Chapter 8
MEASURING THE ECONOMY’S PERFORMANCE
BY J. A. SACCO
CHAPTER OUTLINE
The Simple Circular Flow
 National Income Accounting
 Two Main Methods of Measuring GDP
 Other Components of National Income
Accounting

CHAPTER OUTLINE
Distinguishing Between Nominal and Real
Values
 Comparing GDP Throughout the World

MEASURING THE ECONOMY’S PERFORMANCE
National Income Accounting : To measure a
nations income and its components. To measure
an aggregate performance.
This chapter deals with the methods of measuring
an economy's performance and economic activity
First need to look at the flow of goods and services from
businesses to consumers and payments from consumers to
businesses that constitutes economic activity.
THE CIRCULAR FLOW DIAGRAM
Two Markets
Product Market
Households
are the buyers
Businesses are the sellers
Households buy consumer
goods/services
Pay money to businesses for those
goods/services
Households create the demand
Businesses are the suppliers
Total Output- Total Monetary value
of all goods and services
Resource Market
Businesses
are the buyers
Households are the sellers
Households sell their resources such
as labor, land, capital, and
entrepreneurship.
Businesses are the buyers of these
resources. These expenditures
(payments) become income for
households
Total Income- wages, rents, interest,
profits. The cost of producing entire
output of goods and services
THE CIRCULAR FLOW OF
INCOME AND PRODUCT
Businesses
Households
THE CIRCULAR FLOW OF
INCOME AND PRODUCT
Businesses
Households
THE CIRCULAR FLOW OF
INCOME AND PRODUCT
Businesses
Households
THE CIRCULAR FLOW OF
INCOME AND PRODUCT
Businesses
Households
THE CIRCULAR FLOW OF
INCOME AND PRODUCT
Businesses
Households
THE SIMPLE CIRCULAR FLOW

Two Observations
1) In every economic exchange, the seller receives
exactly the same amount that the buyer spends
2) Goods and services flow in one direction and
money payments flow in the other.
Total Income = Total Output
THE SIMPLE CIRCULAR FLOW

Product Markets

Businesses
Households
Transactions in which
households buy goods
THE SIMPLE CIRCULAR FLOW

Final Goods and
Services

Businesses
Households
Goods and services
that are at their final
stage of production
and will not be
transformed into yet
other goods or
services
THE SIMPLE CIRCULAR FLOW

Factor Markets

Businesses
Households
Transactions in which
business buy
resources
THE SIMPLE CIRCULAR FLOW

Total Income

Businesses
Households
The yearly amount
earned by the nation’s
factors of production
THE SIMPLE CIRCULAR FLOW

Question

Businesses
Households
Why must total
income be identical to
the dollar value of
total output?
WHY THE DOLLAR VALUE OF OUTPUT MUST
ALWAYS EQUAL TOTAL INCOME?
Problem:


Total output (Product Market) = $1,000
Total income (Resource Market)- wages, rents, interest for
that output = $900
Why the discrepancy?
Profit
Always the residual item that makes
Total output = Total Income
18
NATIONAL INCOME ACCOUNTING

Gross Domestic Product (GDP)
 The
total market value of all final goods and services
produced by factors of production located within a
nation’s borders during a year.
 GDP measures the dollar value of output
 GDP measures the dollar value of final goods and
services
 GDP is a Flow!
The key to calculating GDP is in determining
what is counted and what is not counted.
19
NATIONAL INCOME ACCOUNTING

Stress of Final Output
 What
is a final good?
 Wheat?
 Steel?
 Oil?
 Bread?
 Automobile?
 Gasoline?
NATIONAL INCOME ACCOUNTING

