Measuring a Nation’s Income

based on Gregory Mankiw,

Principles of Economics

Macroeconomics Sem. II
Bcom- 2024

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 Chapter 1: Lesson Plan
1. Concept and measures of GVA, GDP, NDP, GNP,NI and PDI
2. Three approaches of measuring NI : Product Method,
Expenditure Method, Factor Income Method and their
equivalence
3. Saving-Investment Identity in a closed and open economy
4. Government Budget Deficit and Twin Deficit
5. Real and Nominal GDP, GDP deflator
6. CPI (CPI and Inflation, CPI vs.GDP Deflator)
7. GDP and Social Welfare
Numerical problems

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Figure 1 The Circular-Flow Diagram

MARKETS
Revenue FOR Spending
GOODS AND SERVICES
Goods •Firms sell Goods and
and services •Households buy services
sold bought

FIRMS HOUSEHOLDS
•Produce and sell •Buy and consume
goods and services goods and services
•Hire and use factors •Own and sell factors
of production of production

Factors of MARKETS Labor, land,

production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, •Households sell Income
and profit •Firms buy
= Flow of inputs
and outputs
= Flow of dollars

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Copyright © 2004 South-Western
Measuring Macroeconomic
performance - GDP
• Gross domestic product (GDP) is a measure of the
income and expenditures of an economy.

• GDP is the total market value of all final goods and

services produced within a country in a given period
of time.

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THE ECONOMY’S INCOME
AND EXPENDITURE

• For an economy as a whole, income must equal

expenditure because:

• Every transaction has a buyer and a seller.

• Every dollar of spending by some buyer is a dollar of
income for some seller.

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THE MEASUREMENT OF
GROSS DOMESTIC PRODUCT
• For an economy as a whole, income must equal expenditure;
• Hence to measure national income we use Gross Domestic
Product (GDP).

GDP is the market value of all final goods and services

produced within a country in a given period of time.

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THE MEASUREMENT OF
GROSS DOMESTIC PRODUCT
• “GDP is the Market Value . . .”
• Output is valued at market prices.

• “...of all FINAL...”

• It records only the value of final goods, not intermediate
goods (the value is counted only once).

• “. . . Goods and Services . . . “

• It includes both tangible goods (food, clothing, cars) and
intangible services (haircuts, housecleaning, doctor visits).

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THE MEASUREMENT OF
GROSS DOMESTIC PRODUCT
• “. . . Produced . . .”
• It includes goods and services currently produced, not
transactions involving goods produced in the past.

• “ . . . Within a Country . . .”
• It measures the value of production within the geographic
confines of a country.

• “. . . In a Given Period of Time.”

• It measures the value of production that takes place within a
specific interval of time, usually a year or a quarter (three
months).
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THE MEASUREMENT OF
GROSS DOMESTIC PRODUCT

• “. . . of ALL Final . . .”
• Supposed to be all goods; but a few major categories of
produced goods and services left out.

WHAT TYPES OF PRODUCTION GET LEFT OUT OF

GDP ACCOUNTS?

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THE MEASUREMENT OF
GROSS DOMESTIC PRODUCT
• GDP includes all items produced in the economy and
sold legally in markets;
• ...but it excludes items produced and sold illicitly, such as illegal
drugs.
• More importantly, GDP excludes most items that are
produced and consumed at home and that never enter
the marketplace; such as...
• Childcare services
• Elderly, sick and disabled care services
• Home cooked meals
• Household maintenance services (washing, cleaning, ironing,...)
• etc.

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Other Measures of National Income:
Gross National Product
• Gross national product (GNP) is another measure of the
income and expenditures of an economy.

• GNP is the total market value of all final goods and

services produced by the nationals of a country in a
given period of time.

