BBM-ME-II

MODULE – A
Macroeconomic Environment
of Business
Measures of Overall Economic
Activity
- Measuring National Income &
Output
Prof. (Dr.) D N Panigrahi
PhD (Finance), MBA (Fin-FMS, DU), CFA & MS-Finance, CAIIB & DFS, M.Sc. (Physics)
 Measures of Overall Economic (Business) Activity

Understanding Measures of Overall Economic Activity: Measurement of

overall economic activity involves measuring an economy’s national income
or the value of output, and is referred to as ‘national income accounting’.
 Aggregate Output and Aggregate Income: The aggregate output of an
economy is the value of all the goods and services produced in the
economy over a specified period of time. The aggregate income of an
economy is the value of all the payments earned by the suppliers of factors
used in the production of goods and services.
 Because the value of the output produced must accrue to the factors of
production, aggregate output and aggregate income within an economy
must be equal. We’ve understood this from our previous slide on “Circular
Flow of Income Model”.
 Measures of Overall Economic (Business) Activity

 Knowing national income and the value of aggregate output is

very useful because this allows us to:
 • assess an economy’s performance over time (are income and
output increasing over time; are they decreasing?) [To assess how
fast the economy has grown over the past periods or to
estimate/forecast the economic growth over some future period.]
 • make comparisons of income and output performance with
other economies
 • establish a basis for making policies that will meet economic
objectives.
 Why Measure Value of Output Not Quantities

 You may have noticed that we often refer to the ‘value’ of output. Why
speak in terms of values, and not in terms of quantities, as we did in
microeconomics?
 The answer is that in macroeconomics we must find a way to add up
quantities of output of hundreds of thousands of different goods and
services. Yet how can we add up quantities of computers, apples, cars and
theatre tickets? What unit of measurement can we use?
 To get around this difficulty, we measure output in money terms, or the
value of goods and services. The ‘value’ of a good is simply its quantity
multiplied by its price. Sometimes ‘value’ may not be explicitly mentioned.
For example, one may speak of ‘the level of aggregate output’ or simply
‘aggregate output’.
 Whatever is the case, in macroeconomics output is always in value terms.
 How Economic Activity is Measured

 Examine the output approach, the income approach and the

expenditure approach when measuring national income and output.
 The circular flow of income model showed that the value of
aggregate output produced is equal to the total (aggregate) income
generated in producing that output, which is equal to the total
expenditures made to purchase that output. For this reason, the term
national income, or the total (aggregate) income of an economy, is
sometimes used interchangeably with the value of aggregate
(national) output. We will now use this principle to see how national
income or the value of aggregate output is measured.
 Three Routes: One Destination

 There are three ways to measure the value of aggregate output, suggested
by the circular flow of income model, all giving rise to the same result:
 • the expenditure approach adds up all spending to buy final goods and
services produced within a country over a time period
 • the income approach adds up all income earned by the factors of
production that produce all goods and services within a country over a time
period
 • the output (or Product/Production) approach calculates the value of all
final goods and services produced in a country over a time period.
 Thus, aggregate (national) output and income can be calculated in three
different ways, which should all result in the same figure. These three
methods are illustrated in the simplified circular flow of income shown in
Fig 26.15 below.
Fig. 26.15 – 3 Methods of Measuring National Income
 Measuring National Income: The Expenditure Approach

 The expenditure approach measures the total amount of spending to buy

final goods and services in a country (usually within a year).
 The term ‘final’ refers to goods and services ready for final use, and can be
contrasted with intermediate goods and services, or those purchased as
inputs for the production of final goods.
 When we measure the value of aggregate output, we include only
purchases of final goods and services.
 For example, food items like meat and vegetables are intermediate goods
for a restaurant that uses them to prepare a meal, and the meal is the final
good.
 If in measuring expenditures we included spending on the food items plus
spending on the meal, this would involve double counting and the value of
aggregate output would be exaggerated.
 Measuring National Income: The Expenditure Approach

 On the other hand, meat and vegetables bought by a household for

consumption count as final goods, since they are not used as inputs for the
production of another good or service.
 Total spending is broken down into four components:
 • Consumption spending, abbreviated as C, includes all purchases by
households on final goods and services in a year (except housing, which is
classified under investment). [Spending by consumers is classified as
spending on (i) consumer durable goods (with an expected life of more
than three years, such as cars, refrigerators, washing machines, televisions,
etc.), (ii) consumer nondurable goods (with an expected life of less than
three years, such as food, clothing and medicines), and (iii) services
(entertainment, banking, health care, education, etc.).]
 Measuring National Income: The Expenditure Approach

