Measuring A Nation's Production and Income: Prepared By: Jamal Husein

CHAPTER
10
Measuring a Nation’s
Production and
Income
Prepared by: Jamal Husein
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin
Macroeconomics
 Macroeconomics is the branch

of economics that deals with any
nation’s economy as a whole.
 Macroeconomics focuses on
issues such as unemployment,
inflation, growth, trade, and the
gross domestic product.
© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 2
Macroeconomics
 Macroeconomics focuses on two key
issues:
 Understanding economic growth in the
long run and the factors behind the
rise in living standards in modern
economies
 Understanding economic fluctuations;
the ups and downs of the economy
over time
Production, Income and the Circular
Flow
 The most fundamental concepts in
macroeconomics are production and income.
 In factor markets,
households supply inputs
to production.
 Households supply labor
and capital to the firms.
 Households are paid wages
for their work, and
interest, dividends and
rents for supplying capital.
Production, Income and the Circular
Flow
 Households use their
income to purchase
goods and services in
product markets.
 The payments received by

firms are used to pay for
factors of production.
 In sum, corresponding to
the production of goods
and services in the
economy are flows of
income to households.
Measuring Gross Domestic Product
(GDP)
 The most common measure of

the total output of an economy is
gross domestic product (GDP)
GDP is the total market value of
all the final goods and services
produced within an economy in a
given year.
 “Total market value” refers to the quantity
of goods multiplied by their respective prices.
Using prices allows us to express the value of
everything in a common unit of measurement.
Quantity Price Value

2 cars $15,000 $30,000
3 computers $3,000 $9,000
Gross domestic product $39,000
 “Final goods and services” refers to the
goods and services that are sold to the
ultimate, or final, purchasers.
 In order to avoid double counting, we do not
count intermediate goods, or goods used in
the production process. The value of the final
good already reflects the price of the
intermediate goods contained in it.
 “In a given year” means that the sale of
goods produced in prior years, for example,
used cars, are not included in GDP this year.
 Since we use the prices times the quantities of
goods to measure the value of GDP, GDP will
increase when prices increase, even if the
physical quantities of the goods produced
remain the same.
Year 1 Year 2
Quantity Price Value Quantity Price Value
2 cars $15,000 $30,000 2 cars $30,000 $60,000
3 computers $3,000 $9,000 3 computers $6,000 $18,000
GDP = $39,000 GDP = $78,000
 A measure of total output that does

not increase just because prices
increase is called real GDP. Real
GDP takes into account price
changes by using the same prices
for both years.
 Nominal GDP is the value of GDP
in current dollars
Year 1 Year 2
Nominal GDP $10,000 Nominal GDP $11,000
Growth in nominal GDP ($13,200/$10,000) = 1.32
 Using year 1 prices to compute GDP in year 2:

Real GDP $10,000 Real GDP $12,000
Growth in real GDP ($12,000/$10,000) = 1.20
U.S. Real GDP 1930-2000
Who Purchases GDP?
 Economists divide GDP into four broad

expenditure categories:
1. Consumption expenditures: purchases by
consumers
2. Private investment expenditures:
purchases by firms
3. Government purchases: purchases by
federal, state, and local governments
4. Net exports: net purchases by the foreign
sector, or domestic exports minus domestic
imports
Composition of U.S. GDP
Composition of U.S. GDP, Third Quarter 2002
(billions of dollars expressed at annual rates)
Private
Consumption Investment Government Net
GDP Expenditures Expenditures Purchases Exports
10,506 7,361 1,597 1,981 -433
In percentage terms:
100% = 70.1% + 15.2% + 18.5% - 4.12%
 GDP figures are produced by the U.S.

Department of Commerce.
Consumption Expenditures
 Consumption expenditures comprise
purchases of currently produced, domestic
or foreign, goods and services.
 Consumption is broken down into:
 Durable goods.
 Nondurable goods.
 Services, the fastest growing component of
consumption.
 Consumption comprises 70% of total
purchases.
Private Investment Expenditures
 Private investment expenditures include:
 Spending on new plants and equipment.
 Newly produced housing.
 Increase in inventories during the
current year.
 Note: investment in everyday talk refers to
the purchase of an existing financial asset.
Investment in GDP accounts refers to the
purchase of new final goods and services by
firms. Don’t confuse the two.
Private Investment Expenditures
 New investment expenditures are called gross
investment. The true addition to the stock of capital
of the economy is net investment. Net investment
equals gross investment minus depreciation.
 Depreciation is the deterioration of plants,
equipment, and housing in a given year.
Third Quarter 2002 (billions $)

Gross Net
Depreciation
Investment Investment
$1,597 $1,175 $422
100% 74% 26%
Government Purchases
 Includes any goods the government
purchases plus the wages and benefits of all
government employees; but does not include
all the government spending.
 Transfer payments, or government
payments to individuals which are not
associated with the production of any
goods and services, are not included in
government purchases.
 This means that a large part of the federal
government budget is not part of GDP.
Net Exports
 Net exports are total exports minus total
imports. By including net exports in GDP,
we correctly measure U.S. production—by
adding exports and subtracting imports.
 Purchases of foreign goods (imports) are
subtracted from GDP because these

goods were not produced in the U.S.
 Any goods that are produced in the U.S.
and sold abroad (exports) are included in

