Learning Unit 8

Determination of
Gross Domestic Product

Learning Objectives
At the end of the lecture class, students will be
able to:
1. Define the GDP, GNP, real and nominal GDP
and GDP deflator.
2. Discuss the elements under the
macroeconomics perspective

GDP and GNP

Gross domestic product (GDP)
The total market value of all final goods and services
produced within a given period by factors of production
located within a country.
Gross national product (GNP)
The total market value of all final foods and services
produced within a given period by factors of production
owned by a countrys citizen, regardless of where the
output is produced.

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.
Nominal GDP is converted to real GDP as follows:

R eal G D P

20X X

N o m in a l G D P 20X X

100
G D P d e f la to r2 0 X X

EXAMPLE
Pizza

Latte

year

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 +

2006:

$11 x 500 + $2.50 x 1100

2007:

$12 x 600 +

$2 x 1000
$3 x 1200

= $6,000

Increase
:
37.5%

= $8,250
= $10,800

30.9%

EXAMPLE:
Pizza

Latte

year

2005

$10 $10

400

$2.00
$2.00

1000

2006

$11

500

$2.50

1100

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

2006:

$10 x 500 + $2 x 1100 = 7,200

2007:

$10 x 600 + $2 x 1200 = 8,400

6

Increase:
20.0%
16.7%

EXAMPLE
year

Nominal
GDP

Real
GDP

2005

$6000

$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).

EXAMPLE
year

Nominal
GDP

2005

$6000

2006

$8250

2007

$10,800

Real
GDP
37.5%

$6000

20.0%

$7200
30.9%

$8400

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
8

The GDP Deflator

The GDP deflator is a measure of the overall level of
prices.
Definition:

nominal
GDP
GDP
GDP deflator
deflator == 100
100 xx
real GDP
One way to measure the economys inflation rate is
to compute the percentage increase in the GDP
deflator from one year to the next.

EXAMPLE
year

Nominal
GDP

Real
GDP

GDP
Deflator

2005

$6000

$6000

100.0

2006

$8250

$7200

114.6

2007

$10,800

$8400

128.6

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) =

10

128.6

14.6%
12.2%

Computing GDP
2007 (base yr)
P
Good A
Good B

$30
$100

Q
900
192

2008

2009

$31
$102

1,000
200

$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.

11

Answers
2007 (base yr)
P

2008

2009
Q

Good A

$30

900

$31

1,000

$36

1050

Good B

$100

192

$102

200

$100

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
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
12

Gross National Income per Capita

To make comparisons of GNP between countries,
currency exchange rates must be taken into account.
Gross National Income (GNI) is a measure used to make
international comparisons of output. GNI is GNP
converted into dollars using an average of currency
exchange rates over several years adjusted for rates
of inflation.
GNI divided by population equals gross national income
per capita.

GDP and Economic well-being

GDP is the best single measure of the economic wellbeing of a society.
GDP per person tells us the income and expenditure of
the average person in the economy.
Higher GDP per person indicates a higher standard of
living.
GDP is not a perfect measure of the happiness or
quality of life, however.

National Income Accounting

The national income accounting are an accounting
framework used in measuring current economic activity.
National Accounts provide a measure for assessing
economic performance.
There are three approaches in measuring the national
account:
A. Product approach: measures the amount of output
produced.
B. Income approach: measures the incomes generated
by production.
C. Expenditure approach: measures the amount of
spending by purchasers.

National Income Accounting

The three approaches are equivalent (fundamental
identity of national income accounting) :
Total Production = Total Income = Total Expenditure
Why are the three approaches equivalent?
They must be, by definition.
Any output produced (product approach) is purchased
by someone (expenditure approach) and results in
income to someone (income approach).

National Income Accounting

National Income Accounting

Product approach: Total value added = $35,000 (OrangeInc) +
$15,000 (JuiceInc) = $50,000.
As JuiceInc processed oranges worth $25,000 into a
product worth $40,000, JuiceIncs value added is $15,000
($40,000 - $25,000).
OrangeInc doesn't use any inputs purchased from other
businesses, so its value added equals its revenue of $35,000.
Income approach:
Before taxes: $20,000 (OrangeInc) + $5000 (JuiceInc) +
$25,000 (wages received by employees of the two
companies) = $50,000.
After taxes: $15,000 (OrangeInc) + $3000 (JuiceInc) +
$25,000 (wages received by employees of the two
companies) + $7000 (taxes received by the government) =
$50,000.

