CHAPTER
10
Measuring a Nation’s Income
Economics
PRINCIPLES OF
N. Gregory Mankiw
Premium PowerPoint Slides
by Ron Cronovich
© 2009 South-Western, a part of Cengage Learning, all rights reserved
In this chapter,
look for the answers to these questions:
 What is Gross Domestic Product (GDP)?
 How is GDP related to a nation’s total income and
spending?
 What are the components of GDP?
 How is GDP corrected for inflation?
 Does GDP measure society’s well-being?
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Micro vs. Macro
 Microeconomics:
The study of how individual households and
firms make decisions, interact with one another
in markets.
 Macroeconomics:
The study of the economy as a whole.
 We begin our study of macroeconomics with the
country’s total income and expenditure.
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Macroeconomics studies the structure of aggregate
economies and the impact of policies on their
performance.
• What determines economic fluctuations? (business
cycle)
• Why some countries grow faster than others ?
(economic growth)
•What causes unemployment ?
•What drives prices changes? (inflation)
•What is the role of economic policies and the
government? (monetary and fiscal policies)
•How being part of a global economic system affects the
economy of a country?
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
(1) Income and Expenditure
 Gross Domestic Product (GDP) measures
total income of everyone in the economy. [later: more
formal definition]
 GDP also measures total expenditure on the economy’s
output of goods and services (g&s).
For the economy as a whole,
income equals expenditure
because every dollar a buyer spends
is a dollar of income for the seller.
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
The Circular-Flow Diagram
 a simple depiction of the macroeconomy
 illustrates GDP as spending, revenue,
factor payments, and income
 Preliminaries:
 Factors of production are inputs like labor,
land, capital, and natural resources.
 Factor payments are payments to the factors
of production (e.g., wages, rent).
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
The Circular-Flow Diagram
Households:
 own the factors of production,
sell/rent them to firms for income
 buy and consume goods & services
Firms
Households
Firms:
 buy/hire factors of production,
use them to produce goods
and services
 sell goods & services
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
The Circular-Flow Diagram
Revenue (=GDP)
G&S
sold
Markets for
Goods &
Services
Firms
Factors of
production
Wages, rent,
profit (=GDP)
Spending (=GDP)
G&S
bought
Households
Markets for
Factors of
Production
Labor, land,
capital
Income (=GDP)
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
What This Diagram Omits
 The government
 collects taxes, buys g&s
 The financial system
 matches savers’ supply of funds with
borrowers’ demand for loans
 The foreign sector
 trades g&s, financial assets, and currencies
with the country’s residents
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
(2) Gross Domestic Product
To understand macroeconomic issues, we
first need information (data).
One very important (may be most important)
concept: Gross domestic product (GDP)
Paul Samuelson and William Nordhaus: “GDP …
among the great inventions of the twentieth century”
(cited in Survey of Current Business, Jan 2000, 6-14)
http://www.bea.gov/scb/pdf/BEAWIDE/2000/0100od.pdf
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.
Goods are valued at their market prices, so:
 All goods measured in the same units
(e.g., Hong Kong dollars, U.S. dollars)
 Things that don’t have a market value are
excluded, e.g., housework you do for yourself.
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.
Final goods: intended for the end user
Intermediate goods: used as components or ingredients in
the production of other goods
GDP only includes final goods – they already embody the
value of the intermediate goods used in their production.
e.g., General Motors (GM) does not produce tires for its
cars; it buys them from tire companies (such as Goodyear)
Tire: intermediate good; GM car: final good
Prevent double counting
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.
GDP includes tangible goods
(like DVDs, mountain bikes, beer)
and intangible services
(dry cleaning, concerts, mobile phone service).
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.
GDP includes currently produced goods,
not goods produced in the past.
e.g. If you bought a Toyota Prius on January 2005, the
purchase (say, at $200,000) was included in GDP (of 2005).
If you sold it on December 2010, that transaction was not
included in GDP (of 2010). Why?
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.
GDP measures the value of production that occurs
within the borders of a country (an economy),
whether done by its own citizens or by foreigners
located there.
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.
Usually a year or a quarter (3 months)
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Gross Domestic Product
Iran
nominal GDP (2007/1389): Rials 4,304,264
billions (US$ 391 billion)
GDP per capita: Rials 59.8 million
(US$ 5,435)
USA
nominal GDP (2007): US$14,077.6 billions
population (est.): 301,290,332 (US Census Bureau)
GDP per capita: US$ 46,724
nominal GDP: measured at current prices
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Gross Domestic Product
Data
USA: Bureau of Economic Analysis (BEA), Department of
Commerce
http://www.bea.gov/
(http://www.bea.gov/national/xls/gdplev.xls)
Iran: Central Bank
http://www.cbi.ir
(http://www.cbi.ir/simplelist/4454.aspx)
releases the information every quarter ?!!!
