Measuring a Nation’s Income

The Economy’s Income & Expenditure The Measurement of Gross Domestic

Product (GDP) The Components of GDP Real versus Nominal GDP GDP and Economic Well-Being

The Economy’s Income & Expenditure

GDP measures two things simultaneously: total income in the economy and total expenditure in the economy

Recall that circular flow illustrates value of output = expenditures = income

The Economy’s Income & Expenditure

Leakage: Income earned, but not spent on goods and services

Injection: Expenditures on goods and services that do not come from household sector

The Economy’s Income & Expenditure

In spite of leakages and injections, every transaction has a buyer and seller, so income and expenditure will always be equal

This means we can measure GDP by adding up all expenditures in the economy or by adding up all incomes in the economy

The Measurement of Gross Domestic Product

GDP is the market value of all final goods and services produced within a country in a given time period

The Measurement of Gross Domestic Product

“Market value” implies we will be using prices as the value of goods and services

GDP tries to includes all final goods and services produced– Ignores household production– Ignores underground economy– Intermediate goods are excluded

The Measurement of Gross Domestic Product

GDP includes final goods– Intermediate goods are excluded in order

to avoid double counting

The Measurement of Gross Domestic Product

Money Value

Farmer grows wheat & sells to miller 0.12 0.12

Miller mills wheat & sells to baker 0.28 0.16

Baker converts to bread & sells to store 0.60 0.32

Store sells bread to consumer 0.75 0.15

TOTALS 1.75 0.75

The Measurement of Gross Domestic Product

GDP includes goods produced in the current time period– Used goods are excluded

GDP measures the value of output produced within a nation – This is different from GNP which measures

the value of output produced by a nation’s current residents

The Components of GDP

GDP can be divided into various components– Consumption– Investment– Government purchases– Net exports

The Components of GDP

Consumption is spending by households on goods and services with the exception of new housing Largest component

Investment is spending on capital equipment, inventories, and structures, including household purchases of new housing Least stable component

The Components of GDP

Government purchases is spending on goods and services by state, local, and federal government Excludes transfer payments

Net exports is spending on domestically produced goods by foreigners (exports) minus spending on foreign goods by domestic residents (imports)

The Components of GDP

GDP can be expressed as:

Y = C + I + G + NX This equation is an identity - true by

definition

Real versus Nominal GDP

A change in GDP does not mean that there has been a change in the level of output GDP is P x Q

GDP can change because of a change in price, a change in quantity, or a change in both

Real versus Nominal GDP

Distinguish between nominal and real GDP

Nominal GDP is output valued in current dollars or current prices Can change because of a change in output

or a change in prices

Real versus Nominal GDP

Real GDP is output valued in constant dollars or constant prices (prices of some base period) Can change only because of a change in

output (we are essentially holding prices constant)

Real versus Nominal GDPYear P of Pizza Q of Pizza P of Coke Q of Coke

1999 $1 100 $.50 50

2000 $1.50 175 $.60 75

Nom GDP1999 = (1.00 X 100) + (.5 X 50) = 125.00

Nom GDP2000 = (1.50 X 175) + (.6 X 75) = 307.50

Real GDP1999 = (1.00 X 100) + (.5 x 50) = 125.00

Real GDP2000 = (1.00 X 175) + (.5 X 75) = 212.50

Real versus Nominal GDP The GDP deflator is a measure of the

price level It measures the current level of prices

relative to the base year level of prices The GDP deflator is calculated as the

ratio of nominal GDP to real GDP multiplied by 100

The deflator for the base year will always be 100

Real versus Nominal GDP

The deflator can be use to examine price changes that have occurred since the base year

A GDP deflator of 106.7 means prices are 6.7% higher than in base period

Real versus Nominal GDP

The GDP deflator can be used to calculate changes in prices over some period of time other than the base

Current deflator - Old deflator X 100

Old deflator

Real versus Nominal GDP

Example Price index 1995 = 120 Price index 1999 = 135 Change in price is:

135 - 120 X 100

120

Real versus Nominal GDP

15 X 100

120

= .125 X 100

= 12.5 percent change in prices

GDP and Economic Well-Being

GDP is an indicator of economic well-being

Should be aware that it is a flawed indicator

Does not include leisure, quality of the environment, types of goods we produce, value of goods that are produced outside markets, etc.

GDP and Economic Well-Being

(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 to be Americans. ----- Robert Kennedy