CHAPTE

23

Measuring a Nations
Income

Economics
N. Gregory
PRINCIPLES OF

Mankiw

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

What is Gross Domestic Product (GDP)?

How is GDP related to a nations total income and
spending?

What are the components of GDP?

How is GDP corrected for inflation?
Does GDP measure societys well-being?

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.

We begin our study of macroeconomics with the

countrys total income and expenditure.

MEASURING A NATIONS INCOME

Income and Expenditure

Gross Domestic Product (GDP) measures
total income of everyone in the economy.

GDP also measures total expenditure on the

economys output of g&s.
For
For the
the economy
economy as
as aa whole,
whole,
income
income equals
equals expenditure
expenditure
because
because every
every dollar
dollar aa buyer
buyer spends
spends
is
is aa dollar
dollar of
of income
income for
for the
the seller.
seller.
MEASURING A NATIONS INCOME

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).

MEASURING A NATIONS INCOME

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 goods
goods &
& services
services
Firms

Households

Firms:
Firms:
buy/hire
buy/hire factors
factors of
of production,
production,
use
use them
them to
to produce
produce goods
goods
and
and services
services
MEASURING
&
sell
A NATIONS
INCOME
sell goods
goods
& services
services

The Circular-Flow Diagram

Revenue (=GDP)
G&S
sold

Markets for
Goods &
Services

Firms
Factors of
production
Wages, rent,
profit (=GDP)

Spending (=GDP)
G&S
bought

Households

Markets for
Factors of
Production

MEASURING A NATIONS INCOME

Labor, land,
capital
Income (=GDP)
7

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 countrys residents

MEASURING A NATIONS INCOME

Gross Domestic Product (GDP)

the market value of all final goods &
Is
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 dont have a market value are

excluded, e.g., housework you do for yourself.
MEASURING A NATIONS INCOME

Gross Domestic Product (GDP)

the market value of all final goods &
Is
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.
MEASURING A NATIONS INCOME

10

Gross Domestic Product (GDP)

the market value of all final goods &
Is
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).

MEASURING A NATIONS INCOME

11

Gross Domestic Product (GDP)

the market value of all final goods &
Is
services produced within a country
in a given period of time.
GDP includes currently produced goods,
not goods produced in the past.

MEASURING A NATIONS INCOME

12

Gross Domestic Product (GDP)

the market value of all final goods &
Is
services produced within a country
in a given period of time.
GDP measures the value of production that occurs
within a countrys borders, whether done by its own
citizens or by foreigners located there.

MEASURING A NATIONS INCOME

13

Gross Domestic Product (GDP)

the market value of all final goods &
Is
services produced within a country
in a given period of time.
Usually a year or a quarter (3 months)

MEASURING A NATIONS INCOME

14

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
Y =
= C
C +
+ II +
+ G
G +
+
NX
NX
MEASURING A NATIONS INCOME

15

GDP
If, Income = Expenditure
And, Income (Y) = Expenditure
GDP base on expenditure is C + I + G + NX
Then Y = C + I + G + NX

MEASURING A NATIONS INCOME

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.

MEASURING A NATIONS INCOME

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.
MEASURING A NATIONS INCOME

18

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.

MEASURING A NATIONS INCOME

19

Net Exports (NX)

NX = exports(X) imports (M)
Exports represent foreign spending on the
economys 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
MEASURING A NATIONS INCOME

20

U.S. GDP and Its Components,

2007
billions

% of GDP

per capita

$13,841

100.0

$45,825

9,734

70.3

32,228

2,125

15.4

7,037

2,690

19.4

8,905

NX

708

5.1

2,344

MEASURING A NATIONS INCOME

21

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 years 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.

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.
23

ACTIVE LEARNING 1

Answers
C. Jane spends $1200 on a computer to use in her
editing business. She got last years 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

Measuring GDP

MEASURING A NATIONS INCOME

25

Calculating GDP

expenditure approach A method of computing

GDP that measures the total amount spent on all
final goods and services during a given period.
income approach A method of computing GDP
that measures the incomewages, rents, interest,
and profitsreceived by all factors of production in
producing final goods and services.
Output approach A method of computing GDP
from the output of each firm or supplier according
to the sectors/industry. Example agriculture,
manufacturing, services

