LECTURE 2

Measuring a Nation’s Income

Some etiquette rules in the
class
• Attendance check is compulsory and
constitutes 10% to the final grade
• Please have your smartphones on silent mode
• Students must do homework before the
tutorial class. If you forget to do them or don’t
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Assessment for the subject will be on the basis of:
• Class Participation Required 10%
• Group assignment(s) Required 10%
• Midterm: 20%, small test: 10%
• To pass this subject students must achieve:
• 50% or more in the final examination, AND an
overall mark of 50% or more (For students
entering Cohort 2016-2020 or earlier)
• An overall mark of 50% or more. (For students
entering Cohort 2017-2021 or after)
 Lecture Objectives
• Consider why an economy’s total income
equals its total expenditure.
• Learn how gross domestic (GDP) is defined
and calculated and its four components.
• Distinguish between real GDP and nominal
GDP.
• Consider whether GDP is a good measure of
economic well-being.
The Economy’s Income and Expenditure
• Gross Domestic Product (GDP)
- Measures the total income of everyone in the
economy
- Measures the total expenditure on the
economy’s output of goods and services
• For an economy as a whole
- Income must equal expenditure
• Circular-flow diagram - assumptions:
• All goods and services - bought by households
• Households - -spend all of their income
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Figure 1

The circular-flow diagram

Households buy goods
and services from firms,
and firms use their
revenue from sales to
pay wages to workers,
rent to landowners, and
profit to firm owners.
GDP equals the total
amount spent by
households in the
market for goods and
services. It also equals
the total wages, rent,
and profit paid by firms
in the markets for the
factors of production.

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Measurement of Gross Domestic Product
• Gross domestic product (GDP)
- Market value of all final goods and services
- Produced within a country
- In a given period of time

• “GDP is the market value…”

Market prices - reflect the value of the goods

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Measurement of Gross Domestic Product
• “… of all…”
- All items produced in the economy
• And sold legally in markets
- Excludes most items
• Produced and sold illicitly
• Produced and consumed at home
• “… final…”
- Value of intermediate goods is already
included in the prices of the final goods

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Measurement of Gross Domestic Product
• “… goods and services…”
- Tangible goods & intangible services
• “… produced…”
- Goods and services currently produced
• “… within a country…”
- Goods and services produced domestically,
regardless of the nationality of the producer
• “… in a given period of time”
- A year or a quarter
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- When Tim buys a new refrigerator, the
transaction contributes to which component of
the GDP?
- The construction of a highway?
- A new pair of Gucci shoes produced in China?
- A new pair of Gucci shoes produced by Chinese
people living in Italy?
 The Components of GDP
• Y = C + I + G + NX
Identity
- Y = GDP
- C = consumption
- I = investment
- G = government purchases
- NX = net exports

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 The Components of GDP
• Consumption
- Spending by households
- On goods and services
- Exception: purchases of new housing
• Investment
- Spending on capital equipment, inventories,
and structures
- Including household purchases of new
housing
- Inventory accumulation 10
 The Components of GDP
• Government purchases
- Government consumption expenditure and
gross investment
- Spending on goods and services
- By local, state, and federal governments
- Does not include
transfer payment
 The Components of GDP
• Net exports = Exports - Imports
- Exports
• Spending on domestically produced goods by
foreigners
- Imports
• Spending on foreign goods by domestic residents

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 The components of U.S. GDP

• 2010, GDP of the United States = $14 trillion

• GDP per person = $45,838
- Consumption = $32,225 per person
- Investment = $7,061 per person
- Government purchases = $8,912 per person
- Net exports = -$2,360 per person

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Table 1
GDP and its components
Total Per person Percent
(in billions of dollars) (in dollars) of total
Gross domestic product, Y $13,843 $45,838 100%
Consumption, C 9,732 32,225 70
Investment, I 2,132 7,061 15
Government purchases, G 2,691 8,912 19
Net exports, NX -712 -2,360 -5

This table shows total GDP for the U.S. economy in 2010 and the breakdown of GDP
among its four components.
When reading this table, recall the identity Y = C + I + G + NX.