 • Investment spending, abbreviated as I, includes:

 Spending by firms on capital goods or physical capital (i.e. buildings,
machinery, equipment, etc.). It also includes the value of any increase
(+) or decrease (-) in stocks or inventories, whether of raw materials,
semi-finished goods or finished goods.
 Thus, I denotes Gross private domestic investment, which includes
business investment in capital goods (e.g., property, plant and
equipment) and changes in inventory (inventory investment)
 Spending on new construction (housing and other buildings).
 Measuring National Income: The Expenditure Approach

 • Government spending, abbreviated as G, refers to spending by

governments on final goods and services within a country (national,
regional, local).
 It includes purchases by the government of factors of production,
including labour services.
 It also includes investment by government, which is referred to as
‘public investment’ (usually on capital goods including roads,
airports, power generators, building schools and hospitals, etc.).
 Measuring National Income: The Expenditure Approach

 • Net exports (exports minus imports), abbreviated as NX = X

− M, refers to the value of all exports (abbreviated as X) minus
the value of all imports (abbreviated as M).
 Exports are goods and services produced within the country and
so must be included in the measurement of aggregate output.
 Imports, however, involve domestic spending on goods and
services that have been produced in other countries, and so must
be subtracted from expenditures measuring domestic output.
 Measuring National Income: The Expenditure Approach

 If we add together the four components of spending, we obtain a

measure of aggregate output known as gross domestic product (GDP):
 GDP = C + I + G + (X − M) = C + I + G + NX where GDP is a
measure of the overall economic activity. This approach allows
comparisons of relative contributions of C, I, G and X-M to GDP.
 Gross domestic product or GDP is defined as the market value of all
final goods and services (output) produced within the domestic
boundaries of a country over a time period (usually a year), regardless
of who owns the factors of production. It includes spending by the
four components, C + I + G + (X − M). It is one of the most
commonly used measures of the value of aggregate output.
 Measuring National Income: The Expenditure Approach

 GDP is used by economists, governments and international

organisations to assess what is produced, earned and spent in an
economy. ‘Gross’ means total, ‘domestic’ refers to the home economy
and product means ‘output’.
 Do not include government spending on benefits (transfer
payments). Since these are not payments for the production of goods
and services.
 Measuring National Income: The Income Approach

 The income approach adds up all income earned by the four factors of
production in the course of producing total output within a country over a
time period (usually a year): wages earned by labour, rent earned by land,
interest earned by capital, and profits earned by entrepreneurship.
 When all factor incomes are added up, the result is national income.
Whereas national income is another measure of the level of overall
economic activity, it is not the same as GDP. To calculate GDP using the
income approach, it is necessary to make some adjustments to national
income.
 So, National Income = Sum of all Factor Incomes = Rent + Wages +
Interest + Profit.
 Do not include transfer payments.
 Measuring National Income: The Income Approach

 If we add depreciation and indirect taxes to national income, we obtain a

measure of aggregate output called gross national income (GNI). Thus,
GNI = National Income + Depreciation + Indirect Taxes
 Depreciation refers to the wearing out of capital goods, can be understood
as capital consumption in a year.
 The reason we add depreciation and indirect taxes to national income in
order to obtain GNI (and GDP) is that the value of output measured by the
expenditure approach includes both these items.
 By contrast, national income, measuring only the incomes of the factors of
production, does not include either of the two.
 This approach allows comparisons of relative income shares or
contributions of all the factors of production to national income and
hence to GDP.
 Measuring National Income: The Output (Product) Approach

 The output (product) approach measures the value of each good and service
(PxQ) produced in the economy over a particular time period (usually a
year) and then sums them up to obtain the total value of all final goods and
services (output produced) which is equal to GDP.
 It includes the value of all final goods and services, in order to avoid the
double counting that would arise from including the values of intermediate
goods and services.
 The method used to obtain the value of only final goods and services is to count
only the value added in each step of the production process. For example, say the
production of a good goes through the following steps. Firm A sells raw materials
for $700 to firm B. Firm B uses the raw materials and produces an intermediate
good that it sells to firm C for $1100. Firm C uses this intermediate good to
produce a final good that it sells for $1700.
 Measuring National Income: The Output (Product) Approach

 How much value has been added in this process? Firm A added $700 of
value. Firm B added $400 of value (= $1100 − $700), and firm C added
$600 of value (= $1700 − $1100). When we add these up we obtain: $700 +
$400 + $600 = $1700.
 Note that the sum of the values that were added in each step of the
production process is exactly equal to the value of the final product.
 If we had added up the values of the two intermediate products and the
final product, we would have: $700 + $1100 + $1700 = $3500, which
greatly exaggerates the value of the product due to double counting. By
counting only values added in each step of the production process, the
problem of double counting is avoided.
 Measuring National Income: The Output (Product) Approach

