Lecture 1: Measuring a Nation’s income

1
N. Gregory Mankiw

Principles of
Macroeconomics Sixth Edition

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Measuring a Nation’s
Income Premium
PowerPoint
Slides by
Ron Cronovich
2012 UPDATE
The Wealth of Nations and Economic Growth

https://mru.org/courses/principles-economics-macr
oeconomics/gdp-per-capita-purchasing-power-pari
ty-example

 What are the main keys take away from this video?
 What concepts do you need to know to understand the
contents of this video?
 What are you sceptical of the contents of the video?
3
 In this lecture, look for the answers to the
following questions:

• What is Gross Domestic Product (GDP)?

• How to measure GDP?
• How is GDP related to a nation’s total income and
spending?
• What are the components of GDP?
• How is GDP corrected for inflation?
• Does GDP measure society’s well-being?
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Recap: What is economics?

 Microeconomics?
 Macroeconomics?

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6
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.

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Briefly explain whether each of the following is primarily a
microeconomic issue or a macroeconomic issue.

1. The effect of higher cigarette taxes 1. The effect of higher cigarette taxes
on the quantity of cigarettes sold. on the quantity of cigarettes sold
<= Micro
2. The effect of higher income taxes
on the total amount of consumer 2. The effect of higher income taxes
spending. on the total amount of consumer
spending <= Macro
3. The reasons for the economies of
East Asian countries growing faster 3. The reasons for the economies of
than the economies of sub-Saharan East Asian countries growing faster
African countries. than the economies of sub-Saharan
African countries. <= Macro
4. The reasons for low rates of profit
in the airline industry. 4. The reasons for low rates of profit
in the airline industry. <= Micro

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Watch this video

 https://mru.org/courses/principles-economics-ma
croeconomics/gross-domestic-product-definition-
what-is-gdp

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Gross Domestic Product
 Definition: GDP is the market value of all final goods and services
produced within an economy in a given period of time.

 There are three ways to view this statistic:

i. is as the total income of everyone in the economy (income method)
ii. is as the total expenditure on the economy’s output of goods and
services (expenditure method).
iii. is as the total value added made by firms involved in the production
process of goods and services (production method).

 To calculate the value added, we need to distinguish: intermediate goods vs

final goods

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Is milk the intermediate or final goods?

Page 11 11
Is milk the intermediate or final goods?

Page 12 12
Gross Domestic Product
 Definition: GDP is the market value of all final goods and services
produced within an economy in a given period of time.

 There are three ways to view this statistic:

i. is as the total income of everyone in the economy (income method)
ii. is as the total expenditure on the economy’s output of goods and
services (expenditure method).

iii. is as the total value added made by firms involved in the production
process of goods and services (production method).

13
Why does Income equal Expenditure?

 Gross Domestic Product (GDP) measures

total income of everyone in the economy.
 GDP also measures total expenditure on the
economy’s output of good and services

For the economy as a whole,

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

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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).

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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 16
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)
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What This Diagram Omits
Revenue (=GDP) Markets for Spending (=GDP)
Goods &
G&S Services G&S
sold bought

Firms Households

Factors of Labor, land,

production capital
Markets for
Factors of
Production Income (=GDP)
Wages, rent,
profit (=GDP)

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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

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Including the Government

20

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A more realistic economy: 4 sectors and 3 markets

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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.)
 Things that don’t have a market value are
excluded, e.g., housework you do for yourself.

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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.
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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).

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George and John, stranded on an
island, use clamshells for money.

Last year George caught 300 fish

and 5 wild boars. John grew 200
bunches of bananas. In the two-
person economy that George and
John set up, fish sell for 1 clamshell
each, boars sell for 10 clamshells
each, and bananas go for 5
clamshells per bunch.

George paid John a total of 30

clamshells for helping him to dig
bait for fishing, and he also
purchased five of John’s mature
banana trees for 30 clamshells
each.

What is the GDP of George’s and

John’s island in terms of
clamshells?
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 GDP is the market value of production and
is equal to:

= (300 fish × 1 clamshell per

fish)
+ (5 boars × 10 clamshells per
boar)
+ (200 bunches of bananas × 5
clamshells per bunch of bananas)
= 300 + 50 + 1,000 = 1,350.

• John digging bait for George represents

an intermediate service that is not
counted in GDP.
• Similarly, George’s purchase of mature
banana trees does not count in GDP
since the trees are an existing asset.

Page 2626
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.

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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.

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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)

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Interactive practise

https://mru.org/courses/principles-economics-micr
oeconomics/whats-included-gdp/interactive-practic
e

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 Measuring GDP
 Definition: GDP is the market value of all final goods and services
produced within an economy in a given period of time.

