5- Part B

Measuring a Nation’s Income

MACROECONOMICS
You need to
bring a
calculator to
this class!
In this chapter, look for the answers to
these questions:
 What is Gross Domestic Product (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?

CHAPTER 5 PART B MEASURING A NATION’S INCOME 2

 Microeconomics vs.
Macroeconomics
 Microeconomics:
Is the study of how individual households and
firms make decisions, interact with one another
in markets.
 Macroeconomics:
Is the study of the economy as a whole.
 We begin our study of macroeconomics with the
country’s total income and expenditure.

CHAPTER 5 PART B MEASURING A NATION’S INCOME 3

 Income and Expenditure
 Gross Domestic Product (GDP): It measures
total income of everyone in the economy.
 GDP also measures total expenditure on the
economy’s output of goods and services.

For
For the
the economy
economy as as aa whole,
whole,
income
income equals
equals expenditure,
expenditure because
expenditure
expenditure, because
every
every dollar
dollar of
of expenditure
expenditure by by aa buyer
buyer
is
is aa dollar
dollar of
of income
income for
for the
the seller.
seller.

4
 The Circular-Flow Diagram
 It is a simple depiction of the macroeconomy.
 It illustrates GDP as spending, revenue, factor
payments, and income.
 First, recall that:
• Factors of production are inputs like labor,
land, capital, and entrepreneur.
• Factor payments are payments to the factors
of production (e.g., wages, rent).

CHAPTER 5 PART B MEASURING A NATION’S INCOME 5

FIGURE 1: The Circular-Flow Diagram

Households:
Households:
 own
own the
the factors
factors of
of production,
production,
sell/rent
sell/rent them
them to
to firms
firms for
for income
income
 buy
buy and
and consume
consume g&s g&s

Firms Households

6
FIGURE 1: The Circular-Flow Diagram

Firms Households

Firms:
Firms:
 buy/hire
buy/hire factors
factors of
of production,
production,

use
use them
them to
to produce
produce g&s
g&s
 sell
sell g&s
g&s
7
FIGURE 1: 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)
8
 What This Diagram Omits
 The government
• collects taxes
• purchases goods and services (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

9
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:

• GDP measures all goods using the same units

(e.g., dollars in the U.S.), rather than “adding
apples to oranges.”
• Things that don’t have a market value are
excluded, e.g., housework you do for yourself.
10
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 are intended for the end user.

Intermediate goods are used as components

or ingredients in the production of other goods.
GDP only includes final goods, as they already
embody the value of the intermediate goods
used in their production.
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).

12
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.

13
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.

14
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).

15
 The Components of GDP
 Recall: GDP is total spending.
 GDP has four components:
• Consumption (C)
• Investment (I)
• Government Purchases (G)
• Net Exports (NX)
 These components add up to GDP (denoted Y):
Y
Y =
= C
C +
+ II +
+ G
G +
+
NX
NX

16
 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. See the footnotes on the next slide
for more details.

17
 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:
Note: “Investment”
“Investment” does
does not
not
mean
mean the
the purchase
purchase of
of financial
financial
assets
assets like
like stocks
stocks and
and bonds.
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.
These payments represent transfers of income,
not purchases of goods & service.

CHAPTER 5 PART B MEASURING A NATION’S INCOME 19

 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
Y =
= C
C +
+ II +
+ G
G +
+
NX
NX

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U.S. GDP and Its Components, 2005

billions % of GDP per capita

Y $12,480 100.0 $42,035

C 8,746 70.1 29,460

I 2,100 16.8 7,072

G 2,360 18.9 7,950

NX –726 –5.8 –2,444

Source for data on GDP & components: http://www.bea.doc.gov
Students go to the same source for up to date data.
21
A C T I V E L E A R N I N G 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.
22
A C T I V E L E A R N I N G 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.

23
A C T I V E L E A R N I N G 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.
24
 Real versus Nominal GDP
 Inflation can distort economic variables like GDP,
so we have two versions of GDP:
One is corrected for inflation, the other is not.
 Nominal GDP values output using current prices.
Nominal GDP is not corrected for inflation.
 Real GDP values output using the prices of
a base year. Real GDP is corrected for inflation.

25
EXAMPLE: (Assume we are producing only two
goods)
Pizza Latte
year P Q P Q
2002 $10 400 $2.00 1000
2003 $11 500 $2.50 1100
2004 $12 600 $3.00 1200

Compute nominal GDP in each year: % Change:

2002: $10 x 400 + $2 x 1000 = $6,000

37.5%
2003: $11 x 500 + $2.50 x 1100 = $8,250
30.9%
2004: $12 x 600 + $3 x 1200 = $10,800
Note: 30.9% = (10,800 / 8,250) – 1 * 100 26
 Example (Continued)
 In pervious example, nominal GDP grows for
two reasons: prices are rising, and the economy
is producing a larger quantity of goods.
 Thinking of nominal GDP as total income, the
increases in income will overstate the increases
in society’s well-being, because part of these
increases are due to inflation.
 We need a way to take out the effects of
inflation, to see how much people’s incomes are
growing in purchasing power terms. That is the
job of real GDP. For this, see next slide.
27
EXAMPLE (Continued):
Pizza Latte
year P Q P Q
2002 $10$10 400 $2.00
$2.00 1000
2003 $11 500 $2.50 1100
2004 $12 600 $3.00 1200

Compute real GDP in each year,

using 2002 as the base year: % Change:

2002: $10 x 400 + $2 x 1000 = $6,000

20.0%
2003: $10 x 500 + $2 x 1100 = $7,200
16.7%
2004: $10 x 600 + $2 x 1200 = $8,400
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 Example (Continued)
 Previous example shows that real GDP in every
year is constructed using the prices of the base
year, and that the base year doesn’t change.
 The growth rate of real GDP from one year to the
next is the answer to the following question:
 “How much would GDP (and hence everyone’s
income) have grown if there had been zero
inflation?”
 Thus, real GDP is corrected for inflation.

