Measuring a Nation’s Income (Chapter 23 in the Book)

What Does GDP Mean GDP refers to the Gross Domestic Product. GDP measures the $ value or market value of all final goods and services produced inside a country during a given period of time (usually a year). GDP is the measure used to evaluate the society’s economic well-being GDP measures the total income of a nation. GDP measures the total expenditures on the economy.

The Measurement of GDP: The Definition itself b. total income and total expenditures of the nation

The Measurement of GDP: a. The Definition itself As we Mentioned GDP is the market value of all final goods and services produced inside an economy during a given period of time (usually a year) Let us look at each part of the definition

GDP is the market value … we know that we cannot compare nor add apples, oranges and cars etc. GDP adds together all these goods and services using a single common measure for all these goods and services which is the market value or market price that reflects the value of those goods and services.

Of all final … GDP includes all items produced in the economy, sold legally in markets and ready for consumption. However not all goods and services produced inside the economy are considered Final Goods and Services, so there are some products that GDP excludes

GDP excludes Of all final … For example, vegetables you buy at the grocery store are part of GDP, but vegetables you grow in your garden are not. Goods that are produced and consumed at home and therefore never enter the market place. For example, GDP includes the price of all cars produced in the economy but it does not include the prices of steel, glass, wheels, plastics etc that are bought by business firms and is used to produce a final product (car) this is due to the fact the price or market value of all these intermediate goods are already included and calculated in the value of the final product (car). Intermediate Goods: these are goods that are used up (purchased) to produce other goods. such as drugs, or guns. All illegal goods that are sold in black illegal markets

Goods and Services… GDP includes both final goods and services that are produced inside the country ready for final consumption by ultimate consumers. Examples are cars, clothes, food, transportation, education and medication.

Produced (currently) … GDP includes all goods and services currently produced. It does not include the value of items produced in the past. When General Motors produces and sells a new car, the market value of this car is included in GDP. When one person sells a used car to another person, the value of the used car is not included in GDP.

Within a country …  GDP measures the value of production within the geographic confines of a country. For example, when a Canadian citizen opens a factory in France, the production of this factory is not part of Canada GDP but part of France GDP.

In a given period of time… GDP measures that value of production that takes place within a specific interval usually a year. If the GDP measures the current quantity of production using current prices of the year, then it is specifically called Nominal GDP.

The Measurement of GDP: b The Measurement of GDP: b. total income and total expenditures of the nation

The Measurement of GDP: b The Measurement of GDP: b. total income and total expenditures of the nation GDP measures two things at the same time: total expenditures on the economy’s output of goods and services and the total income of everyone in the country. The reason that GDP can perform the trick of measuring both total income and total expenditures is that these two things are really the same.

The Measurement of GDP: b The Measurement of GDP: b. total income and total expenditures of the nation Simply because every transaction has two parties: a buyer and a seller. Each dollar of spending by some buyer on buying a certain good or service represents the market value of that good which gets included in GDP and it is simply a transaction of consumption to the buyer (expenditure to the buyer) and this transaction is also a transaction income for some seller (income to the seller) in exactly the same amount. For example, if the market value of that good = $100, then this process of spending contributes equally to the economy’s income and its expenditures. So that total income increases by $100 and total expenditures of the economy increases by $100. S

Circular-flow of Income: The identity of income and expenditures in an economy In this Diagram, we make the following assumptions: Closed economy, no foreign sector and no international trade. No government. No savings by households No investment by households, all income received by households are used for spending or expenditures. In this closed economy, two groups exist: household and business and two markets: goods market and factors of production market.

Explanation of the Diagram The Circular – flow diagram operate such: Households buy goods and services from firms, and firms use this revenue from sales to pay wages to workers, rent to land owners and the remaining part represents profit to firm owners.

Explanation of the Diagram Households represent the owners of factors of production inside the economy. They provide the firms with labor (price of labor = wages), land (price of land = rent) and capital (price of capital = interest), and get their income from business firms for selling the use of the resources in the market of factors of production.

Explanation of the Diagram Household use their income to buy final goods and services from the goods market. The total $ value of household represent the market value of final goods and services and at the same time represent total expenditures on final goods and services in the economy which represent GDP.

Explanation of the Diagram GDP = total amount spent by households in the market for goods and services on final goods and services (upper – loop or total – expenditure approach) = total expenditures on final goods and services In this economy – money continuously flows from households to business firms and then back to households GDP = Total income of everyone inside the economy = income of household and business = Wages + Rent + Profit (lower-loop or total-income approach)

Explanation of the Diagram So we can compute GDP in one of two ways: By adding up the expenditures by households (Total-Expenditure Approach). By adding up the total income of households (wages, rent, profit,….) (Total income Approach).

Other Measures of GDP

Other Measures of GDP In addition of GDP, other measures are also used to help in measuring the economy’s income or level of production: GNP (Gross National Product): is the total income earned by a nation’s permanent residents (called nationals). It differs from GDP by including income that all nationals / citizens earn abroad and excludes income that foreigners earn here. For example, when a Canadian citizen works temporarily in the US, his production is part of US GDP and at the same time part of Canada GNP.

Other Measures of GDP b. Potential GDP (full-employment level of output or natural rate of output): It represents the long-run productive capacity of the economy or the maximum amount that an economy can produce while utilizing all its available resources. We all know that each economy has a limited amount of resources that it utilizes in production. Combining all its available resources with the available technology, the nation will achieve its maximum sustainable level of output to be produced which is called its potential GDP. 