Intermediate Goods not counted!
 Goods
used up entirely in the production of final
goods
 Only final goods are counted in GDP. If you count
intermediate goods you are guilty of double
counting
 We must look at the value added (the amount of
dollars contributed to a product at each stage of
development), not the dollar value of each sale.
SALES VALUE AND VALUE ADDED AT EACH
STAGE OF DONUT PRODUCTION
Stage of Production
Dollar Value of Sales
Value Added
$.01
Stage 1: Fertilizer and Seed
$.01
Stage 2: Growing
.02
Stage 3: Milling
.04
Stage 4: Baking
.10
Stage 5: Retailing
.15
Total dollar value of all sales
$.32
$.01
$.02
$.06
$.05
Total value added
$.15
Value added is what must be calculated.
NATIONAL INCOME ACCOUNTING

Exclusion of Financial Transactions, Transfer
Payments, and Secondhand Goods
 Numerous
transactions occur that have nothing to
do with final goods and services being produced.
NATIONAL INCOME ACCOUNTING

Financial Transactions
1) Securities
 Stocks
and bonds
2) Government Transfer Payments
 Social
security
 Unemployment compensation
3) Private Transfer Payments
 Individual
gifts
 Corporate gifts
NATIONAL INCOME ACCOUNTING

Transfer of Secondhand Goods
 Why
not count the sale of a used car, stereo, or
snowboard as part of GDP?

Other Excluded Transactions
 Household
production
 Legal underground transactions
 Illegal underground transactions
What Should Be Included in GDP?










A painter purchases new paintbrushes for his business.
The services of an accountant.
A purchase of a new automobile.
A Social Security check paid to a retired worker.
The sale of a new home.
An increase in business inventories.
The government’s purchase of a new fighter jet.
Unemployment paid to a laid-off worker.
The wood the carpenter purchases to build a cabinet.
The money you get from your parents for cutting the lawn.
26
TWO MAIN METHODS
OF MEASURING GDP

Expenditure Approach
A
way of computing national income by adding up
the dollar value at current market prices of all final
goods and services.
27
TWO MAIN METHODS
OF MEASURING GDP
Businesses
Expenditure Approach
Households
28
TWO MAIN METHODS
OF MEASURING GDP

Income Approach
A
way of measuring national income by adding up
income received by all factors of production
29
TWO MAIN METHODS
OF MEASURING GDP
Income Approach
Businesses
Households
30
TWO MAIN METHODS
OF MEASURING GDP

Deriving GDP by the Expenditure Approach
 Consumption
Expenditure
(C)
Durables
Life
span of more than three years
Nondurables
Life span of less than three years
Services
Intangible commodities
31
TWO MAIN METHODS
OF MEASURING GDP

Deriving GDP by the Expenditure Approach
 Gross
Private Domestic Investment
 What
(I)
producers do to add to productive capacity
 The creation of capital goods, such as factories and
machines, that can yield production and hence
consumption in the future
32
TWO MAIN METHODS
OF MEASURING GDP

Deriving GDP by the Expenditure Approach
 Gross
Private Domestic Investment
 Fixed
(I)
Investment- Producer durables/capital goods
 Inventory Investment- Final product that is held in
inventory waiting to be sold. Hold inventories of their
product to meet future expected orders. Inventories
include all finished goods on hand, goods in process, and
raw materials. Counted towards present GDP but
subtracted when sold.
 New Residential Structures are part of I, not part of C.
33
TWO MAIN METHODS
OF MEASURING GDP

Deriving GDP by the Expenditure Approach
 Government
 State,
Expenditures
local, and federal
 Valued at cost
(G)
34
TWO MAIN METHODS
OF MEASURING GDP

Deriving GDP by the Expenditure Approach
 Net
Exports (Foreign Expenditures)
(X-M)
Net exports ( X - M )  total exports - total imports
THE COMPONENTS OF GDP
Repetez: GDP is total spending. (Expenditure)
 Four components:

 Consumption
(C)
 Investment (I)
 Government Purchases (G)
 Net Exports (X-M)

These components add up to GDP (denoted Y):
Y = C + I + G + (X-M)
MEASURING U.S. GDP

The Expenditure Approach
Measures
GDP by using data on consumption
expenditure, investment, government expenditure on
goods and services, and net exports.
37
GDP AND ITS COMPONENTS
NET DOMESTIC PRODUCT


