Chapter 19

The Wealth of Nations:

Defining and Measuring
Macroeconomic Aggregates

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Learning Objective
1 Macroeconomic Questions

2 National Income Accounts

: Production = Expenditure = Income

3 What Isn’t Measured by GDP?

4 Real vs. Nominal

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Key Ideas
1. National income accounting
– framework for calculating gross domestic product (GDP)
– GDP : a measure of aggregate economic output.
2. GDP can be measured in three different ways
– Production = Expenditure = Income.
– Three methods should all yield the same answer.
3. GDP has limitations as a measure of economic activity and
as a measure of economic well-being.
4. Economists use price indexes to measure the rate of
inflation
– nominal GDP vs. real GDP (which holds prices fixed)
– real GDP : holds prices fixed.
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National Income Accounts: Production =
Expenditure = Income
Aggregate economic activity in a country can be
measured in three different ways:

• The production approach

• The expenditure approach

• The income approach

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National Income Accounts: Production =
Expenditure = Income
Exhibit 5.1 Circular Flow Diagram

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National Income Accounts: Production =
Expenditure = Income
Each of these approaches is used to measure gross
domestic product, or GDP.

GDP

The market value of the final goods and services

produced within the borders of a country during a
particular time period.

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National Income Accounts:
Production Approach
• Production-based accounting sums up each firm’s value
added, which is the firm’s sales revenue minus the firm’s
purchases of intermediate products from other firms.

• (Example) Starbucks purchases its intermediate goods (such

as coffee beans, paper cups, lids, holders, etc.) for $0.25 per
cup. It sells a cup of coffee to customers for $2.00 per cup.
Therefore, Value-added = $2.00 - $0.25 = $1.75 per cup

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National Income Accounts:
Expenditure Approach
• Expenditure-based accounting sums up the purchases of goods
and services by 5 different categories.
 Consumption (C) : goods and services consumed by domestic
households
 Investment (I) : new physical capital bought by domestic households
and firms
 Government expenditure (G) : goods and services consumed by
government
 Export (X) : goods and services produced domestically and sold
abroad
 Import (M) : goods and services produced abroad and sold
domestically
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National Income Accounts:
Income Approach

• Income-based accounting sums up payments (or

income) received by labor and the owners of
physical or financial capital.

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National Income Accounts: Production =
Expenditure = Income
Aggregate Accounting Identity

Y = GDPPROD = GDPEXP = GDPINCOME

National Income Accounting Identity

Y = C +I +G +X -M

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The Wealth of Nations: Defining and
Measuring Macroeconomic Aggregates
Question: In the United States, what is the total
market value of annual economic production?

Answer: The Bureau of Economic Activity estimated

in 2016 that U.S. GDP was $18.85 trillion, or $58,359
per resident (based on population of 323 million in
2016).

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The Wealth of Nations: Defining and
Measuring Macroeconomic Aggregates
Question: In 2016, how was GDP divided into the
expenditure components?

Trillion of Dollars Share of GDP

Gross Domestic Product $18.86 100%
Consumption $12.98 68.8%
+ Investment $3.11 16.5%
+ Government Exp. $3.31 17.5%
+ Exports $2.26 11.9%
- Imports $2.80 -14.8%

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The Wealth of Nations: Defining and
Measuring Macroeconomic Aggregates
Question: Have U.S. expenditure shares fluctuated or remained
constant over time?
Answer: The U.S. expenditure shares have been relatively
constant over time.

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The Wealth of Nations: Defining and
Measuring Macroeconomic Aggregates
Question: What fraction of income is paid to labor, and what
fraction is paid to capital?
Answer: In the United States, labor receives about two-thirds
of total income, and capital receives about one-third of total
income.
Payments to U.S. Labor (% of total income)
(%)
1.00
0.90
0.80
0.70 average payments to labor = 0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Wages and Salaries Labor benefits
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The Wealth of Nations: Defining and
Measuring Macroeconomic Aggregates
• The national income accounting is useful to identify the
relationship between saving and investment in a country.
Y=C+I+G+X-M
Saving = Y – C – G
Saving = (C + I + G + X – M) – C – G
Saving = I + X – M

• In many economies, X – M is very close from 0

– exactly = 0 in a closed economy
– Saving = Investment, Saving/GDP = Investment/GDP

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The Wealth of Nations: Defining and
Measuring Macroeconomic Aggregates
Exhibit 5.5 The Relationship Between the Saving Rate and
the Investment Rate(1929–2015)

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What Isn’t Measured by GDP?
• GDP is not perfect, and it necessarily leaves out many
details.
– omits depreciation of the physical capital stock and
resources.
– excludes home production of cleaning, cooking, and child
care done in the household
– not capture transactions conducted in the underground
economy
– not count negative externalities such as pollution, noise,
and crime
– not record leisure.
– not include production by U.S. workers and U.S. capital
abroad.
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 What Isn’t Measured by GDP?
• Gross Domestic Product (GDP) vs. Gross National Product (GNP)

 GDP : production in the country regardless of whose labor

and capital (domestic or foreign) is used.

 GNP : production of domestically owned labor and capital in

the country and abroad.

