- GDP is a measure of the market value of all final goods and services produced within a country in a given period of time, usually a year. - There are three main approaches to calculating GDP: expenditure, income, and value added. The expenditure approach sums consumption, investment, government spending, and net exports. - GDP is calculated both nominally, using current prices, and realistically, using prices from a base year to control for inflation. Real GDP isolates changes in output from price changes.

1. Unit 2
Measuring a Nation’s
Income

2. • 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
In this unit, look for the
answers to these questions:

3. • Gross domestic product (GDP) is a measure of
the income and expenditures of an economy.
• GDP is the market value of all final goods and
services produced within a country in a given
period of time.
The measurement of gross
domestic product

4. MEASURING A NATION’S INCOME 4
…the market value of all final goods &
services produced within a country in a
given period of time.
Gross Domestic Product (GDP) Is…
 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.
 GDP includes all items produced and sold legally in
markets and excludes items produced and sold illicitly,
such as illegal drugs.

5. MEASURING A NATION’S INCOME 5
…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: intended for the end user
Intermediate goods: used as components
or ingredients in the production of other goods
GDP only includes final goods

6. MEASURING A NATION’S INCOME 6
…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, beer)
and intangible services
(dry cleaning, concerts, cell phone service).

7. MEASURING A NATION’S INCOME 7
…the market value of all final goods &
services produced within a country in a
given period of time.
Gross Domestic Product (GDP) Is…
It includes goods and services currently produced,
not transactions involving goods produced in the
past.

8. MEASURING A NATION’S INCOME 8
…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 country’s borders, whether done by its own
citizens or by foreigners located there.

9. MEASURING A NATION’S INCOME 9
…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)

10. MEASURING A NATION’S INCOME 10

11. (1) The expenditure approach
(2) The income approach and
(3) The value added (production) approach
• These three approaches are equivalent, with
each rendering the same result.
Three ways to calculate gross
domestic product (GDP)

12. • For an economy as a whole, income must equal
expenditure because:
• Every transaction has a buyer and a seller.
• Every dollar of spending by some buyer is a dollar
of income for some seller.
• Thus, the sum of all expenditure equals the sum of
all income.
• The equality of income and expenditure can be
illustrated with the circular-flow diagram.
The economy’s income and
expenditure

13. The Circular-Flow
Diagram
Firms Household
Markets for factors
of production
Markets for goods
and services
Spending
Revenue
Goods and
services sold
Goods and
services bought
Wages, rent and
profit
Factor of
production
Income
Labor, land and
capital
Expenditure
Income

14. MEASURING A NATION’S INCOME 14

15. Expenditure Approach to
Calculating GDP
• One way to calculate a nation's GDP is to sum
all expenditures in the country. This method is
known as the expenditure approach and is
described below:
• Consumption (C)
• Investment (I)
• Government Purchases (G)
• Net Exports (NX)
 GDP = C + I + G + NX

16. Expenditure Approach to
Calculating GDP:
Consumption (C)
• Consumption (C) is the value of all goods
and services bought by households.
Includes:
• Durable goods: last a long time, ex: cars,
• Non-durable goods: last a short time, ex:
• Services: work done for consumers, ex: dry
travel.
• C excludes new housing bought by
households

17. Expenditure Approach to
Calculating GDP:
Investment (I)
• Def1: spending on [the factor of production]
capital.
• Def2: spending on goods bought for future use.
Note: “Investment” does not
mean the purchase of financial
assets like stocks and bonds.

18. Expenditure Approach to
Calculating GDP:
Investment (I)
• I Includes:
- business fixed investment: spending on plant
that firms will use to produce other goods &
services (machines, tools, factories).
-inventory investment: the change in the value
inventories (goods produced but not yet sold).
-residential fixed investment: spending on
consumers and landlords.

19. Expenditure Approach to
Calculating GDP:
Government purchases (G)
• G includes all government purchases on goods
and services.
• G excludes transfer payments (e.g. unemployment
insurance payments), because they are not made
in exchange for currently produced goods or
services.