Expenditure approach: $10,000 (users purchase from

OrangeInc) + $40,000 (users purchase from JuiceInc) =
$50,000.

NATIONAL INCOME ACCOUNTING

OrangeInc

JuiceInc

35,000

40,000

25,000

35,000

15,000

Product Approach (Value Added)

Revenue
- Input Purchase
Value Added
Total Value Added

50,000

Income Approach (before taxes)

Revenue
- Wages
- Input Purchase
Profit
+ wages
Income
Total Income

35,000

40,000

15,000

10,000

25,000

20,000

5,000

15,000

10,000

35,000

15,000
50,000

NATIONAL INCOME ACCOUNTING

OrangeInc

JuiceInc

35,000

40,000

15,000

10,000

25,000

5,000

2,000

15,000

3,000

+ wages

15,000

10,000

+ taxes

5,000

2,000

35,000

15,000

Income Approach (after taxes)

Revenue
- Wages
- Input Purchase
- Taxes
Profit

Income
Total Income

50,000

Expenditure Approach
User purchase
Total expenditure

10,000

40,000
50,000

Measurement of GDP
A. The Product Approach To Measuring GDP
GDP is the market value of final goods and services newly
produced within a nation during a fixed period of time.
Using market values to measure production makes sense
because it takes into account differences in the relative
economic importance of different goods and services.
A problem with using market values to measure GDP is
that some useful goods and services are not sold in
formal markets.

Cannot value activity in informal markets - e.g. the value

of environmental quality, the underground economy (cash
payment to local handyman or babysitter who does not
report this income).

Government services (that arent sold in markets) are valued

at their cost of production.

Measurement of GDP
Newly produced: counts only things produced in the given
period; excludes things produced earlier
Final goods and services:

Dont count intermediate goods and services that are used

up in the production of other goods and services.

Capital goods (goods used to produce other goods) are final

goods since they arent used up in the same period that
they are produced.

Inventory investment (the amount that inventories of

unsold finished goods, goods in process, and raw materials
have changed during the period) is also treated as a final
good.

Adding up value added works well, since it automatically

excludes intermediate goods.

Measurement of GDP
GNP vs. GDP:

GDP = output produced within a nation.

GDP = GNP - NFP (net factor payments from abroad).

[NFP = payments to domestically owned factors located

abroad minus payments to foreign factors located
domestically]

Example: Engineering revenues for a road built by a U.S.

company in Saudi Arabia is part of U.S. GNP (built by a U.S.
factor of production), not U.S. GDP, and is part of Saudi GDP
(built in Saudi Arabia), not Saudi GNP.
Difference between GNP and GDP is small for the U.S., about
0.2%, but higher for countries that have many citizens
working abroad.

Measurement GDP
B. The Expenditure Approach To Measuring GDP
Measures total spending on final goods and services
produced within a nation during a specified period of time.
Y = C+ I + G + NX (NX = X - M)
Consumption (C) is the spending by domestic households on
final goods and services (including those produced abroad).
C: (durables, semi-durables, non-durables, services) e.g.
fridges, clothes, groceries, health care.
Investment (I) is the spending for new capital goods (fixed
investment) plus inventory investment.
I: (residential construction, non-residential fixed
investment, machinery and equipment, increases in firms
inventory holdings) e.g. new homes, new factory buildings,
tractors.

Measurement GDP
Government purchases of goods and services (G) is the
spending by the government on goods or services (foreign or
domestic).
Not all government expenditures are purchases of goods
& services.
Some are payments that are not made in exchange for
current goods & services, such as transfers (social
security payments, welfare, unemployment benefits) and
interest payments on the government debt.
Net export (NX) refers to exports minus imposts
NX: must add domestic production going abroad and
remove foreign production used domestically.

The Expenditure Approach To Measuring GDP in the US,

1999
Personal consumption expenditure (C)
Durable goods
Nondurable goods
Services

Billions of
dollars
6257
759
1843
3656

Percent of
GDP
67.6
8.2
19.9
39.5

Gross private domestic investment (I)

Business fixed investment
Nonresidential structures
Producers durable equipment
Residential investment
Inventory investment

1623
1167
273
893
411
45

17.5
12.6
3.0
9.7
4.4
0.5

Government purchases of goods and services (G)

Federal
National defense
Nondefense
State and local

1630
571
365
206
1059

17.6
6.2
3.9
2.2
11.4

Net exports (NX)

Exports
Imports

-254
998
1252

-2.7
10.8
13.5

Total (equals GDP) Y

9256

100.0

Measurement GDP
C. The Income Approach To Measuring GDP
Adds up income generated by production (including profits
and taxes paid to the government).
National income is the sum of 5 types of income:
a. Compensation of employees - wages, salaries, benefits.
b. Proprietors income the income of the nonincorporated self-employed (both labor & capital
income).
c. Rental income of persons income earned by
individuals who own land or structures that they rent
to others.
d. Corporate profits firms revenue after wages,
interest, rents, and other costs.
e. Net interest interest earned by individuals from
businesses and foreign sources minus interest paid by
individuals.