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Other Measures of National Income:
Net Domestic Product and
Net National Product
• “Gross” stands for the fact that GDP/GNP accounts
do not take “depreciation” into account.
• Depreciation: The wear and tear down of
machinery, tools, equipment, infrastructure used up
in the production process.
• Hence: NDP = GDP – depreciation
NNP = GNP – depreciation

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 GNP vs. GDP
• Gross National Product (GNP):
Total income earned by the nation’s factors of
production, regardless of where located.
• Gross Domestic Product (GDP):
Total income earned by domestically-located factors
of production, regardless of nationality.
(GNP – GDP) = (factor payments from abroad)
– (factor payments to abroad)

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Discussion question:

In your country,
which would you want
to be bigger, GDP, or GNP?
Why?

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 (GNP – GDP) as a percentage of GDP
selected countries, 2002
U.S.A. 1.0%
Angola -13.6
Brazil -4.0
Canada -1.9
Hong Kong 2.2
Kazakhstan -4.2
Kuwait 9.5
Mexico -1.9
Philippines 6.7
U.K. 1.6
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Method 1: Expenditure Method

• GDP (Y) is the sum of the following:

• Consumption (C)
• Investment (I)
• Government Purchases (G)
• Net Exports (NX)

Y = C + I + G + NX

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 Components of Aggregate Expenditure
• Consumption (C):
• The spending by households on goods and services, with the
exception of purchases of new housing.
• Investment (I):
• The spending on capital equipment, inventories, and structures,
including new housing.
• Government Purchases (G):
• The spending on goods and services by local, state, and federal
governments.
• Does not include transfer payments because they are not made
in exchange for currently produced goods or services.
• Net Exports (NX):
• Exports minus imports.
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Table 1 GDP and Its Components

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Copyright©2004 South-Western
 GDP and Its Components (2001)
Government Purchases
18%
Investment Net Exports
16% -3 %

Consumption
69%

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Can exports exceed GDP?
• Export ratio = X/GDP
• No or Yes?
• 1994 Singapore had an export ratio 140%. How?
• Exports and imports include x and m of both
intermediate and final good

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Government Sector
• If we include the govt. sector in the model, we need to include all the
income and expenditures done by the govt. in an economy.

• Earnings of the Govt.: It includes all tax and non-tax sources of revenue.

• Tax Revenue: The tax earnings are revenues from Direct as well as
Indirect taxes.

• Direct Taxes are those taxes which are paid by the income earners
to the govt. and the burden cannot be shifted to someone else. e.g.
property tax, income tax, wealth tax etc.

• Indirect taxes are the commodity taxes and the burden of indirect
taxes can be shifted to someone else. e.g. GST, Excise Duty etc.

• Non Tax Revenue: The non tax earnings of the govt. include the revenue
from different administrative departments, the profits of public sector
units or enterprises etc.
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• Compared to the tax earnings of the govt. the non tax earnings are significantly
less and that is why ‘non tax revenues’ are not going to be considered in this
analysis.

• Let the total direct tax paid to the govt. be ‘GDT’ or gross direct tax. The govt.
pays back a part of it as ‘Social security supports (SSS)’ to a section of
population. e.g. unemployment benefit, widow pension, old age pension etc. All
these are essentially transfer payments as they are not backed by any productive
activity.

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Government Sector
• Let the total Indirect tax paid by the firms be ‘GIT’ or Gross indirect tax. The
govt pays back a part of it as subsidies to the firms. Subsidies are also a type of
transfer payments and are called negative (-ve) indirect tax.
• Therefore, net direct taxes or Td = GDT – SSS

• And net indirect taxes or Ti = GIT – Subsidies

• Net Total Tax = T = Td + Ti

= (GDT – SSS) + (GIT – Subsidies)

= (GDT + GIT) – (SSS + Subsidies)

= Gross Total Tax – Transfer Payments

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Government Sector

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• A country is considered to be open when the interactions with the rest of the
world are considered. In an open economy transactions may take the following
forms:

• i) A country can export a part of its goods and services produced in the domestic
country to the foreign country. This constitutes the export of goods and services
(Xgs).

• ii) The domestic country can import the goods and services produced in foreign
country. This constitutes the import of goods and services (Mgs).

• iii) The domestic country may own capital stock in foreign country from which it
might earn some investment income from abroad. This is known as income from
the export of capital (Xf). 25
• The foreign country might own capital stock in the domestic country due to
which the foreign country earns investment income from domestic country. This
is the income of the foreign country from import of capital by domestic country.
(Mf).