 Three alternative approaches to measure GDP:

1. expenditure method: GDP = C+ I + G + X - M.

 C: Household consumption
 I: Investment
 G: Government expenditure
 X: Exports
 M: Imports
2. income method: GDP = wage + rent + profit +
interest
3. production method: GDP = the total sum of the value
added added by every firms

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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

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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.

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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.
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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.

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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

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 Measuring GDP
 Definition: GDP is the market value of all final goods and services produced within an
economy in a given period of time.

 Three alternative approaches to measure GDP:

1. expenditure method: GDP = C+ I + G + X - M.

 C: Household consumption
 I: Investment
 G: Government expenditure
 X: Exports
 M: Imports
2. income method: GDP = wage + rent+ profit+interest
3. production method: GDP = the total sum of the value added by every firms

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Splitting GDP

https://mru.org/courses/principles-economics-macr
oeconomics/gdp-national-spending-factor-income-
approach

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 Measuring GDP
 Definition: GDP is the market value of all final goods and services produced within an
economy in a given period of time.

 Three alternative approaches to measure GDP:

1. expenditure method: GDP = C+ I + G + X - M.

 C: Household consumption
 I: Investment
 G: Government expenditure
 X: Exports
 M: Imports
2. income method: GDP = wage + rent+ profit+interest
3. production method: GDP = the total sum of the value added by every firms

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 Example: value added

Coffee shop: $50

Coffee beans:
Milk: $10 Cups: $5
$20

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 Example: value added

Coffee shop: $50

VA4=$50-($10+$20+
$5)=$15

Milk: $10 Coffee beans: $20 Cups: $5

VA1=$10 VA2=$20 VA3 = $5

Total VA=VA1+VA2+VA3+VA4=$50 Total consumption = $50 Total income = $50

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Practice questions

https://mru.org/practice-questions/splitting-gdp-pra
ctice-questions

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 ACTIVE LEARNING 1
GDP and its components

In each of the following cases, determine how much

GDP and each of its components is affected (if at all).
A. Debbie spends $200 to buy her husband dinner
at the finest restaurant in Boston.
B. Sarah spends $1800 on a new laptop to use in her
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.
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 ACTIVE LEARNING 1
Answers

A. Debbie spends $200 to buy her husband dinner

at the finest restaurant in Boston.
Consumption and GDP rise by $200.

B. Sarah spends $1800 on a new laptop to use in

her publishing business. The laptop was built in
China.
Investment rises by $1800, net exports fall
by $1800, GDP is unchanged.

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 ACTIVE LEARNING 1
Answers

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.
Current GDP and investment do not change,
because the computer was built last year.

D. General Motors builds $500 million worth of cars,

but consumers only buy $470 million of them.
Consumption rises by $470 million,
inventory investment rises by $30 million,
and GDP rises by $500 million.
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Real vs Nominal GDP

https://mru.org/courses/principles-economics-macr
oeconomics/real-versus-nominal-gdp

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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

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Real vs Nominal value

 Base year: 2022: 50 cups, P=$5,

 Nominal Income: 50x5=$250 (Nominal value)
 Real value = nominal value = $250
 Current year: 2023: 50 cups, P=$6,
 Nominal Income: 50x6=$300 (Nominal value)
 Real value = 50 x 5 (base year price) = $250
 Economic growth = 0% (based on the real values)

 Nominal growth rate: (300-250)/250 =

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Practise questions

https://mru.org/practice-questions/nominal-vs-real-
gdp-practice-questions

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The nation of Potchatoonie produces hockey pucks, cases of root beer, and sandals. The
following table provides data on prices and quantities of the three goods in the years 2014 and
2017.

Assume that 2014 is the base year. Find nominal GDP and real GDP for both years.

Pucks Root beer Sandals

Year Quantit Price Quantit Price Quantit Price

y y y
2014 100 $5 300 $20 100 $20

2017 125 $7 250 $20 110 $25

Page 5050
Assume that 2014 is the base year. Find nominal GDP and real GDP for both years.

Pucks Root beer Sandals

Year Quantity Price Quantity Price Quantity Price

2014 100 $5 300 $20 100 $20

2017 125 $7 250 $20 110 $25

For the year 2014:

Nominal GDP = (100 pucks × $5 per puck) + (300 cases of root beer × $20 per case) + (100 pairs of sandals ×
$20 per pair)
Nominal GDP = $8,500.
Real GDP (using prices from 2014) = $8,500.

** Notice that nominal GDP and real GDP are always the same for the base year.

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Question 6: Assume that 2014 is the base year. Find nominal GDP and real GDP for both years.