 The output approach calculates the value of output by economic

sector, such as agriculture, manufacturing, and services (transport,
banking, and healthcare etc.) The value of output of each sector is
then added up to obtain the total value of output for the entire
economy.
 This approach provides us with the opportunity to study the
performance of each individual sector and to make comparisons of
performance across sectors (i.e., allows comparison of relative
contributions of each sector to GDP).
 The three approaches give rise to the same result, after allowance is
made for statistical differences that arise in the course of measuring
the different variables involved.
 Test your understanding 8.2

 1 Why are the terms ‘national income’ and ‘aggregate output’ often used
interchangeably?
 2 Why is it useful to know the value of aggregate output?
 3 Explain why (a) we measure aggregate output in value terms, and (b) we
count only the value of final goods and services when measuring the value
of output.
 4 What are the four expenditure components of GDP? Explain each of
these.
 5 (a) Explain three ways that GDP can be measured. (b) Why do they give
rise to the same result?
 GDP Computation: Summary

 Gross domestic product: The main measure of a country’s

output is its gross domestic product (GDP) at market
prices. This is the value of output produced within a country
over a 12-month period in terms of the prices actually paid.
 The three ways of calculating a nation’s GDP are shown in
the following chart.
 Gross value added (GVA) at basic prices is the sum of all
the values added by all the industries in the economy over a
year.
 GDP Computation: Summary

 The value added of a firm is its total revenue less its purchases from
other firms. This is equal to the incomes earned by the factors used in
its production process, i.e. wages, interest, rent and profit.
 The expenditure method adds up all actual expenditure on
domestically produced output (and includes stock under investment).
Expenditure is calculated at market prices.
 Market prices are higher than basic prices where there are taxes on
products, such as VAT/GST, and are lower than basic prices where
there are subsidies on products.
 So, GDP = GVA + Taxes on Products – Subsidies on products
Chart on 3-Ways of Calculating a Nation’s GDP
 Distinctions relating to measures of the value of output:
Distinction between GDP and GNI/GNP
 Distinguish between GDP (Gross Domestic Product) and GNP/GNI
(Gross National Product or Income) as measures of economic activity.
 We learned that the value of output produced in an economy is equal to
the total income generated in producing that output. However, in the real
world, this equality does not always hold.
 Sometimes the output of an economy is produced by factors of
production that belong to foreigners. Consider the case where a United
States multinational firm in India remits (sends back) its profits to the
United States. The output of the multinational is produced in India, but
the profit income is received by residents in the United States.
 Does the profit income count as Indian or US income and output?
 Distinctions relating to measures of the value of output:
Distinction between GDP and GNI/GNP
 Consider also a Russian worker who lives and works in Spain, and
sends a large part of her income to her family in Russia. Her output is
produced in Spain, but the income she sends home is Russian income;
should this income count as Russia’s or Spain’s income and output?
 The concepts ‘domestic’ and ‘national’ are used to distinguish
between measures of aggregate output and income that deal with this
issue.
 The term ‘domestic’ in ‘gross domestic product’ means that output
has been produced by factors of production within the country,
regardless of who owns them (the factors of production) (residents or
foreigners).
 Distinctions relating to measures of the value of output:
Distinction between GDP and GNI/GNP
 The term ‘national’ is used in another measure of aggregate output
known as gross national income (GNI or GNY) (formerly known as
gross national product (GNP)).
 The term ‘national’ in GNI means that the income it measures is the
income of the country’s residents, regardless where this income
comes from (where the factors of production owned by the residents
are located).
 In the example above, the profit income remitted to the United States
is included in Indian GDP because it is created by production taking
place in India, but it is part of United States GNI because it is income
received by United States’ residents.
 Distinctions relating to measures of the value of output:
Distinction between GDP and GNI/GNP
 For the Russian worker in Spain, the value of her output is included in
Spain’s GDP, but her income sent to Russia is part of Russia’s GNI.
 GDP is the total value of all final goods and services produced
within a country over a time period (usually a year), regardless of
who owns the factors of production.
 GNI (or GNP) is the total income received by the residents of a
country, equal to the value of all final goods and services produced
by the factors of production supplied by the country’s residents
regardless where the factors are located.
 Gross national income (GNI) is increasing in importance as a
measure. GNI is included, for instance, by the United Nations in its
Human Development Index.
 Distinctions relating to measures of the value of output:
Distinction between GDP and GNI/GNP
 GNI goes further than GDP in changing the focus from output
produced in a country to income earned by the country’s residents and
firms regardless of where it is earned.
 GDP (the value of output produced within a country) is likely to differ
from the GNI (total income received by the residents of a country)
because incomes of factors of production usually flows across the
international boundaries. Therefore the income received may be
greater or lower than the value of the output produced.
 So, GNI = GDP + Factor Incomes received from Abroad - Factor
Incomes sent Abroad = GDP + Net Factor Incomes from Abroad
(NFIA).
 Distinctions relating to measures of the value of output:
Distinction between GDP and GNI/GNP
 NFIA is also known as Net (Foreign) Income from abroad or Net
Property Income from abroad.
 NFIA includes all factor incomes like remittances, profit of MNCs
repatriated, interest and dividends received on assets (investments).
 GDP is a better measure of the value of aggregate output produced in
a country than GNI (GNP).
 GNI (GNP) is a better measure of the amount of aggregate income
earned by the residents of a country than GDP.
 Net income from abroad is included in GNI but not GDP. If there is no
property income from abroad, the two measures would be equal.
 Both measures are adjusted for indirect taxes and subsidies.
 Transfer payments are not included in either measure.
 Distinctions relating to measures of the value of output:
Distinction between GDP and GNI/GNP
Factor Incomes Received from Abroad is Factor Incomes Sent Abroad is likely to
likely to include include
Incomes received by the domestic residents Wages of foreign workers working
sent to them by their relatives working domestically sent to their relatives back home
abroad (known as inward remittances) (outward remittances)

