MODULE (MIDTERM)

LESSON
6

TITLE: NATIONAL INCOME ACCOUNTING: MEASURING

ECONOMIC GROWTH

TEXT:

 Nebres, Abriel, M., Economics, Concepts, Theories, and Application. First Edition.
Mandaluyong City, Philippines: National Book Store, 2008.
 Nafziger, E. Wayne, Economic Development. Fourth Edition. New York: Cambridge
University Press, 2006.

REFERENCES:

 https://opentextbc.ca/principlesofeconomics
 https://courses.lumenlearning.com/boundless-economics
 https://corporatefinanceinstitute.com/resources/knowledge/economics
 https://ilearnthis.com/a/gdp-deflator/

LESSON OBJECTIVES:

At the end of this lesson, the students will be able to:

 Define national income accounting.
 Define economic growth.
 Explain GDP and its components.
 Define and explain the approaches of assessing GDP: Expenditure, Income and Output.
 Explain what is GDP deflator and now it is calculated.
 Explain labor productivity and economic growth.

National Income Accounting

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National income accounting is a set of rules and statements of meaning for measuring economic
activity in the aggregate economy, that is, the entire economy. It provides a way of measuring
total production broken down into sub-aggregates and defines the relationship among these sub-
aggregates to analyze how much the nation is producing and consuming.

ECONOMIC GROWTH: DEFINITION

Economic growth can be defined as the increase in real gross domestic product (GDP) in the
long-run, or as increased productivity or via an increase in the natural resources (inputs) that
create output. It is important to note that real GDP adjusts for inflation, rather than looking at
output in nominal dollars. Economic growth could also be described as an outward shift in the
production-possibility frontier, allowing for the production of a higher quantity of goods.

DEFINING GROSS DOMESTIC PRODUCTS (GDP)

 Gross domestic product (GDP) is the market value of all final goods and services produced
within the national borders of a country for a given period of time. GDP can be determined in
multiple ways. The income approach and the expenditure approach highlighted below should
yield the same final GDP number.

 Gross domestic product (GDP) is a standard measure of a country’s economic health and an

indicator of its standard of living. Also, GDP can be used to compare the productivity levels
between different countries. The biggest advantage of GDP is that calculations of the
measure are fairly uniform from country to country. Thus, a comparison between countries
provides a high level of accuracy. Furthermore, GDP indicates economic expansion
or compression and the growth or decline of an economy.

 GDP is a measure of national income and output that can be used as a comparison tool.

Components of GDP

GDP (Y) is a sum of Consumption (C), Investment (I), Government Spending (G) and Net
Exports (X – M):

Y=C+I+G+(X−M)Y=C+I+G+(X−M)

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Defining the GDP components

Consumption

Consumption (C) is normally the largest GDP component in the economy, consisting of private
(household final consumption expenditure) in the economy. These personal expenditures fall
under one of the following categories: durable goods, non-durable goods, and services. Examples
include food, rent, jewelry, gasoline, and medical expenses but does not include the purchase of
new housing. Also, it is important to note that goods such as hand-knit sweaters are not counted
as part of GDP if they are gifted and not sold. Only expenditure-based consumption is counted.

Investment

Investment (I) includes, for instance, business investment in equipment, but does not include
exchanges of existing assets. Examples include construction of a new mine, purchase of
software, or purchase of machinery and equipment for a factory. Spending by households (not
government) on new houses is also included in Investment. In contrast to common usage,
‘Investment’ in GDP does not mean purchases of financial products. Buying financial products is
classified as ‘ saving ‘, as opposed to investment. This avoids double-counting: if one buys
shares in a company, and the company uses the money received to buy plant, equipment, etc., the
amount will be counted toward GDP when the company spends the money on those things. To
count it when one gives it to the company would be to count two times an amount that only
corresponds to one group of products. Note that buying bonds or stocks is a swapping of deeds, a
transfer of claims on future production, not directly an expenditure on products.

Government Spending

Government spending (G) is the sum of government expenditures on final goods and services. It
includes salaries of public servants, purchase of weapons for the military, and any investment
expenditure by a government. It does not include any transfer payments, such as social security
or unemployment benefits.

Net Exports

Exports (X) represents gross exports. GDP captures the amount a country produces, including
goods and services produced for other nations’ consumption, therefore exports are added.

Imports (M) represents gross imports. Imports are subtracted since imported goods will be
included in the terms G, I, or C, and must be deducted to avoid counting foreign supply as
domestic.

