Measuring Economic

Activity
Quantitative Measurement

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Measuring Economic Activity
GDP is the total market value of the final goods
and services produced within a nation by using
domestic and foreign inputs during a given year.
GNP is the total value of output by using my
inputs within the country and rest of the world
during a fiscal year.
In Symbols: GDP= C+I+G+X(x-m)=15+50+60+(5-
5)=125
C= Consumption= 15
I=Gross Investment=50
G=Government Purchases of Goods and Services=60
X=Net Exports, Export=5, Import=5
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2 Measures of National Product
GDP can be measured by following ways:
01. A Flow of Final Products Approach:
The GDP is defined as the total money value of the
flow of final products produced by the nation.

02. A sum of Earnings Approach:

GDP is as the total of factor earnings (wage, interest,
rent, profit) that are the costs of producing
society's final products.

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Equivalence of the two Approaches
Both approaches will provide the same outcome:

Expenditure Approach Income Approach

Consumption Wages

Investment Rents

Government Purchases of Interest

Goods and Services
Net Export Profits

= GDP = GDP

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Components of Expenditure Approach
01. Consumption:
i) Durable Consumer Goods(automobiles,
refrigerators)
ii) Non Durable Consumer Goods(bread, milk,
vitamins)
iii) Consumer Expenditure for Services(lawyers,
doctors)

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 02. Gross Private Domestic Investment:
i) All final purchases of machinery, equipment, and
tools by business enterprise
ii) All construction
iii) Changes in inventories

03. Government Purchases:

Government Purchases include
i)Government consumption expenditures
a)Expenditures for goods and services that
government consumes in providing public
services.
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 b)Expenditures

for social
capital such as schools and highways, which have long lifetimes.

ii)Gross Investment

04. Net Exports:

Net Exports= Exports- Imports

Putting All Together, we get GDP:

GDP= C+I+G+X(x-m)

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 The Income Approach:
Total expenditures are allocated as income to those
responsible for producing the output. It would be
simple if we could say that the entire amount flowed
back to them in the form of wages, rent, interest,
and profits.
01. Compensation of Employees:
Wages and salaries paid by business and government
to their employees.
02. Rents:
Rents consist of the income received by the
households and businesses that supply property
resources
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 03. Interest:
Interest consists of the money paid by private
businesses to the suppliers of money capital.
04. Profits:
i)Proprietors Income:
It includes the net income of sole proprietorships,
partnerships, and other unincorporated
businesses.
ii) Corporate Profits:
Corporate profits are the earnings of owners of
corporations.
Wages +Rents +Interest +Profits = GDP

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Accounting Statement for the U.S. Economy, 2005(in Billions)
xpenditure Approach Income Approach
1.Personal Consumption $8746.00 Compensation of $7125.00
Expenditure(C) Employees
2.Gross Private Domestic $2105.00 Rents $73.00
Investment(I) Interest $498.00
03.Government $2363.00 Proprietors’ income $939.00
Purchases(G)
04.Net Exports(X) -$727.00 Corporate Profits $1352.00

GDP =$12,487.00 Taxes on production $917.00

and imports
Net Foreign Factor
Income -$34.00
Statistical
Discrepancy $43.00
Consumption of Fixed $1574.00
Capital

GDP
=$12,487.00
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 The Income Approach
01.Compensation of Employees
02. Rents
03. Interest
04. Proprietors’ Income:
Proprietors’ income flows to the sole
proprietorships, partnerships, and other
unincorporated businesses.
05. Corporate Profits :
Corporate profits are the earnings of owners of
corporations. National income accountants
subdivide corporate profits into 3 categories:
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 i)Corporate Income Taxes:
These taxes are levied on corporations’ net earnings and
flow to the government.

ii)Dividends:
These are the part of corporate profits that are paid to
the corporate stock-holders-the ultimate owners of all
corporations.

iii)Undistributed Corporate Profits:

These are monies saved by corporations to be invested
later in new plants and equipment. They are also
called retained earnings.
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 06. Taxes on Production and Imports:
It includes general sales taxes, excise taxes, business
property taxes, license fees, and customer duties.
Example: Price of a product $1 and sales tax 5%.
07. Net Foreign actor Income:
08. Statistical discrepancy:
09. Consumption of Fixed Capital:
We must recognize that the useful lives of private
capital equipment(oven, automobiles) extend far
beyond the year in which they were produced.

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 The amount allocated is an estimate of how much of
the capital is being used up each year. It is called
depreciation.
The huge depreciation charge made against private
and social capital each year is called consumption
of fixed capital because it is the allowance for
capital that has been consumed in producing the
year’s GDP. It is the portion of GDP that is set aside
to pay for the ultimate replacement of those
capital.

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 The previous table summarizes the expenditures
approach and income approach to GDP. The left
side shows what the U.S. economy produced in
2005 and what was spent to purchase it. The right
side shows how those expenditures , when
appropriately adjusted , were allocated as income.

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Other National Accounts
Net Domestic Product:
NDP= GDP- Consumption of fixed
capital(depreciation)
GDP $12487.00
Consumption of fixed capital -$1574.00
Net Domestic Product $10,913.00

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 National Income:
Net Domestic Product $10,913.00
Statistical Discrepancy -$43.00
Net Foreign Factor Income $34.00
NI $10,904.00
Personal Income:
Personal income includes all income received
whether earned or unearned.
i)Earned but not received:
Taxes on production and imports, Social Security
Taxes, Corporate Income Taxes and undistributed
corporate profits.
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 ii)Received but not Earned:
Transfer Payments are government payments to
individuals that are not made in exchange for
goods or services supplied.
Example: Social Security Payments, Unemployment
Compensation.