Profits of Multi-National Corporations Profits of foreign multi-national corporations

(MNCs) (also a form of income) earned operating domestically sent back to their
abroad and sent home (known as profit home countries (profit repatriation)
repatriation)
Interest & Dividends Received on Foreign Interest & Dividends Paid on Foreign Assets
Assets (Investments) abroad. operating domestically.
 Distinction between Nominal Values and Real Values
of GDP and GNI
 Distinguish between the nominal value of GDP and GNP/GNI and the
real value of GDP and GNP/GNI.
 Earlier we noted that in macroeconomics we measure output in value
terms, and we defined ‘value’ to be the quantity of a good multiplied by its
price (Q x P). Nominal value is money value, or value measured in terms of
prices that prevail at the time of measurement.
 For example, if a pair of shoes costs £100, this is its nominal value. If you
buy this pair of shoes, £100 is your nominal expenditure on these shoes. If
your monthly income is £2000, this is your nominal income. Therefore,
when we calculate the value of aggregate output, or expenditure, or
income, in money terms, we speak of nominal GDP, nominal expenditure,
nominal income, etc.
 Distinction between Nominal Values and
Real Values of GDP and GNI
 Yet prices change over time, and this poses a measurement problem. Let’s
say that nominal GDP increases in a year. This increase may be due to
changes in the quantities of output produced, or changes in the prices of
goods and services, or a combination of both. We have no way of knowing
what part of the increase is due to changes in output and what part to
changes in prices. Yet we are interested in knowing how much the quantity
of goods and services has increased. We must therefore find a measure of
GDP that is not influenced by price changes.
 To eliminate the influence of changing prices on the value of output, we
must calculate real values. Real value is a measure of value that takes into
account changes in prices over time. Meaningful comparisons over time in
the value of output, or expenditures, or income, or any variable that is
measured in money terms, require the use of real values.
 Distinction between Nominal Values and Real Values
of GDP and GNI
 For example, when we make comparisons of GDP in a country over time, we
must be sure to use real GDP values, as these have eliminated the influence of
price changes, and give us an indication of how actual output produced has
changed.
 Nominal GDP and GNI are measures of output or income in terms of current
prices (prices prevailing at the time of measurement), which does not account
for changes in price levels or inflation.
 Real GDP or real GNI are measures of economic activity (output and
income) in terms of constant prices (prices prevailing at one particular year),
therefore represent real values and hence have eliminated the influence of
price level changes (inflation) over time.
 When a variable is being compared over time, it is important to use real values
for getting more accurate pictures of changes in output and income without the
influence of price level changes (inflation).
 Distinction between Total and Per Capita Output & Income
 Distinguish between total GDP and GNP/GNI and per capita GDP and
GNP/GNI: Per capita means per person or per head. A per capita measure takes
the total value (of output, income, expenditure, etc.) and divides this by the total
population of a country. Therefore per capita GDP of a country is total GDP of
that country divided by its population.
 The distinction between total and per capita measures is very important for two
reasons: • Differing population sizes across countries: Let’s say there are two
countries that have identical total GDPs of £10 billion. Country A has a
population of 1 million people and country B has a population of 2 million
people. If we divide total GDP by population we get GDP per capita of £10,000
for country A and £5,000 for country B. Whereas both countries have identical
GDPs, country B’s per capita GDP is only half that of country A, because of
differing population sizes.
Distinction between Total and Per Capita Output & Income