Thus far have looked at “Gross Domestic Product”
Gross means without deductions. Must deduct for the
depreciation (capital consumption allowance) of the
factors of production to get more valid accounting of
the economy.
I
-Machines wear out/need repair
-Houses/Buildings deteriorate
-Most capital/ durable goods deteriorate
An estimate of all of this is subtracted from GDP giving you
“Net Domestic Product”
NET DOMESTIC PRODUCT
Therefore:
 NDP=GDP-depreciation and GDP=C+I+G+(X-M)
NDP=C+I+G+ (X-M)- depreciation
Furthermore because Net I= I- depreciation
then NDP= C + Net I +G + (X-M)
NET DOMESTIC PRODUCT
Net Investment measures changes in our
capital stock over time
 Why do you want Net Investment to be positive
every year?

GDP BY THE INCOME APPROACH
Called GDI (Gross Domestic Income)
 We have looked at GDP through the “product
market” of the Circular Flow Diagram. Now look
at the Resource (Factor) Market or the Income
Approach to determine national accounting of
the macroeconomy.

GDI=GDP
42
GDP BY THE INCOME APPROACH

Deriving GDP by the Income Approach
Businesses
Households
GDP BY THE INCOME APPROACH

Gross Domestic Income (GDI)
1) Wages- All wages, salaries, incentive payments,
social security taxes of both employer/employee
2) Interest (Net Interest)
Interest Received ───
Interest Paid
• Savings accounts
Interest on mortgages
• CD’s
Credit Cards
• Interest Bearing Acc’ts
Loans
GDP BY THE INCOME APPROACH
3) Rent- All income earned by individuals for the
use of their assets
• Farms, Houses, Stores, royalties from
copyrights/patents, oil wells
4) Profits- Total Gross Corporate Profits plus
proprietor’s income or unincorporated
businesses such as sole proprietorships,
partnerships, and producer’s cooperatives.
GDP BY THE INCOME APPROACH
W+I+R+P
Actual factor payments made to owners of the
factors of production. When added together we
still do not have GDI. Must add two other
components.
Indirect Business Taxes
Depreciation
GDP BY THE INCOME APPROACH
Indirect Business Taxes- All business taxes
except the tax on corporate profits (i.e. sales and
business property taxes)
Depreciation- Where we had to deduct
depreciation to go from GDP to NDP. We now must
add depreciation to go from NDI to GDI. Since
someone has paid for the replacement or service
to depreciating capital goods, this becomes
income to that person providing the service or
replacement.
Indirect Business Taxes and Depreciation
are called Non- Income Expense Items.
GDP AND GDI
Regardless: GDP
=
(Expenditure)
GDI
(Income)
GROSS DOMESTIC PRODUCT AND
GROSS DOMESTIC INCOME, 1998
(IN BILLIONS OF 1998 DOLLARS PER YEAR)
Expenditure Point of View--Product Flow
Expenditures by Different Sectors:
Household sector
Personal consumption expenses
$5,659.4
Government sector
Purchase of goods and services
1,466.4
Business sector
Gross private domestic investment
(including depreciation)
1,329.8
Foreign sector
Net exports of goods and services
-123.4
Gross Domestic Product
$8,332.2
GROSS DOMESTIC PRODUCT AND
GROSS DOMESTIC INCOME, 1998
(IN BILLIONS OF 1998 DOLLARS PER YEAR)
Income Point of View--Cost Flow
Domestic Income (at Factor Cost):
Wages
All wages, salaries, and supplemental
employee compensation
Rent
All rental income of individuals plus
implicit rent on owner-occupied dwellings
Interest
Net interest paid by business
Profit
Proprietorial income
Corporate profits before taxes deducted
Nonincome expense items
Indirect business taxes and other adjustments
Depreciation
Statistical discrepancy
Gross Domestic Product
$4,901.4
142.8
464.7
519.7
701.3
730.8
951.3
-79.8
$8,332.2
OTHER COMPONENTS OF
NATIONAL INCOME ACCOUNTING

