Measuring National Output and National Income: Chapter Outline

PART IV CONCEPTS AND PROBLEMS
IN MACROECONOMICS
Measuring National
Output and National
21
Income
CHAPTER OUTLINE
Gross Domestic Product
Final Goods and Services
Exclusion of Used Goods and Paper
Transactions
Exclusion of Output Produced Abroad by
Domestically Owned Factors of
Production
Calculating GDP
The Expenditure Approach
The Income Approach
Nominal versus Real GDP
Calculating Real GDP
Calculating the GDP Deflator
The Problems of Fixed Weights
oi t a N gni r us ae M
Limitations of the GDP Concept

GDP and Social Welfare
The Underground Economy
Gross National Income per Capita
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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster
gross domestic product (GDP) The total

market value of all final goods and services
produced within a given period by factors of
production located within a country.
GDP is the total market value of a country’s

output. It is the market value of all final goods
and services produced within a given period
of time by factors of production located within
a country.
Turkey’s GDP in 2009 was 615.3 billion US$ and

the GDP of Northern Cyprus was 3.6 billion US$.
GDP is one of the key parameters that is used to

evaluate the success or failure of an economy.
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final goods and services Goods and services produced for final use.
intermediate goods Goods that are produced by one firm for use in
further processing by another firm.
Ex: tires sold to automobile manufacturers are intermediate goods.
Why are intermediate goods not counted in GDP?

Suppose that Fiat pays 300$ to Pirelli for tires. Fiat uses this tires to
assemble a car which it sells for 25000$. The value of the car is
25000$ not (25000+300)$. The final price already reflects the value of
all its components.
To count in GDP both the value of tires sold to Fiat and the value of the
cars sold to consumers would result in double counting.
Another way of avoiding double counting is counting only the value added to
a product by each firm in its production process.
value added The difference between the value of goods as they leave a
stage of production and the cost of the goods as they entered that stage.
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In calculating GDP, we can sum up the value

added at each stage of production or we can take
the value of final sales. We do not use the value
of total sales in an economy to measure how much
output has been produced.
TABLE 21.1 Value Added in the Production of a Liter of

Gasoline (Hypothetical Numbers)
Stage Of Production Value Of Sales Value Added
(1)Oil drilling $3.00 $3.00
(2)Refining 3.30 0.30
(3)Shipping 3.60 0.30

(4)Retail sale 4.00 0.40
Total value added $4.00

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Exclusion of Used Goods and Paper Transactions
GDP is concerned only with new, or current,

production. Old output is not counted in current
GDP because it was already counted when it was
produced.
Ex: If you buy a used car, the transaction is not

counted in GDP because no new production has
taken place.
Similarly, a house is counted in GDP only at the
time it is built not at each time it is resold.
GDP does not count transactions in which money

or goods changes hands but in which no new
goods and services are produced.
Sales of stocks and bonds are not counted in GDP

as they are exchanges of ownerships of assets
and do not correspond to current production.
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Exclusion of Output Produced Abroad by Domestically Owned Factors
of Production
GDP is the value of output produced by factors of production located
within a country.
The three basic factors of production are land, labor and capital.
The output produced by citizens of a country abroad, is not counted
in that country’s GDP.
Profit earned abroad by companies of a country are not counted in

that country’s GDP:
Output produced by foreigners working for ex. in Germany is counted

in Germany’s GDP as the output is produced in Germany.
Also profits earned in for ex. Turkey by foreign owned companies are
counted in Turkey’s GDP.

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Gross National Product
gross national product (GNP) The total market value of all final goods and
services produced within a given period by factors of production owned by a
country’s citizens, regardless of where the output is produced.
Generally, the difference between GDP and GNP is small.
Sometimes the distinction between GDPand GNP can be tricky:

Example: Consider the Honda plant in Ohio. The plant is owned by a Japanese
firm, but most of the workers are US workers. Although all the output is included
in US GDP, only part of it is included in US GNP. The wages paid to US citizens
are part of US GNP but the profits from the firm are not. They are counted in
Japanese GNP.
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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 7 of 35
Calculating GDP
expenditure approach A method of computing

GDP that measures the total amount spent on all
final goods and services during a given period.
income approach A method of computing GDP

that measures the income—wages, rents, interest,
and profits—received by all factors of production in
producing final goods and services.
These two approaches lead to the same value:

Every payment (expenditure) by a buyer is at the
same time a receipt (income) for the seller.
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Calculating GDP
There are four main categories of expenditure:
Personal consumption expenditures (C):

household spending on consumer goods
Gross private domestic investment (I):

spending by firms and households on new
capital, that is, plant, equipment, inventory,
and new residential structures
Government consumption and gross

investment (G)
Net exports (X - M): net spending by the rest

of the world, or exports (X) minus imports (M)
GDP = C + I + G + (X - M)
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Calculating GDP
TABLE 21.2 Components of U.S. GDP, 2007: The Expenditure Approach

Billions Of Dollars Percentage of GDP
Personal consumption expenditures (C) 9,734.2 70.3
Durable goods 1,078.2 7.8
Nondurable goods 2,833.2 20.5
Services 5,822.8 42.1
Gross private domestic investment (l) 2,125.4 15.4
Nonresidential 1,481.8 10.7
Residential 640.7 4.6
Change in business inventories 2.9 0.0
Government consumption and gross 2,689.8 19.4
investment (G)
Federal 976.0 7.1
State and local 1,713.8 12.4
Net exports (X – M) −708.0 − 5.1
Exports (X) 1,643.0 11.9

Imports (M) 2,351.0 17.0
Gross domestic product 13,841.3 100.0
Note: Numbers may not add exactly because of rounding.
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
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Calculating GDP
Personal Consumption Expenditures (C)
personal consumption expenditures (C)

Expenditures by consumers on goods and services.
Three main categories of consumer expenditures:
durable goods Goods that last a relatively long

time, such as cars and household appliances.
nondurable goods Goods that are used up fairly

quickly, such as food, gasoline and clothing.
services The things we buy that do not involve

the production of physical things, such as legal
and medical services, and education.

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Calculating GDP
Gross Private Domestic Investment (I)
gross private domestic investment (I) Total

investment in capital—that is, the purchase of new
housing, plants, equipment, and inventory by the
private (or nongovernment) sector. It has three
components.
nonresidential investment Expenditures by
firms for machines, tools, plants, and so on.
Because these are goods that firms buy for their
own final use, they are part of “final sales” and
counted in GDP.
residential investment Expenditures by

households and firms on new houses and

apartment buildings.
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Calculating GDP

Change in Business Inventories
change in business inventories The amount by

which firms’ inventories change during a period.
Inventories are the goods that firms produce now
but intend to sell later.
GDP = Final sales + Change in business inventories
(Remember that GDP is not the market value of

total final sales during a period, it is the market
value of total production)
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Calculating GDP

Gross Investment versus Net Investment
gross investment The total value of all newly produced

capital goods (plant, equipment, housing, and inventory)
produced in a given period.
depreciation The amount by which an asset’s value falls in a

given period.
Ex: A PC purchased by a business today may be expected to
have a useful life of 4 years before becoming worn out or
obsolete. Over that period the PC steadily depreciates.
net investment Gross investment minus depreciation.

It is a measure of how much the stock of capital changes

during a period.
capitalend of period = capitalbeginning of period + net investment
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Calculating GDP
Government Consumption and Gross Investment (G)
government consumption and gross

investment (G) Expenditures by federal, state,
and local governments for final goods (school
buildings, PCs) and services (school teachers’ and
military salaries).
Government transfer payments (such as social

security benefits, etc.) are not included in GDP
because these transfers are not purchases of
anything currently produced.
Because interest payments on the government

debt are also counted as transfers, they are
excluded form GDP.
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Calculating GDP
Net Exports (X - M)
net exports (X - M) The difference between exports (sales to

foreigners of home produced goods and services) and imports
(purchases of goods and services from abroad). The figure
can be positive or negative.
• Why are net exports included in the definition of GDP?

• C, I, and G include expenditures on goods produced at
home and abroad. Therefore, C+I+G overstates domestic
production because it contains expenditures on foreign-
produced goods, that is, imports.
• At the same time, C+I+G understates domestic production
because some of what a nation produces is sold abroad and

therefore is not included in C, I or G. That is, exports have to
be added in.
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Calculating GDP
The Income Approach
national income The total income earned by the

factors of production owned by a country’s
citizens. It is the sum of 8 items.
TABLE 21.3 National Income of US, 2007

Billions of Percentage of National
Dollars Income
National Income 12,221.1 100.0
Compensation of employees 7,874.2 64.4
Proprietors’ income 1,042.6 8.5
Rental income 65.4 0.5
Corporate profits 1,598.2 13.1
Net interest 602.6 4.9
Indirect taxes minus subsidies 961.4 7.9
Net business transfer payments 94.2 0.8
−14.5 −0.1
Surplus of government enterprises

Source: See Table 6.2.
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Calculating GDP
The Income Approach
compensation of employees Includes wages,

salaries, and various supplements—employer
contributions to social insurance and pension
funds, for example—paid to households by firms
and by the government.
proprietors’ income The income of

unincorporated businesses.
rental income The income received by property

owners in the form of rent.
corporate profits The income of corporations.

net interest The interest paid by business.

