rates:the use of PPP
measures

Problem with comparing GDP figures of different countries. They

are measured in the local currency and have to be converted into
a common currency (e.g. dollars) at the current exchange rate.
But the exchange rate may be a poor indicator of the purchas-
ing power of the currency at home. E.g. $1 may exchange for,
110KES. But will $1 in the US buy the same amount of goods as
110KES in Kenya?

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Taking account of exchange rates:the use of PPP
measures

GDP can be converted into a common currency at a purchasing-

power parity rate - rate of exchange that would allow a given
amount of money in one country to buy the same amount of
goods in another country after exchanging it into the currency of
the other country.
E.g. the OECD publishes PPP rates against the US dollar for all
OECD currencies. Using such rates to measure GDP gives the
purchasing-power standard (PPS) GDP.
See: World Bank - International Comparison Program (ICP)

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Economic growth

Growth in actual and potential output

Actual growth rate: percentage increase in output over a
12-month period.
Potential output: output produced when the economy is
operating at its normal level of capacity. Less than full-capacity
output
Potential growth rate: percentage annual increase in the
economy’s potential output. Speed at which the economy could
grow.
The output gap = actual output less potential output.

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Economic growth and the business cycle

Actual output sometimes grows more quickly and at other times

more slowly than the trend of potential output.
The phases of the business cycle
1 the upturn
2 the expansion
3 the peaking out
4 the slowdown or recession

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Business cycle

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Business cycle

Main cause of variations in actual output and actual growth is

the level of aggregate demand (AD). Boom: associated with a
in AD. Recession: associated with a in AD.
Rapid rise in AD cannot by itself, ensure a high level of growth
over successive years. Without an increase in potential output,
the economy would reach full capacity.
Economy’s productive capacity will increase if there is an
increase in:
i)
ii)

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Business cycle

Main cause of variations in actual output and actual growth is

the level of aggregate demand (AD). Boom: associated with a
in AD. Recession: associated with a in AD.
Rapid rise in AD cannot by itself, ensure a high level of growth
over successive years. Without an increase in potential output,
the economy would reach full capacity.
Economy’s productive capacity will increase if there is an
increase in:
i) The quantity of resources.
ii) The productivity of resources.

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Determinants of Economic Growth?

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Determinants of Economic Growth

Investment in physical capital

Investment in human capital
Technological progress
Proper use of natural resources
Enforcement of private property rights
Stable political environment

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Do GDP statistics give a good indication of a
country’s standard of living?

Discuss and read article on eLearning

https://steadystate.org/wp-content/uploads/CASSE_Brief_
GDP.pdf

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Do GDP statistics give a good indication of a
country’s standard of living?

Larger GDP tends to be associated with:

Good life, better healthcare
Better educational systems
Measure of our ability to obtain many of the inputs into a
worthwhile life
GDP – not a perfect measure of well-being
Doesn’t include:

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Do GDP statistics give a good indication of a
country’s standard of living?

GDP – not a perfect measure of well-being

Doesn’t include:
Leisure
Value of almost all activity that takes place outside markets
(The ‘underground’ or ‘shadow’ economy, non-marketed items)
Quality of the environment
Nothing about distribution of income
Production is desirable only to the extent that it enables us to
consume more

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