National Income (NI)
 The
total of all factor payments to resource owners.
 It can be obtained by subtracting indirect taxes
from NDP

Personal Income (PI)
 The
amount of income that households actually
receive before they pay personal income taxes.
OTHER COMPONENTS OF
NATIONAL INCOME ACCOUNTING

Disposable Personal Income (DPI/DI)
 Personal
income after personal income taxes have
been paid
GOING FROM GDP TO
DISPOSABLE INCOME, 1998
Billions of Dollars
Gross domestic product (GDP)
Minus depreciation
7,566.9
-891.8
Net domestic product (NDP)
Minus indirect business taxes and other adjustments
6,675.1
-674.3
National Income (NI)
Minus corporate taxes, Social Security contributions,
corporate retained earnings
Plus government and business transfer payments
6,000.8
-1,032.5
+1,311.1
Personal Income (PI)
Minus personal income tax and nontax payments
6,279.4
-798.7
Disposable personal income (DPI)
5,480.7
REAL VERSUS NOMINAL GDP


1.
2.
Review- GDP measures the total spending on goods
and services in all markets of the economy.
If total production and spending rises from one year to
the next, at least one of two things must be true.
The economy is producing a larger output of goods
and services or
Goods and services are being sold at higher prices.
2 apples X $2.00 = $4.00
3 apples X $3.00 = $9.00
REAL VERSUS NOMINAL GDP

Inflation can distort economic variables like
GDP, so we have two versions of GDP:

Nominal GDP
 values
output using current prices
 not corrected for inflation

Real GDP
 values
output using the prices of a base year
 is corrected for inflation
NOMINAL GDP
 To
calculate Nominal GDP:
Current year price X Current year quantity
If more than one good/service
add them up
EXAMPLE:
Pizza
Latte
year
P
Q
P
Q
2011
$10
400
$2.00
1000
2012
$11
500
$2.50
1100
2013
$12
600
$3.00
1200
Compute nominal GDP in each year:
2011: $10 x 400 + $2 x 1000
= $6,000
2012: $11 x 500 + $2.50 x 1100 = $8,250
2013: $12 x 600 + $3 x 1200
= $10,800
REAL GDP

To calculate Real GDP:
Prices of
goods/services
of base year
X
Quantity of good/services
in current year
If more than one good/service then add them up!
Remember Real GDP is the
same as Nominal GDP in the base year!.
EXAMPLE:
Pizza
Latte
year
P
Q
P
Q
2011
$10
400
$2.00
1000
2012
$11
500
$2.50
1100
2013
$12
600
$3.00
1200
Compute real GDP in each year,
using 2011 as the base year:
2011:
$10 x 400 + $2 x 1000 = $6,000
2012: $10 x 500 + $2 x 1100 = $7,200
2013: $10 x 600 + $2 x 1200 = $8,400
EXAMPLE:
year
Nominal
GDP
Real
GDP
2011
$6000
$6000
2012
$8250
$7200
2013
$10,800
$8400
In each year,

nominal GDP is measured using the (then) current
prices.

real GDP is measured using constant prices from
the base year (2011 in this example).
EXAMPLE:
Nominal
GDP
year
Real
GDP
2011
$6000
$6000
2012
$8250
$7200
2013
$10,800
$8400

The change in nominal GDP reflects both prices and
quantities.
 The change in real GDP is the amount that
GDP would change if prices were constant
(i.e., if zero inflation).
Hence, real GDP is corrected for inflation.
ECONOMIC GROWTH RATE IN GDP

To determine the rate of economic growth in GDP
from year to year.
Real GDP in year 2 Real GDP in year 1
Real GDP 1
X
GDP GROWTH
100
REAL GDP OVER RECENT HISTORY

The GDP data
 Real
GDP grows over time
 Growth – average 3% per year since 1965
 Growth is not steady
 GDP
growth interrupted by recessions
REAL GDP OVER RECENT HISTORY