Measurement GDP
National income = compensation of employees + proprietors
income + rental income of persons + corporate profits + net
interest.
National income + indirect business taxes = net national
product
Indirect business taxes (sales & excise taxes) do not
appear in any of the five categories of income above, but as
they are income to the government, they must be added to
national income.
Net national product + depreciation = gross national product
(GNP)
Depreciation is the consumption of fixed capital.
In the calculation of the components of national income,
depreciation is subtracted from total or gross income.
Thus, to compute the total or gross amount of income, we
must add back in depreciation.
GNP - net factor payments (NFP) = GDP

The Income Approach To Measuring GDP in the US,

1999

Billions of Percent of
dollars
GDP
Compensation of employees
5332
57.6
Proprietors income
659
7.1
Rental income of persons
146
1.6
Corporate profits
893
9.6
Net interest
468
5.1
Total (equals National Income)
7496
81.0
+ Indirect business taxes (and other small items)
604
6.5
Equals Net National Product
8100
87.5
+ Consumption of fixed capital
1136
12.3
Equals Gross National Product (GNP)
9236
99.8
- Factor income received from rest of world
302
3.3
+ Payments of factor income to rest of world
322
3.5
Equals Gross Domestic Product (GDP)
9256
100.0

Measurement GDP
C. Private Sector & Government Sector Income
Private disposable income = income of the private
sector = private sector income earned at home (Y or
GDP) and abroad (NFP) + payments from the
government sector [transfers (TR), and interest on
government debt (INT) - taxes paid to government
(T)].
Private disposable income = GDP + NFP + TR +
INT T
Governments net income = taxes - transfers interest payments.
Governments net income = T - TR INT
Private disposable income + governments net income
= GDP + NFP
= GNP

Equilibrium Level of Gross

Domestic Product
Output in the short run
What determines the GDP in short run?
the circular flow of income
If the injection (J) do not equal the withdrawals
(W), a state of disequilibrium exists. What brings
them back to equilibrium is the GDP and
employment.
Keynesian argued that to reach a national economy
equilibrium, total planned withdrawal must be equal
to total planned injections, i.e., S+T+M = I+G+X.

Injections (J)
There are also three types of injections into the circular
flow of income:
Investment (I)
Investment in capital goods is a form of spending an
output, which is additional to expenditure by
households.
Just as savings are a withdrawal of funds,
investment
is an injection of funds into the circular flow of income,
adding to the total economic wealth that is being created
by the country.

Injections (J)
Government spending (G)
Government spending is also an injection into the
circular flow of income.
In most mixed economies, total spending by the
government on goods and services represents a large
proportion of total national expenditure.
The funds to spend come from either taxation
income or government borrowing.
Exports (X)
Firms produce goods and services for export.
Exports earn income from abroad, and therefore
provide an injection into a country's circular flow
of income.

Withdrawals (W)
These are movements of funds out of the circular flow of
income. There are three types of withdrawal from the
circular flow of income:
Savings (S)
Households do not spend all their income.
They save some, and these savings out of income are
withdrawals from the circular flow of income quite
simply because savings are not spent.
Taxation (T)
Households must pay some of their income to the
government, as taxation.
Taxes cannot be spent by households, because the funds
go to the government.

Withdrawals (W)
Imports (M)
Spending on imports is expenditure, but on goods made
by firms in other countries.
The payments for imported goods go to firms in other
countries. Spending on imports therefore withdraws
funds out of a country's circular flow of income.