 • Population growth: Changes in the size of GDP per capita over time
depend very much on the relationship between growth in total GDP and
growth in population. In general, if total GDP increases faster than the
population, then GDP per capita increases. But if the country’s population
increases faster than total GDP, then GDP per capita falls.
 Total measures of the value of output and income (such as GDP and
GNI), provide a summary statement of the overall size of an economy.
 Per capita figures [Per Capita GDP = Total GDP/Population and Per
Capita GNI = Total GNI/Population] are useful as a summary measure
of the standard of living in a country, because they provide an indication
of how much of total output or income in the economy corresponds to each
person in the population on average.
 Distinction between Gross and Net

 Physical capital, a produced factor of production, consists of

buildings, equipment and machinery.
 All of these have a finite life; in other words, they do not last forever.
Within any given year, some of the capital goods in an economy
become worn out and are thrown away. This capital that gets worn out
is called depreciation.
 Each year, the worn out capital goods must be replaced. This means
that in any year, of the total new production of capital goods, a part
goes to replace capital goods that have been thrown out and the rest
are new additions of capital goods.
 Distinction between Gross and Net

 Investment (I) [which is one of the components of GDP under

expenditure approach], as we know, refers to spending by businesses
on capital goods. Total investment is known as gross investment, and
is divided into two parts:
 • the part that goes toward replacing thrown-out capital goods
(depreciation): Replacement Investment
 • the part that consists of new additions of capital goods, known as
net investment: New Investment
 To put it more simply: Gross Investment = Depreciation + Net
Investment
 Or, Total Investment = Worn-out Capital Goods + additions of New
Capital
 Distinction between Gross and Net

 In the expression for gross domestic product, GDP = C + I + G + (X −

M), I refers to gross (or total) investment.
 This is because GDP measures an economy’s total output, and
therefore includes total spending on capital goods, including
replacements of depreciated capital and new additions to capital
goods.
 In an alternative way of measuring aggregate output, net investment is
used to arrive at net domestic product (NDP):
 NDP = C + In + C + X − M where In = net investment.
 Therefore NDP = GDP − Depreciation.
 Test your understanding 8.3

 1 (a) Define GDP and GNI, and explain how they differ. (b) Think of
some examples of countries where (i) GNI is likely to be larger than
GDP, and (ii) GDP is likely to be larger than GNI.
 2 Why do price changes over time pose a problem when we want to
make comparisons of GDP (or any measure of output or income) over
time?
 3 Explain the difference between nominal GDP and real GDP (or
nominal and real GNI).
 4 Why is it important to use real values when making comparisons
over time?
 Test your understanding 8.3

 5 You read in the newspaper that government spending on education

in your country increased by 7% last year. What information do you
need to be able to make sense of this figure?
 6 Explain the difference between a total GDP (or GNI) and per capita
GDP (or GNI).
 7 Why is it sometimes important to make a distinction between total
measures and per capita measures of income and output?
 Evaluating the Use of National Income Statistics

 Evaluate the use of national income statistics, including their use

for making comparisons over time, their use for making
comparisons between countries and their use for making
conclusions about standards of living.
 When real per capita GDP or real per capita GNI of a country
increases over time, we might expect that the population of this
country achieves a higher standard of living.
 Alternatively, if GDP per capita or GNI per capita in one country is
higher than in another country, we might expect that the first country
enjoys a higher standard of living. But would these conclusions be
valid?
 Evaluating the Use of National Income Statistics