• v) Net Unilateral Transfers: There can be unilateral transfer of funds between

domestic country and foreign country. This generally includes the gifts, grants
and remittances that are transferred from one country to another country. Since
these are transfer payments, they are not included in National Income.

• Net Unilateral Transfer

• = Transfer Payments received from Foreigners – Transfer payments made to

foreigners

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Method 2: Income Method
• GDP (Y) is the sum of the following:
• Wage Income (w)
• Profit Income (p)
• Interest Income (i)
• Rent (r)

Y=w+r+p+i

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Method 2: The Income Approach

National income is the total income earned by

citizens and businesses in a country in one year.
It consists of:
• Employee compensation consists of payments for
labor such as salaries and wages.
• Rents are payments for use of land and buildings.
• Interest includes payments for loans by households
to firms.
• Profits are payments to the owners of firms.

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Method 3: The Value Added Method/
Output Method
• GDP (Y) is the sum of the total value added
produced by all firms in the economy:

Value Added of firm i VAi = Revenuesi – Intermediate

Costsi

GDP = sum of value added of all firms

Y =∑Ii=1 VAi

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The Components of GDP
Value Added Approach
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• In the expenditure method, we avoid intermediate goods and

used goods to eliminate the problem of double counting
• We also avoid transfer payments
• This may be confusing at times
• For example,
• The tires that come with the car are not counted but if there is
puncture in the tire and it has to be replaced, then the new tire
bought is counted
• To avoid such confusions, we use Value Added Approach for
calculating GDP
The Components of GDP
Value Added Approach
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Participants Cost of Value of Value Added

Materials Sales
Farmer $ 0 $ 100 $ 100
Cone factory 100 250 150
and ice
cream-maker
Middleperson 250 400 150
Vendor 400 500 100
Totals $ 750 $1,250 $500
The Components of GDP
Value Added Approach
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Production Generated Added

Farmer harvest wheat $100 $100

Miller makes into flour 200 100

Baker makes into bread 300 100

Total $600 $300
GDP counts only the $ value of This is the same as the “value-
the final good added”
National Income:
• Nationals can earn either property based income or labour
based/wage income by engaging themselves in production
activity.
• So the sum of all the property based income and wage
income earned by all the nationals in the course of
production activity during a year is known as National
Income
• National Income = ∑wage income + ∑ property based
income
• Productive Activities of a Firm
• In order to calculate National Income we need to look into
the production activities of a firm in a course of a year. The
production activities of a firm in the course of a year is
summarised by the Production Account or Current Account.
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Production account or current
account …
• (i) Receivables (credit) and (ii) Payables (Debit) Current Account.

• Receivables (Right to receive or Credit):

• Gross Value of the Product (GVP) = Price of the product(P) × Quantity of output
produced (Q)

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Payables (liability to pay or
Debit):
(i) Value of materials used up in production (VMU)

(ii) Wages paid to its employees (w)

(iii)Rent paid on land (r)

(iv)Interest on Capital (i)

(v) Profit of entrepreneurs (π)

(v)Depreciation Allowance (D)

The Current Account represents an identity between the
Gross Value of Product or 𝑮𝑽𝑷 ≡ 𝑽𝑴𝑼 + 𝒘 + 𝒓 + 𝒊 + 𝛑 + 𝐃

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“Production is a Value-Added Activity” - Explain

• The Gross Value Added (GVA) by a firm is a measure of the productive

contribution of a firm in the course of a year.

• CREDIT ≡ DEBIT → 𝐺𝑉𝑃 ≡ 𝑉𝑀𝑈 + 𝑤 + 𝑟 + 𝑖 + π + D

• → 𝐺𝑉𝐴 ≡ 𝐺𝑉𝑃 − 𝑉𝑀𝑈 ≡ 𝑤 + 𝑟 + 𝑖 + π + D

• Let us consider the example of a furniture

manufacturing firm which produces furniture
worth Rs. 1,10,000 (GVP).

