Chapter 5-Measuring a Nation’s Income

The main objective of policy makers is to maintain the highest possible level of
economic activity and a stable price level in the economy.
Macroeconomics specifically answers questions like these:
What is the income level or estimate of economic activity in the country?
What is the rate of economic growth in the economy?
Why is average income high in some countries and low in others?
Why do prices rise rapidly in some periods and slowly in others?
Why do production and employment expand in some years and contract in
others?
What is the unemployment rate and its reasons in the economy?
Why does economic activity fluctuate or why do business cycles emerge in the
economy?
How does govt. smoothen business cycles through monetary and fiscal policies?
 Measurement of economic activity
Economic activity is measured by 2 alternative methods; sum of factor incomes;
wages & salaries, rental income, interest earnings and profits which are earned in
factor markets and sum of expenditures on goods and services (G&S) which are
spent in product markets.
The two measures give almost equal number because every rupee that is earned by
households after selling factors of production is spent to purchase (G&S) either for
consumption or for investment purposes.
In reality, almost every household saves some of its income. However, if savings are
deposited in banks, then banks loan them out, so bank-borrowers spend them to
buy (G&S). Hence, sum of expenditures remains equal to sum of incomes.
If some savings are kept idle (under mattresses or in lockers) or some income is spent
to import G&S, even then sum of incomes remains equal to sum of expenditures,
because the G&S, which remains unsold, are added to inventories. These G&S are
treated as if the firms which produced them have themselves purchased them.
However, accumulation of unplanned inventories, induces producers to cut off
production in subsequent year.
 Gross Domestic Product (GDP) at market prices
GDP is the generic or most commonly used phrase for economic activity. There are
some other measures of economic activity which will be discussed later.
GDP is the total market value of all final G&S produced within a country in a given
period of time. The underlined words have special meanings.
Market value: Since different goods are measured in different units. For example,
bananas are counted, apples are weighed, milk is measured. Therefore, they
cannot be summed up in one figure. To take care of this problem, the market value
(quantity multiplied with corresponding market price) is calculated.
Salary of employees measures the value of their work. The value of an owner-
occupied house is imputed at the rent of a similar house.
The value of hobbies and house jobs is left unaccounted because it is difficult to find a
unanimous price for each of them.
The value of underground economy or illicit G&S is not counted for the same reason.
Its volume depends on tax system and corruption. It amounts 20% of reported
GDP in developed countries and up to 60% in developing countries.
 Final vs. intermediate goods
Value of all tangible goods such as food, clothing and cars and value of all intangible
goods which are services such as haircuts, housekeeping and doctor visits are counted
Final goods are those goods which are sold to their final users. For example, bread
is a final good because it is ready for use by purchasers.
Intermediate goods are sold by their producers to producers of other goods.
For example, the wheat to floor-mill and similarly wheat-flour to a baker
are used as intermediate goods.
Either count the value of final G&S leaving out the value of intermediate ones or
sum up the value-added at each stage of production. Otherwise, counting value
of both types of goods in GDP would result in overestimation of GDP.
If price of wheat and wheat-flour is Rs.60 and Rs.80 per kg respectively and price
of bread made of one kg wheat-flour is Rs200, then count either Rs.200 or sum
of Rs.60 as value added of farmer + (80-60=20) as value-added of flour mill +
(200-80=120) as value-added of baker that is also Rs.200.
 Another example of final and intermediate goods
Suppose a dairy farmer sells milk worth Rs.50,000 to an ice-cream company and
he does not buy anything from any other firm.
The total income of the dairy farmer or his value-added is, therefore, Rs.50,000
The ice-cream company uses the milk to produce ice-cream which it sells for
Rs.75,000 and the ice-cream company does not buy anything else other than
the dairy.
Therefore, the total income of the owners and employees of the ice-cream firm or
their value-added is Rs.25,000.
Therefore, the total income of this country is either the value of ice cream
Rs.75,000 or the sum of incomes of farmer and ice-cream factory owner and
employees. The sum of the value of milk and ice-cream amounts to Rs.125,000
that overstates the GDP because of counting the value of milk twice.
In this example, all quantity of milk is used as an intermediate good and ice-cream
is a final good. If some quantity of milk is used as final good, then its value is
also included in GDP.
 Produced within country …in a given period
GDP measures the value of all G&S produced within the geographic
boundaries of a country whether by foreigners or by locals whether sold to
foreigners (exported) or consumed by locals.