A Simplified Circular Flow of

Income Model

J=I+G+X

Incomes

Equilibrium achieve
when J=W

Cd

W=S+T+M

Equilibrium Level of Gross

Domestic Product
Effect on output of a change in injections
and/or withdrawals :
[if J>W Y W

until J=W]

[if J<W Y W until J=W]

J > W : national income rises
W > J : national income falls

Multiplier Effect

Equilibrium Level of Gross

Domestic Product
Using the Keynesian diagram to show equilibrium 2
approaches
1. The Withdrawals and Injections approach
the withdrawals curve (W)
the injections curve (J)
equilibrium

Equilibrium GDP:
Withdrawals and Injections
W, J
At (a-b) injection more than withdrawals and
GDP is less than GDPe while at (c-d) W>J and
GDP is more than GDPe

W
c
a

x
d

b
O

GDP1

J
GDP

GDPe

GDP2

Equilibrium Level of
Gross Domestic Product
2. The Keynesian diagram: the Income and Expenditure
approach
the 45 line (GDP=C+W)
the expenditure curve (E=AD=C+J)
Equilibrium (point Z)
If the national expenditure exceeded GDP at GDP1,
there would be excess demand in the economy (e-f).
People would buy more than what been produced. Firm
would increased the production and GDP would rise
until it reach at equilibrium at point Z.
If GDP > national expenditure, there would be
insufficient demand for goods and services currently
being produced. Firm would produce less and
employing fewer factor of production. GDP would fall
until point Z.

Deriving equilibrium GDP

GDP = Cd + W

Cd, W, J

g
h
z

E = AD = Cd + J
Cd

e
f

GDP
O

GDP1

GDPe

GDP2

The Multiplier
When the J rise (or W fall), this will cause GDP to rise. But
by how much?
By definition multiplier is the number of times by which
a rise in GDP (GDP) exceeds the rise in the (J)
that cause it [GDP/J].
Example: If J rose by RM 10 million and as the results
GDP rose by RM20 million then multiplier is 2.
The Multiplier is the ratio of the change in the
equilibrium level of output to a change in some
autonomous variable (always regarded as J=I+G+X).

The Multiplier
The Withdrawals and Injections approach
Graphical analysis: shift in the E line
J increase will make equilibrium adjust from a to b. GDP
will also increase to GDPe2.
Size of multiplier is depends on the slope of W curve
( GDP/ W).
The flatter the curve the bigger the multiplier and
( GDP/ W) is known as marginal propensity to
withdraw (MPW).
If MPW is 0.1 then multiplier is 10 and if J increased
RM 10 million then GDP would increased to RM100 million

The Multiplier: A shift in J curve

W, J

Multiplier = GDP / J
= GDP/ W
= c-a / b-c
= 1/mpw or 1/(1mpcd)

J2
J1
O

b
J

c
GDPe1

GDP

GDPe2

J2
J1
GDP

The Multiplier
The Income and Expenditure approach
graphical analysis: shift in the E line
Assume that J rise RM20 billion. The expenditure line
would shift to E2. GDP increase RM60 billion (point e).
Then the size of multiplier is RM60 billion/RM20 billion
= 3.
Also can be derived as 1/(1mpcd), where mpcd is given by
slope Cd/ GDP = RM40billion/RM60billion =2/3 and
1/1-2/3= 3

The multiplier:
A shift in the expenditure curve
GDP = Cd + W
Cd, E, W, J
($bn)

Multiplier = GDP / J
= 60 /20 = 3

E2

160

Cd

GDP
120
J
100
Cd = 40

E1

100 GDP

160

E1 = Cd + J
160 = Cd + 120

GDP ($bn)

Keynesian Analysis of
Unemployment and Inflation
'Full-employment GDP

In a simple Keynesian model, there is the maximum

level of GDP. If the level GDP is at this level, there
will be no deficiency of aggregate demand and hence
no disequilibrium unemployment.

The deflationary gap

If the GDP is below the full employment GDP there

will be excess capacity in the economy and hence
demand-deficient unemployment.

The Deflationary Gap

W, J, E

If GDPF is the GDP of full

employment, then (a-b) and
(c-d) is the deflationary gap.
At (a-b) GDP is more than E
while at (c-d) J<W.

GDP
E
a
b
Deflationary gap

W
c
d
O

GDPe

GDPF

J
GDP

Keynesian Analysis of
Unemployment and Inflation
The inflationary gap if at full employment of GDP,
national expenditure exceeds GDP. This will result in
the demand-pull inflation. This situation is refer to
inflationary gap.
This is shown by gaps (e-f) and (g-h) in the next figure.
At the gap (e-f) the E>GDP while at (g-h) the J>W.
Policy implication to close the deflationary gap is by
raising aggregate demand (increase government
expenditure or lower tax) while to close inflationary
gap government can reduce aggregate demand.

The Inflationary Gap

GDP
W, J, E

e
Inflationary gap

W
g

GDPF

GDPe

GDP