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• The firm purchases timber purchased be worth Rs.50,000 (VMU). If we
want to calculate the productive contribution of the furniture
manufacturing firm then we must subtract the value of timber from the
value of furniture because value of timber represents the productive
contribution of the firm that has produced the timber. Therefore productive
contribution of furniture manufacturing firm:

= value of furniture – value of timber

= GVP – VMU or (Rs.1,10,000- Rs.50,000)

= GVA or Rs.60,000

Hence we can say that productive contribution of a firm is measured by

GVA.

So, production is essentially a value added activity.

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Macroeconomic value of Gross Value Added (GVA):
• Suppose there are ‘n’ number of firms in the economy. Then
Gross Value Added by Firm 1 is:

• 𝐺𝑉𝐴1 ≡ 𝑤1 + 𝑟1 + 𝑖1 + 𝜋1 + 𝐷1

• Then Gross Value Added by Firm 2 is:

• 𝐺𝑉𝐴2 ≡ 𝑤2 + 𝑟2 + 𝑖2 + 𝜋2 + 𝐷2

• 𝐺𝑉𝐴3 ≡ 𝑤3 + 𝑟3 + 𝑖3 + 𝜋3 + 𝐷3

• 𝐺𝑉𝐴4 ≡ 𝑤4 + 𝑟4 + 𝑖4 + 𝜋4 + 𝐷4

--- --- --- --- --- ---

Similarly Gross Value Added by Firm n is:

• 𝐺𝑉𝐴𝑛 ≡ 𝑤𝑛 + 𝑟𝑛 + 𝑖𝑛 + 𝜋𝑛 + 𝐷𝑛 38
• Then GVA of the whole economy is:

• σ𝑛𝑗=1 𝐺𝑉𝐴𝑗 ≡ σ𝑛𝑗=1 𝑤𝑗 + σ𝑛𝑗=1 𝑟𝑗 + σ𝑛𝑗=1 𝑖𝑗 + σ𝑛𝑗=1 𝜋𝑗 + σ𝑛𝑗=1 𝐷𝑗

• Here, σ𝑛𝑗=1 𝐺𝑉𝐴𝑗 represents the aggregate productive

contribution of all the firms in a closed economy without the
government sector. Hence it is the Gross National Product
(GNP) of the economy.

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Intermediate Good and Final
Good:
• A good is classified as Intermediate Good if it is used in the production
process for further processing and manufacturing. e.g. Timber.

• A good is classified as a Final good if it is purchased for final use and

not for further processing or manufacturing. e.g. Furniture.

• However this concept is very much relative, which means the same
commodity can be considered as intermediate good in one case and as
well as final good in another case depending upon it’s use.

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Example of Intermediate and Final
• For example: If Mr.A purchases flour for baking a cake at home it is considered
to be final good. However if Mr.B purchases it for baking a cake in his bakery,
which will be sold in the market, then it is considered as raw material or input or
intermediate good. For Mr.A , flour is a final good and for Mr.B, flour is an
intermediate good.

• The price of the final good represents the gross value added by a firm. This can
be illustrated using the following example.

• Suppose a farmer produces wheat worth Rs. 50 and sells it to the miller who
produces flour worth Rs.120. The miller then sells flour to a baker who produces
bread worth Rs. 200 and sells to the consumers. The final good is bread and it’s
price is Rs.200.
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• Value added by the farmer (V1) = GVP –VMU = 50 – 0 = 50

• Value added by the miller (V2) = GVP –VMU = 120 – 50 = 70

• Value added by the baker (V3) = GVP –VMU = 200 – 120 = 80

• --------------------------------------------------------------------------------

• Gross Value Added (GVA) = V1+V2+V3 = 50+70+80 = 200 = Price of

the final good bread.

• Therefore Gross Value Added is the total productive contribution of the

firms in the economy and it is represented by the final price. Hence GNP
in a closed economy is redefined as the aggregate value of goods and
services produced in an economy during a specified period of time.

