Measuring a Nation’s

Income
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?

2
 GDP 2012
 Pakistan’s nominal GDP = $240 billion (44th
largest) BUT since
 Population = 183 million (6th largest)
 GDP per capita = $1578
 US GDP = $15.6 trillion (1000 billion = 1 trillion)
 US GDP per capita = $ 49, 965
 US population = 313 million
 Find out for India

MEASURING A NATION’S INCOME 3

 MICRO VS. MACRO

MEASURING A NATION’S INCOME 4

 10.1. 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
country’s total income and expenditure.

MEASURING A NATION’S INCOME 5

 10.1 Micro vs. Macro
 Macro – the problem of inflation
the level of unemployment
economic growth
BOP
 Thus a macroeconomist would study GDP
figures, FED moves, KSE Index, the Dow Jones
Industrial Index, CPI, PPI, etc.
 Micro – the economics of heath care or
agriculture or labor
 Trade unions, labor shift, company’s profit
maximization
MEASURING A NATION’S INCOME 6
 10.1 Micro vs. Macro
 Although "micro" means small and "macro"
means large, the two shouldn't be separated by
the size of an economy or firm. For example,
Wal-Mart may be many times the size of the
economy of a small nation; however, Wal-Mart's
costs and supply/demand curves will be
governed by microeconomic decisions while the
GDP of the small economy is an aspect of
macroeconomics.

MEASURING A NATION’S INCOME 7

 10.1 Micro vs. Macro

 Microeconomics examines small economic

units, the components of the economy.
 For example: individuals, households, firms,
industries

 Macroeconomics looks at aggregates.

 For example: national output, overall price
level, aggregate unemployment
 10.1 Micro vs. Macro
 Both are closely intertwined
 To understand macro developments,
microeconomic decisions must be considered.
 The two fields are interdependent since there are
overlapping issues
 Example: Increased inflation (macro-effect)
would cause the price of raw materials to
increase for companies & in turn affect the end
product’s price charged to the public.

MEASURING A NATION’S INCOME 9

 THE ECONOMY’S INCOME
AND EXPENDITURE

MEASURING A NATION’S INCOME 10

 10.2 Income and Expenditure
 Gross Domestic Product (GDP) measures
total income of everyone in the economy.
 GDP also measures total expenditure on the
economy’s output of g&s.

For
For the
the economy
economy as as aa whole,
whole,
income
income equals
equals expenditure
expenditure
because
because everyevery dollar
dollar aa buyer
buyer spends
spends
is
is aa dollar
dollar of
of income
income forfor the
the seller.
seller.

MEASURING A NATION’S INCOME 11

 10.2 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 NATION’S INCOME 12

10.2 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 goodsgoods & & services
services

Firms Households

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

use
use them
them toto produce
produce goods
goods
and
and services
services
MEASURING
sell
sell goods
goods &
& services
services
A NATION’S INCOME 13
10.2 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)
MEASURING A NATION’S INCOME 14
 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

MEASURING A NATION’S INCOME 15

 QUICK QUIZ
 What two things does GDP measure?
 How can it measure two things at once?

MEASURING A NATION’S INCOME 16

 THE MEASUREMENT OF
GROSS DOMESTIC
PRODUCT (GDP)

MEASURING A NATION’S INCOME 17

10.3 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.

MEASURING A NATION’S INCOME 18

10.3 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.
MEASURING A NATION’S INCOME 19
10.3 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).

MEASURING A NATION’S INCOME 20

10.3 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.

MEASURING A NATION’S INCOME 21

10.3 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.

MEASURING A NATION’S INCOME 22

10.3 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)

MEASURING A NATION’S INCOME 23

 QUICK QUIZ
Q 1. Which contributes more to GDP – the
production of a pound of ham burger or the
production of a pound of caviar?
 Why?
 Note: Caviar are pickled eggs of a large fish.

MEASURING A NATION’S INCOME 24

 QUICK QUIZ
Q 2. A farmer sells wheat to a baker for $2. The
baker uses the wheat to make bread, which is
sold for $3. What is the total contribution of these
transactions to GDP?
Q 3. Many years ago, Peggy paid $500 to put
together a record collection. Today, she sold her
albums at a garage sale for $100. How does this
sale affect current GDP?

MEASURING A NATION’S INCOME 25

 THE COMPONENTS OF
GDP

MEASURING A NATION’S INCOME 26

 10.4 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 NATION’S INCOME 27

 10.4 Consumption (C)
 “is total spending by households on goods &
services, with the exception of purchases of new
housing.”
 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 NATION’S INCOME 28

 10.4 Consumption (C)
 HHs spend on durable goods like appliances and
cars, non-durable goods like food & clothing,
services like haircuts, education, medical care.

MEASURING A NATION’S INCOME 29

 10.4 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 NATION’S INCOME 30
 10.4 Investment (I)
 Treatment of inventory
 When IBM produces a computer, & instead of
selling it, adds it to its inventory, IBM is assumed
to have “purchased” the computer for itself. Thus,
the computer is part of IBM investment spending.
 If IBM later sells the computer out of inventory,
inventory investment will be negative, offsetting
the positive consumption expenditure of the
buyer.