Production by home country’s citizens working in other countries is not
counted in home country’s GDP. It is counted in foreign country’s GDP.
The given period to count GDP is usually a year but sometimes it is half-year,
quarter or month. Goods which were produced before the given year but
are traded in the given year are not counted in given year’s GDP.
Trading of used cars, already-built houses and stocks issued in previous years
is merely the transfer of ownership of an asset from one person to another.
So the value of such trades is not counted in current year’s GDP.
However, if trading of already produced items in the current period is
through dealers, then commission of dealers is counted in the current GDP.
 Components of GDP
We need to pay attention not only to the total expenditure on all final G&S
produced within the country but we also need to watch where the
expenditure is coming from.
Therefore, total expenditures are divided into 4 components. This
disaggregation helps us to enumerate total GDP more easily and to know
which component is moving relatively fast or relatively slow during
recessionary and expansionary periods so that policy makers can propose
corrective measures.
GDP = consumption spending + investment spending + government
spending + Net exports (Exports – Imports).
Consumption is the largest component and investment is the most volatile
component in most of the economies. That is, the relative size of
investment increases during expansionary periods and decreases during
recessionary periods.
 Sub-components of GDP
The first 3 components of GDP are further divided into sub-components.
consumption spending is divided into 3 sub-components.
non-durables such as food and beverages.
durables such as cars and refrigerators.
services such as haircuts, education and medical care. As a convention, purchase of
houses is not counted as consumption but as investment spending.
Investment spending is also divided into 3 sub-components.
machinery and equipment such as photo-copy machine and telephone cables and sets.
buildings or structures such as office buildings, commercial buildings and residential
houses and apartments.
inventories refer to unsold goods which are treated as if the firms which produced
them purchase these goods for themselves. Inventories are counted at their actual cost
to the producing firm, not at their market value.
Government spending is divided by the levels of government hierarchy such as local or
union council, district, provincial and federal level governments.
 Other measures of a country’s income
In addition to GDP, 5 measures are also reported in data sources.
Gross National Product (GNP) measures total income earned by citizens of a
country. GNP = GDP + income earned by citizens of home country working
abroad - income earned by foreigners working in home country.
Net National Product (NNP) is total income net of depreciation or wear & tear of
machinery, equipment and structures. It is approximated under given guidelines
of accounting standards followed in a country.
National Income (NI) is total income of citizens and incorporated firms. NNP and NI
are almost equal. Small difference due to data collection from different sources is
called statistical discrepancy. NI = NNP – depreciation + statistical discrepancy.
Personal Income (PI) is total income of citizens only. PI = NI – corporate taxes and
indirect taxes such as sales tax – retained earnings of incorporated firms +
transfer payments such as pensions and scholarships.
Personal Disposable Income (PDI) is that part of personal income which citizens can
spend after paying taxes. PDI = PI – direct taxes such as income tax.
 Nominal vs. real GDP and GDP-deflator
The GDP we talked about so far is nominal GDP. A change in its value from one
year to another is either due to change in quantity of G&S or due to change
in their prices or due to both. Therefore, to isolate the effect of prices on
GDP, real GDP is calculated by researchers.
Real GDP, not the nominal GDP, determines the standard of living in a country.
If G&S produced in a given year are valued at current prices or at prices of the
same year, the resulting figure is called nominal GDP and if they are valued
at prices of a specified base-year, then the resulting figure is called real GDP
at base-year prices.
The ratio of nominal and real GDPs multiplied by 100 is called the GDP-deflator.
Its value is 100 for the base year and its value for a given year shows the
change in prices from 100 over the period between the given and the base
years. Then annual percentage increase in GDP-deflator index denotes
inflation rate.
 Calculation of GDP-deflator index and inflation rate
•The
  GDP-deflator index is calculated as follows:
GDP-deflator index
real GDP = and
nominal GDP = (real GDP * GDP-deflator) / 100.
The GDP Deflator tells us how much of the rise in nominal GDP over a period of
time is attributable to a rise in prices (rather than to a rise in the quantity of
production).
The inflation rate is calculated as follows:
I
The inflation rate tells the percentage increase in general price level from base to
the current year.
 Numerical illustration of nominal vs. real GDP & GDP-deflator
Initially we assume that a country produces only one commodity.
Year Q P Nominal GDP Real GDP (base- GDP-deflator (base-year
year =2016) =2016)