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GDP and GNP
43

• Gross National Product (GNP) is the aggregate final output of

citizens and businesses of an economy in one year
• GDP measures the economic activity that occurs within a country
while GNP measures the economic activity of the citizens and
businesses of a country
• Net foreign factor income is added to GDP to create the GNP
GNP=GDP+NFIA
❑ Net foreign factor income is the income from foreign sources to
domestic factor minus foreign factor incomes earned domestically
❑ In other words, we must add the foreign income of our citizens and
subtract the income of residents who are not citizens
• For most countries, domestic residents are responsible for most
domestic production, so GDP and GNP are quite close
44
GDP and GNP
• In a closed economy, GDP and GNP are conceptually same. GDP refers to the
Gross Value Added by all factors of productions operating within the domestic
boundary of the country during a specified period of time.

• However Aggregate demand in an open economy comprises four parts.

Consumption (C), Investment (I), Govt. Expenditure (G), Export of goods and
services (Xgs)

• C, I and G has a domestic component as well as an import component. i.e.

• C = CD + CM; I = ID + IM ; G = GD + GM

• AD = C + I + G + Xgs – Mgs

• = (CD + CM)+ (ID + IM)+ (GD + GM)+ Xgs – Mgs 45

• GDP = (CD + CM)+ (ID + IM)+ (GD + GM)+ Xgs – (CM + IM + GM)

• = C + I + G + (Xgs – Mgs) where Mgs = CM + IM + GM

• Gross National Product is defined as an aggregate value of income generated by

Nationally owned factors of production operating either inside or outside the
geographical boundary of the country during a specified time period. Therefore
GNP includes Net Factor Income earned from abroad.

• GNP = GDP + NFA

• NFA = Xf - Mf

• GNP = GDP + Xf - Mf

= C + I + G + (Xgs – Mgs) + (Xf - Mf)

= C + I + G + (Xgs + Xf) – (Mgs + Mf)

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 =C+I+G+X–M

where, X = Xgs + Xf (Total Exports) and M = Mgs + Mf (Total Imports)

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National Income Accounting Identities in
Open Economy:
• GDP = C + Igross + G + (Xgs – Mgs)

• GNP = C + Igross + G + (X – M)

• NNP = GNP – D = C + (Igross – D) + G + (X – M)

• NNP = C + Inet + G + X – M

• Basically, NNP|MP = C + Inet + G + X – M

• Again, NNP|MP = C + S + T

• C + Inet + G + X – M = C + S + T

• or, Inet ≡ S + (T–G) + (M – X) 48

• Here Inet represents Net Total National investment. S represents private savings,
(T-G) represents public savings and (M-X) represents import surplus or foreign
savings. Therefore the above identity suggests that, Net Total Investment is
funded by private savings or public savings or foreign savings.

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Problem of Twin Deficit:
• The simultaneous presence of budget deficit and trade deficit is known as twin
deficit.

(T – G) > 0 → Budget Surplus (X – M) > 0 → Current account surplus

(T – G) = 0 → Balanced Budget (X – M) = 0 → Current account balance
(T – G) < 0 → Budget Deficit (X – M) < 0 → Current account deficit
• We have the identity, Inet ≡ S + (T–G) + (M – X)

• Or Inet – S ≡ (T–G) + (M – X)

• Let us assume that, Inet > S → Inet – S > 0 →(T–G) + (M – X) > 0

• Now suppose a country is running a budgetary deficit,

• i.e. (T-G) < 0; or T<G → Govt is dissaving.

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Twin Deficit
• Here either of the following will take place:

• (i) Private savings must rise (people may reduce consumption)

• (ii) Investment must fall

• (iii) Foreign savings has to increase

• → current account deficit → (M – X) must rise.

• From the above identity it is obvious that, (M-X) must be greater than 0, or M>X
which implies that, if there is budget deficit in a country, it will automatically
lead to trade deficit. This is known as problem of Twin Deficit.
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Twin Deficit
• If we assume private savings and Net Investment to be constant, then we get a
relationship between fiscal deficit and current account deficit. Holding private
savings and investment constant, if fiscal deficit goes up current account deficit
must go up as well leading to the problem of twin deficit in the economy.

