Measuring Domestic Output and National Income

Lecture 2

Chapter 7

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Measuring Domestic Output and National Income

Assessing the Economy’s Performance

National income accounting measures economy’s overall performance

Bureau of Economic Analysis compiles National Income and Product Accounts

Assess health of economy

Track long-run course

Formulate policy

National income accounting does for the economy what private accounting would do for an individual household or business. The Bureau of Economic Analysis, an agency of the Department of Commerce, compiles the data and reports it in National Income and Product Accounts. This information is used by economists and policymakers in formulating decisions for the best interest of the nation.

Gross Domestic Product(GDP)

GDP is the dollar value of all final goods and services produced within the borders of a country during a specific period of time.

Measure of aggregate output

Monetary measure

Avoid multiple counting

One way to avoid multiple counting is to include market value of final goods and ignore intermediate goods

Another approach is to count value added

The primary measure of the economy’s performance as a whole is its aggregate output. This is most commonly calculated as Gross Domestic Product, or GDP. GDP is a monetary measure in that everything is valued in dollars. All goods and services produced must be converted into dollar values for GDP to work. To avoid multiple counting of goods, GDP includes only the market value of final goods and ignores intermediate goods, which are goods either purchased for resale or for further processing into final goods. GDP could also avoid multiple counting by counting only the value added at each stage. Value added is the market value of a firm’s output less the value of the inputs that the firm purchased from others.

Intermediate goods are products that are purchased for resale or further processing or manufacturing. Final goods are products that are purchased by their end users.e.g Lettuce, carrots and vinegar in restaurant salads are intermediate goods, restaurant salads are final goods.

Monetary Measure


GDP is a monetary measure because we would not otherwise be able to determine if total output has changed from year to year if the mix of goods and services changes.


Gross Domestic Product Continued


Stage of Production


Sales Value

of Materials

or Product


$ 0

Firm A, sheep ranch


Firm B, wool processor


Firm C, coat manufacturer


Firm D, clothing wholesaler


Firm E, retail clothier


Total Sales Value


Value Added (total income)





]——–$120 (= $120 – $ 0)

]——– 60 (= 180 – 120)

]——– 40 (= 220 – 180)

]——– 50 (= 270 – 220)

]——– 80 (= 350 – 270)





This table illustrates the value-added in a five-stage production process. The value added is the market value of a firm’s output less the value of the inputs the firm has bought from others. Using this method will avoid multiple counting.

Gross Domestic Product Concluded

Exclude financial transactions

Public transfer payments e.g social security payments, welfare payments etc

Private transfer payments e.g money that parents give to children

Stock market transactions

Exclude second hand sales

Sell used car to a friend


Nonproduction transactions must be excluded from GDP since they have nothing to do with the production of final goods. There are two types: purely financial transactions and secondhand sales. Purely financial transactions include such items as public transfer payments like Social Security, private transfer payments (Christmas gifts), and stock market transactions. Secondhand sales contribute nothing to current production so they are ignored in calculating GDP.

Two Approaches to GDP

Income approach

Count income derived from production

Wages, rental income, interest income, profit

Expenditure approach

Count sum of money spent buying the final goods

Who buys the goods?


GDP can be viewed from two different perspectives. The income approach looks at GDP in terms of the income derived, or created, from producing goods and services. The expenditures approach measures GDP as the sum of all of the money spent in buying the output. In theory, either method should yield equal results. The expenditures and income approaches are two different ways to look at the same thing. You could look at a quarter from the heads side or the tails side, but it is still worth the same amount. This is the same as the expenditures and income approaches for calculating GDP.

Two Approaches to GDP Cont’d









Consumption by


Investment by





By Foreigners













Expenditures or Output Approach

Income or

Allocations Approach


Here the two different approaches to measuring GDP are illustrated. On the left, the expenditures approach measures GDP as the sum of four items: (1) consumption by households, (2) investment by businesses, (3) government purchases, and (4) expenditures by foreigners. On the right, the income approach uses different inputs: (1) wages, (2) rents, (3) interest, (4) profits, and (5) statistical adjustments. Each of these items will be further discussed next.

