Chapter 20 Measuring a Nation’s Income
Introduction
Economics is divided into two branches: Microeconomics and macroeconomics.
Microeconomics is the study of how individual households and firms make decisions and how they
interact with one another in markets.
Macroeconomics is the study of the economy as a whole. The goal of macroeconomics is to explain
the economic changes that affect many households, firms and markets simultaneously.
- Why is average income high in some countries while it is low in others?
- Why do prices rise rapidly in some periods of time while they are more stable in other
periods?
- Why do production and employment expand in some years and contract in others?
- What, if anything, can the government do to promote rapid growth in incomes, low inflation
and stable employment?
= These questions are all macroeconomic in nature because they concern the workings of the entire
economy.
The Economy’s Income and Expenditure
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. That is where the GDP is for.
GDP is the most closely watched economic statistic because it is thought to be the best single
(although not perfect) measure of a society’s economic well-being.
It measures two things at once:
1. The total income of everyone in the economy
2. The total expenditure on the economy’s output of goods and services
For an economy it must be à Income = Expenditure.
These two things are really the same because every transition has a buyer and a seller.
Some businesses will invest in new capital à (I)
Leakages are Taxes (T), Saving (S) and spending on Imports (M)
Injections into the economy come from Government spending (G), Export (X) and Investment
spending (I).
,The Circular-Flow-Diagram:
The Measurement of Gross Domestic Product
Gross domestic product (GDP) is the market value of all final goods and services produced within a
country in a given period of time.
GDP per capita is found by dividing the GDP of a country by the population of that country to express
national income per head of the population. This measure is useful in comparing GDP across
different countries.
IN SHORT à Dividing the GDP of a country by the population of that country
GDP Includes:
- Comprehensiveness
- All items produced in the economy and sold legally in markets.
- Measuring the market value of all final goods and services produced within a county in a
given period of time.
- The market value of the housing services provided by the economy’s stock of housing.
- Tangible goods (food, clothing, cars)
- Intangible services (haircuts, house cleaning, doctor’s visits)
- Goods and services currently produced.
- Measuring the value of production within the geographic confines of a country.
- Measuring the value of production that takes place within a specific interval of time.
(economy’s flow of income and expenditure during that interval)
GDP excludes:
- Most items produced and sold illicitly (illegal products)
- Most items that are produced and consumed at home. (goods that never enter the
marketplace)
- Transactions involving items produced in the past
,When a paper company sells paper to a greetings card company, the paper is called an intermediate
good, and the card is called a final good.
GDP includes only the value of final goods. The reason is that the value of intermediate goods is
already included in the prices of the final goods. (The paper is in the card and therefore already
included in the price)
An important exception:
When an intermediate good is produced and, rather than being used, is added to a firm’s inventory
of goods to be used or sold at a later date. à In this case, the intermediate good is taken to be ‘final’
for the moment, and its value as inventory investment is added to GDP.
The Components of GDP
Formula: Y ≡ C + I + G + NX
GDP (Y) is divided into four components:
1. Consumption (C)
2. Investment (I)
3. Government purchases (G)
4. Net exports (NX)
The difference of the value of exports minus
the value of (expenditure on) imports (X – M):
Consumption
1.Consumption (C) spending by households on goods and services, with the exception of purchases
of new housing.
- ‘Goods’ include household spending on durable goods, such as cars and appliances like
washing machines and fridges, and non-durable goods, such as food and clothing.
- ‘Services’ include such intangible items as haircuts, entertainment and medical care.
Investment
2.Investment (I) is the purchase of goods that will be used in the future to produce more goods and
services. It is the sum of purchases of capital equipment, inventories and structures.
(Investment in structures includes expenditure on new housing)
,Government Spending
3.Government Purchases (G) include spending on goods and services by local and national
governments. It includes the salaries of government workers and spending on public works.
- Transfer Payment is a payment for which no good or service is exchanged. And can alter
household income, but they do not reflect the economy’s production. (From a
macroeconomic standpoint, transfer payments are like negative taxes.)
Because GDP is intended to measure income from, and expenditure on, the production of goods and
services, transfer payments are not counted as part of government purchases.
Net Exports
4.Net Exports (NX) equal the purchases of domestically produced goods and services by foreigners
(exports) minus the domestic purchases of foreign goods (imports).
NX à Export- Import
(For example, if Japan sells Sony phones to the USA à Increases net exports. This increases profit =
positive. If Japan imports mineral fuels from China, it costs them money = negative.
Real Versus Nominal GDP
If total spending (GDP) rises from one year to the next, one of two things must be true (or a
combination of the two):
(1) the economy is producing a larger output of goods and services (a real increase)
or (2) goods and services are being sold at higher prices (a nominal increase)
Economist want to separate these two effects; they want a measure of the total quantity of goods
and services the economy is producing that is not affected by changes in the prices of those goods
and services.
To do this, economists use a measure called real GDP.
Real GDP is the measure of the value of the output in the economy which takes into account the
changes in prices overtime.
Real GDP = Nominal GDP
GDP Deflator
GDP at constant prices gross domestic product calculated using prices that existed at a particular
base year which takes into account changes in inflation over time.
GDP at current or market prices gross domestic product calculated by multiplying the output of
goods and services by the price of those goods and services in the reporting year.
, A Numerical Example
Nominal GDP the production of goods and services valued at current prices.
Quantity x Price (Each Year)
GDP deflator is a measure of the price level calculated as the ration of nominal GDP to real GDP
times 100.
GDP Deflator = Nominal GDP x 100
Real GDP
The growth rate in real GDP takes the difference between GDP across the two time periods under
consideration denoted by GDPt – GDPt–1, divided by GDP in year t–1, minus one. Multiplying the
result by 100 gives the percentage rate of growth in real GDP.
(GDPt – GDP t−1)
Growth rate of real GDP in year t =
GDP t−1 −1
Real and nominal GDP, which is a better measure of economic well-being?
Real gross domestic product is a measurement of economic output that accounts for the effects of
inflation or deflation. It provides a more realistic assessment of growth than nominal GDP.
Without real GDP, it could seem like a country is producing more when it's only that prices have gone
up.
Exercise from the lesson Fri 6-Sept:
Milk Bread
P Q P Q Nominal GDP Real GDP
2017 €1,00 1,000 €2,00 500 (1,000 * €1.00) + (€2,00 * (1,000 * €1.00) + (€2,00 * 500) = 2,000
500) = 2,000
2018 €2,00 1,200 €3,00 100 (1,200 * €2.00) + (€3,00 * (1,200 * €1.00) + (€2,00 * 100) = 2,000
100) = 2,700
Gross Value Added the contribution of domestic producers, industries and sectors to an economy.
Annual chain-linking a method of calculating GDP volume measures based on prices in the previous
year.
The Limitations of GDP as a Measure of Well-Being
GDP does not directly measure those things that make life worthwhile, but it does measure our
ability to obtain the inputs into a worthwhile life.
International Differences in GDP and the quality of life.
GDP data is used as a way of comparing well-being across different countries. Rich and poor
countries have vastly different levels of GDP per person.
