Chapter 8
Measuring the Economy’s
Performance
Learning Objectives
• Describe the circular flow of income and
output
• Define gross domestic product (GDP)
• Understand the limitations of using GDP as
a measure of national welfare
8-2
Learning Objectives (cont'd)
• Explain the expenditure approach to
tabulating GDP
• Explain the income approach to computing
GDP
• Distinguish between nominal GDP and real
GDP
8-3
The Simple Circular Flow
The concept of the circular flow of income
involves two principles:
1. In every economic exchange, the seller receives
exactly the same amount that the buyer
spends.
2. Goods and services flow in one direction and
money payments flow in the other.
8-4
The Simple Circular Flow
(cont'd)
• Profits explained
– Question
• Why is profit a cost of production?
– Answer
• Profits are the return entrepreneurs receive for the risk
they incur when organizing productive activities.
8-5
The Simple Circular Flow
(cont'd)
• Final Goods and Services
– Goods and services that are at their final stage of
production and will not be transformed into yet other
goods or services
8-6
Figure 8-1 The Circular Flow of
Income and Product
8-7
The Simple Circular Flow
(cont'd)
• Product Markets
– Transactions in which households buy goods
8-8
The Simple Circular Flow
(cont'd)
• Factor Markets
– Transactions in which businesses buy resources
8-9
The Simple Circular Flow
(cont'd)
• Total Income
– Wages, rent, interest, profits
8-10
The Simple Circular Flow
(cont'd)
• Question
– Why must total income be
identical to the dollar value
of total output?
• Answer
– Every transaction
simultaneously involves an
expenditure and a receipt.
8-11
National Income Accounting
• National Income Accounting
– A measurement system used to estimate
national income and its components
• Total Income
– The yearly amount earned by the nation’s
resources (factors of production)
8-12
National Income Accounting
(cont'd)
• Gross Domestic Product (GDP)
– The total market value of all final goods and
services produced by factors of production
located within a nation’s borders
8-13
National Income Accounting
(cont'd)
• Observations
– GDP measures the dollar value of final output.
– GDP measures the dollar value of final goods and
services produced per year by factors of
production located within a nation’s borders.
8-14
National Income Accounting
(cont'd)
• Intermediate Goods
– Goods used up entirely in the production of final
goods
• Value Added
– The dollar value of an industry’s sales minus the
value of intermediate goods (for example, raw
materials and parts) used in production
8-15
Table 8-1 Sales Value and Value Added
at Each Stage of Donut Production
8-16
National Income Accounting
(cont'd)
Numerous transactions occur that have
nothing to do with final goods and services
being produced:
• Financial transactions
• Transfer Payments
• Secondhand Goods
8-17
National Income Accounting
(cont'd)
• Exclusion of financial transactions
– Securities
• Stocks and bonds
– Government transfer payments
• Social Security
• Unemployment compensation
– Private transfer payments
• Individual gifts
• Corporate gifts
8-18
National Income Accounting
(cont'd)
• Transfer of secondhand goods excluded
– Why not count the sale of a used computer,
guitar, or snowboard as part of GDP?
• Other excluded transactions
– Household production
– Legal and illegal underground transactions
8-19
National Income Accounting
(cont'd)
• GDP’s limitations
– Excludes non-market production
– It is not necessarily a good measure of the wellbeing of a nation.
8-20
National Income Accounting
(cont'd)
• GDP is a measure of the value of production
in terms of market prices, and an indicator
of economic activity.
• GDP is not a measure of a nation’s overall
welfare.