Expenditures Approach

Personal consumption expenditures (C)

Durable goods

Nondurable goods

Consumer expenditures for services


Personal consumption expenditures, indicated by a “C” notation, covers all expenditures by households on final goods and services during a year. In any given year, approximately 10% of those expenditures are for durable consumer goods, which are defined as having a life of three years or more. Another 30% go to nondurable goods such as food, clothing, and gasoline. The other 60% are for services leading to the U.S. economy frequently being referred to as a service economy.

Expenditures Approach Continued

Gross private domestic investment (Ig)

Machinery, equipment, and tools

All construction

Positive and negative changes in inventories

Expenditures on R&D as well as money spent to develop new works of writing,art,music and software

Noninvestment transactions excluded


The second component of the expenditures approach is gross private investment, which includes all final purchases of machinery, equipment, and tools by businesses, all construction, and changes in inventories. All of these items represent ways businesses invest in themselves. Construction also includes residential construction because homes could be rented to produce income.


Expenditures Approach: Investment

January 1

Year’s GDP

December 31




and net exports







Stock of





Gross Investment


Net Investment





When gross investment exceeds depreciation during a year, net investment occurs. This net investment expands the stock of private capital from the beginning of the year to the end of the year, allowing the economy’s production capacity to expand, all other things equal.

Expenditures Approach Concluded

Government purchases (G)

Expenditures for goods and services

Expenditures for publicly owned capital

Excludes transfer payments

Net exports (Xn)

Add exported goods

Subtract imported goods

Xn= exports (X) – imports (M)

GDP = C + Ig + G + Xn


The last two components of the expenditures approach are government purchases and net exports. Government purchases are officially labeled “government consumption expenditures and gross investment.” It includes expenditures for goods and services that the government uses in providing public services and expenditures for publicly owned capital such as for schools or roads. It excludes government transfer payments such as Social Security because they simply transfer government receipts to certain households and does not generate any sort of production.

Net exports are calculated by subtracting the value of imported goods from the value of exported goods.

Adding up all four components provides a measure of GDP, a measure of the market value of a specific year’s total output.

Accounting Statement for the U.S. Economy, 2015


This table calculates GDP for 2015 in the United States by both the expenditures approach and the income approach. Note that both methods come to the same total of GDP for the year.

Comparative GDP


In this table comparing GDPs for selected nations for 2014, the United States, China, and Japan have the world’s highest GDP. Note that all data have been converted to U.S. dollars via international exchange rates.


Government National Product(GNP) GNP measures the levels of production of all the citizens or corporations from a particular country working or producing in any country. For example, the United States’ GNP measures and includes the production levels of any American or American-owned entity, regardless of where in the world the actual production process is taking place, and defines the economy in terms of the private or corporate citizens’ output Government Domestic Product(GDP) refers to and measures the domestic levels of production in a country. It represents the monetary value of all goods and services produced within a nation’s geographic borders over a specified period of time

For example, the output of a Toyota plant in Kentucky isn’t included in America’s GNP, although it’s counted in America’.s GDP


Discussion Question # 12

Which of the following are included or excluded in this year’s GDP? Explain your answer in each case.

a. Social Security payments received by a retired factory worker.

b. Unpaid services of a family member in painting the family home.

c. Income of a dentist from the dental services provided.

d. A monthly allowance a college student receives from home.

e. Money received by Josh when he resells his nearly brand-new Honda automobile to Kim.

f. The publication and sale of a new college textbook.

g. An increase in leisure resulting from a 2-hour decrease in the length of the workweek, with no reduction in pay.

h. A $2 billion increase in business inventories.

i. The purchase of 100 shares of Google common stock.


a. Excluded. A transfer payment from taxpayers for which no service is rendered (in this year).

b. Excluded. Nonmarket production.

c. Included. Payment for a final service. You cannot pass on a tooth extraction!

d. Excluded. A private transfer payment; simply a transfer of income from one private individual to another for which no transaction in the market occurs.

e. Excluded. The production of the car had already been counted at the time of the initial sale.

f. Included. It is a new good produced for final consumption.

g. Excluded. The effect of the decline will be counted, but the change in the workweek itself is not the production of a final good or service or a payment for work done.

h. Included. The increase in inventories could only occur as a result of increased production.

i. Excluded. Merely the transfer of ownership of existing financial assets


Problem # 3

If in some country personal consumption expenditures in a specific year are $50 billion, purchases of stocks and bonds are $30 billion, net exports are -$10 billion, government purchases are $20 billion, sales of second-hand items are $8 billion, and gross investment is $25 billion, what is the country’s GDP for the year?