Other Measures of GDP c. National Income (NI): is the total income earned by the nation’s residents in the production of goods and services. d. Personal Income (PI): is the income that an average household receives regardless of the source of this income. e. Disposable Income (DI): It represents that part of personal income that people are left with after all their tax payments and debt-obligation settlements. DI is what actually goes into the hands of public to dispose of as he pleases. DI is what people divide between personal consumption and personal savings. DI = C + S

Components of GDP

The Components of GDP GDP = C + I + G + NX GDP, as the above shows, is divided into four components: Consumption (C): It represents the spending of households on all goods and services.

The Components of GDP Investment ( I ): (Capital Formation) I consists of the addition to the nation’s capital stock of buildings, equipment, inventories during a year that will increase the production capacity of the nation in the future. Investment consists of the new houses, factories, trucks, equipment, machinery, and inventories produced in a year that is the additional goods to the available level of factories, houses and technology.

The Components of GDP A confusion is always correlated with the word ( I ) in Economics. If I take $1000 from my safe and deposit it in the bank, in economic terms no investment has taken place. All that has happened is that the composition of the financial assets has changed. Only when production of a new good takes place, through building a new house or producing a truck is these what the economist calls investment.  

The Components of GDP Government Purchases or Spending (G): it represents spending by the government on goods and services. Government is considered as one of the biggest consumers in an economy. The Government expenditures include costs of roads, public works, and wages to all public employees of the government.  

The Components of GDP Does this mean that every dollar of government expenditures get included in GDP as G? Definitely not GDP includes only government spending on goods and services and excludes spending on what is called transfer payments. Transfer payments are government payments to individuals that are not made in exchange for goods and services supplied. These would include unemployment, old-age, very poor and disabled payments.  

The Components of GDP Next Exports (NX): = X – M = $ value of exports - $ value of imports.

Real vs. Nominal GDP

Real vs. Nominal GDP GDP measures the total spending on goods and services in markets inside the economy. So if an economy produces only 2 goods (x) and (y), then its GDP = (Qx X Px) + (Qy X Py) Reasons of Change in GDP From the above formula, we can conclude that any increase in GDP, one of three things must be the reason:  An increase in quantities. OR An increase in prices OR Both

Real vs. Nominal GDP IN order for economists to separate these two effects to detect the actual increase in GDP that is due to the increase in the quantity of production of goods and services and not due to increase in prices of those goods and services, they use the concept of REAL GDP. Real GDP measures current production of the year using prices that are fixed at past levels or in other words using prices of past years. Whereas calculating current production of the year using current prices of the year is called Nominal GDP.

Example To see how real GDP is constructed, let us make this example. (table 22-2 pp501 on your book) The table represents a closed economy producing only two goods Hotdogs and Hamburgers over the period 2001-2003. In this example, we will calculate Nominal and Real GDP s over all years under the analysis and compare between them.

Calculate Nominal GDP number and % change

Calculate Nominal GDP number and % change Looking at the table, Nominal GDP shows an increase from $200 to $600 to $1,200 through 2001 – 2003. This increase in Nominal GDP should be due to increase in Q of Production or increase in P or both.   To calculate the exact % increase in Nominal GDP from 2001 – 2003, we calculate the % increase in Nominal GDP among all years under study by applying the following formula: % change in Nominal GDP (2001-2002) = N. GDP 2002-N.GDP2001 x 100 N. GDP 2001 % change in Nominal GDP (2001-2002) = 200% % change in Nominal GDP (2002-2003) = 100%

Calculate Real GDP number and % Change To obtain a measure of the increase in GDP which is due to increase in Qs only and not due to any increase in Ps. We need to measure Real GDP by using current Q of production and prices of a past year (we call it base year).

Calculate Real GDP number and % Change

Calculate Real GDP number and % Change The calculation of Real GDP over the same period shows an increase from $200 to $350 to $500. % change in Real GDP (2001-2002) = R. GDP 2002-R.GDP2001 x 100 R. GDP 2001 % change in Real GDP (2001-2002) = 75% % change in Real GDP (2002-2003) = 42.8%   When we talk about economic growth of the country, we measure that growth as the % change in Real GDP from one period to another.

The GDP Deflator

GDP Deflator = Nominal GDP x 100 The GDP Deflator Nominal GDP represents both the changes in the prices of goods and services the changes in Quantities of these goods and services the economy is producing using current prices of that year. Real GDP reflects only the changes in quantities produced. From these two variables, we can compute a third variable called the GDP Deflator which reflects the prices of goods and services but not the quantities produced. GDP Deflator = Nominal GDP x 100 Real GDP

The GDP Deflator GDP Deflator measures the rise in Nominal GDP from the base year that cannot be attributed to a rise in Real GDP (or in other words to a rise in quantities of production). So GDP Deflator reflects what is happening to prices and not quantities of production. It is used by economist to monitor the average level of prices in the economy. As such GDP Deflator can be used to calculate the rate of inflation inside an economy.

EXAMPLE Calculating GDP Deflator in the above example, it shows an increase from 100 to 171

Calculating the Inflation using GDP Deflator To use these values in calculating the Rate of Inflation we will get the following results: Rate of Inflation (2001-2002) = GDP Deflator 2002-GDP Deflator 2001 x 100 GDP Deflator 2001 = 171 – 100 x 100 = 71% 100 Rate of Inflation (2002-2003) = 240-171 x 100 = 40.35% 171

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