ECON 151 – PRINCIPLES OF MACROECONOMICS
Chapter 8:
Measuring the Economy’s Performance
Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.
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

2
Learning Objectives
Explain the expenditure approach to
tabulating GDP
 Explain the income approach to
computing GDP
 Distinguish between nominal GDP and
real GDP

3
National Income Accounting

National Income Accounting
 A measurement
system used to estimate
national income and its components
4
The Simple Circular Flow
Figure 8-1
5
The Simple Circular Flow
Figure 8-1
6
The Simple Circular Flow
Figure 8-1
7
The Simple Circular Flow
Figure 8-1
8
The Simple Circular Flow

Two observations


In every economic exchange, the seller
receives exactly the same amount that the
buyer spends.
Goods and services flow in one direction
and money payments flow in the other.
9
The Simple Circular Flow

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
10
The Simple Circular Flow

Product Markets
 Transactions
in which
households buy goods
11
The Simple Circular Flow

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
12
The Simple Circular Flow

Factor Markets
 Transactions
in which
businesses buy
resources
13
The Simple Circular Flow

Total Income
 The
yearly amount
earned by the nation’s
factors of production
14
The Simple Circular Flow

Question


Why must total income be
identical to the dollar value
of total output?
Answer

Every transaction
simultaneously involves an
expenditure and a receipt
15
National Income Accounting

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
16
National Income Accounting

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
17
National Income Accounting

Intermediate Goods
 Goods
used up entirely in the production of
final goods
18
Sales Value and Value Added
at Each Stage of Donut Production
Stage of Production
Stage 1: Fertilizer and Seed
Dollar Value of Sales
$.03
$.03
Stage 2: Growing
.06
Stage 3: Milling
.12
Stage 4: Baking
.30
Stage 5: Retailing
.45
Total dollar value of all sales
Value Added
$.96
$.03
$.06
$.18
$.15
Total value added
$.45
19
National Income Accounting

Exclusion of financial transactions,
transfer payments, and secondhand
goods
 Numerous
transactions occur that have
nothing to do with final goods and services
being produced.
20
National Income Accounting

Financial transactions
 Securities

Stocks and bonds
 Government


Social Security
Unemployment compensation
 Private


transfer payments
transfer payments
Individual gifts
Corporate gifts
21
National Income Accounting

Transfer of secondhand goods
 Why
not count the sale of a used car, stereo,
or snowboard as part of GDP?

Other excluded transactions
 Household
production
 Legal underground transactions
 Illegal underground transactions
22
Recognizing GDP Limitations

GDP’s limitations
 Excludes
non-market production
 Different countries have different legal versus
illegal activities
 Quality of life is not measured
 GDP poorly measures a nation’s well-being
23
Two Main Methods
of Measuring GDP

Expenditure Approach
 A way
of computing national income by
adding up the dollar value at current market
prices of all final goods and services
24
Two Main Methods
of Measuring GDP
Expenditure Approach
25
Two Main Methods
of Measuring GDP

Income Approach
 A way
of measuring national income by
adding up income received by all factors of
production
26
Two Main Methods
of Measuring GDP
Income Approach
27
Two Main Methods
of Measuring GDP

Deriving GDP by the expenditure
approach
 Consumption

Durables


Life span of more than three years
Nondurables


Expenditure (C)
Life span of less than three years
Services

Intangible commodities
28
Two Main Methods
of Measuring GDP

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
29
Two Main Methods
of Measuring GDP

Deriving GDP by the expenditure
approach
 Government
Expenditures (G)
State, local, and federal
 Valued at cost

30
Two Main Methods
of Measuring GDP

Deriving GDP by the expenditure
approach
 Net
Exports (Foreign Expenditures)
Net exports (X) = total exports - total imports
31
Two Main Methods
of Measuring GDP

Mathematical representation using the
expenditure approach
GDP = C + I + G + X
32
GDP and Its Components
Figure 8-4
33
Two Main Methods
of Measuring GDP

