Gross Domestic Product Measures Total Production
Gross domestic product (GDP) The market
value of all final goods and services produced
in a country during a period of time, typically
one year.
GDP Is Measured Using Market Values, Not Quantities
The worth of a thing is the price it will bring.
Final good or service A good or
service purchased by a final user:
•Household consumption—C
•Business investment, including all
residential construction—I
vs
Intermediate good or service
A good or service that is an
input into another good or
service, such as a tire on a
truck.
•Government purchases—G
•Exports to foreigners—X
GDP Includes Only Current Production
Production, Income, and the Circular Flow Diagram
PRODUCTION AND PRICE STATISTICS FOR 2007
(1)
PRODUCT
(2)
QUANTITY
(3)
PRICE PER UNIT
100
$50.00
Pizzas
80
10.00
Textbooks
20
100.00
2,000
0.10
Eye examinations
Paper (for textbooks)
PRODUCT
(1)
QUANTITY
(2)
PRICE PER UNIT
(3)
VALUE
Eye examinations
100
$50
$5,000
Pizzas
80
10
800
Textbooks
20
100
2,000
Total GDP = $7,800
Measuring GDP by the Value-Added Method
Value added The market value a firm adds to a product.
FIRM
VALUE OF PRODUCT
VALUE ADDED
Value of raw cotton = $1
Value added by cotton
farmer
=1
Value of raw cotton woven
into cotton fabric = $3
Value added by cotton
textile
mill = ($3 – $1)
=2
Shirt
Company
Value of cotton fabric made
into a shirt = $15
Value added by shirt
manufacturer = ($15 –$3)
= 12
L.L. Bean
Value of shirt for sale on
L.L. Bean’s Web site = $35
Value added by L.L. Bean
= ($35 – $15)
= 20
Cotton
Farmer
Textile Mill
Total Value Added
= $35
Components of GDP
Personal Consumption Expenditures, or “Consumption”
Consumption (C) Spending by households on
goods and services, not including spending on
new houses.
Gross Private Domestic Investment, or “Investment”
Investment (I) Spending by firms on new
factories, office buildings, machinery, and
additions to inventories, and spending by
households on new houses.
Government Consumption and Gross Investment, or
“Government Purchases”
Government purchases (G)
Spending by federal, state, and local
governments on goods and services.
Net Exports of Goods and Services, or “Net Exports” (NX)
The mantra: Y = C + I + G + NX
Y  C  I  G  NX
Components of GDP in 2006
GDP Facts
Consumer spending on services is greater than the
sum of spending on durable and nondurable goods.
• Business fixed investment is the largest component of
investment. Gross private domestic investment includes
New plant and equipment
New residential construction
Net additions to business inventories
• Purchases made by state and local governments are
greater than purchases made by the federal government.
• Imports are greater than exports net exports are
negative.
Transfer payments are not included in GDP:
Payments by the government to individuals for which the
government does not receive a new good or service in return.
•Unemployment benefits paid to someone not working.
•Social security benefits paid to someone who is retired.
•Interest income paid to a government bondholder
Since the government doesn’t produce anything for
the market, the interest payment can’t be for any
productive service.
“Underground economy” activities are not included in GDP
•Production “off-the-books”
•Illegal activities…a matter of the law
•Legalize prostitution GDP up
Household production is not included in GDP
•Marry your gardener  GDP down
Does GDP Measure What We Want It to Measure?
GDP Not a Measure of Well-Being…but pretty close
The Value of Leisure Is Not Included in GDP
GDP Is Not Adjusted for Pollution or Other Negative
Effects of Production
GDP Is Not Adjusted for Changes in Crime and
Other Social Problems
GDP Measures the Size of the Pie but Not How the
Pie Is Divided Up
GDP Accounting Conventions
•Which component of GDP will be affected by each of these transaction?
•You buy a ticket to fly to Seattle.
•American Airlines buys a new jetliner from Boeing.
•AA buys new seats for a jetliner it already owns.
•AA buys 100 million gallons of jet fuel.
•A resident of France buys a ticket to fly from Paris to NY.
•Clark County extends a runway at McCarran so AA can land larger jets.
•In recent years, the BEA has classified government purchases into gov’t
consumption and gross gov’t investment expenditures. How would you classify
Homeland Security expenditures?
•Which of the following would increase measured GDP and which would reduce
it?
•The fraction of women working outside the home increases.
•There is a sharp increase in the crime rate.
•Higher tax rates cause some people to hide more of the income they earn.
•What would you expect to happen to household production as unemployment
rises during a recession?
•Would you therefore expect fluctuation in actual production—GDP plus household
production—to be greater or less than fluctuation in GDP?
Real GDP versus Nominal GDP
Nominal GDP The value of this
year’s final goods and services
evaluated at this year’s prices.
Real GDP The value of this year’s
vs final goods and services evaluated
at base-year prices.
2000
PRODUCT
2009
QUANTITY
PRICE
QUANTITY
PRICE
Eye examinations
80
$40
100
$50
Pizzas
90
11
80
10
Textbooks
15
90
20
100
$Y2009 = Nominal GDP = GDP in current year prices = $7,800
PRODUCT
2009
QUANTITY
Eye examinations
100
$40
$4,000
80
11
880
Pizzas
2000
PRICE
VALUE
Textbooks
20
90
1,800
Y2009 = Real GDP = GDP in base year prices =$6,680
Comparing Real GDP and Nominal GDP
Nominal GDP and
Real GDP, 1990–2006
Base year prices >
Current year prices
 Y > $Y
Base year prices <
Current year prices
 Y < $Y
The GDP Deflator
GDP deflator A measure of the price
level, calculated by dividing nominal GDP
by real GDP and multiplying by 100.
$ GDP = Price Level x Real Output
$Y = P x Y
P = $Y/Y
GDP deflator 
Nominal GDP
 100
Real GDP
In practice,, the GDP deflator is estimated first:
Deflatorthis yr = (Cost of outputthis yr /Cost of same stufflast yr) x Deflatorlast yr
Then,
Real GDPthis yr = $GDPthis yr/(GDP Deflator)this yr
Other Measures of Total Production and Total Income
Gross National Product (GNP)
=GDP + Net Foreign Earnings of US Residents
•Compensation of employees earned abroad
•Interest and profits earned abroad
Net National Product (NNP) = GNP - Capital Consumption
Allowance (depreciation)
National Income (NI) = NNP - Indirect Business Taxes
+ Statistical discrepancy
= Income earned from production of national product
Personal Income (PI) = NI + Net Transfer Payments
– Corporate Retained Earnings
Disposable Income (DI) = PI - Income Taxes
Disposable Income is split between consumption and saving
YD = C + S
Other Measures of Total Production and Total Income
FIGURE 7-4
Measures of Total Production
and Total Income, 2006
Other Measures of Total Production and Total Income
FIGURE 7-5
The Division of Income
Real GDP—NI/PI/DI
• If the quantity of final goods and services produced decreased,
• Could real GDP increase?
• Could nominal GDP increase?
• Suppose the amount the federal government collects in
personal income taxes increases, while the level of GDP
remains the same. What will happen to the values of
• National income
• Personal income
• Personal disposable income
Key Terms
Business cycle
Macroeconomics
Consumption
Microeconomics
Economic growth
Net exports
Expansion
Nominal GDP
Final good or service
Price level
GDP deflator
Real GDP
Government purchases
Recession
Gross domestic product (GDP)
Transfer payments
Inflation rate
Underground economy
Intermediate good or service
Value added
Investment