CHAPTER 20. Measuring GDP and Economic Growth
GDP or gross domestic product - the market value of all the final goods and services
produced within a country in a given time period – usually a year.
This definition has four parts:
Market value
Final goods and services - final good (or service) is an item that is bought by its final
user during a specified period. It contrasts with an intermediate good (or service),
which is an item that is produced by one firm, bought by another firm and used as a
component of a final good or service.
Produced within a country
In a given time period
Factors of production: Types of income:
Labor Wage
Capital Interest
Natural resources Rent
Entrepreneurship Profit
Spending components: Economic entities:
Consumption Households
Investment Firms
Government spending Governments
Net Exports Foreigners
The Circular Flow of Expenditure and Income
Households and Firms (Consumption Expenditure (C))- buy the services of labour, capital
and land in factor markets. For these factor services, firms pay incomes to households:
wages for labour services, interest for the use of capital and rent for the use of land. A fourth
factor of production, entrepreneurship, receives profit.
Governments (Government Expenditure (G))- buy goods and services from firms, and their
expenditure on goods and services is called government expenditure.
Rest of World (Export (X) and Imports (M) = Net Exports = X-M) - firms in the UK sell goods
and services to the rest of the world, exports, and buy goods and services from the rest of
the world, imports.
,Spending Components
Consumption expenditure is the expenditure by UK households on goods and services
produced, no matter where they are produced. It includes goods such as cars and services
such as healthcare, but it does not include the purchase of new houses; they are counted as
part of investment.
Investment is expenditure on capital equipment and buildings and the additions to
inventories by firms. It also Includes expenditure on new homes by households.
Government expenditure is the expenditure by all levels of government on goods and
services such as national defence, law and order, street lighting and refuse collection. It does
not include unemployment benefits because they are not expenditure on goods or services.
GDP Equals Expenditure Equals Income
GDP can be measured in two ways: by the total expenditure on goods and services (called
the expenditure approach) or by the total income earned by producing goods and services
(called the income approach).
Aggregate expenditure is the sum of consumption expenditure, investment, government
expenditure and net exports – the sum of the red flows in Figure 20.1 .
Aggregate income earned by producing goods and services is the sum of wages, interest,
rent and profit – the blue flow in Figure 20.1 .
, Y= C + I + G + X- M
GDP equals aggregate expenditure and equals aggregate income.
Taxes, Market Price and Factor Cost
Governments collect income taxes and pay benefits such as pensions to households. These
items are neither expenditures on goods and services nor incomes of factors of production,
so they are not part of the circular flow of expenditure and income. But indirect taxes – taxes
such as those on petrol and beer – are included in market prices. And subsidies – payments
to firms such as farm subsidies – lower market prices. So aggregate expenditure valued at
market prices includes indirect taxes minus subsidies.
Gross and Net
Gross means before deducting the depreciation of capital. The opposite of ‘gross’ is net,
which means after deducting the depreciation of capital.
Depreciation is the decrease in the value of a firm’s capital that results from wear and tear
and obsolescence. The total amount spent on purchases of new capital and on replacing
depreciated capital is called gross investment. The amount by which the value of the firm’s
capital increases is called net investment.
Net investment = Gross investment - Depreciation
Measuring GDP
The expenditure approach measures
GDP as the sum of consumption
expenditure ( C ), investment ( I ),
government expenditure on goods and
services ( G ) and net exports of goods
and services (X- M).
The income approach measures GDP
by summing the incomes paid by firms
to households for the services of the
factors of production they hire – wages
for labour, interest for capital, rent for
land and profit for entrepreneurship.
The Blue Book groups these incomes
into three components:
1. Compensation of employees -
the total payments by firms for
labour services. This item includes gross wages and benefits such as pension
contributions.
, 2. Gross operating surplus - the total profit made by companies and the surpluses
generated by publicly owned enterprises. Some of the profits are paid to households
as dividends and some are retained by companies as undistributed profits, but they
are all income.
3. Mixed income - combination of rental income and income from self-employment.
The sum of the incomes is called gross
domestic income at factor cost. The term
factor cost is used because it is the cost of
the factors of production used to produce
final goods and services. When we sum all
the expenditures on final goods and
services, we arrive at a total called
domestic product at market prices. Market
prices and factor cost would be the same
except for indirect taxes and subsidies.
An indirect tax is a tax paid by consumers
when they buy goods and services, such as
VAT. An indirect tax makes the market price
exceed the factor cost. A subsidy is a
payment by the government to a producer.
With a subsidy, the factor cost exceeds the
market price. To get from factor cost to
market price, we add indirect taxes and
subtract subsidies.
The gap between the expenditure and income measure of GDP is called the statistical
discrepancy and it is calculated as the GDP expenditure total minus the GDP income total.
Nominal GDP and Real GDP
Real GDP - the value of final goods and services produced in a given year when
valued at the prices of a base year. By comparing the value of production in the two
years at the same prices, we reveal the change in production. Real GDP per person is
real GDP divided by the population.
Nominal GDP - the value of final goods and services produced in a given year when
valued at the prices of that year. Nominal GDP is just a more precise name for GDP.
The Uses of Real GDP
We use estimates of real GDP for two main purposes. They are:
To compare the standard of living over time
To compare the standard of living across countries