Recession
 Two
consecutive quarters of falling GDP
 Real GDP declines
 Lower income
 Rising unemployment
 Falling profits
 Increased bankruptcies
NOMINAL AND REAL GDP IN THE U.S.,
1965–2012
$16,000
$14,000
billions
$12,000
$10,000
$8,000
Real GDP
(base year
2005)
$6,000
$4,000
Nominal
GDP
$2,000
$0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
65
REAL VERSUS NOMINAL GDP

The GDP deflator
 Price
index (like the CPI) but for the
macroeconomy
 Is 100 for the base year
 Measures the current level of prices relative to the
level of prices in the base year
 Can be used to take inflation out of nominal GDP
(“deflate” nominal GDP) to give you Real GDP
nominal GDP
Real GDP 
x 100
GDP Deflator
THE GDP DEFLATOR
The GDP deflator is a measure of the overall
level of prices.
 Definition:

nominal GDP
GDP deflator = 100 x
real GDP
 One way to measure the economy’s inflation
rate is to compute the percentage increase in
the GDP deflator from one year to the next.
EXAMPLE:
year
Nominal
GDP
Real
GDP
GDP
Deflator
2011
$6000
$6000
100.0
2012
$8250
$7200
114.6
2013
$10,800
$8400
128.6
Compute the GDP deflator in each year:
2011:
100 x (6000/6000) =
100.0
2012:
100 x (8250/7200) =
114.6
2013:
100 x (10,800/8400) =
128.6
The GDP Deflator for base year is always 100!
ACTIVE LEARNING
COMPUTING GDP
2
2011 (base yr)
P
Good A
Good B
$30
$100
Q
2012
P
900 $31
192 $102
2013
Q
P
Q
1000
200
$36
$100
1050
205
Use the above data to solve these problems:
A. Compute nominal GDP in 2011.
B. Compute real GDP in 2012.
C. Compute the GDP deflator in 2013.
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ACTIVE LEARNING
ANSWERS
2
2011 (base yr)
P
Good A
Good B
$30
$100
Q
2012
P
2013
Q
900 $31 1,000
192 $102
200
P
Q
$36
$100
1050
205
A. Compute nominal GDP in 2011.
$30 x 900 + $100 x 192 = $46,200
B. Compute real GDP in 2012.
$30 x 1000 + $100 x 200 = $50,000
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ACTIVE LEARNING
ANSWERS
2
2011 (base yr)
P
Good A
Good B
$30
$100
Q
2012
P
2013
Q
900 $31 1,000
192 $102
200
P
Q
$36
$100
1050
205
C. Compute the GDP deflator in 2013.
Nom GDP = $36 x 1050 + $100 x 205 = $58,300
Real GDP = $30 x 1050 + $100 x 205 = $52,000
GDP deflator = 100 x (Nom GDP)/(Real GDP)
= 100 x ($58,300)/($52,000) = 112.1
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
71
REAL VERSUS NOMINAL GDP
After you calculate the GDP deflator for each
year you can now determine the rate of inflation
for the macroeconomy
 Inflation rate (calculated from the GDP Deflator)

 Percentage
change in some measure of the price
level from one period to the next
Inflation in year 2 
GDP deflator in year 2-GDP deflator in year 1

 100
GDP deflator in year 1
72
GDP

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
 Nothing
about distribution of income
73
DISTINGUISHING BETWEEN NOMINAL AND REAL
VALUES

Per Capita GDP
 Adjusting
for population growth and for price
changes
 Real GDP per capita is the main indicator of the
average person’s standard of living.
Real GDP
Per Capita Real GDP 
population
74
COMPARING GDP
THROUGHOUT THE WORLD

True Purchasing Power
 Accounting
for goods and services that are not
traded in the world market
 Purchasing Power Parity
 Adjustments
in exchange rate conversions that takes into
account differences in the true cost of living across
countries
75
INTERNATIONAL DIFFERENCES: GDP & 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
GDP and the Quality of Life
TABLE 3
The table shows GDP per person and three other measures of the quality of life for
twelve major countries.
76