• If foreign savings is utilized properly current account deficit is not going to be a

problem. However, if this foreign savings or import surplus is not utilized
properly there is a risk. In the Long run, foreign exchange reserve will deplete
making domestic currency unstable and and it will be extremely difficult to
serve the foreign liability in future.

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Questions:

1. Derive Savings Investment Identity in Open Economy

2. Explain the problem of Twin Deficit

3. How is (M-X) considered as foreign savings?

• →Suppose M = $16 billion and X = $12 billion. Then M-X is -$4billion.

Therefore the country has a payment deficit of $4billion with the foreigners. In
order to finance this deficit, the country has to take loans from foreigners and
foreign loans come from foreign savings. Therefore (M-X) is considered as
foreign savings.

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GDP and NDP
54

• Net domestic product (NDP) is the sum of consumption

expenditures, government expenditures, net foreign expenditures,
and investment less depreciation;
• Net domestic product is GDP adjusted for depreciation:
NNP=GNP- D
GDP = C + I + G + (X - M)
NDP = C + I + G + (X - M) – Depreciation

• Depreciation is a reduction in the value of an asset over time, due in

particular to wear and tear;
• NDP and NNP is actually preferable to GDP and GNP resp. as an
expression of a nation's domestic output;
Calculating National Income from
GDP
1. Add net foreign factor income to GDP.
• National income is all income earned by citizens of a nation and
is equal to GNP.
• To move from "domestic" to "national" we add net foreign
factor income.
2. Subtract depreciation from GNP.
3. Subtract indirect business taxes from NNP mp.
GDP +NFIA=GNP
GNP-D=NNP at mp
National Income= NNP at fc =NNP mp –NIT
NI=GDP+NFIA-D-NIBT

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Equality of Expenditure and
Income
Net foreign Depreciation
factor income
Net exports Indirect business taxes
Government Rents
expenditures
Interest
Investment
Profits

GN Natio
GD
Consumption P nal
P
Incom
Employee
compensation
e

(1) (2) (3)

Expenditures = Output = Income

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Other National Income Terms
• Personal income (PI) is national income plus net
transfer payments from government minus
amounts attributed but not received.

PI = NI + Transfer payments from government

+ Net non-business interest income
– Corporate retained earnings
– Social security taxes

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Other National Income Terms
• Disposable personal income is personal income
minus personal income taxes and payroll taxes.

⚫ Disposable personal income is what people have

readily available to spend.
DPI = PI - Personal taxes

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REAL VERSUS NOMINAL GDP
• Nominal GDP values the production of goods and
services at current prices.
• Real GDP values the production of goods and
services at constant prices.

• An accurate view of the economy requires adjusting

nominal to real GDP by using the GDP deflator.

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Table 2 Real and Nominal GDP

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Copyright©2004 South-Western
Table 2 Real and Nominal GDP

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Copyright©2004 South-Western
Table 2 Real and Nominal GDP

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Copyright©2004 South-Western
The GDP Deflator

• The GDP deflator is calculated as follows:

Nominal GDP
GDP deflator =  100
Real GDP

The GDP deflator is a measure of the price level calculated as

the ratio of nominal GDP to real GDP times 100.

It tells us the rise in nominal GDP that is attributable to a rise

in prices rather than a rise in the quantities produced.

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The GDP Deflator

• Converting Nominal GDP to Real GDP

• Nominal GDP is converted to real GDP as follows:

Nominal GDP20XX
Real GDP20XX =  100
GDP deflator20XX

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Table 2 Real and Nominal GDP

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Copyright©2004 South-Western
 Practice problem, part 1

2006 2007 2008

P Q P Q P Q

good A $30 900 $31 1,000 $36 1,050

good B $100 192 $102 200 $100 205

• Compute nominal GDP in each year.

• Compute real GDP in each year using 2006 as the
base year.