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Sometimes, net exports is simply written as NX, but is the same thing as X-M.

Note that C, G, and I are expenditures on final goods and services; expenditures on intermediate
goods and services do not count.

APPROACHES IN ASSESSING GDP

Expenditure Approach

The expenditure approach is basically an output accounting method. It focuses on finding the
total output of a nation by finding the total amount of money spent. This is acceptable, because
like income, the total value of all goods is equal to the total amount of money spent on goods.
The basic formula for domestic output takes all the different areas in which money is spent
within the region, and then combines them to find the total output.

Formula: Y = C + I + G + (X – M); where: C = consumption (household consumption

expenditures and personal consumption expenditures), I = gross private domestic investment, G
= government consumption and gross investment expenditures, X = gross exports of goods and
services, and M = gross imports of goods and services.

Example Problem:

Assume the consumer spending for a country was P500,000 for a particular period. The
government spending stood at P400,000. Fixed investment expenditure in the economy was
placed at P300,000 made up of P70,000 machinery purchases, P130,000 on inventory investment
and P100,000 on residential investment. Country’s exports was worth P400,000 while exports
amounted to P300,000.

Solution:

GDP = 500,000 + 400,000 +300,000 + (400,000-300,000)

= 1.3 Million

Income Approach

The income approach to calculating gross domestic product (GDP) states that all economic
expenditures should equal the total income generated by the production of all economic goods
and services.

The GDP formula takes the total income generated by the goods and services produced.

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Formula: Total National Income + Sales Taxes + Depreciation + Net Foreign Factors Income

Total National Income

The sum of all wages, rent, interest and profits.

Sales Taxes

Consumer taxes imposed by the government on sales of goods and services.

Depreciation

Cost allocated to a tangible asset over its useful life.

Net Foreign Income Factor

The difference between the total income that a country’s citizens and companies generated in
foreign countries, versus the total income foreign citizens and companies generate in the
domestic countries.

The income approach equates the total output of a nation to the total factor income received by
residents or citizens of the nation. The main types of factor income are:

 Employee compensation (cost of fringe benefits, including unemployment, health, and

retirement benefits);
 Interest received net of interest paid;
 Rental income (mainly for the use of real estate) net of expenses of landlords;
 Royalties paid for the use of intellectual property and extractable natural resources.

All remaining value added generated by firms is called the residual or profit or business cash
flow.

Example Problem:

Table `1: Income (Million)

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 Interest Income (i) 150
Depreciation 36
Wages (W) 67
Business Profit (PR) 200
Indirect Business Taxes 74
Rental Income (R) 75

Solution:

National Income = W + R + I + PR (67 +75 + 150 + 200)

= 492

GDP = 492 + 74 + 36

= 602

Output Approach

The output approach is also called “net product” or “value added” method. It focuses on finding
the total output of a nation by directly finding the total value of all goods and services a nation
produces. Because of the complication of the multiple stages in the production of a good or
service, only the final value of a good or service is included in the total output. This avoids an
issue referred to as double counting, where the total value of a good is included several times in
national output, by counting it repeatedly in several stages of production.

For example, in meat production, the value of the good from the farm may be $10, then $30 from
the butchers, and then $60 from the supermarket. The value that should be included in final
national output should be $60, not the sum of all those numbers, $90.

Formula: GDP (gross domestic product) at market price = value of output in an economy in the
particular year – intermediate consumption at factor cost = GDP at market price – depreciation +
NFIA (net factor income from abroad) – net indirect taxes.

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Real and Nominal GDP

To separate rises in GDP brought about by inflation from rises in GDP that stand for real rises in
production and income, economist differentiate between real and nominal GDP.
Nominal GDP is GDP calculated at existing prices.
Real GDP is nominal GDP adjusted for inflation. To adapt nominal output for inflation we lead
to a price index – a measure of how much the price level has increased from one year to the next,
and divided nominal GDP by that price index. That price index is the GDP deflator.

GDP Deflator

The GDP deflator, also described the implicit price deflator for GDP, is defined as the ratio of
nominal GDP to real GDP.

GDP Deflator formula:

Nominal GDP
GDP Deflator = ------------------

Real GDP

The GDP deflator reveals the status of overall level of prices in the economy.

To better understand this, consider an economy again with only one item, CAR.

If P is the price of the car and Q is the number of units sold, then nominal GDP is the total
number of dollars spent on car in that year, P × Q.