20. Expenditure Approach to
Calculating GDP:
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 g&s produced abroad.

21. MEASURING A NATION’S INCOME 21

22. 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,

24. Income Approach to Calculating
GDP
• The GDP is equivalent to the total income
received by factors of production engage in the
process of production during a certain period,
usually one year.

25. Income Approach to Calculating
GDP
• GDP is calculated as the summation of
• wages and salaries;
• capital interest;
• land rent;
• depreciation;
• profit; and
• net indirect taxes.
• GDP = W + I + R + Dp + M + Te

26. Value added Approach to
Calculating GDP
• Value added (VA)
A firm’s value added = the value of its output-
the value of the intermediate goods the firm
used to produce that output.
• GDP = sum of VA
• The value of the final goods already includes
the value of the intermediate goods, so
including intermediate goods in GDP would be
double-counting.

27. Value added Approach to
Calculating GDP
• A farmer grows a bushel of wheat and sells it
to a miller for $1.00.
• The miller turns the wheat into flour and sells
it to a baker for $3.00.
• The baker uses the flour to make a loaf of
bread and sells it to an engineer for $6.00.
• The engineer eats the bread.
• Compute
• value added at each stage of production
• GDP

28. Real vs. Nominal GDP
• GDP is the value of all final goods and
services produced.
• Nominal GDP measures these values using current
prices.
GDPt
n = Σ Qi
t Pi
t (i=1,n)
• Real GDP measure these values using the prices
of a base year.
GDPt
r = Σ Qi
t Pi
0 (i=1,n)

29. MEASURING A NATION’S INCOME 29
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
EXAMPLE: Compute nominal GDP

30. MEASURING A NATION’S INCOME 30
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
$10 $2.00
EXAMPLE: Compute real GDP,
based 2005

31. Real GDP controls for
inflation
• Changes in nominal GDP can be due to:
- changes in prices
- changes in quantities of output produced
• Changes in real GDP can only be due to changes
in quantities.

32. GDP growth rate (g)
gt =
GDPr
t – GDPr
t-1
GDP r
t-1
x 100 (%)

33. GDP Deflator
• The inflation rate is the percentage increase
in the overall level of prices.
• One measure of the price level is the GDP
Deflator, defined as
GDP deflator =
GDPn
t
X 100
GDPr
t

34. MEASURING A NATION’S INCOME 34
EXAMPLE:
Compute the GDP deflator in each year:
year
Nominal
GDP
Real
GDP
GDP
Deflator
2005 $6000 $6000
2006 $8250 $7200
2007 $10,800 $8400
2005: 100 x (6000/6000) = 100.0
100.0
2006: 100 x (8250/7200) = 114.6
114.6
2007: 100 x (10,800/8400) = 128.6
128.6
14.6%
12.2%

35. Computing GDP
35
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.
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

37. GDP and economic well- being
• GDP is the best single measure of the economic
well-being of a society.
• GDP per person tells us the income and
expenditure of the average person in the
economy

38. • Higher GDP per person indicates a higher
standard of living.
• GDP is not a perfect measure of the happiness
or quality of life, however.
GDP and economic well- being

39. • Some things that contribute to well-being are
not included in GDP.
• The value of leisure.
• The value of a clean environment.
• The value of almost all activity that takes place
outside of markets, such as the value of the time
parents spend with their children and the value of
volunteer work.
GDP and economic well- being

40. GDP, life expectancy and
literacy

42. Other measures of income
• Gross National Product (GNP)
• Net National Income (NI)
• Personal Income (PI)
• Disposable income (Yd)

43. Measures of Income: GNP vs. GDP
• Gross National Product (GNP): total income
earned by the nation’s factors of production,
regardless of where located
• Gross Domestic Product (GDP): total income
earned by domestically-located factors of
production, regardless of nationality.
• (GNP – GDP) = (factor payments from abroad) –
(factor payments to abroad)

44. Other measures of income
• NNP = GNP - Deprecation
• NI= NNP - indirect taxes
• PI= NI - retained profits – social insurance
contributions + Government transfers
• Yd= Pi - personal taxes