Measuring a

NatioN’s
Income
Micro vs. Macro
▪ Microeconomics:
The study of how individual households and firms make decisions,
interact with one another in markets.
▪ Macroeconomics:
The study of the economy as a whole.
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 dollar a buyer spends
is a dollar of income for the seller.
The Circular-Flow Diagram
▪ a simple depiction of the macroeconomy
▪ illustrates GDP as spending, revenue,
factor payments, and income
▪ Preliminaries:
▪ Factors of production are inputs like labor, land, capital, and
natural resources.
▪ Factor payments are payments to the factors of production (e.g.,
wages, rent).
The Circular-Flow Diagram

Households:
▪ own the factors of production,
sell/rent them to firms for income
▪ buy and consume goods & services

Firms Households

Firms:
▪ buy/hire factors of production,
use them to produce goods
and services
▪ sell goods & services
The 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)
What This Diagram Omits
▪ The government
▪ collects taxes, buys g&s
▪ The financial system
▪ matches savers’ supply of funds with borrowers’ demand for loans
▪ The foreign sector
▪ trades g&s, financial assets, and currencies with the country’s
residents.
Government in the circular flow
I
C+I+G C + I + G - Te
C
S G
Te

Households Government Firms

B - Td
Y + B - Td Y

8
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

Goods are valued at their market prices, so:

▪ All goods measured in the same units
(e.g., dollars in the U.S. or rupees in India)
▪ Things that don’t have a market value are
excluded, e.g., housework you do for yourself.
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

Final goods: intended for the end user

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.
Exception: When an intermediate good is produced and, rather than
being used, is added to the firm’s inventory for use or sale at a later date,
the IG is taken to be “final” for the moment and its value as inventory
investment is included as part of GDP.
Thus additions to inventory add to GDP, and when the goods in inventory
are later used or sold, the reductions in inventory subtract from GDP.

11
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

GDP includes tangible goods

(like DVDs, mountain bikes, beer)
and intangible services
(dry cleaning, concerts, cell phone service).
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

GDP includes currently produced goods,

not goods produced in the past.
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

GDP measures the value of production that occurs

within a country’s borders, whether done by its own
citizens or by foreigners located there.
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

Usually a year or a quarter (3 months)

The Components of GDP
▪ Recall: GDP is total spending.
▪ Four components:
▪ Consumption (C)
▪ Investment (I)
▪ Government Purchases (G)
▪ Net Exports (NX)
▪ These components add up to GDP (denoted Y):

Y = C + I + G + NX
Consumption (C)
▪ is total spending by households on g&s.
▪ 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.
Investment (I)
▪ is total spending on goods that will be used in the future to
produce more goods.
▪ includes spending on
▪ capital equipment (e.g., machines, tools)
▪ structures (factories, office buildings, houses)
▪ inventories (goods produced but not yet sold)

Note: “Investment” does not

mean the purchase of financial
assets like stocks and bonds.
Government Purchases (G)
▪ is all spending on the g&s purchased by govt
at the federal, state, and local levels.
▪ G excludes transfer payments, such as
Social Security or unemployment insurance benefits.
They are not purchases of g&s.
Net Exports (NX)
▪ NX = exports – imports
▪ Exports represent foreign spending on the economy’s g&s.
▪ Imports are the portions of C, I, and G
that are spent on g&s produced abroad.
▪ Adding up all the components of GDP gives:

Y = C + I + G + NX
Real versus Nominal GDP
▪ Inflation can distort economic variables like GDP, so we have two
versions of GDP:
▪ Nominal GDP
▪ values output using current prices
▪ not corrected for inflation
▪ Real GDP
▪ values output using the prices of a base year
▪ is corrected for inflation
EXAMPLE:
Pizza Latte
year P Q P Q
2011 $10 400 $2.00 1000
2012 $11 500 $2.50 1100
2013 $12 600 $3.00 1200

Compute nominal GDP in each year:

Increase:
2011: $10 x 400 + $2 x 1000 = $6,000
37.5%
2012: $11 x 500 + $2.50 x 1100 = $8,250
30.9%
2013: $12 x 600 + $3 x 1200 = $10,800
EXAMPLE:
Pizza Latte
year P Q P Q
2011 $10 400 $2.00 1000
2012 $11 500 $2.50 1100
2013 $12 600 $3.00 1200

Compute real GDP in each year,

using 2011 as the base year: Increase:
2011: $10 x 400 + $2 x 1000 = $6,000
20.0%
2012: $10 x 500 + $2 x 1100 = $7,200
16.7%
2013: $10 x 600 + $2 x 1200 = $8,400
EXAMPLE:
Nominal Real
year GDP GDP
2011 $6000 $6000
2012 $8250 $7200
2013 $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 (2011 in this example).
EXAMPLE:
Nominal Real
year GDP GDP
2011 $6000 $6000
37.5% 20.0%
2012 $8250 $7200
2013 $10,800 30.9% $8400 16.7%

▪ The change in nominal GDP reflects both prices

and quantities.
▪ The change in real GDP is the amount that
GDP would change if prices were constant
(i.e., if zero inflation).
Hence, real GDP is corrected for inflation.
The GDP Deflator
▪ Also known as GDP price deflator or the implicit price deflator,
measures the changes in prices for all the G&S produced in an
economy.
▪ Formula:
nominal GDP
GDP deflator = 100 x
real GDP

▪ One way to measure the economy’s inflation

rate is to compute the percentage increase in
the GDP deflator from one year to the next.
EXAMPLE:
Nominal Real GDP
year GDP GDP Deflator
2011 $6000 $6000 100.0
14.6%
2012 $8250 $7200 114.6
2013 $10,800 $8400 128.6
12.2%

Compute the GDP deflator in each year:

2011: 100 x (6000/6000) = 100.0

2012: 100 x (8250/7200) = 114.6

2013: 100 x (10,800/8400) = 128.6

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.
GDP Does Not Value:
▪ the quality of the environment
▪ leisure time
▪ non-market activity, such as the child care
a parent provides at home
▪ an equitable distribution of income
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 and Life Expectancy in 12 countries
90

Bangladesh China Japan

Life expectancy (years)

80 U.S.
Mexico
Brazil Germany
70 Russia
Indonesia
India
60
Pakistan

50 Nigeria

40
$0 $10,000 $20,000 $30,000 $40,000 $50,000
Real GDP per person
GDP and Average Schooling in 12 countries
14
Germany
Japan
12 U.S.
Average years of school
Russia
10 China
Mexico
8
Brazil
6 Indonesia

4
India

2
$0 $10,000 $20,000 $30,000 $40,000 $50,000
Real GDP per person
 GDP and Water Quality in 12 countries
100%
Indonesia Germany

Satisfaction with water quality

90% Bangladesh U.S.
Japan
(% of population) Brazil
80%

China
70%
Mexico
India
60%
Pakistan Russia
50%
Nigeria

40%
$0 $10,000 $20,000 $30,000 $40,000 $50,000
Real GDP per person
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.