8-21
Two Main Methods of Measuring
GDP
• Expenditure Approach
– Computing GDP by adding up the dollar value at
current market prices of all final goods and
services
8-22
Two Main Methods of Measuring
GDP (cont'd)
Expenditure Approach
8-23
Two Main Methods of Measuring
GDP (cont'd)
• Income Approach
– Measuring GDP by adding up all components of
national income, including wages, interest, rent,
and profits
8-24
Two Main Methods of Measuring
GDP (cont'd)
Income Approach
8-25
Two Main Methods of Measuring
GDP (cont'd)
Deriving GDP by the Expenditure Approach
– Consumption Expenditure (C)
• Durable Consumer Goods
– Life span of more than three years
• Nondurable Consumer Goods
– Goods that are used up in three years
• Services
– Mental or physical help
8-26
Two Main Methods of Measuring
GDP (cont'd)
Deriving GDP by the Expenditure Approach
– Gross Private Domestic Investment (I)
• The creation of capital goods, such as factories and
machines, that can yield production and hence
consumption in the future
– Also included: changes in business inventories and repairs
made to machines, buildings
8-27
Two Main Methods of Measuring
GDP (cont'd)
Deriving GDP by the Expenditure Approach
– Gross Private Domestic Investment (I)
• Producer Durables or Capital Goods
– Life span of more than three years
• Fixed Investment
– Purchases by business of newly produced producer
durables or capital goods
• Inventory Investment
– Changes in stocks of finished goods and goods in process,
as well as changes in raw materials
8-28
Two Main Methods of Measuring
GDP (cont'd)
Deriving GDP by the Expenditure Approach
– Government Expenditures (G)
• State, local, and federal
• Valued at cost
8-29
Two Main Methods of Measuring
GDP (cont'd)
Deriving GDP by the Expenditure Approach
– Net Exports (Foreign Expenditures)
Net exports (X) = Total exports – Total imports
8-30
Two Main Methods of Measuring
GDP (cont'd)
Presenting the Expenditure Approach
– Where
• C = consumption expenditures
•I
= investment expenditures
• G = government expenditures
• X = net exports
GDP = C + I + G + X
8-31
Figure 8-2 GDP and Its
Components
8-32
Two Main Methods of Measuring
GDP (cont'd)
Deriving GDP by the Income Approach
8-33
Figure 8-3 Gross Domestic Product and Gross
Domestic Income, 2009 (in billions of 2009
dollars per year)
Sources: U.S. Department of Commerce and author’s estimates.
8-34
Other Components of National
Income Accounting
• National Income (NI)
– The total of all factor payments to resource
owners
• Personal Income (PI)
– The amount of income that households actually
receive before they pay personal income taxes
8-35
Other Components of National
Income Accounting (cont'd)
• Disposable Personal Income (DPI)
– Personal income after personal income taxes
have been paid
8-36
Distinguishing Between Nominal
and Real Values
• Nominal Values
– Measurements in terms of the actual market
prices at which goods are sold; expressed in
current dollars, also called money values
• Real Values
– Measurements after adjustments have been
made for changes in the average of prices
between years; expressed in constant dollars
8-37
Distinguishing Between Nominal
and Real Values (cont'd)
• Constant Dollars
– Dollars expressed in terms of real purchasing
power
– This price-corrected GDP is the real GDP.
8-38
Example: Correcting GDP for
Price Index Changes
• Correcting GDP for price index changes
– Nominal (current) dollars GDP
– Real (constant) dollars GDP
Nominal GDP
x 100
Real GDP =
Price index*
*Price index: measured by the GDP deflator
8-39
Table 8-3 Correcting GDP for Price
Index Changes
8-40
Distinguishing Between Nominal
and Real Values (cont'd)
• Per capita GDP
– Adjusting for population growth
Real GDP
Per capita real GDP =
Population
8-41
Figure 8-4 Nominal and Real GDP
Source: U.S. Department of Commerce
8-42
Comparing GDP Throughout the
World
• Foreign Exchange Rate
– The price of one currency in terms of another
8-43
Comparing GDP Throughout the
World (cont'd)
• Foreign exchange rate
• $1.50 = 1 euro, or $1 = .67 euros
• French income per capita = 24,120 euros
• French per capita income in terms of dollars equals
24,120 euros x $1.50 = $36,180
8-44
Comparing GDP Throughout the
World (cont'd)
• Purchasing Power Parity
– Adjustments in exchange rate conversions that
takes into account differences in the true cost of
living across countries
8-45
Table 8-4 Comparing GDP
Internationally
8-46
Summary Discussion of Learning
Objectives
• The circular flow of income and output
– In every economic transaction, receipts exactly
equal expenditures
– Goods and services flow in one direction and
money payments flow in the other
• Gross domestic product (GDP)
– The total market value of a nation’s final output
of goods and services produced in a year using
factors of production located within its borders
8-47
Summary Discussion of Learning
Objectives (cont'd)
• The limitations of using GDP as a measure
of national welfare
– Excludes non-market transactions
– Does not measure national well-being
• The expenditure approach to tabulating GDP
– GDP = C + I + G + X
8-48
Summary Discussion of Learning
Objectives (cont'd)
• The income approach to computing GDP
– The sum of wages, rent, interest, profits
• Distinguishing between nominal GDP and
real GDP
– Nominal GDP is the value of newly produced final
output measured in current market prices.
– Real GDP adjusts nominal GDP into constant
dollars by correcting for price level changes.
8-49