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 Real Versus Nominal GDP
• Total spending rises from one year to the next
- Economy - producing a larger output of goods
and services
- And/or goods and services are being sold at
higher prices
• Nominal GDP
- Production of goods and services
- Valued at current prices

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 Real Versus Nominal GDP
• Real GDP
- Production of goods and services
- Valued at constant prices
- Designate one year as base year
- Not affected by changes in prices
• For the base year
- Nominal GDP = Real GDP

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Table 2
Real and Nominal GDP
Prices and Quantities
Price of Quantity of Price of Quantity of
Year hot dogs hot dogs hamburgers hamburgers
2008 $1 100 $2 50
2009 $2 150 $3 100
2010 $3 200 $4 150
Calculating Nominal GDP
2008 ($1 per hot dog × 100 hot dogs) + ($2 per hamburger × 50 hamburgers) = $200
2009 ($2 per hot dog × 150 hot dogs) + ($3 per hamburger × 100 hamburgers) = $600
2010 ($3 per hot dog × 200 hot dogs) + ($4 per hamburger × 150 hamburgers) = $1,200
Calculating Real GDP (base year 2008)
2008 ($1 per hot dog × 100 hot dogs) + ($2 per hamburger × 50 hamburgers) = $200
2009 ($1 per hot dog × 150 hot dogs) + ($2 per hamburger × 100 hamburgers) = $350
2010 ($1 per hot dog × 200 hot dogs) + ($2 per hamburger × 150 hamburgers) = $500
Calculating the GDP Deflator
2008 ($200 / $200) × 100 = 100 This table shows how to calculate real GDP, nominal GDP,
2009 ($600 / $350) × 100 = 171 and the GDP deflator for a hypothetical economy that
2010 ($1,200 / $500) × 100 = 240 produces only hot dogs and hamburgers.
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 Real Versus Nominal GDP
• The GDP deflator
- Measure of the price level
- Ratio of nominal GDP to real GDP times 100
- =100 for the base year
- Measures the current level of prices relative to
the level of prices in the base year
• Inflation
- Economy’s overall price level is rising

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 Real Versus Nominal GDP
• Inflation rate
- Percentage change in some measure of the
price level from one period to the next

Inflationin year 2 GDP deflator in year 2 - GDP deflator in year 1

 100
GDP deflator in year 1

• The GDP deflator

- Can be used to take inflation out of nominal
GDP (“deflate” nominal GDP)

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 Real GDP over recent history

• The GDP data

- Real GDP grows over time
- Growth is not steady
- https://www.youtube.com/watch?v=wykaDgXoajc
• Recession
- Real GDP declines
- Lower income
- Rising unemployment
- Falling profits
- Increased bankruptcies

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Figure 2

Real GDP in the United States

This figure shows quarterly data on real GDP for the U.S. economy since 1965.
Recessions—periods of falling real GDP—are marked with the shaded vertical bars.21
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GDP - Good Measure of Economic Well-being?
• GDP - “single measure of the economic well-
being of a society”
- Economy’s total income
- Economy’s total expenditure
- Larger GDP
• Good life
• Better healthcare
• Better educational systems
- Measure - ability to obtain many of the inputs
into a worthwhile life
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GDP - Good Measure of Economic Well-being?
• GDP - not a perfect measure of well-being
- Doesn’t include
• Leisure
• Value of almost all activity that takes place
outside markets
• Quality of the environment
- No distribution of income
- https://www.telegraph.co.uk/travel/news
/vienna-mercer-quality-of-living-2018/

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 International differences in GDP
and the quality of life
• Rich countries - Higher GDP per person
- Better
• Life expectancy
• Literacy
• Internet usage
• Poor countries - Lower GDP per person
- Worse
• Life expectancy
• Literacy
• Internet usage

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 International differences in GDP
and the quality of life
• Low GDP per person
- More infants with low birth weight
- Higher rates of infant mortality
- Higher rates of maternal mortality
- Higher rates of child malnutrition
- Less common access to safe drinking water
- Fewer school-age children are actually in school
- Fewer teachers per student
- Fewer televisions; Fewer telephones
- Fewer paved roads
- Fewer households with electricity 26
Table 3
GDP and the quality of life
Real GDP per Life Adult literacy Internet usage
Country person (2005) expectancy (% of population) (% of population)
United States $41,890 78 years 99% 63 %
Japan 31,267 82 99 67
Germany 29,461 79 99 45
Russia 10,845 65 99 15
Mexico 10,751 76 92 18
Brazil 8,402 72 89 19
China 6,757 72 91 9
Indonesia 3,843 70 90 7
India 3,452 64 61 3
Pakistan 2,370 65 50 7
Bangladesh 2,053 63 47 0.3
Nigeria 1,128 47 69 4

The table shows GDP per person and three other measures of the quality of life for
twelve major countries.

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