The GDP deflator reveals the status of overall level of prices in the economy.

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To better understand this, consider an economy again with only one item, CAR.

If P is the price of the car and Q is the number of units sold, then nominal GDP is the total
number of dollars spent on car in that year, P × Q.

Then nominal GDP is the total number of dollars spent on the car in that year is P × Q.

Real GDP is the number of cars of bread produced in that year times the price of cars in same
base year, Pbase × Q. The GDP deflator is the price of car in that year relative to the price of car
in the base year, P/Pbase.

The definition of the GDP deflator allows us to separate nominal GDP into two parts: one part
measures quantities (real GDP) and the other measures prices (the GDP deflator). That is,

Nominal GDP = Real GDP × GDP Deflator.

Nominal GDP calculates the current dollar value of the output of the economy. Real GDP
measures the output valued at constant prices. The GDP deflator measures the price of output
relative to its price in the base year.

We can also write this equation as…

Nominal GDP

Real GDP = ----------------------

GDP Deflator

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This way, you can see how the deflator earns its name: it is used to deflate (that is, take inflation
out of) nominal GDP to yield real GDP

GDP Deflator Examples

To understand why this is correct, consider a couple of simple examples.

First, assume that the quantities produced in the market rise over time but prices remain constant.

In this example, both nominal and real GDP increase together, so the GDP deflator is consistent.

Now imagine, instead, that prices increase over time, but the quantities produced stay the same.

Let’s now return to our numerical example in Table below

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The GDP deflator is calculated at the bottom of the table above. For GDP deflator year 2001,
nominal GDP is two hundred dollars, and real GDP is same as well, so the GDP deflator is 100.

For the year 2002, nominal GDP is Six hundred dollars, and real GDP is $350, so the GDP
deflator is calculated 171.

GDP deflator increased in the year 2002 from 100 to 171 which is 7%.

The GDP deflator is one measure that economists use to monitor the average level of prices in
the economy.

MEASURING ECONOMIC OUTPUT

Economists’ initially measure of domestic output: real gross domestic product (real GDP). Gross
Domestic Product (GDP) is the aggregate market value of all final goods and services in an
economy in a one-year period.
The economic action of the citizens and businesses of a country is measured by Gross National
Product (GNP), the total final output of citizens and businesses of an economy in a one-year
period. So, the economic activity of Filipino citizens working abroad is counted in the
Philippine GNP.
To shift from GDP to GNP we must add net income factor to GDP. Net foreign factor income is
the income from foreign domestic factor sources minus foreign factor income received
domestically. We must add the foreign income of our citizens and subtract the income of
residents who are not citizens.

Standard Measures of Economic Growth

Measuring economic growth is reasonably straight-forward, primarily focusing on either

increases in productivity or increases in the available production inputs in a given system. This
increase in productivity is converted into a relative percent based upon previous years, and
expressed as a growth or decline.

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For example, if a given economy is producing $1,000,000 in 1900 and 1,050,000 in 1901, the
economic growth rate (or GDP growth) will be expressed as 5%. If inflation is calculated to be
3% between 1900 and 1901, real economic growth will equate to 2%.

SHORT-RUN ECONOMIC GROWTH VERSUS LONG-RUN ECONOMIC GROWTH

In economics, economic growth refers to the growth of potential output. It shows how a country
is developing its economy. Economic growth is directly impacted by human capital, which is the
level of school or knowledge attainment in a country. The cognitive skills of a population
directly impact economic growth. In general, economic growth is recorded and studied over the
short-run and long-run.

Short-run Economic Growth

The business cycle refers to economy-wide fluctuations in production, trade, and economic
activity over several months or years. The short-run variation in economic growth is called the
business cycle. Economists use it to distinguish between short-run variations in economic growth
and long-run economic growth. The cycle is made up of increases and decreases in production
that occur over months and years. The changes in the business cycle are a result of fluctuations in
aggregate demand.

Long-run Economic Growth

Long-run economic growth is measured as the percentage rate increase in the real gross domestic
product. The GDP is defined as the market value of all officially recognized final goods and
services produced within a country in a given period of time. There are three approaches used to
determine the GDP:

 Product (output) approach: adds together the outputs of every class of enterprise to provide
the total.
 Income approach: calculates the sum of all the producers’ incomes.
 Expenditure approach: the value of the total product must be equal to the people’s total
expenditures.

In principle, all of the approaches should yield the same result for the GDP of a country.

For example, the equation for the expenditure approach is: GDP = C + I + G + (X – M).