GDP.
Net Exports
 Net exports for the U.S. in 3rd

quarter of 2002 were -$433. This
means that the U.S. bought $433
billion more goods and services
from abroad than it sold abroad.
 The balance of trade:
 Trade deficit: imports > exports
 Trade surplus: imports < exports
 Trade balance: imports = exports
U.S. Trade Balance As a Share of GDP
1960-2000
The Meaning of Continued Trade
Deficits
 When the U.S. runs a trade deficit, we are
forced to sell some of our assets to individuals
or governments in foreign countries.
 We give up more dollars from exports than we
receive from imports. Excess dollars in the
hands of foreigners are used to buy U.S. assets
such as stocks, bonds or real estate.
 If a country runs a trade surplus with one
country and an equally large deficit with
another, it does not add to its stock of foreign
assets.
Who Gets the Income?
 Three adjustments must be made to GDP in order
to arrive at national income:
1. Add the net income earned by U.S. firms and
residents abroad; subtract income earned in
the U.S. by foreign firms to arrive at GNP or
gross national product.
2. Subtract depreciation from GNP to arrive at
net national product, or NNP.
3. Subtract indirect taxes, which are sales taxes
or excise taxes on products, because the part
of sales revenue that goes to the government is
not part of private sector income.
Who Gets the Income
From GDP to National Income, Composition of U.S.

Third Quarter 2002 (billions) National Income, Third
Gross domestic product $10.506 Quarter 2002 (billions)
plus net income from abroad = National income 8,388
Gross national product Compensation $6,027
of employees
minus depreciation = 10,495
Corporate profits 771
Net national product
Rental Income 144
minus indirect taxes (and other
adjustments) Proprietor’s income 759
9,090
Net interest 687
National income 8,388
Real Versus Nominal GDP
 Differences between nominal GDP and real
GDP arise only because of changes in prices.
Quantity Produced Price Nominal

Year Cars Computers Cars Computers GDP
2004 4 1 $10,000 $5,000 $45,000
2005 5 3 12,000 5,000 $75,000
 To calculate real GDP we use constant prices
Quantity Produced Price
Real GDP
Year Cars Computers Cars Computers
2004 4 1 $10,000 $5,000 $45,000
2005 5 3 10,000 5,000 $65,000
Calculating the Growth of Real GDP
Quantity Produced Price

Real GDP
Year Cars Computers Cars Computers
2004 4 1 $10,000 $5,000 $45,000
2005 5 3 10,000 5,000 $65,000
 Using the information on the table, we can calculate

the growth of real GDP for this economy:
($65,000 - $45,000)/$45,000 = .444, or 44.4%
 We can also measure the change in prices over time using

an index number called the GDP deflator.
The GDP Deflator
 An index is set at 100 in a given year, say the year 2004,
called the base year. Prices in other years are compared to
prices in 2004:
Value of GDP deflator in 2005 = 100 x [(Nominal GDP in

2005)/(Real GDP in 2005)]
100 x ($75,000/$65,000) = 100 x 1.15 = 115
 The value 115 means that prices rose by 15% ([115-100)/100]

between the two years.
 The Commerce Department uses a chain index to calculate
price changes which is based on an average of price changes
using base years from neighboring years.
GDP As a Measure of Welfare
 GDP is our best measure of the value of
output produced, but not a perfect
measure:
 GDP ignores transactions that do not take
place in organized markets, such as the
work we perform at home.
 GDP ignores the underground economy,
where transactions are not reported to
official authorities.
GDP As a Measure of Welfare
 The Internal Revenue Service estimated that in

the 1990s, about $100 billion in income from the
underground economy escaped federal taxes each
year.
 If the average tax rate is 20%, about $500 billion
($100/0.20) escaped the GDP accountants, or 7%
of GDP.
 Finally, GDP does not value changes in the
environment that arise from the production of
output, such as pollution and depletion of
nonrenewable resources.

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CHAPTER

 Macroeconomics is the branch

 The payments received by

 The most common measure of

Quantity Price Value

3 computers $3,000 $9,000

Gross domestic product $39,000

 A measure of total output that does

 Using year 1 prices to compute GDP in year 2:

 Economists divide GDP into four broad

 GDP figures are produced by the U.S.

 Services, the fastest growing component of

 Newly produced housing.

 Increase in inventories during the

Third Quarter 2002 (billions $)

subtracted from GDP because these

and sold abroad (exports) are included in

 Net exports for the U.S. in 3rd

From GDP to National Income, Composition of U.S.

Quantity Produced Price Nominal

Quantity Produced Price

 Using the information on the table, we can calculate

 We can also measure the change in prices over time using

Value of GDP deflator in 2005 = 100 x [(Nominal GDP in

100 x ($75,000/$65,000) = 100 x 1.15 = 115

 The value 115 means that prices rose by 15% ([115-100)/100]

 The Internal Revenue Service estimated that in

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