Measuring a Nation’s Income

Measuring a Nation’s Income

In this chapter,
look for the answers to these questions:

• What is Gross Domestic Product (GDP)?

• How is GDP corrected for inflation?
• How is GDP related to a nation’s total income and
spending?
• What are the components of GDP?
• Does GDP measure society’s well-being?
• Is there any other measures of income (output)?

Chapter 23- Measuring a Nation’s Income 2

I. Gross Domestic Product (GDP)

1.Definition
GDP is the market value of all final goods and services
produced within a country in a given period of time.

 “Market value”: measure value of economic activity via

market prices

n
GDPt   Pi Qit
i 1

Chapter 23- Measuring a Nation’s Income 3

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 Measuring a Nation’s Income

EXAMPLE:
Pizza Coffee
year P Q P Q
2005 $10 400 $2.00 1000
2006 $11 400 $2.50 1000
2007 $12 600 $3.00 1200

Compute GDP in each year:

Increase:
2005:
2006:
2007:
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I. Gross Domestic Product (GDP)

 Nominal GDP (GDPn): measure the value of output in a
give period in the price of that period
→ current prices

 Real GDP (GDPr): measure changes in physical output

→ constant prices

Chapter 23- Measuring a Nation’s Income 5

EXAMPLE:
Pizza Coffee
year P Q P Q
2005 $10 400 $2.00
$2.00 1000
2006 $11 400 $2.50 1000
2007 $12 600 $3.00 1200
Compute real GDP in each year,
using 2005 as the base year: Increase:
2005:
2006:
2007:
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 Measuring a Nation’s Income

EXAMPLE:
Nominal Real
year GDP GDP
2005 $6000 $6000
2006 $6900 $6000
2007 $10,800 $8400

In each year,
• nominal GDP is measured using the (then) current
prices.
• real GDP is measured using constant prices from the
base year (2005 in this example).

EXAMPLE:
Nominal Real
year GDP GDP
2005 $6000 $6000
2006 $6900 $6000
2007 $10,800 $8400
• The change in nominal GDP reflects changes both
prices and quantities.
 The change in real GDP reflects only changes in
quantities,

Hence, real GDP is corrected for inflation.

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The GDP Deflator

• measures the current level of prices relative to the
level of prices in the base year  a measure of the
overall level of prices.
• Definition:
nominal GDP
GDP deflator = x 100
real GDP

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 Measuring a Nation’s Income

EXAMPLE:
Nominal Real GDP
year GDP GDP Deflator
2005 $6000 $6000 100.0
15%
2006 $6900 $6000 115.0
2007 $10,800 $8400 128.6 11.83%

Compute the GDP deflator in each year:

2005: 100 x (6000/6000) = 100.0

2006: 100 x (6900/6000) = 115.0

2007: 100 x (10,800/8400) = 128.6

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NOW YOU TRY:

Real vs. Nominal GDP
2007 (base yr) 2008 2009
P Q P Q P Q
Good A $30 900 $31 1,000 $36 1050
Good B $100 192 $102 200 $100 205

Use the above data to solve these problems:

A. Compute nominal GDP in 2007.
B. Compute real GDP in 2008.
C. Compute the GDP deflator in 2009.
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I. Gross Domestic Product (GDP)

• “all ”:
includes all items produced in the economy and sold
legally in markets
Excludes:
- Goods and services are not traded in the market:
produced and consumed at home (vegetable,
housework, taking care of your baby,…)
- Items are produced and sold illegal: drugs,
underground economy

Chapter 23- Measuring a Nation’s Income 12

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 Measuring a Nation’s Income

I. Gross Domestic Product (GDP)

• “final goods and services ”:
A good or service that is consume by the end user and is
not used as an input in the production process of some
other goods.

Intermediate goods: used as components or ingredients in

the production of other goods
GDP only includes final goods – they already embody the
value of the intermediate goods used in their production
→ no double-count

Chapter 23- Measuring a Nation’s Income 13

I. Gross Domestic Product (GDP)

•“produced”:
includes goods and services currently produced
used goods and inventory of previous years are not part of
GDP
•“within a country”:
value of production within the geographic confines of a
country
• “period of time”:
measures the economy’s flow of income and expenditure
during an interval ( a year or a quarter).

Chapter 23- Measuring a Nation’s Income 14

I. Gross Domestic Product (GDP)

2. The ways of defining GDP

• Circular - Flow Diagram

→ Flow of products and Flow of money

- a simple depiction of the macroeconomy

- illustrates GDP as spending, revenue, factor payments,

and income

Chapter 23- Measuring a Nation’s Income 15

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 Measuring a Nation’s Income

• 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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Equivalent Definitions of GDP

• GDP is a flow of…

- Expenditures

- Incomes

- Production
- These must be equivalent since they are akin to the
3 sides of any transaction
Product
Buyer Seller

Expenditure Income
Chapter 23- Measuring a Nation’s Income 17

Income and Expenditure

• Gross Domestic Product (GDP) measures

total income of everyone in the economy.
• GDP also measures total expenditure on the
economy’s output of g&s.

For the economy as a whole,

income equals expenditure
because every unit of money a buyer spends
is a unit of income for the seller.