 The answer is that we cannot be sure. There are two reasons why this
is so. One is that national income statistics (or statistical data used to
measure national income and output and other measures of economic
performance) do not accurately measure the ‘true’ value of output
produced in an economy.
 The other is that standards of living are closely related to a variety of
factors that GDP and GNI are unable to account for.
 As a result, per capita figures of both GDP and GNI may be
misleading when used to make comparisons over time or
comparisons between countries, and when used as the basis for
standard of living conclusions.
 Why per capita figures of GDP & GNI may be misleading
GDP/GNI may Underestimate GDP/GNI may Overestimate GDP/GNI may Under- or Over-
Standards of Living because they Standards of Living because they estimate Standards of Living
because they
Do not include the output sold in the Do not take into account the value of Disregard what output consists of
underground (informal) economy negative externalities that reduce the (Ex.: high military goods output and
(Ex.: Unreported Income of a standard of living (Ex.: Pollution) low merit goods output or the
Plumber) reverse)
Do not include the output that is Not
sold in the Market (Ex.: Food grown
for own Consumption)
Do not take into account the Do not take into account the Disregard the distribution of Income
improvements in the quality of goods destruction of natural resources (Ex.: (Ex.: high Income Inequality or low
and services (Ex.: Improved Forests, Wildlife, Soil Quality) Income Inequality)
Computers)
Do not take into account the Disregard differing price levels in
standard of living factors (Ex.: Level different countries (Ex.: $100 of
of Education, Health and Life output translates into more output in
Expectancy) a low price country than in a high
price country)
 Test your understanding 8.4

 1 Explain some reasons why national income statistics do not measure

the ‘true’ value of income and output.
 2 Explain some reasons why GDP per capita or GNI per capita may be
inappropriate as the basis for making comparisons of a society’s
standards of living over time, or for comparisons of standards of
living between countries.
 The Meaning and Significance of Green GDP

 Explain the meaning and significance of ‘green GDP’, a measure of

GDP that accounts for environmental destruction.
 Measures of GDP and GNI do not take into account negative
environmental externalities and environmental degradation and destruction
arising from the production and consumption activities in the economy.
 Measures of GDP and GNI are subject to the following limitations:
 • They neglect to account for the loss of environmental resources and losses
in environmental quality, with the result that they overestimate the ‘true’
value of national output and standards of living.
 • They include expenditures undertaken for the purposes of cleaning up
pollution as increases in the value of national output.
 The Meaning and Significance of Green GDP

 For example, if a country experiences an oil spill, the funds spent to

clean up the pollutants are added to the value of national output.
 Similarly, health care expenditures to treat people suffering from poor
health due to pollution are also added to national output.
 The result is that the country looks better after the oil spill than if it
had not occurred, as well as after treating people from pollution-
induced diseases.
 Once again, the ‘true’ value of output and well-being is overestimated.
 To correct these deficiencies, environmental economists have
suggested computation of Green GDP.
 The Meaning and Significance of Green GDP
 Green GDP = GDP – the Value of Environmental Degradation or Destruction
– P,
 Where P stands for all expenditures resulting from cleaning up pollution,
avoiding further environmental damage, and health care costs of pollution-
induced illnesses
 Green GDP < GDP
 Significance of Green GDP
 Corrects serious deficiency of conventionally measured GDP which
neglects/ignores environmental destruction resulting from production methods
that destroy natural resources and have major negative environmental
externalities
 Raises awareness of policymakers and public of the importance of clean
technologies that minimise environmental damage and may even increase the
quantity and quality of natural resources (natural capital)
 Test Your Understanding 8.5

 1 What are the limitations of current national income accounting methods

as far as the environment is concerned?
 2 Explain the meaning of green GDP and green national accounting
methods.
 3 Is green GDP likely to be higher or lower than conventionally measured
GDP? Explain.
 4 What do you think would be the advantages of adopting green national
accounting methods?
 Applying your skills
 1 Explain the concept of green GDP.
 2 Why is green GDP expected to be lower than conventionally measured
GDP?
 3 What might be some benefits for India from calculations of green GDP?
 Calculating Nominal GDP
using the Expenditure Approach
Calculate nominal GDP from sets of national income data, using the
expenditure approach.
 Suppose we are given the national income statistics for a country
called Mountainland in Table 8.1 (Mnl is Mountainland’s national
currency).
Consumer spending 11.3

Investment spending 3.2

Government spending 3.5

Exports of goods and services 2.5

Imports of goods and services 2.1

 Calculating Nominal GDP
using the Expenditure Approach
 Solution: Measurement of GDP using the expenditure approach involves
adding up the four spending components: consumption (C), firm
investment (I), government spending (G) and exports minus imports (X –
M). Therefore, GDP = C + I + G + (X − M).
 Using the above information, we find that nominal GDP = 11.3 + 3.2 + 3.5
+ 2.5 − 2.1 = 18.4 billion Mnl in 2009.
 Note that all these figures are in nominal terms; therefore, this value of
GDP is a nominal value.
 Calculation of GNP/GNI

 Calculate GNP/GNI from data.