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Calculating GDP
The Income Approach
indirect taxes minus subsidies Taxes such as

sales taxes, customs duties, and license fees less
subsidies that the government pays for which it
receives no goods or services in return.
Thus, the value of indirect taxes minus subsidies is
the net income received by governments.
net business transfer payments Net transfer

payments by businesses to others.
surplus of government enterprises Income of

government enterprises.
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Calculating GDP
The Income Approach
TABLE 21.4 GDP, GNP, NNP and National Income of US, 2007
Dollars
(Billions)
GDP 13,841.3
Plus: Receipts of factor income from the rest of the world + 817.5
Less: Payments of factor income to the rest of the world − 721.8
Equals: GNP 13,937.1
Less: Depreciation − 1,686.6
Equals: Net national product (NNP) 12,250.5
Less: Statistical discrepancy − 29.4
Equals: National income 12,221.1
Note that the national income is the income of the country’s citizens,
not the income of the residents of the country. So we first need to move
form GDP to GNP.
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Calculating GDP
The Income Approach
net national product (NNP) Gross national

product minus depreciation; a nation’s total
product minus what is required to maintain the
value of its capital stock.
statistical discrepancy Data measurement error.
personal income The total income of households

before they pay income taxes.
As the following table shows, almost all of national

income is personal income.
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Calculating GDP
The Income Approach
TABLE 21.5 National Income, Personal Income, Disposable Personal Income, and
Personal Saving of US, 2007
Dollars
(Billions)
National income 12,221.1

Less: Amount of national income not going to households − 561.6
Equals: Personal income 11,659.5
Less: Personal income taxes − 1,482.5
Equals: Disposable personal income 10,177.0
Less: Personal consumption expenditures − 9,734.2
Personal interest payments −262.8
Transfer payments made by households −137.1
Equals: Personal saving 42.9
Personal saving as a percentage of disposable personal income: 0.4%

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Calculating GDP
The Income Approach
disposable personal income or after-tax

income Personal income minus personal income
taxes. The amount that households have to spend
or save.
As it can be seen on the previous table there are
three categories of spending: (1) personal
consumption expenditures, (2) personal interest
payments, (3) transfer payments made by
households
personal saving The amount of disposable
income that is left after total personal spending in a
given period.
personal saving rate The percentage of
disposable personal income that is saved. If the

personal saving rate is low, households are
spending a large amount relative to their incomes;
if it is high, households are spending cautiously.
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Problem 1
In a simple economy suppose that all income is either compensation of employees or profits. Suppose also there are no indirect taxes. Calculate GDP
from the following set of numbers. Show that the expenditure approach and the income approach add up to the same number.
Consumption 5000
Investment 1000
Depreciation 600
Profits 900
Exports 500
Compensation of Employees 5300
Government purchases 1000
Direct taxes 800
Saving 1100
Imports 700
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nominal GDP Gross domestic product measured

in current prices.
In most applications in macroeconomics, however,

nominal GDP is not what we are after.
Ex: an economy produces just pizza. It produces
100 units in year 1 and 2. Price in year 1 is 1 and
in year 2 is 1.1.
Although production does not grow the GDP
increases.
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TABLE 21.6 A Three-Good Economy

(1) (2) (3) (4) (5) (6) (7) (8)
GDP in GDP in GDP in GDP in
Year 1 Year 2 Year 1 Year 2
in in in in
Production Price Per Unit Year 1 Year 1 Year 2 Year 2
Year 1 Year 2 Year 1 Year 2 Prices Prices Prices Prices
Q1 Q2 P1 P2 P1 x Q1 P1 x Q2 P2 x Q1 P2 X Q2
Good A 6 11 $0.50 $0.40 $3.00 $5.50 $2.40 $4.40
Good B 7 4 0.30 1.00 2.10 1.20 7.00 4.00
Good C 10 12 0.70 0.90 7.00 8.40 9.00 10.80
Total $12.10 $15.10 $18.40 $19.20
Nominal GDP Nominal
in year 1 GDP
in year 2
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Nominal GDP adjusted for price changes is

called real GDP.
We will see two methods to calculate the real
GDP.
base year The year chosen for the weights in a
fixed-weight procedure.
fixed-weight procedure A procedure that uses
weights from a given base year.
weight The importance attached to an item within
a group of items.
If we use the fixed-weight procedure and year 1 as

the base year column 5 gives us the real GDP in
year 1 and column 6 gives as the real GDP in year

