Measuring GDP and Economic Growth

Chapter 21, Michael Parkin

 OBJECTIVES

•After studying this chapter, you will able to

• Define GDP and use the circular flow model to explain why GDP equals
aggregate expenditure and aggregate income
• Explain the two ways of measuring GDP
• Explain how we measure real GDP and the GDP deflator
• Explain how we use real GDP to measure economic growth and describe
the limitations of our measure
 AN ECONOMIC BAROMETER

•What exactly is GDP?

•How do we use it to tell us whether our economy is in a recession or
how rapidly our economy is expanding?
•How do we take the effects of inflation out of GDP to compare
economic well-being over time?
•And how to we compare economic well-being across countries?
 GROSS DOMESTIC PRODUCT

•GDP Defined
GDP or gross domestic product, is the market value of all final
goods and services produced in a country in a given time period.

This definition has four parts:

• Market value
• Final goods and services
• Produced within a country
• In a given time period
 GROSS DOMESTIC PRODUCT

GDP and the Circular Flow of Expenditure and Income

GDP measures the value of production, which also equals total
expenditure on final goods and total income.

The equality of income and output shows the link between

productivity and living standards
CIRCULAR FLOW OF INCOME AND
EXPENDITURE
 MEASURING COUNTRY’S GDP

•Two approaches to measure GDP:

 The expenditure approach
 The income approach
 MEASURING GDP

The Expenditure Approach

•The expenditure approach measures GDP as the sum of consumption
expenditure, investment, government expenditures on goods and
services, and net exports.
•GDP = C + I + G + X  M
 COMPONENTS OF EXPENDITURE
APPROACH
Personal consumption expenditures (C) includes purchases for durable consumer
goods, which are goods that have an expected lifetime exceeding 1 year, such as
automobiles, household appliances, and electronic equipment; nondurable consumer
goods are goods with an expected lifetime of 1 year or less, such as food and toiletries, and
consumer expenditures for services, such as for doctors, dentists etc. Used goods are not
included in the calculation of GDP.

Gross private domestic investment (I) includes all final purchases of machinery,

equipment, and tools by businesses; all construction; plus changes in
inventories.  Investment includes residential construction, since residential buildings can be
rented out, even if they are occupied by owners. Owner occupied residences have an imputed
rent, which is added to GDP, even though the homes are not actually rented out. The
treatment of inventories depends on if the goods are stored or if they spoil. If the goods are
stored, their value is included in GDP. If they spoil, GDP remains unchanged. When the
goods are finally sold out of inventory, they are considered used goods (and are not counted).
 COMPONENTS OF EXPENDITURE
APPROACH
• Government purchases include goods and services that the
government uses to provide public services and expenditures
for social capital, such as for schools and highways. Government
purchases include purchases made by all government entities,
including federal, state, and local governments. However, it does
not include transfer payments, such as the payment of Social
Security or welfare benefits.

•  Net exports is simply equal to exports minus imports, which is

often represented by the symbol X. Note that when the value of
imports exceeds the value of exports, then net exports is negative,
and is subtracted from the GDP.
THE EXPENDITURE APPROACH
 MEASURING GDP

•The Income Approach

The income approach measures GDP by summing the incomes
that firms pay households for the services of the factors of
production they hire—wages for labor, interest for capital, rent
for land, and profit for entrepreneurship.
 THE INCOME APPROACH TO MEASURE
GDP

The National Income and Product Accounts divide incomes into

two big categories:
1. Compensation of employees
2. 2. Net operating surplus
Compensation of employees is the payment for labor services.
It includes net wages and salaries (called “take-home pay”) that
workers receive plus taxes withheld on earnings plus fringe
benefits such as Social Security and pension fund contributions.
Net operating surplus is the sum of all other factor incomes. It
has four components: net interest, rental income, corporate
profits, and proprietors’ income.
 THE INCOME APPROACH TO MEASURE
GDP
• Net interest is the interest households receive on loans they make minus the
interest households pay on their own borrowing.
• Rental income is the payment for the use of land and other rented resources.
• Corporate profits are the profits of corporations, some of which are paid to
households in the form of dividends and some of which are retained by
corporations as undistributed profits. They are all income.
• Proprietors’ income is the income earned by the owner-operator of a business,
which includes compensation for the owner’s labor, the use of the owner’s
capital, and profit.
• Adding all of these will give us Net domestic income at factor cost.
• Indirect taxes less subsidies will allow us to calculate Net domestic income at
market prices
• Finally adding Depreciation and Statistical discrepancy will give us GDP using
income approach
INCOME AND EXPENDITURE APPROACH
TO MEASURE GDP
 NOMINAL AND REAL GDP

• 
RULES FOR COMPUTING GDP
MEASURING ECONOMIC GROWTH

We use real GDP to calculate the economic growth rate.

The economic growth rate is the percentage change in the quantity of
goods and services produced from one year to the next.
•We measure economic growth so we can make:
 Economic welfare comparisons
 International comparisons
 Business cycle forecasts
DO GDP REALLY MEASURE ECONOMIC
GROWTH?
Real GDP is not a perfect measure of economic welfare for seven
reasons:
1. Quality improvements tend to be neglected in calculating real GDP,
so the inflation rate is overestimated and real GDP is underestimated.
2. Real GDP does not include household production—productive
activities done in and around the house by members of the household.
MEASURING ECONOMIC GROWTH

3. Real GDP, as measured, omits the underground economy, which is

illegal economic activity or legal economic activity that goes unreported
for tax avoidance reasons.
4. Health and life expectancy are not directly included in real GDP.
5. Leisure time, a valuable component of an individual’s welfare, is not
included in real GDP.
6. Environmental damage is not deducted from real GDP.
7. Political freedom and social justice are not included in real GDP.
 PRACTICE EXERCISE

• An economy produces only apples and oranges. The base year is 2009, and the table
gives the quantities produced and the prices.
Quantities 2009 2010 2011
Apples 60 160 180
Oranges 80 220 240
Prices 2009 2010 2011
Apples $0.50 $1.00 $ 1.10
Oranges $0.25 $2.00 $ 2.20

1. Calculate nominal GDP in 2009, 2010 and 2011.

2. Calculate real GDP in 2009, 2010 and 2011 expressed in base-year prices.
3. Calculate economic growth from 2009 to 2010
4. Calculate GDP deflator for 2009, 2010 and 2011
5. Calculate inflation rate from 2009 to 2010 and 2010 to 2011