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Answers to practice problem, part 1
nominal GDP multiply Ps & Qs from same year
2006: $46,200 = $30  900 + $100  192
2007: $51,400
2008: $58,300

real GDP multiply each year’s Qs by 2006 Ps

2006: $46,200
2007: $50,000
2008: $52,000 = $30  1050 + $100  205

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 Practice problem, part 2

GDP Inflation
Nom. GDP Real GDP
deflator rate

2006 $46,200 $46,200 n.a.

2007 51,400 50,000

2008 58,300 52,000

• Use your previous answers to compute

the GDP deflator in each year.
• Use GDP deflator to compute the inflation rate from
2006 to 2007, and from 2007 to 2008.
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 Answers to practice problem, part 2

Nominal GDP Inflation

Real GDP
GDP deflator rate

2006 $46,200 $46,200 100.0 n.a.

2007 51,400 50,000 102.8 2.8%

2008 58,300 52,000 112.1 9.1%

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The Consumer Price Index
70

• Consumer price index (CPI)

• Measure of the overall level of prices
• Measure of the overall cost of goods and services
– Bought by a typical consumer
• Bureau of Labor Statistics
Calculating Consumer Price Index
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1. Fix the basket
• Which prices are most important to the typical consumer
• Different weight
2. Find the prices
• At each point in time
3. Compute the basket’s cost
• Same basket of goods
• Isolate the effects of price changes
4. Chose a base year and compute the CPI
• Base year = benchmark
• Price of basket of goods & services in current year
• Divided by price of basket in base year
• Times 100
5. Compute the inflation rate

CPI in year 2 - CPI in year 1

Inflationrate in year 2 =  100
CPI in year 1
 Calculating the Consumer Price Index and the
Inflation Rate: An Example
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 Calculating the Consumer Price Index and the
Inflation Rate: An Example
73
 Calculating the Consumer Price Index and the
Inflation Rate: An Example
74
 Calculating the Consumer Price Index and the
Inflation Rate: An Example
75
 Calculating the Consumer Price Index and the
Inflation Rate: An Example
76
Problems in measuring CPI
77

• Problems in measuring the cost of living

• Substitution bias
• Prices do not change proportionately
• Consumers substitute toward goods that have become relatively less
expensive
• Introduction of new goods
• More variety of goods
• Unmeasured quality change
• Changes in quality
GDP Deflator versus CPI
78

• GDP deflator - Reflects prices of all goods & services produced

domestically
• CPI - Reflects prices of goods & services bought by consumers
• GDP deflator - Compares the price of currently produced goods and
services
• To the price of the same goods and services in the base year
• CPI - Compares price of a fixed basket of goods and services
• To the price of the basket in the base year
• Q. Suppose you give Rs. 10 to a beggar, will it be added to NI? What if the
beggar sings a song for you?

• Ans. If we give Rs.10 to a beggar it should not be added to the National Income
because it is transfer payment i.e. transfer of money from one pocket to another
without being backed by any production activity. If the beggar sings a song, he is
doing some activity and is receiving money for that. Therefore this should have
been added to the National Income. However due to computational complexities
this part is not included in National Income.

79
80
Problems:
1. Assume that GDP is 6000 INR, PDI is 5100 INR , G-T is 200 INR, C=3800
INR and M-X = 100 INR . Find the value of S, I and G.

Sol: PDI = Personal Income – Tax

= PI- T
T = PI – PDI = 6000 – 5100 = 900 INR (ans)
Personal Disposable Income , PDI = C + S
5100 = 3800 + S
S = 5100 -3800 = 1300 INR
G – T = 200
G= 200 + T = 1100 INR (ans)

GDP = C + I + G + X – M
6000 = 3800 + I + 1100 - 100
I = 6000-3800-1100+100
I = 1200 INR (ans)
81

2. Suppose in a two sector model, that individual receive the following payments
from the business sector: Wages = $ 520, interest = $30, rent = $10, and
profits $80. Consumption spending is $550 and investment is $90.
a) find the market value of final output and household saving.
b) what is the relationship of saving and investment?