In moving from national income to personal

income, we must subtract the income that is
earned but not received and add the income that is
received but not earned.

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 For the United States in 2005.
ITEMS in billions

NI $10,904.00
Taxes on production and imports -$917.00
Social Security Contributions -$871.00
Corporate Income Taxes -$378.00
Undistributed Corporate Profits -$460.00
Transfer Payments +$1970.00
Personal Income $10,248.00

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 Disposable Income:
Disposable income is personal income less personal
taxes.
Disposable income is the amount of income that
households have left over after paying their
personal taxes. They are free to divide that income
between consumption and saving.
DI=C+S
For the United States in 2005: in billions
PI $10,248.00
Personal Taxes -$1210.00
DI $9038.00
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Nominal GDP versus Real GDP
We determine the value of GDP by multiplying total
output by market prices.
With the passage of time, the price level is changing.
The value of money changes in response to
inflation(rising prices) or deflation(falling prices).

Real GDP is calculated by tracking the volume or

quantity of production after removing the
influence of changing prices or inflation/deflation.

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 The difference between the growth of nominal GDP
and real GDP is the growth in the price of GDP,
sometimes called the GDP deflator.

Nominal GDP vs Real GDP

Year Price Quantity Nominal

in Units GDP
Y1 $1 1000 $1000.00

Y2 $2 1010 $2020.00

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 Let’s base year Y1

GDP Deflator= Current Year Price

Base Year Price

Real GDP= Nominal GDP

GDP Deflator

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 Calculation of Real GDP
Year Price Quantity Nominal GDP Real GD
in Units GDP Deflator

1 $1 1000 $1000.00 =$1/$1=1 =$1000/1

=$1000.0

2 $2 1010 $2020.00 =$2/$1=2 =$2020.0

=$1010.0

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 Price Index and Inflation
A price index (with symbol P) is a measure of the average level of
prices. Inflation (with symbol , or “pi”) denotes a rise in the general
level of prices. The rate of inflation is defined as the rate of change
of the general price level and is measured as follows:

The opposite of inflation is deflation, which occurs when the general

price level is falling. Deflations have been rare in the last half-century.

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 A price index is a weighted average of the price of a basket of
goods and services. In constructing price indexes,
economists weight individual prices by the economic
importance of each good. The most important
price indexes are
1. the consumer price index
2. the GDP price index,
3. and the producer price index.
1. The Consumer Price Index (CPI):
The CPI is a measure of the average price paid by urban
consumers for a market basket of consumer goods and
services.

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 A Price Index is constructed by weighting each price according to the
economic importance of the commodity in question.

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 02. the GDP price index,
03. and the producer price index:
The Producer Price Index (PPI). This index, dating from 1890,
is the oldest continuous statistical series published by the BLS.
It measures the level of prices at the wholesale or producer
stage. It is based on over 8000 commodity prices, including
prices of foods, manufactured products, and mining products.
The fixed weights used to calculate the PPI are the net sales of
each commodity. Because of its great detail, this index is
widely used by businesses.

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 Shortcomings of GDP
01. Nonmarket Activities:
Certain productive activities do not take place in any
market.
Example: Activities for own self.
So, GDP understates a nation’s total output.
02. Leisure:
It fails to evaluate the value of leisure.
03. Underground Economy:
Some of the people who conduct business there are
gamblers, smugglers, prostitutes, drug growers, and
drug dealers. They have good reason to conceal
their incomes.
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 04. GDP and Environment:
Sometimes production process produces negative
impact on the environment such as dirty water,
polluted water, toxic waste, congestion and noise..
Since these costs are not deducted from total
output, GDP overstates our national well-being.

05. The problem of double counting:

06. Female Household Activities are not

evaluated appropriately.

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 Savings and Investment
Usually, output can be either saved or consumed.

Investment is an essential economic activity because it

increases the capital stock available for future
production. One of the most important points about
national accounting is the identity between saving
and investment.
We will show that “ Measured saving is exactly equals to
measured investment.”
This equality is an identity, which means that it must
hold by definition.
SAVING = INVESTMENT
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 Assumption:
01. There is no government
02. There is no foreign sector.
GDP= C+I+G+(X-M), (Net Export=Export-Import)
If, G=0, NX=0, GDP=C+I

Investment is that part of national output which is

not consumed .
Saving is that part of national income which is not
consumed.

Since national income and output are equal, this means

that saving equals investment.
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 In symbols:
I= Product-approach GDP minus C, I=GDP-C
S=Earnings-approach GDP minus C , S=GDP-C
I=S
But the measures always give the same measure of
GDP, so
I=S; the identity between measured saving and
investment.

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Inclusion of Government and Foreign Sector
When we include government sector and foreign
sector:
ST= SP+SG
ST = Total National Saving
SP = Private Saving
SG =Government Saving( it comes from budget
surplus)

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 IT= I+ X
IT = National Investment
I= Gross Private Domestic Investment
X= Net Foreign Investment
National Investment=Private Investment + Net Exports
= Private saving +Government Saving
= National Saving
IT= I+ X = SP+SG = ST

National saving equals national investment by

definition. These identities must hold always whatever
the state of the business cycle.
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