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Measuring a Nations Income
(Chapter 23)



Lecture 15
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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?
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Microeconomics vs. Macroeconomics
Microeconomics:
The study of how individual households and firms make decisions,
interact with one another in markets.
Macroeconomics:
The study of the aggregates in the economy.
Macroeconomics answers questions like the following:
Why is average income high in some countries and low in
others?
Why do prices rise rapidly in some time periods while they are
more stable in others?
Why do production and employment expand in some years and
contract in others?

Three of the major concerns of macroeconomics are:
Inflation
Output growth
Unemployment
We begin our study of macroeconomics with the countrys total
income and expenditure.
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Much of the
framework of modern
macroeconomics
comes from the
works of John
Maynard Keynes,
whose General
Theory of
Employment, Interest
and Money was
published in 1936.
John Maynard Keynes
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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 goods and services.
For the economy as a whole,
income equals expenditure, because
every peso of expenditure by a buyer
is a peso of income for the seller.
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The Circular-Flow Diagram
is a simple depiction of the macroeconomy.
illustrates GDP as spending, revenue,
factor payments, and income.
Some 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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Figure 1 The Circular-Flow Diagram
Spending
Goods and
services
bought
Revenue
Goods
and services
sold
Labor, land,
and capital
Income
= Flow of inputs
and outputs
= Flow of dollars
Factors of
production
Wages, rent,
and profit




FIRMS
Produce and sell
goods and services
Hire and use factors
of production




Buy and consume
goods and services
Own and sell factors
of production
HOUSEHOLDS


Households sell
Firms buy
MARKETS
FOR
FACTORS OF PRODUCTION


Firms sell
Households buy
MARKETS
FOR
GOODS AND SERVICES
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THE COMPONENTS OF THE MACROECONOMY
FIGURE 2 The Circular Flow of Payments
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What this Diagram Indicates
The government
collects taxes
purchases 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
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the market value of all final goods &
services produced within a country
in a given period of time.
Gross Domestic Product (GDP) Is
Goods are valued at their market prices, so:
GDP measures all goods using the same units (e.g.,
dollars in the U.S., pesos in the Philippines), rather than
adding apples to oranges.
Things that dont have a market value are excluded,
e.g., housework you do for yourself.
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the market value of all final goods &
services produced within a country
in a given period of time.
Gross Domestic Product (GDP) Is
Final goods are intended for the end user,
produced for final use.
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.
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GROSS DOMESTIC PRODUCT
Tires taken from that pile and mounted on the wheels of the new
car before it is sold are considered intermediate goods to the auto
producer. Tires from that pile to replace tires on your old car are
considered final goods. If, in calculating GDP, we included the
value of the tires (an intermediate good) on new cars and the
value of new cars (including the tires), we would be double
counting.
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GROSS DOMESTIC PRODUCT
In calculating GDP, we can either sum up the value added at each
stage of production or we can take the value of final sales. We do not
use the value of total sales in an economy to measure how much
output has been produced.
TABLE 23.1 Value Added in the Production of a Gallon of Gasoline
(Hypothetical Numbers)
STAGE OF PRODUCTION VALUE OF SALES VALUE ADDED
(1) Oil drilling P 100.00 P 100.00
(2) Refining 130.00 30.00
(3) Shipping 160.00 30.00
(4) Retail sale 200.00 40.00
Total value added P 200.00
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the market value of all final goods &
services produced within a country
in a given period of time.
Gross Domestic Product (GDP) Is
GDP includes tangible goods
(like DVDs, mountain bikes, books)
and intangible services
(dry cleaning, concerts, cell phone service).
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the market value of all final goods &
services produced within a country
in a given period of time.
Gross Domestic Product (GDP) Is
GDP includes currently produced goods,
not goods produced in the past.
GDP is concerned only with new or current
production
EXCLUSION OF USED GOODS AND PAPER TRANSACTIONS
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the market value of all final goods &
services produced within a country
in a given period of time.
Gross Domestic Product (GDP) Is
GDP measures the value of production that occurs
within a countrys borders, whether done by its own
citizens or by foreigners located there.
EXCLUSION OF OUTPUT PRODUCED ABROAD BY
DOMESTICALLY OWNED FACTORS OF PRODUCTION
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the market value of all final goods &
services produced within a country
in a given period of time.
Gross Domestic Product (GDP) Is
usually a year or a quarter (3 months).
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CALCULATING GDP
Expenditure approach: a method of
computing GDP that measures the amount
spent on all final goods 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.
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CALCULATING GDP
THE EXPENDITURE APPROACH
There are four main categories of expenditure:
Expenditure Categories:
Personal consumption expenditures (C): household
spending on consumer goods
Gross private domestic investment (I): spending by firms
and households on new capital, i.e., plant, equipment,
inventory, and new residential structures
Government consumption and gross investment (G)
Net exports (NX): net spending by the rest of the world, or
exports (X) minus imports (M)
GDP = C + I + G + NX
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Consumption (C)
is total spending by households on goods &
services.
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 goods & services
purchased by govt at the national and local
levels.
G excludes transfer payments, such as
Social Security, or pension benefits or
scholarships.
These payments represent transfers of income,
not purchases of goods & services .
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Net Exports (NX)
NX = exports imports
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 = C + I + G + NX
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In each of the following cases, determine how much GDP
and each of its components is affected (if at all).
A. Debbie spends P2000 to buy her friend dinner
at the finest restaurant in Makati.
B. Sarah spends P18,000 on a new laptop to use in her
publishing business. The laptop was built in China.
C. Jane spends P12,000 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 P500 million worth of cars,
but consumers only buy P470 million worth of them.