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
(3) The Components of GDP
 Recall: GDP is total spending.
 Four components:
 Consumption (C)
 Investment (I)
 Government Purchases (G)
 Net Exports (NX)
 These components add up to GDP (denoted Y):
Y = C + I + G + NX
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Consumption (C)
 is total spending by households on g&s.
 Note on housing costs:
 For renters,
consumption includes rent payments.
 For homeowners,
consumption includes the imputed rental value
of the house, but not the purchase price or
mortgage payments.
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Investment (I)
 is total spending on goods that will be used in the
future to produce more goods.
 includes spending on
 capital equipment (e.g., machines, tools)
 structures (factories, office buildings, houses)
 inventories (goods produced but not yet sold)
Note: “Investment” does not
mean the purchase of financial
assets like stocks and bonds.
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Government Purchases (G)
 is all spending on the g&s purchased by govt.
at the federal, state, and local levels.
 G excludes transfer payments, such as
Social Security or unemployment insurance
benefits.
They are not purchases of g&s.
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Net Exports (NX)
 NX = exports – imports
 Exports represent foreign spending on the
economy’s g&s.
 Imports are the portions of C, I, and G
that are spent on g&s produced abroad.
 If HK consumers buy $10 million worth of
watches made in Switzerland, that spending is
included in consumption expenditure. However,
the imports do not represent domestic production.
Thus, the value of these imports is subtracted
from GDP (see the next equation).
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
GDP and Its Components
 Adding up all the components of GDP gives:
Y = C + I + G + NX
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ACTIVE LEARNING
1
GDP and its components
In each of the following cases, determine how much GDP
and each of its components is affected (if at all).
A. Debbie spends $200 to buy her husband dinner
at the finest restaurant in the Central.
B. Sarah spends $1800 on a new laptop to use in her
publishing business. The laptop was built in Japan.
C. Jane spends $1200 on a computer to use in her
editing business. She got last year’s model on sale
for a great price from a local manufacturer.
D. A car company builds $500 million worth of cars,
but consumers only buy $470 million worth of them.
ACTIVE LEARNING
1
Answers
A. Debbie spends $200 to buy her husband dinner
at the finest restaurant in the Central.
Consumption and GDP rise by $200.
B. Sarah spends $1800 on a new laptop to use in
her publishing business. The laptop was built in
Japan.
Investment rises by $1800, net exports fall
by $1800, GDP is unchanged.
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ACTIVE LEARNING
1
Answers
C. Jane spends $1200 on a computer to use in her
editing business. She got last year’s model on
sale for a great price from a local manufacturer.
Current GDP and investment do not change,
because the computer was built last year.
D. A car company builds $500 million worth of cars,
but consumers only buy $470 million of them.
Consumption rises by $470 million,
inventory investment rises by $30 million,
and GDP rises by $500 million.
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
U.S. GDP and Its Components, 2007
billions
% of GDP
per capita
Y
$13,841
100.0
$45,825
C
9,734
70.3
32,228
I
2,125
15.4
7,037
G
2,690
19.4
8,905
NX
–708
–5.1
–2,344
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Iran GDP and Its Components, 1389
Consumption
= 1767 Trillion Rial
(41%)
Investment
= 1785 T Rial
(41%)
- Gross domestic fixed
capital formation
= 1146 T Rial
- Changes in inventories
= 639 T Rial
Government consumption
= 481 T Rial
Exports
= 1194 T Rial
Imports
= 896 T Rial
GDP = C + I + G + (X - M) = 4333 T Rial
(11%)
(100%)
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
GDP and Its Components
USA vs. Iran (2007)
• Consumption: 70.3% in USA; 41% in Iran.
• Investment: 15.4% in USA; 41% in Iran.
• Government purchases: 19.4% in USA; 11% in Iran.
• Net exports: negative in USA; positive in Iran (7%).
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
(4) Real versus Nominal GDP
 Inflation can distort economic variables like GDP,
so we have two versions of GDP:
One is corrected for inflation, the other is not.
 Nominal GDP values output using current prices.
It is not corrected for inflation.
 Real GDP values output using the prices of
a base year. Real GDP is corrected for inflation.