 Example: Suppose in 2010, Riverland’s GDP was $46 billion: income
earned abroad and sent home to Riverland was $2.7 billion; income earned
in Riverland and sent abroad was $4.7 billion. What was Riverland’s 2010
GNI?
 Solution: Riverland’s net income from abroad was $2.7 billion minus $4.7
billion = –$2 billion.
 Therefore, 2010 GNI = GDP – NFIA = 46 – 2 = $44 billion.
 Calculating Real GDP using a Price Index
(GDP Deflator)
 Understanding the difference between nominal and real GDP with an
Example Calculation: We will use a numerical example based on a
hypothetical economy to show how real GDP can be calculated from
nominal GDP.
 Table 8.2 assumes a simple economy producing three items (burgers,
haircuts and tractors). Part (a) shows their quantities and prices for three
years (2001/2002/2003) and the corresponding nominal GDP.
 In each year, price and quantity of each item is multiplied to get the value
of output of each item, then adding up the three total values, we find
nominal GDP.
 Nominal GDP is the amount of production of goods and services in an
economy over the year valued at current prices.
 Calculating Real GDP using a Price Index
(GDP Deflator)
 Part (b) of Table 8.2 shows that to find real GDP, it is only necessary to
find the value of quantities produced in 2001, 2002 and 2003 using the
same prices of a single year, called a base year. Any year can be used as the
base year. In the table the base year is 2001. To calculate real GDP, we
simply multiply the quantities of output produced each year by 2001 prices.
 Adding up the resulting values of the three items in each year, we get a
measure of real GDP of each year in 2001 prices.
 Therefore, real GDP is a measure of output (amount of goods & services
produced in an economy over the year) valued at constant (unchanging)
prices (that is not affected by changes in prices).
Table 8.2 – Nominal & Real GDP Calculation
in a Hypothetical Economy
 Nominal GDP –Vs- Real GDP

 Examining the changes in real GDP that occurred between 2001 and
2003, we find that real GDP increased from 2001 to 2002 (from £881
to £976), but decreased between 2002 and 2003, falling from £976 to
£941.
 Note that real GDP fell in 2002–03 even as nominal GDP increased
over the same period (from £1,160 to £1,223); price increases caused
nominal GDP to rise, while falling quantities meant that real GDP
was falling.
 (Note that in the base year, 2001, nominal GDP is equal to real GDP;
this is always so for the base year since real GDP is valued at base
year prices.)
 Nominal GDP –Vs- Real GDP

 Nominal GDP measures the value of current output valued at

current prices, while real GDP measures the value of current output
valued at constant (base year) prices.
 When we refer to real GDP figures, we must also refer to the specific
base year used for the computation. In the example above, we say ‘in
2003 real GDP at 2001 prices was £941’. The figure of £941 is
otherwise meaningless, because if we had used a different base year,
we would have arrived at a completely different figure for 2003 real
GDP.
 It is also meaningless to compare real GDP figures calculated on the
basis of different base years.
 Understanding how the GDP Deflator is derived

 In the real world, the above method of converting nominal values into real
values is extremely lengthy and complicated, as there are hundreds of
thousands of products whose values must be measured. However, this is
not a problem because economists use short-cut methods that take the form
of price indices.
 A price index is a measure of average prices in one period relative to
average prices in a base year. A price index commonly used to convert
nominal GDP to real GDP is a price deflator known as the GDP deflator:
 GDP deflator = (nominal GDP/real GDP) × 100
 Statistical services derive the GDP deflator by using the values of nominal
and real GDP they have already calculated (by the method in Table 8.2):
 Understanding how the GDP Deflator is derived
 GDP deflator in 2001 = (881/881) × 100 = 100.0
 GDP deflator in 2002 = (1160/976) × 100 = 118.8
 GDP deflator in 2003 = (1223/941) × 100 = 130.0
 These results are summarised in Table 8.3.
 Note that the GDP deflator is 100.0 for 2001. The index number for the base year
is always equal to 100, for all indices. This follows from the equality of nominal
and real GDP in 2001, as we had selected 2001 to be the base year.
 Table 8.3 Nominal & Real GDP and GDP Deflator
Year Nominal GDP Real GDP GDP Deflator

2001 £881 £881 100.0

2002 £1,160 £976 118.8

2003 £1,223 £941 130.0

 Using the GDP Deflator to Calculate Real GDP

 Calculate real GDP, using a price (GDP) deflator.