GDP and its components
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A. Debbie spends P2000 to buy her friend dinner
at the finest restaurant in Makati.
Consumption and GDP rise by P2000.
B. Sarah spends P18,000 on a new laptop to use in
her publishing business. The laptop was built in
China.
Investment rises by P18,000, net exports fall
by P18,000, GDP is unchanged.

Answers
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C. Jane spends P12000 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 P500 million worth of cars,
but consumers only buy P470 million of them.
Consumption rises by P470 million,
inventory investment rises by P30 million,
and GDP rises by P500 million.

Answers
26 27
2010: Turning Point For Private
Domestic Investment
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CALCULATING GDP
GDP by sector (sectoral approach):
Agriculture: activities primarily undertaken in the
rural areas extracting production from land and
other natural resources (i.e., rice production)
Industry: activities primarily undertaken in the
urban areas that utilize machinery and
mechanized tools (I.e., food production)
Services: activities primarily undertaken that
utilize labor of professionals and workers (i.e.,
hotels)
GDP
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1
st
Half 2013: Industrial Vigor
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TABLE 21.3 National Income, 2009
Billions of
Dollars
Percentage of
National Income
National income 12,280.
0
100.
0
Compensation of employees 7,783.5 63.4
Proprietors income 1,041.0 8.5
Rental income 268.1 2.2
Corporate profits 1,308.9 10.7
Net interest 788.2 6.4
Indirect taxes minus subsidies 964.3 7.9
Net business transfer payments 134.1 1.1
Surplus of government enterprises -8.1 -0.1
Calculating GDP
The Income Approach
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Income Approach
Net national product (NNP) Gross national product minus
depreciation; a nations total product minus what is required
to maintain the value of its capital stock.
National income NNP minus statistical discrepancy.
Personal income The total income of households before
paying personal income taxes.
Disposable personal income or after-tax income Personal
income minus personal income taxes. The amount that
households have to spend or save.
Personal saving The amount of disposable income that is left
after total personal spending in a given period.
Personal saving rate The percentage of disposable personal
income that is saved. If the personal saving rate is low,
households are spending a large amount relative to their
incomes; if it is high, households are spending cautiously
Statistical discrepancy Data measurement error
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TABLE 21.4 GDP, GNP, NNP, and National Income, 2009
Dollars
(Billions)
GDP 14,256.3
Plus: Receipts of factor income from the rest of the world +589.4
Less: Payments of factor income to the rest of the world -484.5
Equals: GNP 14,361.2
Less: Depreciation -1,864.0
Equals: Net national product (NNP) 12,497.2
Less: Statistical discrepancy -217.3
Equals: National income 12,280.0
Calculating GDP
The Income Approach
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TABLE 21.5 National Income, Personal Income, Disposable Personal
Income, and Personal Saving, 2009
Dollars
(Billions)
National income 12,280.0
Less: Amount of national income not going to households -261.0
Equals: Personal income 12,019.0
Less: Personal income taxes -1,101.7
Equals: Disposable personal income 10,917.3
Less: Personal consumption expenditures -10,089.1
Personal interest payments -213.9
Transfer payments made by households -155.7
Equals: Personal saving 458.6
Personal saving as a percentage of disposable personal
income:
4.2%
Calculating GDP
The Income Approach
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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.
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EXAMPLE:
Compute nominal GDP in each year:
2011: P10 x 400 + P2 x 1000 = P6,000
2012: P11 x 500 + P2.50 x 1100 = P8,250
2013: P12 x 600 + P3 x 1200 = P10,800
Pizza Chocolatte
year P Q P Q
2011 P10 400 P2.00 1000