2. Thus, the real GDP has grown 24.8%.
If we use year 2 as the base year the GDP growth
is 4.3%.
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 New method (two changes):

 Take the geometric average between the two
growth rates. The geometric average is the square
of the product of the two numbers.
 In our case, the square of 24.8 *4.3 is 14.09.
 When calculating the percentage change

between years 1 and 2 use years 1 and 2 as base
years, then use years 2 and 3 as the base years
when computing the percentage changes between
years 2 and 3, and so on.
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Calculating the GDP Deflator
The GDP deflator is one measure of the overall price level.
Overall price increases can be sensitive to the choice of the

base year. For this reason, using fixed-price weights to
compute real GDP has some problems.
Ex. Table 21.6.

Let’s use year 1 as the base year. Thus, we use year 1’s
quantities as weight. Then, the bundle price in year 1 is 12.10
(column 5) and the bundle price in year 2 is 18.40 (column 7).
Thus, the bundle price has increased 52.1%.
If we use year 2 as the base year, then the bundle price in year
1 is 15.10 (column 6) and in year 2 is 19.20 (column 8). The
increase is 27.2%.
If we use the newer method (taking the geometric mean of the

two numbers) the increase would be 39.1%
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Exercise 1:
If nominal GDP is $8 trillion and real GDP is $6 trillion, the GDP deflator is…
Exercise 2:
The GDP deflator in year 2 is 110 using year 1 as a base year. This means that, on average, the price of goods and services is
A) 110% higher in year 2 than in year 1.
B) 10% higher in year 2 than in year 1.
C) 5% higher in year 1 than in year 2.
D) 10% higher in year 1 than in year 2.
Exercise 3:
The GDP deflator in year 2 is 110 and the GDP deflator in year 3 is 118. The rate of inflation between years 2 and 3 is …
Exercise 4:
Is the following statement true or false? “If in the same period output doubles and the price level remains the same, nominal GDP doubles.”
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The Problems of Fixed Weights
The use of fixed-price weights to estimate real

GDP leads to problems because it ignores:
• Structural changes in the economy.
• Supply shifts, which cause large decreases in

price and large increases in quantity supplied
or the other way around.
• The substitution effect of price increases.
• There is no “right” way of computing real GDP.

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GDP and Social Welfare
Society is better off when crime decreases; however, a decrease in crime is
not reflected in GDP.
An increase in leisure is an increase in social welfare, but not counted in

GDP.
Most nonmarket and domestic activities, such as housework and child care,
are not counted in GDP even though they amount to real production.
GDP has nothing to say about the distribution of output among the
individuals of the society. It does not distinguish for example, between the
case in which most output goes to a few people and the case in which
output is evenly distributed among all people.
We cannot use it to measure the effects of redistributive policies. (policies

that take income from some people and give it to others)
It is neutral about the type of goods produced. Ex: guns vs. medicines
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The Underground Economy
underground economy The part of the economy

in which transactions take place and in which
income is generated that is unreported and
therefore not counted in GDP.
Tax evasion is usually thought to be the major

incentive for people to participate in the
underground economy.
Estimates for Switzerland’s underground economy

range from 3 to 5% and estimates for Italy range
from 10 to 35%.
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gross national income (GNI) GNP converted

into dollars using an average of currency
exchange rates over several years adjusted for
rates of inflation.
GNI is used to be able to make better comparisons

between countries.
Gross national income per capita is GNI divided

by population.
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 FIGURE 21.1 Per Capita Gross National Income for Selected Countries, 2006
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REVIEW TERMS AND CONCEPTS
base year net interest

change in business inventories net investment
compensation of employees net national product (NNP)
corporate profits nominal GDP
current dollars nondurable goods
depreciation nonresidential investment
disposable personal income, or after-tax personal consumption expenditures
income (C)
durable goods personal income
expenditure approach personal saving
final goods and services personal saving rate
fixed-weight procedure proprietors’ income
government consumption and gross rental income
investment (G) residential investment
gross domestic product (GDP) services
gross investment statistical discrepancy
gross national income (GNI) surplus of government enterprises
gross national product (GNP) underground economy
gross private domestic investment (I) value added
income approach weight
indirect taxes minus subsidies Expenditure approach to GDP: GDP =
intermediate goods C + I + G + (EX - IM)

national income GDP = Final sales - Change in
national income and product accounts business inventories
net business transfer payments Net investment = Capital end of period
net exports (EX - IM) - Capital beginning of period
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Exercise
Use the table above to answer the following questions:

1.Personal consumption expenditures in billions of dollars are ….$
2.The value for gross private domestic investment in billions of dollars
is …. $
3.The value for net exports in billions of dollars is ….$
4.The value of government spending in billions of dollars is …$

5.value for gross domestic product in billions of dollars is …$
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Exercise 1:
If a Swiss dealer sells a newly produced Swiss watch on eBay to a
U.S. customer, the value of the watch is
A) counted in U.S. GDP.
B) counted in U.S. GDP and Swiss GDP.
C) counted in Swiss GDP.
D) not counted in either U.S. or Swiss GDP.
Exercise 2: True or False?
a.If nominal GDP rises, then so must real GDP.
b.If real GDP rises, then so must nominal GDP.
c.Disposable personal income is personal income minus personal taxes
d.All economic activities in the economy are included in the GDP.
Exercise 3:
A company produced 8 dishwasher machines in 2005. The company sold 6
in 2005 and added 2 to its inventories. The market value of the dishwasher
machines in 2005 was $200 per unit. What is the value of this company's
output that will be included in the 2005 GDP?
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Exercise 4:
Consider an economy that produces only three goods. In the year
2007 the prices of each good where p1=5, p2=10 and p3=15 and the
quantities produced where q1=20, q2=25 and q3=10. In 2008, the prices
increased to p1=6, p2=12 and p3=16 respectively. On the other hand,
the production increased to q1=21, q2=27 and q3=11. How much did
the economy grow?
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Measuring National Output and National Income: Chapter Outline

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PART IV CONCEPTS AND PROBLEMS

Limitations of the GDP Concept

gross domestic product (GDP) The total

GDP is the total market value of a country’s

Turkey’s GDP in 2009 was 615.3 billion US$ and

GDP is one of the key parameters that is used to

Why are intermediate goods not counted in GDP?

In calculating GDP, we can sum up the value

TABLE 21.1 Value Added in the Production of a Liter of

(1)Oil drilling $3.00 $3.00

(2)Refining 3.30 0.30

(3)Shipping 3.60 0.30

(4)Retail sale 4.00 0.40

Total value added $4.00

GDP is concerned only with new, or current,

Ex: If you buy a used car, the transaction is not

GDP does not count transactions in which money

Sales of stocks and bonds are not counted in GDP

Profit earned abroad by companies of a country are not counted in

Output produced by foreigners working for ex. in Germany is counted

counted in Turkey’s GDP.

Generally, the difference between GDP and GNP is small.

Sometimes the distinction between GDPand GNP can be tricky:

expenditure approach A method of computing

income approach A method of computing GDP

These two approaches lead to the same value:

There are four main categories of expenditure:

Personal consumption expenditures (C):

Gross private domestic investment (I):

Government consumption and gross

Net exports (X - M): net spending by the rest

TABLE 21.2 Components of U.S. GDP, 2007: The Expenditure Approach

Exports (X) 1,643.0 11.9

Personal Consumption Expenditures (C)

personal consumption expenditures (C)

durable goods Goods that last a relatively long

nondurable goods Goods that are used up fairly

services The things we buy that do not involve

and medical services, and education.

Gross Private Domestic Investment (I)

gross private domestic investment (I) Total

residential investment Expenditures by

households and firms on new houses and

Gross Private Domestic Investment (I)

change in business inventories The amount by

GDP = Final sales + Change in business inventories

(Remember that GDP is not the market value of

Gross Private Domestic Investment (I)

gross investment The total value of all newly produced

depreciation The amount by which an asset’s value falls in a

net investment Gross investment minus depreciation.

It is a measure of how much the stock of capital changes

Government Consumption and Gross Investment (G)

government consumption and gross

Government transfer payments (such as social

Because interest payments on the government

net exports (X - M) The difference between exports (sales to

• Why are net exports included in the definition of GDP?

because some of what a nation produces is sold abroad and

national income The total income earned by the

TABLE 21.3 National Income of US, 2007

Surplus of government enterprises