29
EXAMPLE (Continued):
Nominal Real
Summary of
year GDP GDP
Previous Two
2002 $6000 $6000 Slides

2003 $8250 $7200

2004 $10,800 $8400

In each year,
 Nominal GDP is measured using the current
prices.
 Real GDP is measured using constant prices
from the base year (2002 in this example).
30
 Example (Continued)
 Question:
 “How much would GDP (and hence everyone’s
income) have grown if there had been zero
inflation?”
 Again, the growth rate of real GDP from one year
to the next is the answer to this question, and this
is why real GDP is corrected for inflation. See next
slide.

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 Note: 16.7% =
EXAMPLE (Continued): (8,400/7,200) -1 * 100
Nominal % Real
year GDP Change GDP % Change
2002 $6000 $6000
37.5% 20.0%
2003 $8250 $7200
30.9% 16.7
2004 $10,800 $8400
%
 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 there had been zero inflation).

Hence, real GDP is corrected for inflation.

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 Nominal and Real GDP in the U.S.,
1965-2005
Billions
$12,000

$10,000
Real GDP
$8,000 (base year
2000)
$6,000

$4,000
Nominal
$2,000 GDP
$0
1965 1970 1975 1980 1985 1990 1995 2000 2005

See notes to this slide 33

 The GDP Deflator
 The GDP deflator is a measure of the overall
level of prices.
 Definition:
nominal GDP
GDP
GDP deflator 100 xx
deflator == 100
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.

34
EXAMPLE (Continued):
Nominal Real GDP Inflation
year GDP GDP Deflator Rate
2002 $6000 $6000 100.0
14.6%
2003 $8250 $7200 114.6
2004 $10,800 $8400 12.2%
128.6

Compute the GDP deflator in each year: (128.6/114.6) -1 * 100

= 12.2%
2002: 100 x (6000/6000) = 100.0
2003: 100 x (8250/7200) = 114.6

2004: 100 x (10,800/8400) = 128.6

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A C T I V E L E A R N I N G 2:
Computing GDP
2004 (base yr) 2005 2006
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 2004.
B. Compute real GDP in 2005.
C. Compute the GDP deflator in 2006.

36
A C T I V E L E A R N I N G 2:
Answers
2004 (base yr) 2005 2006
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 2004.

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

B. Compute real GDP in 2005.

$30 x 1000 + $100 x 200 = $50,000
37
A C T I V E L E A R N I N G 2:
Answers
2004 (base yr) 2005 2006
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 2006.

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
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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.
 Most economists, policymakers, social scientists,
and businesspersons use a country’s real GDP
per capita as the main indicator of the average
person’s standard of living in that country.
 But GDP is not a perfect measure of well-being.
 Robert Kennedy issued a very eloquent yet harsh
criticism of GDP:

39
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 is not a perfect measure of well-
being
 Much of what Robert Kennedy said about GDP is
correct.
 GDP does not value the quality of the environment.
 GDP does not value leisure time.
 GDP does not value non-market activity, such as
the child care a parent provides his/her child at
home.
 GDP does not value an equitable distribution of
income.
41
 Then Why Do We Care About
GDP?
 Having a large GDP enables a country to afford
better schools, a cleaner environment, health care,
etc.
 In short, GDP does not directly measure those
things that make life worthwhile, but it does
measure our ability to obtain the inputs into a
worthwhile life.
 Many indicators of the quality of life are positively
correlated with GDP. For example…

42
 GDP and Life Expectancy in 12 Countries
90
Life
expectancy 85
Japan
(in years)
80 U.S.
75 Mexico Germany
China
70 Brazil
Indonesia
65 India Russia
60 Pakistan
Bangladesh
55
Nigeria
50
$0 $10,000 $20,000 $30,000 $40,000
Real GDP per capita, 2002
 GDP and Adult Literacy in 12 Countries

Adult 100 Russia

Literacy China Japan U.S.
90 Mexico
(% of Germany
population) 80 Brazil
Indonesia
70 Nigeria
60 India

50
Pakistan
40
Bangladesh
30
$0 $10,000 $20,000 $30,000 $40,000
Real GDP per capita, 2002
 GDP and Internet Usage in 12 Countries
60
Internet
U.S.
Usage
50
(% of
Japan
population)
40 Germany

The lowest-income 30
countries are all
clustered near the 20
origin, so their Mexico
names don’t all fit China
on the graph. 10
Brazil
Russia
0
$0 $10,000 $20,000 $30,000 $40,000
Real GDP per capita, 2002
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.
CHAPTER 5 PART B MEASURING A NATION’S INCOME 46