Overview

1. Why an economy’s total income equals its

total expenditure or value added.
2. How gross domestic product (GDP) is
defined and calculated.
3. Breakdown GDP into its four major
components.
4. Distinguish between real and nominal
GDP.
 The Economy’s
Income and Expenditure
When judging whether the economy
is doing well or poorly, it is natural
to look at the total income that
everyone in the economy is
earning.
 Gross Domestic Product

• Gross domestic product (GDP) is a

measure of the income and
expenditures of an economy.
• It is the total market value of all final
goods and services produced within
a country in a given period of time.
 The Measurement of GDP
Output is valued at market prices.
It records only the value of final goods, not
intermediate goods (the value is counted only
once).

It includes goods and services currently

produced, not transactions involving goods
produced in the past.
It measures the value of production within the
geographic confines of country.
What Is and What Is Not Counted in
GDP?
GDP includes all items produced in the
economy and sold legally in markets.
-Non-Market Activities: GDP does not include
items produced and consumed at home that
never enter the marketplace.
-Underground Activities: It does not include
items produced and sold illicitly, such as illegal
drugs, smuggling etc.
 The Economy’s
Income and Expenditure
• For an economy as a whole, income must
equal expenditure because:
◆ Every transaction has a buyer and a seller.
◆ Every rupee of spending by some buyer is a
rupee of income for some seller.
The Circular-Flow Diagram

The equality of income and

expenditure can be
illustrated with the circular-
flow diagram.
 The Circular-Flow
(2) ProductionDiagram
Revenue

Goods &
Services
bought
Consumption
Spending
(3) Expenditure
 The circular flow of income

(2) Production

Factor Payments
(Wages, rent, and profit)
Consumption of
domestically
produced goods
and services (Cd)
(3) Expenditure

(1) Incomes • The inner flow

 The Circular Flow of Income
◆ The inner flow
◆ Withdrawals
– net savings
– net taxes
– import expenditure
◆ Injections
– investment
– government expenditure
– export expenditure
 The circular flow of income

Consumption of
Factor domestically
BANKS, etc
payments produced goods
and services (Cd)

Net
saving (S)
 The circular flow of income

Investment (I)

Consumption of
Factor domestically
BANKS, etc
payments produced goods
and services (Cd)

Net
saving (S)
 The Circular Flow of Income
◆ The inner flow
◆ Withdrawals
– net savings
– net taxes
– import expenditure
◆ Injections
– investment
– government expenditure
– export expenditure
 The circular flow of income

Investment (I)

Consumption of
Factor domestically
BANKS, etc GOV.
payments produced goods
and services (Cd)

Net
Net taxes (T)
saving (S)
 The circular flow of income

Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV.
payments produced goods
and services (Cd)

Net
Net taxes (T)
saving (S)
 The Circular Flow of Income
a) The inner flow

b) Withdrawals
– net savings
– net taxes
– import expenditure

c) Injections
– investment
– government expenditure
– export expenditure
 The circular flow of income

Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)
 The circular flow of income

Export
expenditure (X)
Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)
 The circular flow of income

INJECTIONS

Export
expenditure (X)
Investment (I)
Government
Consumption of expenditure (G)

Factor domestically
BANKS, etc GOV. ABROAD
payments produced goods
and services (Cd)
Import
Net expenditure (M)
Net taxes (T)
saving (S)

WITHDRAWALS
 National
National income
income accounts
accounts

The 3 - methods of
national income accounting
The circular flow of National income

(2) Production

(1) Incomes

(3) Expenditure
 3- Methods of Computing An
Economy’s Income
1. Resource Cost or Income Approach:
Sum the total wages and profit paid by
firms for resources (see the circular
flow).
1. Value Added or Production Method
Sum the value added at each stage of
production process
1. Expenditure Approach:
Sum the total expenditures by
households (from the top portion of the
circular flow).
 1. The Income Method
Hypothetical Example

Gross trading surplus of public sector Rs4627 m 0.7

Percentage of GDP
Income from employment 62.3
Rs400 354 m

Income from self-employment

Rs70 116 m 10.9

Gross trading profits of companies

Rs100 231 m 15.6

Rent Rs63 850 m 9.9

Other Rs3738 m 0.6

Total GDP Rs642 916 m

100.0
Agriculture, forestry and fishing Rs.11 700 m 1.8
Mining, energy and water supply Rs31 674 m 4.9

2. The Product Method

Manufacturing
Rs137 006 m 21.3

Construction Rs33 748 m 5.3

Percentage of GDP
Distribution, hotels, catering; repairs
Rs. 93 091 m 14.5

Transport and communication Rs54 056 m 8.4

Banking, finance, insurance, etc.