2013 2014 2015

GDP (in $billions) 17,089 17,692 18,223
(+): income receipts from the rest of the world 857 852 799
(--): income payments to the rest of the world 573 615 587
= GNP (in $billions) 17,373 17,929 18,435

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What Isn’t Measured by GDP?
Why don’t we ask people how happy or satisfied they are and
compare these responses to GDP? (Positive Correlation)

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Real vs. Nominal
• An increase in GDP will record both
 increases in actual production (and income)
 increases in prices of those goods and services.

• Need to distinguish between nominal and real GDP.

Nominal GDP
The total value of production using current market prices

Real GDP
The total value of production using market prices from a
specific base year

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Real vs. Nominal
• Nominal GDP for 2009:
P a0p9p le s  Q a0p9p le s  P b0ig9 m ac  Q b0 ig9 m ac  . . .  P z0u9c c h in i  Q 09
z u c c h in i

• Nominal GDP for 2013:

Pa1p3p le s  Q a1p3 p le s  P b1ig3 m ac  Q b1 ig3 mac  ...  P zu1 3c c h in i  Q zu
13
c c h in i

• Real GDP for 2009 (base year 2009):

P a0p9p l e s ? 09
a p p le s + P b0i g9 m ac ? 09
b ig m a c + . . . + P z0u9c c h i n i ? 09
z u c c h in i

• Real GDP for 2013 (base year 2009):

P a0p9p l e s ? 13
a p p le s + P b0i g9 m ac ? 13
b ig m a c + . . . + P z0u 9c c h i n i ? 13
z u c c h in i

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Real vs. Nominal
Calculate nominal GDP for 2012 and 2013.
Peanut Butter Jelly
Year Quantity Price Quantity Price
2012 20 $4.00 50 $2.00
2013 30 $5.00 100 $2.00

• Nominal GDP for 2012

Ppb12 Qpb
12
 Pjelly
12
Q12
jelly  $4.00  20  $2.00  50
 $80  $100  $180

• Nominal GDP for 2013

Ppb13 Qpb
13
 Pjelly
13
Q13
jelly  $5.00  30  $2.00 100
 $150  $200  $350

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Real vs. Nominal
Calculate real GDP for 2012 and 2013.
Peanut Butter Jelly
Year Quantity Price Quantity Price
2012 20 $4.00 50 $2.00
2013 30 $5.00 100 $2.00

• Real GDP for 2012 (base 2012) :

12
Ppb  Qpb
12
 Pjelly
12
 Q12
jelly  $4.00  20  $2.00  50
 $80  $100  $180

• Real GDP for 2013 (base 2012) :

12
Ppb  Qpb
13
 Pjelly
12
 Q13
jelly  $4.00  30  $2.00  100
 $ 12 0  $ 2 00  $ 3 2 0

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Real vs. Nominal
• Growth Rate

(Y2013 – Y2012)/Y2012 = lnY2013 - lnY2012

• Growth in Nominal GDP:

($350 - $180)/$180 = 0.94 (or 94%)

• Growth in Real GDP:

($320 - $180)/$180 = 0.78 (or 78%)

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Real vs. Nominal
• Two price indexes is used to measure overall changes in the
price level and inflation.

• GDP Deflator: the ratio of nominal GDP to real GDP.

– It is a measure of how prices of goods and services

produced in a country have risen since the base year.

• Consumer Price Index: the cost of buying a basket of goods

and services in the current year divided by the cost of the
same basket in the base year.

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Real vs. Nominal
GDP deflator

Consumer Price Index (CPI)

: The price level of a particular basket of consumer
goods and services:

cost of consumer basket in current year

CPI =
cost of consumer basket in base year
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Real vs. Nominal
To calculate the CPI, assume that a typical household
buys 2 units of peanut butter, and 2 units of jelly.

blank blank Peanut Butter Jelly Cost of

Basket
YEAR Quantity Price Exp. Price Exp.
2012 2 $4.00 $8.00 $2.00 $4.00 $12.00
2013 2 $5.00 $10.00 $2.00 $4.00 $14.00

CPI = ($14.00/$12.00)*100 = 116.7

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Real vs. Nominal
• The GDP deflator and the CPI formula look nearly identical.

• What are the differences?

 The GDP deflator includes things not purchased by

households, like trains, subways, and submarines.

 The CPI includes imports like Chinese laptops.

 Housing-related expenditures like shelter and utility bills

have a large weight in the CPI.

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Real vs. Nominal
Inflation rate :The percentage change in a price index.

Inflation rate in 2013 =

(Price index in 2013)  (Price index in 2012)
 100
(Price index in 2012)

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Real vs. Nominal
In which year did a worker on minimum wage earn the most
in real terms?
Convert each year’s minimum wage to a constant year’s dollars (say
2016).
Value of 1981 min. wage in 2016 dollars = Min. wage in 1981 (CPI
2016/ CPI 1981) = $3.35 (239.5/90.9) = $8.83

Year Minimum Wage CPI Value in 2016 dollars

1956 $1.00 27.2 $8.80
1967 $1.40 33.4 $10.03
1975 $2.10 53.8 $9.35
1981 $3.35 90.9 $8.83
1996 $4.75 156.9 $7.25
2007 $5.85 207.3 $6.76
2016 $7.25 239.5 $7.25

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