Understanding Economics

6th edition
by Mark Lovewell

Copyright 2012 by McGraw-Hill Ryerson

Limited. All rights reserved.

Understanding
Economics
6th edition
by Mark Lovewell

Chapter 8
Measures of Economic Activity
Copyright 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

Learning Objectives
After this chapter you will be able to:
1. explain why economists choose to
concentrate on Gross Domestic Product (GDP)
and the two approaches to calculating it
2. identify real GDP and per capita GDP and their
possible uses and limitations when comparing
living standards in different years or different
countries
3. distinguish other economic measures
developed from the national income accounts

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National Income
Accounts

Canadas national income accounts show the

levels of total income and spending in the
Canadian economy.
Among other measures, these accounts
highlight Gross Domestic Product (GDP).

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Gross Domestic Product

GDP is the total dollar value of all final goods
and services produced in an economy during
a particular period.
GDP is calculated using two approaches:

the income approach

the expenditure approach

The GDP identity states that GDP expressed

as total income is identical to GDP expressed
as total spending.
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Calculating Gross Domestic Product

Figure 8.1, Page 214

Product

Current Price Annual Product Total Dollar Value

(P)
(Q)
(P x Q)

Surgical lasers
Milkshakes

$1000
2

3
1000

$3000
2000
GDP = $5000

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Circular Flow in a Simple Economy

Figure 8.2, Page 215

Income Approach
Economic Resources

Resource Markets
Household Incomes
Businesses

Households
Consumer Spending
Product Markets
Consumer Products
Expenditure Approach

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The Income Approach (a)

The income approach includes four classes of

income:
wages and salaries
corporate profits
interest income
proprietors incomes and rents

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The Income Approach (b)

The income approach also includes three

other categories to balance GDP calculated
with the expenditure approach:
indirect taxes
depreciation
the statistical discrepancy, which is the

difference between the GDP estimates using

the two approaches, with half added to the
lower estimate and half deducted from the
higher estimate

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The Expenditure
Approach

The expenditure approach:

is the sum of purchases in product markets

is based on value added at each production

stage to avoid double counting

excludes financial exchanges and second-hand
purchases

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Value Added in Making

Paper
Figure 8.4, Page 218
Production
Stage
1. Wood is cut and
transported to
paper mill
2. Paper is
processed and
sold to retailer
3. Paper is sold by
retailer to
consumer

Total Value
Paid/Received

Value Added

$1.0
0

$1.00

logging
company

1.75 (2.75
1.00)

paper
company

2.75

Business That
Adds Value

retailer
4.00

1.25 (4.00
2.75)

$7.7
5

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$4.00

Components of the Expenditure

Approach (a)

There are four components of the expenditure

approach.
Personal consumption (C) consists of household

purchases of services and nondurable and

durable goods.
Gross investment (I) represents business and
government purchases of real capital (including
added inventories) and is financed through
retained earnings and personal saving.

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Components of the Income

Approach (b)
Government purchases (G) exclude transfer

payments and are financed through taxes and

borrowing.
Net exports (X-M) equals exports (foreign
purchases of Canadian products) minus imports
(Canadian purchases of foreign products).

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Canadas Gross Domestic Product

(2010)
Figure 8.3, Page 217

Income Approach
($ billions)

Expenditure Approach
($ billions)

Wages and salaries

852.1
Corporate profits
190.6
Interest Income
69.4
Proprietors incomes and rents 106.6
Indirect taxes
173.1
Depreciation
229.1
Statistical discrepancy
0.5

Personal consumption (C)

Gross investment (I)
Government purchases (G)
Net exports (X M)
Statistical Discrepancy

Gross Domestic Product

Gross Domestic Product

1621.5

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941.4
358.7
352.7
29.9
-0.7

1621.5

Gross and Net

Investment

Net investment:

is the annual change in an economys capital

stock
equals gross investment minus depreciation
is positive in a growing economy with an
increasing capital stock
is negative in a declining economy with a
decreasing capital stock

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Net Investment and Capital Stock

Figure 8.5, Page 219

Capital Stock
at Start of Year

Depreciation

Gross
Investment

$200 billion

$40 billion

$100 billion

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Capital Stock
at End of Year
$260 billion

Financial Market Flows

The sources of funds for investment come

from:
businesses retained earnings
personal saving (S)

These are inflows into financial markets, while

investment is an outflow.