Depreciation and net domestic product
 Deducting
for depreciation (capital
consumption allowance)

Reduction in the value of capital goods over a
one-year period due to physical wear and tear,
and also to obsolescence
NDP = GDP - depreciation
34
Two Main Methods
of Measuring GDP



GDP = C + I + G + X
NDP = C + I + G + X - depreciation
Net Investment = I - depreciation
 Domestic
investment minus an estimate of the wear
and tear on the existing capital stock

NDP = C + net I + G + X
35
Two Main Methods
of Measuring GDP

Deriving GDP by the income approach
36
Deriving GDP
by the Income Approach

Gross Domestic Income (GDI)
 The
sum of all income—wages, interest, rent,
and profits—paid to the four factors of
production
37
Two Main Methods
of Measuring GDP

Gross Domestic Income (GDI)
 Wages
 Interest
 Rent
 Profits
38
Two Main Methods
of Measuring GDP
Gross domestic product equals gross
domestic income plus indirect business
taxes and depreciation.
 These last items are called nonincome
expense items.

39
Gross Domestic Product
and Gross Domestic Income, 2005
(in billions of 2005 dollars per year)
Figure 8-5
Source: U.S. Department of Commerce. First quarter preliminary data annualized.
40
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
41
Other Components
of National Income Accounting

Disposable Personal Income (DPI)
 Personal
income after personal income taxes
have been paid
42
Going from GDP
to Disposable Income, 2005
Source: U.S. Department of Commerce, and author’s estimates
Table 8-2
43
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
44
Distinguishing Between Nominal
and Real Values

Real Values
 Measurements
after adjustments have been
made for changes in the average
of prices between years; expressed in
constant dollars
45
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 level*
*Price level: measured by the GDP deflator
46
Example: Correcting GDP
for Price Index Changes
Table 8-3
Source: U.S. Department of Commerce, Bureau of Economic Analysis,
and author’s estimates
47
Nominal and Real GDP
Figure 8-6
Source: U.S. Department of Commerce
48
Distinguishing Between Nominal
and Real Values

Per capita GDP
 Adjusting
for population growth
real GDP
Per capita real GDP =
population
49
Nominal and Real GDP


The Bureau of Economic Analysis now uses a
chain-weighted measure of real GDP.
This means that changes in the prices and
output levels of a certain good will contribute to
overall changes in GDP to the extent that the
good accounts for a significant share of overall
economic activity.
50
Distinguishing Between Nominal
and Real Values

Some issues
 The
distribution of output
 Changes in leisure time
 Increased traffic congestion
 Air pollution
 Crime
 Housework
51
Comparing GDP
Throughout the World

Example
 France
$1.25 = 1 euro
 Per capita income = 23,168.80 euros

 France
per capita income in terms of dollars
equals
23,168.80 x 1.25 = $28,961.
52
Comparing GDP
Throughout the World

True purchasing power
 Accounting
for goods and services that are
not traded in the world market
 Purchasing Power Parity

Adjustments in exchange rate conversions that
takes into account differences in the true cost of
living across countries
53
International Example:
Purchasing Power Parity Comparisons of Incomes
Table 8-4
Source: World Bank
54
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
55
Summary Discussion
of Learning Objectives

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
56
Summary Discussion
of Learning Objectives

The income approach to computing GDP
 The
sum of wages, rent, interest, profit,
depreciation, and indirect business taxes

Distinguishing between nominal GDP and
real GDP
 Nominal
GDP is the value of newly produced final
output in the current year measured in current
market prices.
 Real GDP adjusts nominal GDP into constant
dollars by correcting for price level changes.
57
ECON 151 – PRINCIPLES OF MACROECONOMICS
Chapter 8:
Measuring the Economy’s Performance
Materials include content from Pearson Addison-Wesley which has been modified
by the instructor and displayed with permission of the publisher. All rights reserved.