Rs89 500 m 13.9

Ownership of dwellings Rs47 814 m 7.5

Public administration and defence Rs38 244 m 5.9

Education and health Rs81 876 m 12.7

Other services Rs24 713 m 3.8

Total GDP Rs642 916 m 100.0

 3. The Expenditure Method Rs.million
Consumers’ expenditure 473 509
Government final consumption 155 732
Gross domestic fixed capital formation (including new housing) 114 623
Value of physical increase in stocks and work in progress 2 917
Total domestic expenditure 746 781
plus Exports of goods and services 217 147
Total final expenditure 963 928
less Imports of goods and services −222 603
Statistical discrepancy 975
Gross domestic product at market prices 742 300
less Taxes on expenditure −108 484
plus Subsidies 9 100
Gross domestic product at factor cost 642 916
plus Net property income from abroad 9 652
Gross national product (at factor cost) 652 568
less Capital consumption (depreciation) −77 372
Net national product (national income) 575 196
Gross National Product
The total market value of
all final goods and

€
services produced during
a given period of time by
the nation’s residents,
regardless of the place
produced.
National Income & Related Aggregates
Four Important distinctions
◆ Between a Gross Concept and a Net
Concept – GDP Vs NDP (Depreciation)
◆ Between a At Factor Costs Concept and a
At Market Prices Concept – GNPfc Vs GNPmp
(N Indirect Taxes)
◆ Between a At domestic Concept and a
National Prices Concept - GDP Vs GNP
(NFIA)
◆ Real and Nominal concept - Inflation
 The Components of GDP
1. GDP (Y) is the sum of:
– Consumption (C)
– Investment (I)
– Government Purchases (G)
– Net Exports (NX) or Exports minus Imports

Y = C + I + G + NX
 The Four Components of GDP
1. Consumption (C): Is the spending by
households on goods and services
• e.g. buying clothing, food, movie tickets
2. Investment (I): Is the purchases of capital
equipment and structures, e.g. factory, houses,
etc.
3. Government Purchases (G):Includes spending
on goods and services by local, provincial and
federal governments (e.g. roads, police, etc.).
Does not include transfer payments, because it is
not made in exchange for currently produced
goods or services.
4. Net Exports (NX): Exports minus imports.
 Real versus Nominal GDP
1. GDP is the market value of the economy’s
current production, referred to as Nominal GDP.
2. Real GDP measures any given year’s total
output in “constant” prices.
3. An accurate view of the economy requires
adjusting nominal to real GDP, using the GDP
Price Deflator.
 GDP Price Deflator
1. The GDP Price Deflator is a price index that
uses a bundle of all final goods and services.

– It tells us the rise in nominal GDP that is

attributable to a rise in prices.
1. Converting Nominal GDP to Real GDP:
Real GDP200x =
(NominalGDP20xx )
RealGDP20xx = X 100
(GDPdeflator
20xx)
 Real and Nominal GDP

Price of Quantity of Price of Quantity of

Year Hot dogs Hot dogs Hamburgers Hamburgers
2001 $1 100 $2 50
2002 $2 150 $3 100
2003 $3 200 $4 150
 Sales Receipts and their Distribution
Sector Sales Materials Allocation of Sales Receipts
Receipts
Wages & Mixed Other Saved
Salaries Income of Income
self Payments
employed
Bakers 9,000 5,000 2,500 ---- 1,000 500

Machine 1,000 400 500 ---- 100 ----

Makers

Millers 5,000 1,900 9,000 ---- 700 600

Farmers 2,500 600 9,000 900 200 ----

Total 17,500 7,900 5,600 900 2,000 1,100

 Money Flow vs. Product Flow
Farmer Miller Baker
2,500 5,000

1,000
Machine Maker
Four Branches in the Economy:
Farmers, Millers, Bakers, Machine Makers