Pucks Root beer Sandals

Year Quantity Price Quantity Price Quantity Price
2014 100 $5 300 $20 100 $20
2017 125 $7 250 $20 110 $25

For the year 2017:

Nominal GDP = (125 pucks × $7 per puck) + (250 cases of root beer × $20 per case) + (110
pairs of sandals × $25 per pair)
Nominal GDP = $8,625.

Real GDP (using prices from 2014) = (125 pucks × $5 per puck) + (250 cases of root beer ×
$20 per case) + (110 pairs of sandals × $20 per pair)
Real GDP (using prices from 2014) = $7,825.
Nominal GDP rose from 2014 to 2017, but real GDP actually fell during the same period as
the value of the reduced root beer production was greater than the value of the increased pucks
and sandal production.

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 Nominal and Real GDP in the U.S.,
1965–2012
$16,000

$14,000

$12,000

Real GDP
billions

$10,000
(base year
$8,000 2005)

$6,000

$4,000
Nominal
GDP
$2,000

$0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
questions

 Why real GDP is smaller than  Real GDP is often smaller than nominal
nominal GDP? GDP because nominal GDP measures the
total value of goods and services
produced within an economy at current
market prices, while real GDP adjusts for
inflation or deflation, providing a more
accurate reflection of an economy's
 Why real GDP is larger than output over time.

nominal GDP?  So, if real GDP were larger than nominal

GDP, it would imply that prices have
decreased over time (deflation), which is
relatively uncommon in most economies.
In most cases, nominal GDP is larger than
real GDP due to the presence of inflation,
which inflates the prices of goods and
services over time, making nominal GDP
higher.
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The GDP Deflator
 The GDP deflator is a measure of the overall
level of prices.
 Definition:

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.

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EXAMPLE:
Nominal Real GDP
year GDP GDP Deflator
2011 $6000 $6000 100.0
14.6%
2012 $8250 $7200 114.6
2013 $10,800 $8400 12.2%
128.6

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

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 ACTIVE LEARNING 2
Computing GDP

2011 (base yr) 2012 2013

P Q P Q P Q
Good A $30 900 $31 1000 $36 1050
Good B $100 192 $102 200 $100 205

Use the above data to solve these problems:

A. Compute nominal GDP in 2011.
B. Compute real GDP in 2012.
C. Compute the GDP deflator in 2013.

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 ACTIVE LEARNING 2
Answers

2011 (base yr) 2012 2013

P Q P Q P Q
Good A $30 900 $31 1,000 $36 1050
Good B $100 192 $102 200 $100 205

A. Compute nominal GDP in 2011.

$30 x 900 + $100 x 192 = $46,200

B. Compute real GDP in 2012.

$30 x 1000 + $100 x 200 = $50,000
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 ACTIVE LEARNING 2
Answers

2011 (base yr) 2012 2013

P Q P Q P Q
Good A $30 900 $31 1,000 $36 1050
Good B $100 192 $102 200 $100 205

C. Compute the GDP deflator in 2013.

Nom GDP = $36 x 1050 + $100 x 205 = $58,300
Real GDP = $30 x 1050 + $100 x 205 = $52,000
GDP deflator = 100 x (Nom GDP)/(Real GDP)
= 100 x ($58,300)/($52,000) = 112.1
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Limitations of GDP

https://www.youtube.com/watch?v=yOHPrlaWks4

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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.
 Robert Kennedy issued a very eloquent
yet harsh criticism of GDP:

61
Gross Domestic Product…
“… does not allow for the health of our
children, the quality of their education,
or the joy of their play. It does not
include the beauty of our poetry or
the strength of our marriages, the
intelligence of our public debate or
the integrity of our public officials.
It measures neither our courage, nor our wisdom,
nor our devotion to our country. It measures everything,
in short, except that which makes life worthwhile, and it
can tell us everything about America except why we are
proud that we are Americans.”
- Senator Robert Kennedy, 1968
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

63
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…

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GDP and Life Expectancy in 12 countries

Indonesia
Japan
China
Life expectancy (years)

U.S.
Mexico Germany
Brazil
Pakistan
Russia
India
Bangladesh

Nigeria

Real GDP per capita 65

 GDP and Literacy in 12 countries
China Russia U.S.
Germany Japan
Mexico
(% of population)

Brazil
Adult Literacy

Indonesia

Nigeria

India

Pakistan

Bangladesh

Real GDP per capita 66

 GDP and Internet Usage in 12 countries

Japan
U.S.
(% of population)
Internet Usage

Germany

Brazil
Indonesia
Mexico
Pakistan
Russia
China
Nigeria India

Bangladesh Real GDP per capita 67

 GDP per capita 2020 (2020 USD

Source: OECD National Accounts Database (2021); World Bank (2021), World Development Indicators.

68
 S U M M A RY

• 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.
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.