Chapter 23- Measuring a Nation’s Income

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 Measuring a Nation’s Income

(1) Component of GDP by expenditure

- Consumption (C):

spending by households on goods and services

+ Nondurable goods: food, clothing,…
(that last a short time)
+ Durable goods: car, TV, washing-machine,…
+ Services : haircuts, doctor visits, massage,…

Chapter 23- Measuring a Nation’s Income 19

Consumption (C)

• 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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Chapter 23- Measuring a Nation’s Income

(1) Component of GDP by expenditure

- Investment (I): total spending on goods that will be used in
the future to produce more goods
+ Business fixed investment: purchase new plant and
equipment by firms
+ Residential fixed investment: purchase new housing by
households
+ Inventory investment: goods produced but not yet sold
(the increase in firms’ inventories of goods)

Chapter 23- Measuring a Nation’s Income 21

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 Measuring a Nation’s Income

(1) Component of GDP by expenditure

- Government Purchases(G): total spending on goods and
services by local and central government: salary, public
goods, military equipment.

Note: G excludes transfer payments, such as Social

Security or unemployment insurance benefits.
They are not purchases of g&s.

Chapter 23- Measuring a Nation’s Income 22

(1) Component of GDP by expenditure

- Net Exports (NX):

• NX = exports – imports
• Exports: foreign spending on the economy’s g&s.
• Imports: spending on foreign goods & services by
domestic residents  one part of C, I, and G
are spent on g&s produced abroad.
• Adding up all the components of GDP gives:
GDP = C + I + G + NX
Total spending on new goods & services. Excludes resales
Chapter 23- Measuring a Nation’s Income 23

NOW YOU TRY:

a. GDP = 200, affecting C (consumption)
Components of GDP by Expenditure
In each of the following cases, determine how much GDP b. GDP = 0, affecting NE because the laptop was produced in China
and each of its components is affected (if at all). => imported good
A. Debbie spends $200 to buy her husband dinner
c. GDP = 0, affecting none of component because the laptop was
at the finest restaurant in Boston.
produced last year => not included in GDP of current year
B. Sarah spends $1800 on a new laptop to use in her
d. GDP = $470 millions, affecting C (consumption)
publishing business. The laptop was built in China.
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. 24

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 Measuring a Nation’s Income

(2) Component of GDP by Income

- Labor income (w):
wages and fringe benefits earned by workers
- Rental income (r): income that landlords receive
- Interest (i) : income of money-lender
- Profit (Pr) :
The income of corporation after payments to their workers
and creditors
fringe benefits: phúc lợi cho ng lao động

Chapter 23- Measuring a Nation’s Income 25

(2) Component of GDP by Income

- Net domestic income at factor cost = w + r + i + Pr

Indirect tax (Ti), depreciation (De)

Market price

GDP = w + r + i + Pr + Ti + De

(A direct tax is borne entirely by the entity that pays it, and cannot
be passed on to another entity)

Chapter 23- Measuring a Nation’s Income 26

(3) Component of GDP by Value Added (production)

Example
Cotton → Fiber → Cloth → Coat
30 45 70 100

VA

GDP = → market value of final good

Chapter 23- Measuring a Nation’s Income 27

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 Measuring a Nation’s Income

(3) Component of GDP by Value Added

- Value Added (VA) is amount of value added by a firm or an

industry to the total worth of the product

VA = value of its production – value of intermediate goods

bought from other firms and used in production

Chapter 23- Measuring a Nation’s Income 28

(3) Component of GDP by Value Added

• GDP = value of final goods produced

= sum of value added at all stages
of production.

n
GDPVA  VAi
i 1

Chapter 23- Measuring a Nation’s Income 29

3. 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.

Chapter 23- Measuring a Nation’s Income 30

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 Measuring a Nation’s Income

3. GDP and Economic Well-Being

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

Chapter 23- Measuring a Nation’s Income 31

3. GDP and Economic Well-Being

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…

 GDP is the main indicator of a country’s economic

well-being, even though it is not perfect.
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Chapter 23- Measuring a Nation’s Income

II. Other Measures of Output

1. Gross National Product (GNP)

GNP is the total income earned by a nation’s permanent
resident

GDP GNP

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 Measuring a Nation’s Income

II. Other Measures of Output

NFA (net foreign assets) = the total value of a country’s foreign assets
1. Gross National Product (GNP) minus the total value of assets within a country that are owned by
foreigners
GNP is the total income earned by a nation’s permanent
resident

GNP = GDP + factor payment from abroad

– factor payment to abroad
= GDP + net factor payment from abroad (NFA)

Chapter 23- Measuring a Nation’s Income 34

NOW YOU TRY:

Discussion Question

In our country,
which would you
want to be bigger,
GDP or GNP?

Why?

Chapter 23- Measuring a Nation’s Income 35

2. Net National Product (NNP)

NNP = GNP – De
3. National Income (NI or Y)
NI =Y= NNP – Ti
4. Disposable Income (Yd)
Yd = NI – net personal taxes = NI - T

Chapter 23- Measuring a Nation’s Income 36

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 Measuring a Nation’s Income

CHAPTER 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.
• GNP is more appropriate to measure total income of
citizens 37

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