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Calculating GDP
The Expenditure Approach
There are four main categories of expenditure:
Personal consumption expenditures (C):
household spending on consumer goods
Gross private domestic investment (I):
spending by firms and households on new
capital, that is, plant, equipment, inventory,
and new residential structures
Government consumption and gross
investment (G)
Net exports (EX - IM): net spending by the
rest of the world, or exports (EX) minus
imports (IM)
GDP = C + I + G + (EX - IM)
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Calculating GDP
The Expenditure Approach
TABLE 21.2 Components of U.S. GDP, 2007: The Expenditure Approach
Billions Of Dollars
Personal consumption expenditures (C)
Durable goods
Nondurable goods
Services
Gross private domestic investment (l)
Nonresidential
Residential
Change in business inventories
Government consumption and gross
investment (G)
Federal
State and local
Net exports (EX IM)
Exports (EX)
Imports (IM)
Gross domestic product

9,734.2

Percentage of GDP
70.3

1,078.2
2,833.2
5,822.8
2,125.4

7.8
20.5
42.1
15.4

1,481.8
640.7
2.9
2,689.8

10.7
4.6
0.0
19.4

976.0
1,713.8
708.0

7.1
12.4
5.1

1,643.0
2,351.0
13,841.3

11.9
17.0
100.0

Note: Numbers may not add exactly because of rounding.

Source: U.S. Department of Commerce, Bureau of Economic Analysis.

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Calculating GDP
The Income Approach
national income The total income earned by the
factors of production owned by a countrys citizens.

TABLE 21.3 National Income, 2007

National Income
Compensation of employees
Proprietors income
Rental income
Corporate profits
Net interest
Indirect taxes minus subsidies
Net business transfer payments
Surplus of government enterprises

Billions of
Dollars
12,221.1
7,874.2
1,042.6
65.4
1,598.2
602.6
961.4
94.2
14.5

Percentage of
National Income
100.0
64.4
8.5
0.5
13.1
4.9
7.9
0.8
0.1

Source: See Table 6.2.

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Calculating GDP
The Income Approach
compensation of employees Includes wages,
salaries, and various supplementsemployer
contributions to social insurance and pension
funds, for examplepaid to households by firms
and by the government.
proprietors income The income of
unincorporated businesses.
rental income The income received by property
owners in the form of rent.
corporate profits The income of corporations.
net interest The interest paid by business.

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Calculating GDP
The Income Approach
indirect taxes minus subsidies Taxes such as
sales taxes, customs duties, and license fees less
subsidies that the government pays for which it
receives no goods or services in return.
net business transfer payments Net transfer
payments by businesses to others.
surplus of government enterprises Income of
government enterprises.

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Calculating GDP
The Income Approach
TABLE 21.4 GDP, GNP, NNP and National Income, 2007

GDP
Plus: Receipts of factor income from the rest of the world

Dollars
(Billions)
13,841.3
+ 817.5

Less:
Equals:
Less:
Equals:
Less:
Equals:

721.8
13,937.1
1,686.6
12,250.5
29.4
12,221.1

Payments of factor income to the rest of the world

GNP
Depreciation
Net national product (NNP)
Statistical discrepancy
National income

Source: See Table 6.2.

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Output Methods

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Gross National Product

Exclusion of Output Produced Abroad by Domestically Owned Factors
of Production
GDP is the value of output produced by factors of
production located within a country.
gross national product (GNP) The total market
value of all final goods and services produced
within a given period by factors of production
owned by a countrys citizens, regardless of where
the output is produced.
GNP = GDP + foreign capital inflow foreign
capital outflow

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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.

It is not corrected for inflation.

Real GDP values output using the prices of

a base year. Real GDP is corrected for inflation.

MEASURING A NATIONS INCOME

35

Real and Nominal GDP

Year 1 = 500units x $1 = $500
Year 2 = 600 units x $2 = $1200Nominal GDP Y2
Year 2 = 600 units x $1 = $600 Real GDP Y2

Year 1 = 500units x $1 = $500

Year 2 = 500 units x $2 = $1000
(Inflation)

MEASURING A NATIONS INCOME

36

EXAMPLE:
Pizza

Latte

year

2005

$10

400

$2.00

1000

2006

$11

500

$2.50

1100

2007

$12

600

$3.00

1200

Compute nominal GDP in each year:

2005: $10 x 400 +

$2 x 1000

= $6,000

2006: $11 x 500 + $2.50 x 1100 = $8,250

2007: $12 x 600 +

$3 x 1200

MEASURING A NATIONS INCOME

= $10,800

Increase:
37.5%
30.9%
37

EXAMPLE:
Pizza

Latte

year

2005

400
500

$2.00
$2.00
$2.50

1000

2006

$10$10
$11

2007

$12

600

$3.00

1200

Compute real GDP in each year,

using 2005 as the base year:
2005: $10 x 400 + $2 x 1000 = $6,000
2006: $10 x 500 + $2 x 1100 = $7,200
2007: $10 x 600 + $2 x 1200 = $8,400
MEASURING A NATIONS INCOME

1100

Increase:
20.0%
16.7%
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EXAMPLE:
year
2005

Nominal
GDP
$6000

Real
GDP
$6000

2006

$8250

$7200

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).
MEASURING A NATIONS INCOME

39

EXAMPLE:
year
2005

Nominal
GDP
$6000

2006

$8250

37.5%

Real
GDP
$6000
$7200

20.0%

16.7
2007 $10,800
$8400
%
The change in nominal GDP reflects both prices
and quantities.
30.9%

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.
MEASURING A NATIONS INCOME

40

Nominal and Real GDP in the U.S.,

1965-2007

Real GDP
(base year
2000)

Nominal
GDP

41

The GDP Deflator

The GDP deflator is a measure of the overall
level of prices.

Definition:
nominal GDP
GDP
GDP deflator
deflator == 100
100 xx
real GDP

One way to measure the economys inflation

rate is to compute the percentage increase in
the GDP deflator from one year to the next.
MEASURING A NATIONS INCOME

42

EXAMPLE:
year

Nominal
GDP

Real
GDP

GDP
Deflator

2005

$6000

$6000

100.0

2006

$8250

$7200

114.6

2007

$10,800

$8400

128.6

14.6%
12.2%

Compute the GDP deflator in each year:

2005:

100 x (6000/6000) =

100.0

2006:

100 x (8250/7200) =

114.6

2007:

100 x (10,800/8400) =

128.6

MEASURING A NATIONS INCOME

43

ACTIVE LEARNING 2

Computing GDP
2007 (base yr)
P
Good A
Good B

$30
$100

2008
P

2009
Q

900
$31 1,000
192 $102
200

$36
$100

1050
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.
44

ACTIVE LEARNING 2

Answers
2007 (base yr)
P
Good A
Good B

$30
$100

2008
P

2009
Q

900
$31 1,000
192 $102
200

$36
$100

1050
205

A. Compute nominal GDP in 2007.

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

B. Compute real GDP in 2008.

$30 x 1000 + $100 x 200 = $50,000

45

ACTIVE LEARNING 2

Answers
2007 (base yr)
P
Good A
Good B

$30
$100

2008
P

2009
Q

900
$31 1,000
192 $102
200

$36
$100

1050
205

C. Compute the GDP deflator in 2009.

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
46

GDP and Economic Well-Being

Real GDP per capita is the main indicator of the
average persons standard of living.

GDP measures the income and expenditure in

the country

GDP per capita meaures the average income and

expenditure of a person living in the country.

But GDP is not a perfect measure of social

well-being.

Robert Kennedy issued a very eloquent

yet harsh criticism of GDP:
MEASURING A NATIONS INCOME

47

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

48

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

MEASURING A NATIONS INCOME

49

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

MEASURING A NATIONS INCOME

50

Life expectancy (years)

GDP and Life Expectancy in 12

countries
Indonesia
China

Japan

Mexico

U.S.
Germany

Brazil
Pakistan
India

Russia

Bangladesh
Nigeria

Real GDP per capita

51

GDP and Literacy in 12 countries

China

Russia

Adult Literacy
(% of population)

Mexico

Germany

Japan

U.S.

Brazil
Indonesia
Nigeria
India
Pakistan
Bangladesh

Real GDP per capita

52

GDP and Internet Usage in 12

countries

Internet Usage
(% of population)

Japan

Pakista
n
Nigeria

U.S.

Germany

Indonesia

Brazil
Mexico

Russia
China
India

Bangladesh

Real GDP per capita

53

CHAPTER SUMMARY
Gross Domestic Product (GDP) measures a
countrys 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 countrys economic

well-being, even though it is not perfect.

54