2016 10 50 (10*50)=500 (10*50)=500 (500/500)*100=100

2017 20 60 (20*60)=1200 (20*50)=1000 (1200/1000)*100=120
2018 30 60 (30*60)=1800 (30*50)=1500 (1800/1500)*100=120

If base-year is taken 2017, then calculation of real GDP changes to 600, 1200 and 1800
respectively for the 3 years and calculation of GDP-deflator changes to 83.3, 100 and 100
respectively for the 3 years.
If base-year is taken 2018, then calculations remain the same as those for base-year 2017. The
reason is that the price level does not change.
Another illustration of nominal and real GDP
 One more illustration of nominal vs. real GDPs and GDP-deflator
Now we assume that a country produces 2 commodities X and Y.
Yr X Px Y Py Nominal GDP Real GDP (b=1) GDP-deflator (b=1)
1 2 10 6 30 (2*10+6*30)=200 (2*10+6*30)=200 (200/200)*100=100
2 3 15 8 40 (3*15+8*40)=365 (3*10+8*30)=270 (365/270)*100=135
3 5 20 9 50 (5*20+9*50)=550 (5*10+9*30)=320 (550/320)*100=172

If base-year is 2, then calculation of real GDP changes to 270, 365 and 435
respectively for the 3 years and calculation of GDP-deflator changes to
74.1, 100 and 126.4 respectively for the 3 years.
If base-year is 3, then calculation of real GDP changes to 340, 460 and 550
respectively for the 3 years and calculation of GDP-deflator changes to
58.8, 83 and 100 respectively for the 3 years.
 Indices and growth rates
For easy comparison, given values are converted into indices by designating a
base-year as (current-year value/base-year value) multiplied by 100.
Yr Nom Nom Annual Real Real Annual GDP- Annual
GDP GDP change GDP GDP change deflator change
index index
1 200 100 - 200 100 - 100 -
2 365 182.5 82.5% 270 135 35% 135 35%
3 550 275 50.7% 320 160 18.5% 172 27.4%

Looking at the index of any variable, year-wise comparison becomes much easier and
calculation of growth rate over a year or over any number of periods can easily be
calculated from indices. To calculate growth rate, the difference of current and
previous-year values is divided by the previous year value and multiplied by 100.
 Is GDP a perfect measure of economic well-being?
No, but still it is considered one of the best one-number measures we have. It measures
only the financial or material well-being. There are many other measures of well being.
Life expectancy, number of hospital beds per 1000 population and infant mortality rate
which indicate the health level in a country.
Adult literacy rate, level of higher and professional education which indicate the human
capital of a country
Internet usage and number of tv-sets per 1000 population which indicate development of
communication sources
Infrastructure which indicates the welfare stage in a country
Law and order situation which indicates the peace of mind of residents.
Any country which has high GDP but lacks in some or all of them is not included in the
category of developed countries.
Inequality, volunteer work, level of underground economy, leisure and environment also
matter for quality of life.