Written out in full, the gross domestic product (GDP) equals private consumption (C) plus, gross
investment (I), government spending (G), and the exports minus the imports (X – M).

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For economic purposes, the economic growth is calculated and compared to the population, also
known as per capita income (indicator of a country’s standard of living). When the per capita
income increases it is called intensive growth. When the GDP growth is only caused by increases
in population or territory it is called extensive growth.

Factors that Impact Economic Growth

There are specific factors that have a direct impact on the economic growth of a country. Every
country is unique based on population, technology, government, wealth, etc. Economic growth
can be compared between countries, although no two countries are the same. Some of the factors
that impact economic growth include:

 Growth of productivity: the growth of productivity is the ratio of economic output to input

(capital, labor, energy, materials, and services). When productivity increases the cost of
goods decreases causing an increase in the per capita GDP. Lower prices create an increase
in higher aggregate demand. The growth of productivity is the driving force behind economic
growth.
 Demographics: demographics change the employment to population ratio as well as the
labor force participation rate. The age structure of the population affects the labor force
participation rate. For example, when women entered the workforce in the U.S. it contributed
to economic growth, as did the entrance of the baby boomers into the workforce.
 Labor force participation: the rate of labor force participation impacts economic growth. It
is the number of people working in the labor force. When manufacturing increased, it created
a higher productivity rate, but lowered the labor force participation, prices fell, and
employment shrank.
 Human capital: human capital is referred to as the skills of the population. Education is a
commonly used measurement for human capital. Human capital increases the society’s skill
which increases economic growth.
 Inequality: inequality in wealth and income has a negative impact on economic growth.
Inequality results in high and persistent unemployment. This has a negative effect on long-
run economic growth.
 Trade: international trade represents a significant part of GDP for most countries. It is the
exchange of goods and services across national borders.
 Quality of life: happiness has been shown to increase with a higher GDP per capita. Quality
of life is a direct result of economic growth. When poverty is alleviated and society has
access to what it needs, the quality of life increases. Consistent quality of life leads to
continued economic growth.
 Employment rate: in order for the employment rate to have a positive impact on economic
growth there must also be increases in productivity. If employment increases, but
productivity does not, then there is a higher number of working poor.
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LABOR PRODUCTIVITY AND ECONOMIC GROWTH

Sustained long-term economic growth comes from increases in worker productivity, which
essentially means how well we do things. In other words, how efficient is your nation with its
time and workers? Labor productivity is the value that each employed person creates per unit
of his or her input.

What determines how productive workers are? The answer is pretty intuitive. The first
determinant of labor productivity is human capital. Human capital is the accumulated
knowledge (from education and experience), skills, and expertise that the average worker in an
economy possesses. Typically, the higher the average level of education in an economy, the
higher the accumulated human capital and the higher the labor productivity.

The second factor that determines labor productivity is technological change. Technological

change is a combination of invention—advances in knowledge—and innovation, which is
putting that advance to use in a new product or service. 
The third factor that determines labor productivity is economies of scale. Recall that economies
of scale are the cost advantages that industries obtain due to size. 

MEASURING PRODUCTIVITY

COMPONENTS OF ECONOMIC GROWTH

Over decades and generations, seemingly small differences of a few percentage points in the
annual rate of economic growth make an enormous difference in GDP per capita. In this module,
we discuss some of the components of economic growth, including physical capital, human
capital, and technology.

The category of physical capital includes the plant and equipment used by firms and also things
like roads (also called infrastructure). Again, greater physical capital implies more output.
Physical capital can affect productivity in two ways: (1) an increase in the quantity of physical

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capital (for example, more computers of the same quality); and (2) an increase in the quality of
physical capital (same number of computers but the computers are faster, and so on). Human
capital and physical capital accumulation are similar: In both cases, investment now pays off in
longer-term productivity in the future.

The category of technology is the “joker in the deck.” Earlier we described it as the combination
of invention and innovation. When most people think of new technology, the invention of new
products like the laser, the smartphone, or some new wonder drug come to mind. In food
production, the development of more drought-resistant seeds is another example of technology.
Technology, as economists use the term, however, includes still more. It includes new ways of
organizing work, like the invention of the assembly line, new methods for ensuring better quality
of output in factories, and innovative institutions that facilitate the process of converting inputs
into output. In short, technology comprises all the advances that make the existing machines and
other inputs produce more, and at higher quality, as well as altogether new products.

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