MEASURING A NATION’S INCOME 31

 10.4 Government Purchases
(G)
 is all spending on the goods & services
purchased by government at the federal, state,
and local levels.
 G excludes transfer payments, such as
Social Security or unemployment insurance
benefits. They are not purchases of goods &
services. Next slide explains why.

MEASURING A NATION’S INCOME 32

 10.4 Government Purchases
(G)
 transfer payments, like Social Security checks,
are excluded from G to avoid double-counting:
retired persons spend part or all of their Social
Security benefits on food, rent, prescriptions, and
so forth, all of which count in consumption. If we
also counted the Social Security check as part of
G, then the same money would be counted
twice, which would make GDP look bigger than it
really is.

MEASURING A NATION’S INCOME 33

 10.4 Net Exports (NX)
 NX = exports – imports
 Exports represent foreign spending on the
economy’s goods & services.
 Imports are the portions of C, I, and G
that are spent on goods & services produced
abroad.
 Adding up all the components of GDP gives:
Y
Y =
= C
C +
+ II +
+ G
G +
+ NX
NX

MEASURING A NATION’S INCOME 34

 10.4 Net Exports (NX)
 The “net” in “net exports” refers to the fact that
we are subtracting imports from exports. This
subtraction is important, because imports are
also counted in the other components of GDP;
failing to subtract them would cause GDP to
measure not just the value of goods produced
domestically, but also goods produced abroad
and imported.

MEASURING A NATION’S INCOME 35

 10.4 Net Exports (NX)
 For example, if a consumer spends $100 on a
DVD player imported from Japan, that $100
counts in “consumption,” even though the player
was not produced domestically. We subtract off
that $100 import so that GDP ends up including
the value of only domestically-produced goods
and services.

MEASURING A NATION’S INCOME 36

 U.S. GDP and Its Components,
2007

billions % of GDP per capita

Y $13,841 100.0 $45,825

C 9,734 70.3 32,228

I 2,125 15.4 7,037

G 2,690 19.4 8,905

NX –708 –5.1 –2,344

MEASURING A NATION’S INCOME 37

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.
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.

39
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.
40
 ACTIVE LEARNING 1
GDP and its components
 What components of GDP (if any) would each of
the following transactions affect? Explain.
 A. family buys a new refrigerator.
 Aunt Jane buys a new house.
 Ford sells a car from its inventory.
 You buy a pizza.
 Honda expands its factory in Ohio.

MEASURING A NATION’S INCOME 41

 REAL VS. NOMINAL GDP

MEASURING A NATION’S INCOME 42

 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 NATION’S INCOME 43

EXAMPLE:
Pizza Latte
year P Q P Q
2005 $10 400 $2.00 1000
2006 $11 500 $2.50 1100
2007 $12 600 $3.00 1200

Compute nominal GDP in each year: Increase:

2005: $10 x 400 + $2 x 1000 = $6,000
37.5%
2006: $11 x 500 + $2.50 x 1100 = $8,250
30.9%
2007: $12 x 600 + $3 x 1200 = $10,800
MEASURING A NATION’S INCOME 44
EXAMPLE:
Pizza Latte
year P Q P Q
2005 $10$10 400 $2.00
$2.00 1000
2006 $11 500 $2.50 1100
2007 $12 600 $3.00 1200

Compute real GDP in each year,

using 2005 as the base year: Increase:
2005: $10 x 400 + $2 x 1000 = $6,000
20.0%
2006: $10 x 500 + $2 x 1100 = $7,200
16.7%
2007: $10 x 600 + $2 x 1200 = $8,400
MEASURING A NATION’S INCOME 45
EXAMPLE:
Nominal Real
year GDP GDP
2005 $6000 $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 NATION’S INCOME 46
EXAMPLE:
Nominal Real
year GDP GDP
2005 $6000 37.5%
$6000
20.0%
2006 $8250 $7200
30.9% 16.7
2007 $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 zero inflation).
Hence, real GDP is corrected for inflation.
MEASURING A NATION’S INCOME 47
Nominal and Real GDP in the U.S.,
1965-2007
Billions
$12,000

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

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

48
 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.

MEASURING A NATION’S INCOME 49

EXAMPLE:
Nominal Real GDP
year GDP GDP Deflator
2005 $6000 $6000 100.0
14.6%
2006 $8250 $7200 114.6
2007 $10,800 $8400 12.2%
128.6

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 NATION’S INCOME 50

ACTIVE LEARNING 2
Computing GDP
2007 (base yr) 2008 2009
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 2007.
B. Compute real GDP in 2008.
C. Compute the GDP deflator in 2009.
51
ACTIVE LEARNING 2
Answers
2007 (base yr) 2008 2009
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 2007.
$30 x 900 + $100 x 192 = $46,200

B. Compute real GDP in 2008.

$30 x 1000 + $100 x 200 = $50,000
52
ACTIVE LEARNING 2
Answers
2007 (base yr) 2008 2009
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 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
53
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:

MEASURING A NATION’S INCOME 54

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 55
 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 NATION’S INCOME 56

 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 NATION’S INCOME 57

 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 58

 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 59

 GDP and Internet Usage in 12
countries
Japan
U.S.
(% of population)
Internet Usage

Germany

Brazil
Indonesia
Mexico
Pakista
Russia
n
China
Nigeria India

Bangladesh Real GDP per capita 60

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. 61