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Financial Markets and the Circular flow

Figure 8.6, Page 220
Income

Investment Funds

Businesses

Resource
Markets
Financial
Markets

Income

Saving (S)

Households

Retained Earnings

Investment (I)

Spending

Product
Markets

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Consumption (C)

Government Flows
Financial inflows to government include:
household taxes minus transfer payments
business taxes minus subsidies
government borrowing
Government purchases are a financial outflow

from government.

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Government and the Circular Flow

Figure 8.7, Page 221

Resource
Markets

Income

Income

Financial
Markets
Government Borrowing

Businesses

Business Taxes
Government
(-Subsidies)

Household Taxes
Households
(- Transfer Payments)

Government Purchases (G)

Spending

Product
Markets

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Consumption (C)

Connections with the Rest of the

World
Net exports represent a net inflow into
Canadian product markets.
Lending by foreigners represents an inflow
into Canadian financial markets.
Borrowing by foreigners represents an
outflow from Canadian financial markets.

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The Rest of the World and the Circular

Flow
Figure 8.8, Page 222
Resource
Markets

Income

Income

Financial
Markets
Foreign Lending
(-Foreign Borrowing)
Rest of the
World

Businesses

Export (X)

Spending

Households
Imports (M)

Product
Markets

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Consumption (C)

GDP and Living

Standards

Per capita GDP is GDP per person and equals

GDP divided by population.
Per capita real GDP is:

per capita GDP expressed in constant dollars

from a given year

used to compare living standards in a given
country over time

Per capita GDPs for various countries are

measured in a single currency.
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Limitations of GDP (a)

GDP has limitations as an indicator of living

standards because it does not:
include nonmarket activities and those that

take place in the underground economy

fully capture improvements in product quality
indicate the composition of output
indicate the distribution of income

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Limitations of GDP (b)

indicate how much leisure is enjoyed by a

countrys citizens
distinguish between activities that are and are
not harmful to the environment

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Other Economic
Measures (a)

Gross National Product (GNP):

is the total income acquired by Canadians both

within Canada and elsewhere

equals GDP minus net investment income to
the rest of the world

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Deriving Gross National Product (2010)

Figure 8.9, Page 227

($ billions)
Gross Domestic Product (GDP) 1621.5
Deduct: Net investment income to the rest of the world (-) 27.5
Gross National Product (GNP) 1594.0

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Other Economic
Measures (b)

Disposable Income (DI):

is personal income minus personal taxes and

other personal transfers to government

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Other Income Measures

(2010)
Figure 8.10, Page 228

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Adding the Human Dimension (a)

Mahbub ul Haq was instrumental in devising the

Human Development Index (HDI) published

annually for various countries by the United
Nations Development Programme.
This index is based on per capita GDP adjusted for
purchasing power parity, the average of years of
schooling of the countrys adult citizens, the
expected years of schooling for children of schoolgoing age, and life expectancy at birth.

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The Debate Over the HDI

(a)
There are three main issues with the HDI that

its critics highlight:

The HDI rankings for rich countries are

numerically very close, making it difficult to use

these rankings in any meaningful way.

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The Debate Over the HDI

(b)
Increases in per capita GDP for rich countries

are discounted at higher and higher rates, a

method criticized by some observers.
Life expectancy statistics change very gradually
and are difficult to estimate.
Haq was aware of these suggestions, and
realized that the HDI would be modified over
time.

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Refining the HDI

Each year, the UNDP has been including

adjusted HDIs that highlight income

disparities within countries and disparities
between men and women. Such extensions
are certain to continue.

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Understanding
Economics
6th edition
by Mark Lovewell

Chapter 8
The End
Copyright 2012 by McGraw-Hill Ryerson Limited. All rights reserved.