Answer: $85 billion

Nominal GDP vs. Real GDP

GDP is a dollar measure of production

Using dollar values creates problems

Nominal GDP

Based on prices that prevailed when output was produced

Real GDP

Reflect changes in the price level

Use base year price


GDP measures production at current dollar values which creates problems because the value of a dollar changes over time. One hundred years ago, the purchasing power of one dollar was much different than it is today. To get around that problem, there are two different GDPs. Nominal GDP is based upon the prices that were in effect when the output was produced. A GDP that has been deflated or inflated to reflect changes in price levels is referred to as real GDP. In order to calculate real GDP, a base year must be selected and then the current year’s prices adjusted accordingly.

GDP Price Index

Use price index to determine real GDP



In Given






Price of Market Basket

in Specific Year

Price of Same Basket

in Base Year

Real GDP in given year



Nominal GDP in given year

This is the formula used to calculate real GDP. We use a price index that is equal to the price of a collection of goods and services in the specific year divided by the price for the same goods and services in a base year multiplied by 100. Nominal GDP is then divided by the price index (in hundredths) to determine real GDP.

GDP Growth rate

GDP Price Index Continued

Calculating Real GDP (Base Year = Year 1)

Year (1) Units of Output (2) Price of Pizza Per Unit (3) Price Index (Year 1 = 100) (4) Unadjusted, or Nominal, GDP (1) × (2) (5) Adjusted, or Real, GDP
1 5 $10 100 $ 50 $50
2 7 20 200 140 70
3 8 25 250 200 80
4 10 30
5 11 28


In this table, nominal GDP and real GDP are calculated based upon the formula. Years 1 to 3 have been calculated. Complete the table for years 4 and 5.

Extra Credit 2: Nominal GDP for Year 4=10×30=300 ; Price index for year 4=(30/10)x100=300; Real GDP for year 4=300/(300/100)=100


Consider the production of fries and burger in an economy:





Where Q represents quantity and P represents prices; 2013 is the base year.

Find the nominal GDP for each year

Find the real GDP for each year

What is the nominal growth rate?

What is the real growth rate?


Note: Real GDP is calculated using base year’s prices.


Real World Considerations

This table shows some of the relationships between nominal GDP, real GDP and the GDP price index over the past decade. Here the base year is 2009 (note that is the year where the index is 100). To test your understanding of the relationships, determine the value of the price index for 1995 and real GDP for 2005 and 2009.


GDP price index for 1995= (7664/10167.3)x100=75.4


Shortcomings of GDP

Nonmarket activities


Improved product quality

The underground economy

GDP and the environment

Composition and distribution of output

Noneconomic sources of well-being


While GDP is a reasonably accurate and highly useful measure of how the economy is performing, it does have several shortcomings. Certain productive activities occur outside of any market and therefore are not measured in the traditional way. The value of leisure time, weekends, holidays, etc., is also not included, but they certainly add value due to the added satisfaction they provide to workers.

GDP fails to capture the full value of improvements in product quality. Let’s face it, a $200 cell phone purchased today is of very different quality than a cell phone that cost $200 just a decade ago. There is also a huge underground economy, mainly comprised of illegal activities, that produces income that is not measured through traditional GDP methods. Included in this underground economy are legal activities that provide income that the recipients refuse to report to the I.R.S. and pay taxes on. Environmental issues and noneconomic sources of well-being are also problematic in that GDP does not really have a way to accurately value and report the issues.

Underground Economy


This table shows the underground economy as a percentage of GDP in several nations.

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