ECN 111 Chapter 5 Lecture Notes

5.1. GDP, Income, and Expenditure

A. GDP Defined
Gross Domestic Product or GDP is the market value of all the final goods and
services produced within a country in a given time period.
1. Value Produced
The items are valued at their market value,—at the price at which each item is
traded in markets.
2. What Produced
A final good or service is a good or service that is produced for its final user and
not as a component of another good or service. To calculate GDP, we value all the
final goods and services.
a. An intermediate good or service is a good or service that is produced by one
firm, bought by another firm, and used as a component of a final good or
service.
3. Where Produced
Goods and services produced within a country count as part of that country's GDP.
4. When Produced
GDP measures the value of production during a given time period.
B. Circular Flows in the U.S. Economy
Four groups buy the final goods and services produced: household, firms,
governments, and the rest of the world.
1. Consumption expenditure is the expenditure by households on goods and
services.
2. Investment is the purchase of new capital goods (tools, instruments, machines,
buildings, and other constructions) and additions to inventories.
3. Government purchases of goods and services are the purchases by all levels
of government on goods and services.
4. Net exports of goods and services is the value of exports of goods and services
minus the value of imports of goods and services. Exports of goods and
services are items that firms in the United States produce and sell to the rest of
the world. Imports of goods and services are items that households, firms, and
governments in the United States buy from the rest of the world.
5. Total expenditure equals the sum of the four types of expenditure, C + I + G + NX.
6. Income is the sum of wages, interest, rent, and profit.
C. Expenditure Equals Income
The circular flow shows that income, Y, equals expenditure, C + I + G + NX. So the
value of production equals income equals expenditure.
5.2. Measuring U.S. GDP
A. The Expenditure Approach
The expenditure approach measures GDP by using data on consumption expenditure,
investment, government purchases, and net exports.
B. Expenditures Not in GDP
1. Used goods are not part of GDP because they already were part of GDP in the
period in which they were produced.
2. The expenditure on newly produced capital goods is part of GDP, but the purchase
of financial assets is not.
C. The Income Approach
The income approach measures GDP by summing the incomes that firms pay
households for the resources they hire–wages for labor, interest for the use of capital,
rent for the use of land, and profits for entrepreneurship.
1. Compensation of Employees—the payment for labor services.
2. Net Interest—the interest households receive on loans they make minus the
interest households pay on their own borrowing.
3. Rental Income of Persons—payments for the use of land and other rented inputs.
4. Corporate Profit—profits of corporations.
 5. Proprietors’ Income—payments to people who run their own businesses. It is a
mixture of the previous four items.
6. From Factor Cost to Market Price
The sum of compensation of employees, net interest, rental income of persons,
corporate profit, and proprietor’s income is net domestic product at factor
cost. To convert the value at factor cost to the value at market prices, we add
indirect taxes and subtract subsidies.
7. From Gross to Net
To convert this net domestic product at factor cost to GDP, depreciation, the
decrease in the value of capital that results from its use and from obsolescence
(also call capital consumption), must be added.
D. Valuing the Output of Industries
Value added, the value of a firm’s production minus the value of the intermediate
goods it buys from other firms, can be used to measure the contribution each
industry makes to GDP.
5.3. Nominal GDP Versus Real GDP
A. Calculating Real GDP
Real GDP is the value of the final goods and services produced in a given year when
valued at constant prices. Nominal GDP is the value of the final goods and services
produced in a given year valued at the prices that prevailed in that same year.
1. Nominal GDP Calculation—value the products produced at the current price and
then sum these values.
2. Traditional Real GDP Calculation—the traditional method values the quantities
produced in each year at the prices of the base year.
3. New Method of Calculating GDP—this method uses the prices of two adjacent years
to calculate the real GDP growth rate.
a. Value last year’s production and this year’s production at last year’s prices and
then calculate the growth rate of this number from last year to this year.
b. Value last year’s production and this year’s production at this year’s prices and
then calculate the growth rate of this number from last year to this year.
c. Calculate the average of the two growth rates. This average growth rate is the
growth rate of real GDP from last year to this year.
4. Chain Linking
By applying the calculated percentage change to the real GDP of the preceding
real GDP, each year is linked back to the dollars of the base year like the links in a
chain.
B. Calculating the GDP Deflator
The GDP deflator is an average of current prices as a percentage of base-year
prices and equals (Nominal GDP  Real GDP)  100.
5.4. Real GDP and the Standard of Living
A. Goods and Services Omitted from GDP
1. Household production
Household production is productive activities at the home that do not involve
market transactions.
2. Underground production
Underground production is the part of the economy that is hidden from the view of
the government either because people want to avoid taxes and regulations or
because the goods and services being produced are illegal.
3. Leisure time
Leisure time is an economic good that does not get measured in the official GDP
figures. Leisure time is a good that must be at least as valuable to us as the wage
we earn for working.
4. Environment quality
If our standard of living is adversely affected by pollution, our GDP measure does
not show this fact. The reason is that the devices that we produce to mitigate
pollution count as part of GDP but the pollution itself is not subtracted.
B. Other Influences on the Standard of Living
1. Health and Life Expectancy
 Health and life expectancy have improved as infant deaths and death in childbirth
have almost been eliminated. Life expectancy has increased from 70 years at the
end of WWII to nearly 80 years today. These gains have been checked somewhat
by AIDS and drug abuse, which take away from our standard of living.
2. Political freedom and social justice
A country might enjoy a very large GDP but have limited political freedom and
social justice.