2012 P11 500 P2.50 1100
2013 P12 600 P3.00 1200
37.5%
Increase:
30.9%
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EXAMPLE:
Compute real GDP in each year,
using 2011 as the base year:
Pizza Chocolatte
year P Q P Q
2011 $10 400 $2.00 1000
2012 P11 500 P2.50 1100
2013 P12 600 P3.00 1200
20.0%
Increase:
16.7%
P10 P2.00
2011: P10 x 400 + P2 x 1000 = P6,000
2012: P10 x 500 + P2 x 1100 = P7,200
2013: P10 x 600 + P2 x 1200 = P8,400
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EXAMPLE:
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).
year
Nominal
GDP
Real
GDP
2011 P6000 P6000
2012 P8250 P7200
2013 P10,800 P8400
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EXAMPLE:
The change in nominal GDP reflects both prices
and quantities.
year
Nominal
GDP
Real
GDP
2011 P6000 P6000
2012 P8250 P7200
2013 P10,800 P8400
20.0%
16.7%
37.5%
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.
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The GDP Deflator
The GDP deflator is a measure of the overall
level of prices.
Definition:
One way to measure the economys inflation
rate is to compute the percentage increase in
the GDP deflator from one year to the next.
GDP deflator = 100 x
nominal GDP
real GDP
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EXAMPLE:
Compute the GDP deflator in each year:
year
Nominal
GDP
Real
GDP
GDP
Deflator
2011 P6000 P6000
2012 P8250 P7200
2013 P10,800 P8400
2011: 100 x (6000/6000) = 100.0
100.0
2012: 100 x (8250/7200) = 114.6
114.6
2013: 100 x (10,800/8400) = 128.6
128.6
14.6%
12.2%
A C T I V E L E A R N I N G :
Computing GDP
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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.
2011 (base yr) 2012 2013
P Q P Q P Q
good A P30 900 P31 1,000 P36 1050
good B P100 192 P102 200 P100 205
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A C T I V E L E A R N I N G :
Answers
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A. Compute nominal GDP in 2011.
P30 x 900 + P100 x 192 = P46,200
B. Compute real GDP in 2012.
P30 x 1000 + P100 x 200 = P50,000
2011 (base yr) 2012 2013
P Q P Q P Q
good A P30 900 P31 1,000 P36 1050
good B P100 192 P102 200 P100 205
A C T I V E L E A R N I N G 2:
Answers
44
C. Compute the GDP deflator in 2012.
Nom GDP = P36 x 1050 + P100 x 205 = P58,300
Real GDP = P30 x 1050 + P100 x 205 = P52,000
GDP deflator = 100 x (Nom GDP)/(Real GDP)
= 100 x (P58,300)/(P52,000) = 112.1
2011 (base yr) 2012 2013
P Q P Q P Q
good A P30 900 P31 1,000 P36 1050
good B P100 192 P102 200 P100 205
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GDP and Economic Well-Being
Real GDP per capita is the main indicator of
the average persons standard of living.
But GDP is not a perfect measure of
well-being.
Robert Kennedy issued a very eloquent
yet harsh criticism of GDP:

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
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LIMITATIONS OF THE GDP CONCEPT
GDP AND SOCIAL WELFARE
Society is better off when crime decreases; however, a
decrease in crime is not reflected in GDP.
An increase in leisure is an increase in social welfare,
but not counted in GDP.
Nonmarket and household activities are not counted in
GDP even though they amount to real productio such as
the child care a parent provides his or her child at home.
GDP does not value the quality of the environment and
an equitable distribution of income.
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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
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Real GDP per capita, 2008
U.S.
Germany
Japan
Mexico
Russia
Brazil
China
India
Indonesia
Pakistan
Bangladesh
Nigeria
GDP and Literacy in 12 countries
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Real GDP per capita, 2008
U.S.
Germany
Japan
Mexico
Russia
Brazil
China
India
Indonesia
Nigeria
Pakistan
Bangladesh
GDP and Internet Usage in 12 countries
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Real GDP per capita, 2008
U.S.
Germany
Japan
Mexico
Russia
Brazil
China
India
Indonesia
Nigeria
Bangladesh
Pakistan
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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.