Sol: a) market value of final output GDP = w + r+ p+ I

= 520+30+10+80 = $640

Or GDP = C + I = 550+90 = $640

S = Y –C = 640-550 = 90.
b) We have saving investment balance: S = I = 90
In a 2 sector model leakage=injection.
 Calculate: a) NI b) PI c) PDI and d)
82 PS
Data In Dollar ($)
Compensation of employees 1866.3
Business interest payments 264.9
Rental income 34.1
Corporate profits 164.8
Proprietors’ Income 120.3
Corporate Dividends 66.4
Social Security Contributions 253.0
Personal Taxes 402.1
Interest paid by consumers 64.4
Interest paid by the government 105.1
Government and Business Transfers 374.5
Personal Consumption Expenditure 1991.9
83

Sol: a) NI= Compensation of employees+Business interest payments+Rental

Income+Corporate Profits+Proprietors’ income
NI = 1866.3+264.9+34.1+164.8+120.3=2450.4
b) PI:
NI $ 2450.4
Minus (-)
Corporate pr, $164.8
Social Security Contri 253.0 -(417.8)
Plus: (+)
Govt and business transfers, 374.5
Interest paid by gov, 105.1
corporate dividends 66.4 +(546.0)
Personal Income $2578.6
84

Sol: c) PDI= PI –T =$2578.6-$402.1 = $ 2176.5

d) PS: PDI –C- Int paid by consumers = $2176.5-$1991.9-$64.4=$120.0
GDP PER CAPITA and
ECONOMIC WELL-BEING
GDP per capita = __GDP__
Population

• GDP per person tells us the income and

expenditure of the average person in the economy;
• and is commonly used as a measure of the
economic well-being of a society.

85
International Comparisons of Income:
Purchasing Power Parity

• Qi,m = output vector of all newly produced final goods or services

i, in country M
• Pi,us = price vector for goods and services i in US prices
• As such PPP measure provides the estimated value of
Mozambique’s physical output and income weighted by the prices
for such goods and services prevailing in the U.S.

86
GDP PER CAPITA and
ECONOMIC WELL-BEING
• Higher GDP per person generally indicates a higher
standard of living;

• YET GDP is not a perfect or sufficient measure of

the happiness or quality of life and needs to be
complimented by other measures.

87
GDP PER CAPITA and
ECONOMIC WELL-BEING
• Why is GDP not a perfect or sufficient measure of the happiness or quality of
life? Because

1. It is just an average number that does not reflect the inequalities in the
distribution of income.

2. It is simply an indicator of purchasing power and as such does not

necessarily capture a series of quality of life factors that contribute to well-
being such as
• The value of leisure.
• The value of a clean environment.
• The value of almost all activity that takes place outside of markets, such as the
value of the time parents spend with their children and the value of volunteer
work.
• The value of the quality of education and health services available
• The value of a democratic, participatory and transparent system of governance
free of corruption and rights violations;
• The value of peace
88
Table 3 GDP, Life Expectancy, and Literacy

89
Copyright©2004 South-Western
90
The Indicators Criteria of Well-being

• Measure of Economic Welfare (MEW)

• Genuine Progress Indicator (GPI)

• Human Development Index (HDI)

“longevity, knowledge, and a decent standard of
living”
• Gender-related Development Index (GDI)
• Human Poverty Index

91
 The human development index gives a more
complete picture than income

92
Summary
• Because every transaction has a buyer and a seller, the
total expenditure in the economy must equal the total
income in the economy.
• Gross Domestic Product (GDP) measures an economy’s
total expenditure on newly produced goods and
services and the total income earned from the
production of these goods and services.
• GDP is the market value of all final goods and services
produced within a country in a given period of time.
• GDP is divided among four components of expenditure:
consumption, investment, government purchases, and
net exports.
93
Summary
• Nominal GDP uses current prices to value the
economy’s production. Real GDP uses constant base-
year prices to value the economy’s production of goods
and services.
• The GDP deflator—calculated from the ratio of nominal
to real GDP—measures the level of prices in the
economy.
• GDP is a good measure of economic well-being because
people prefer higher to lower incomes.
• It is not a perfect measure of well-being because some
things, such as leisure time and a clean environment,
aren’t measured by GDP.
94