 Statistical services in each country regularly publish GDP deflators (and
other price indices). Using this information, it is a simple matter for
economists to calculate real GDP from nominal GDP:
 real GDP = (nominal GDP/price (GDP) deflator) × 100
 For example, suppose we are given the following values of nominal GDP:
£7,850 billion in 2001; £9,237 billion in 2002; and £10,732 billion in 2003.
We are also given the GDP deflator in Table 8.3, and are asked to calculate
real GDP:
 real GDP in 2001 = (7850/100.0) × 100 = £7,850 billion
 real GDP in 2002 = (9,237/118.8) × 100 = £7,775 billion
 real GDP in 2003 = (10,732/130.0) × 100 = £8,255 billion
 Using the GDP Deflator to calculate Real GDP

 Note that an increasing GDP deflator indicates rising prices on average,

while a decreasing GDP deflator indicates falling prices on average.
 Suppose we have the following price index representing the GDP deflator:
2004 2005 2006 2007 2008

95.7 97.7 100.0 105.9 102.4

 We can see that whereas prices on average increased in the period 2004–7,
in 2008 they fell. We can also see that the base year is 2006. Note that it is
possible for some years to have a price index that is less than 100.0, which
means simply that in those years, the average price level was lower than in
the base year.
 Test Your Understanding 8.6
 1 Calculate nominal GDP, given the following information from the national
accounts of Flatland for the year 2007 (all figures are in billion Ftl, the national
currency). Consumer spending = 125; government spending = 46; investment
spending = 35; exports of goods and services = 12; imports of goods and services
= 17.
 2 Now suppose that profits of foreign multinational corporations in Flatland and
incomes of foreign workers in Flatland that were sent home in 2007 were Ftl 3.7
billion. The profits of Flatland’s multinational corporations abroad and income of
Flatland workers abroad that were sent back to Flatland were Ftl 4.5 billion. What
was Flatland’s GNI in 2007?
 3 You read in one source of information that real GDP in a hypothetical country
in 2001 was $243 billion; in another source of information you read that real GDP
in 2002 was $277 billion. What information do you need to be sure that the two
figures can be compared with each other?
 Test Your Understanding 8.6
 4 You are given the following information on an imaginary country called
Lakeland.
Year 2006 2007 2008 2009 2010

Nominal GDP 19.9 20.7 21.9 22.6 22.3

(billion Lkl)

GDP deflator 98.5 100.0 102.3 107.6 103.7

 (a) Which year is the base year? (b) Calculate real GDP for each of the five years
in the table. (c) For which year is real GDP the same as nominal GDP? Why? (d)
In 2008 – 9, nominal GDP increased, but real GDP fell (check that this is what
your calculation shows). Explain how this could have happened. (e) In 2009–10,
nominal GDP fell, but real GDP increased (check that this is what your
calculation shows). Explain how this could have happened.
 Definitions
 Gross value added (GVA) at basic prices The sum of all the values added by all
industries in the economy over a year. The figures exclude taxes on products
(such as VAT/GST) and include subsidies on products.
 Gross domestic product (GDP) (at market prices) The value of output
produced within a country over a 12-month period in terms of the prices actually
paid.
 GDP = GVA + taxes on products - subsidies on products.
 Gross national income (GNI) GDP plus net factor income from abroad.
 Depreciation (capital) The decline in value of capital equipment due to age or
wear and tear.
 Net national income (NNI) GNI minus depreciation.
 Households’ disposable income The income available for households to spend,
i.e. personal incomes after deducting taxes on incomes and adding benefits.
 Summary
 1. National income is usually expressed in terms of gross domestic
product (GDP). This is simply the value of domestic production over the
course of the year. It can be measured by the product (output),
expenditure or income methods.
 2. The product (output) method measures the values added in all
parts/sectors of the economy.
 3. The income method measures all the incomes generated from domestic
production: wages and salaries, rent, interest and profit.
 4. The expenditure method adds up all the categories of expenditure:
consumer expenditure, government expenditure, investment and exports.
We then have to deduct the element of each that goes on imports in order
to arrive at expenditure on domestic products.
 Thus GDP = C + I + G + X - M.
 Summary
 5. GDP at market prices measures what consumers pay for output
(including taxes and subsidies on what they buy). Gross value added
(GVA) measures what factors of production actually receive. GVA,
therefore, is GDP at market prices minus taxes on products plus subsidies
on products.
 6. Gross national income (GNI) takes account of incomes earned from
abroad (+) and incomes earned by people abroad from this country (-).
Thus GNI = GDP plus net factor incomes from abroad (NFIA).
 7. Net national income (NNI) takes account of the depreciation of capital.
Thus NNI = GNI - depreciation.
 8. Households’ disposable income is a measure of household income after
the deduction of income taxes and the addition of benefits.
 KEY TERMS

• Nominal and real GDP, GDP & GNI, NDP & NNI,
GDP Deflator, Net Exports, Product (Output)
Method, Expenditure Method, Income Method, Per
Capita GDP/GNI, Green GDP

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