1. Measurement of National
Economy
Lecture 3

2. Economy’s Income and
Expenditure
• When judging how a person is doing
economically, we might first look at his/her
income.
• Similarly, when judging whether the
economy is doing well or poorly, it is natural
to look at the total income that everyone in
the economy is earning.
• This is the task of “GDP”.

3. Economy’s Income and
Expenditure
Cont…
• GDP measures two things at once:
– The total income of everyone in the economy
– The total expenditure on the economy’s output of
goods and services.
• The reason that GDP can perform this trick of
measuring both total income and total
expenditure is that these two things are
really the same.
• “Therefore, for an economy as a whole ,
income must equal expenditure”.

4. Economy’s Income and
Expenditure
Cont…
• Why is this true???
– An economy’s income is the same as its
expenditure because every transaction has two
parties: A ‘buyer’ and a ‘seller’.
– E.g. A pays B Rs. 500 to clean her lawn.
– In this case, B is the seller of a service and A is the
buyer.
– B earns Rs. 500 and A spends Rs. 500.
– Thus, this transaction contributes equally to the
economy’s income and to it’s expenditure.
• Hence, GDP, whether measured as total
income or total expenditure, rises by Rs. 500.

5. Economy’s Income and Expenditure
Cont…
• The equality of income and expenditure can
be illustrated with the circular-flow diagram:

6. Figure 1 The Circular-Flow Diagram
MARKETS
Revenue FOR Spending
GOODS AND SERVICES
•Firms sell Goods and
Goods
•Households buy services
and services
sold bought
FIRMS HOUSEHOLDS
•Produce and sell •Buy and consume
goods and services goods and services
•Hire and use factors •Own and sell factors
of production of production
Factors of MARKETS Labor, land,
production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, •Households sell Income
and profit •Firms buy
= Flow of inputs
and outputs
= Flow of dollars
Copyright © 2004 South-Western

7. Measurement of GDP
• In simple terms, Gross Domestic Product
(GDP) is a measure of the income and
expenditures of an economy.
“It is the total market value of all final goods
and services produced within a country in a
given period of time”.

8. Measurement of GDP
Cont…
• Break-up of Definition:
– “GDP is the Market Value . . .”
Output is valued at market prices.
– “. . . Of All Final . . .”
It records only the value of final goods, not
intermediate goods.
– “. . . Goods and Services . . .”
It includes both tangible goods (food, clothing,
cars) and intangible services (haircuts,
housecleaning, doctor visits).

9. Measurement of GDP
Cont…
– “. . . Produced . . .”
It includes goods and services currently
produced, not transactions involving goods
produced in the past.
• E.g. When Toyota produces and sells a new car, the
value of the car is included in GDP.
• But when a person sells a used car to another
person, the value of the used car is NOT included
in the GDP.
– “ . . . Within a Country . . .”
It measures the value of production within the

10. Measurement of GDP
Cont…
– “. . . In a Given Period of Time.”
It measures the value of production that takes
place within a specific interval of time, usually a
year.

11. Components of GDP
• GDP includes all items produced in the
economy and sold legally in markets.
• GDP excludes items that never enter the
marketplace.
• It excludes items produced and sold illicitly,
such as illegal drugs.

12. Components of GDP
Cont…
• GDP is divided into four components:
• Consumption (C)
• Investment (I)
• Government Purchases (G)
• Net Exports (NX)
• GDP (Y) is the sum of these and is
calculated as per the following equation:
Y = C + I + G + NX

13. Components of GDP
Cont…
• Consumption (C):
– The spending by households on goods
and services.
• Investment (I):
– The purchase of goods and services to be
used in future.
– The spending on capital equipment,
inventories, and structures etc.

14. Components of GDP
Cont…
• Government Purchases (G):
– The spending on goods and services by
local, state, and federal governments.
• Net Exports (NX):
– Is the difference between the monetary
value of exports and imports.
– In simple terms, it refers to exports minus
imports.

15. GDP and Economic Well-Being
• GDP is the measure of the economic well-
being of a society.
• GDP tells us the income and expenditure of
the people in the economy.
• Higher GDP indicates a higher standard of
living.
• However, GDP is not a perfect measure of the
happiness or quality of life.

16. GDP and Economic Well-Being
Cont…
• Following factors contribute to well-being
but are not included in GDP.
– The value of leisure.
– The value of a clean environment.
– The value of certain activities such as the
value of the time parents spend with their
children and the value of volunteer work
etc.