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Real versus Nominal GDP
Nominal GDP of Iran, 1388 and 1389
Consumption
1540 Trillion Rial
1767 Trillion Rial
Investment
1424 T Rial
1785 T Rial
- Gross domestic fixed
capital formation
949 T Rial
1146 T Rial
- Changes in inventories
475 T Rial
639 T Rial
Government consumption 445 T Rial
481 T Rial
Exports
923 T Rial
1194 T Rial
Imports
756 T Rial
896 T Rial
GDP = C + I + G + (X - M) 3577 T Rial (2006) 4333 T Rial (1389)
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Real versus Nominal GDP
Reason for Introducing Real GDP
When GDP increases from one year (1388) to the next
(1389) by 21%, can we conclude that the quantity of
production increases by 21%?
Because GDP is measured in value terms, it can be
changed by changes in prices, not quantities. We should
be careful about interpreting changes over time.
To separate price changes from quantity changes, we
introduce a concept called real GDP.
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Real versus Nominal GDP
Calculating Real GDP
Nominal GDP The value of final goods and
services evaluated at current-year prices.
= P1Q1+ P2Q2+…+PnQn
Real GDP The value of final goods and services
evaluated at base-year prices.
 P Q1  P Q2  ...  P Qn
b
1
b
2
b
n
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
EXAMPLE:
Pizza
Latte
year
P
Q
P
Q
2005
$10
400
$2.00
1000
2006
$11
500
$2.50
1100
2007
$12
600
$3.00
1200
Compute nominal GDP in each year:
2005: $10 x 400 +
$2 x 1000
= $6,000
Increase:
37.5%
2006: $11 x 500 + $2.50 x 1100 = $8,250
2007: $12 x 600 +
$3 x 1200
= $10,800
30.9%
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
EXAMPLE:
Pizza
Latte
year
P
Q
P
Q
2005
$10
400
1000
2006
$11
500
$2.00
$2.50
2007
$12
600
$3.00
1200
Compute real GDP in each year,
using 2005 as the base year:
2005: $10 x 400 + $2 x 1000 = $6,000
1100
Increase:
20.0%
2006: $10 x 500 + $2 x 1100 = $7,200
2007: $10 x 600 + $2 x 1200 = $8,400
16.7%
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
EXAMPLE:
year
2005
Nominal
GDP
$6000
Real
GDP
$6000
2006
$8250
$7200
2007
$10,800
$8400
In each year,
 nominal GDP is measured using the (then)
current prices.
 real GDP is measured using constant prices from
the base year (2005 in this example).
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
EXAMPLE:
year
2005
Nominal
GDP
$6000
2006
$8250
2007
$10,800
37.5%
30.9%
Real
GDP
$6000
$7200
$8400
20.0%
16.7%
 The change in nominal GDP reflects both prices
and quantities.
 The change in real GDP is the amount that
GDP would change if prices were constant
(i.e., if zero inflation).
Hence, real GDP is corrected for inflation.
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Nominal and Real GDP in the U.S.,
1965-2007
Billions
$12,000
$10,000
Real GDP
$8,000
$6,000
$4,000
$2,000
(base year
2000)
Nominal
GDP
$0
1965 1970 1975 1980 1985 1990 1995 2000 2005
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Which measure of GDP represents changes strictly
in the quantity of goods and services produced in
the economy, not the prices?
a. Nominal GDP.
b. Real GDP.
c. The GDP measure that sums up the value of
goods and services evaluated at current year
prices.
d. None of the above.
ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Which measure of GDP represents changes strictly
in the quantity of goods and services produced in
the economy, not the prices?
a. Nominal GDP.
b. Real GDP.
c. The GDP measure that sums up the value of
goods and services evaluated at current year
prices.
d. None of the above.
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
The GDP Deflator
 One by-product of real GDP calculation is to
compute the general price level.
 The GDP deflator is a measure of the overall
level of prices.
 Definition:
nominal GDP
GDP deflator = 100 x
real GDP
 One way to measure the economy’s inflation
rate is to compute the percentage increase in
the GDP deflator from one year to the next.
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
EXAMPLE:
year
Nominal
GDP
Real
GDP
GDP
Deflator
2005
$6000
$6000
100.0
2006
$8250
$7200
114.6
2007
$10,800
$8400
128.6
14.6%
12.2%
Compute the GDP deflator in each year:
2005:
100 x (6000/6000) =
100.0
2006:
100 x (8250/7200) =
114.6
2007:
100 x (10,800/8400) =
128.6
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ACTIVE LEARNING
2
Computing GDP
2007 (base yr)
P
Good A
Good B
$30
$100
Q
2008
P
2009
Q
900 $31 1,000
192 $102
200
P
Q
$36
$100
1050
205
Use the above data to solve these problems:
A. Compute nominal GDP in 2007.
B. Compute real GDP in 2008.
C. Compute the GDP deflator in 2009.
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ACTIVE LEARNING
2
Answers
2007 (base yr)
P
Good A
Good B
$30
$100
Q
2008
P
2009
Q
900 $31 1,000
192 $102
200
P
Q
$36
$100
1050
205
A. Compute nominal GDP in 2007.
$30 x 900 + $100 x 192 = $46,200
B. Compute real GDP in 2008.
$30 x 1000 + $100 x 200 = $50,000
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ACTIVE LEARNING
2
Answers
2007 (base yr)
P
Good A
Good B
$30
$100
Q
2008
P
2009
Q
900 $31 1,000
192 $102
200
P
Q
$36
$100
1050
205
C. Compute the GDP deflator in 2009.
Nom GDP = $36 x 1050 + $100 x 205 = $58,300
Real GDP = $30 x 1050 + $100 x 205 = $52,000
GDP deflator = 100 x (Nom GDP)/(Real GDP)
= 100 x ($58,300)/($52,000) = 112.1
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
(5) GDP and Economic Well-Being
 Real GDP per capita is the main indicator of
the average person’s standard of living.
 But GDP is not a perfect measure of
well-being.
 Robert Kennedy issued a very eloquent
yet harsh criticism of GDP:
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Gross Domestic Product…
“… does not allow for the health of our
children, the quality of their education,
or the joy of their play. It does not
include the beauty of our poetry or
the strength of our marriages, the
intelligence of our public debate or
the integrity of our public officials.
It measures neither our courage, nor our wisdom,
nor our devotion to our country. It measures everything,
in short, except that which makes life worthwhile, and it
can tell us everything about America except why we are
proud that we are Americans.”
- Senator Robert Kennedy, 1968
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
GDP Does Not Value:
 the quality of the environment
 leisure time
 non-market activity, such as the child care
a parent provides his or her child at home
 an equitable distribution of income
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Then Why Do We Care About GDP?
 Having a large GDP enables a country to afford
better schools, a cleaner environment,
health care, etc.
 Many indicators of the quality of life are
positively correlated with GDP. For example…
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Life expectancy (years)
GDP and Life Expectancy in 12 countries
Indonesia
China
Japan
U.S.
Mexico
Germany
Brazil
Pakistan
India
Russia
Bangladesh
Nigeria
Real GDP per capita
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GDP and Literacy in 12 countries
China
Russia
Germany
Adult Literacy
(% of population)
Mexico
Japan
U.S.
Brazil
Indonesia
Nigeria
India
Pakistan
Bangladesh
Real GDP per capita
52
GDP and Internet Usage in 12 countries
Internet Usage
(% of population)
Japan
Pakista
n
Nigeria
U.S.
Germany
Brazil
Indonesia
Mexico
Russia
China
India
Bangladesh
Real GDP per capita
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CHAPTER SUMMARY
 Gross Domestic Product (GDP) measures a
country’s total income and expenditure.
 The four spending components of GDP include:
Consumption, Investment, Government Purchases,
and Net Exports.
 Nominal GDP is measured using current prices.
Real GDP is measured using the prices of a
constant base year and is corrected for inflation.
 GDP is the main indicator of a country’s economic
well-being, even though it is not perfect.
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© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Growth around the World
 Growth rates in developing countries (including
China and India) are on average higher than those in
developed countries. Does this mean convergence?
 During the last decade of the 20th century 54
developing countries had negative average growth
rates, and most of those with positive growth rates
were growing slower than high-income countries
 Even worse; due to much faster population, GDP per
capita growth rates in most developing countries are
relatively low or even negative
ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME
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ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME
56
© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME
57
© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME
58
© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
1338
1340
1342
1344
1346
1348
1350
1352
1354
1356
1358
1360
1362
1364
1366
1368
1370
1372
1374
1376
1378
1380
1382
1384
1386
1388
© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Iran GDP (current prices)
5000000
4500000
500000
4304264
4000000
3500000
3000000
2500000
2000000
1500000
1000000
284
0
ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME
59
1338
1340
1342
1344
1346
1348
1350
1352
1354
1356
1358
1360
1362
1364
1366
1368
1370
1372
1374
1376
1378
1380
1382
1384
1386
1388
© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
Iran GDP (fixed prices, 1376)
600000
539219
500000
400000
300000
200000
100000 43911
0
ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME
60
© 2009 South-Western Principles of Macroeconomics, by N. G. Mankiw.
-0,05
1339
1341
1343
1345
1347
1349
1351
1353
1355
1357
1359
1361
1363
1365
1367
1369
1371
1373
1375
1377
1379
1381
1383
1385
1387
1389
Iran Economic Growth
0,2
0,15
0,1
0,05
0
-0,1
-0,15
-0,2
ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME
61