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Chapter 20
The Measurement of
National Income
Copyright © 2011 Pearson Canada Inc.
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In this chapter you will learn...
1. …how the concept of value added solves the problem of
“double counting” when measuring national income.
2. …the income approach and the expenditure approach to
measuring national income.
3. …the difference between real and nominal GDP and the
meaning of the GDP deflator.
Copyright © 2011 Pearson Canada Inc.
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In this chapter you will learn...
4. …about the many important omissions from official
measures of GDP.
5. …why real per capita GDP is a good measure of average
material living standards but an incomplete measure of
overall well-being.
Copyright © 2011 Pearson Canada Inc.
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20.1 National Output and Value
Added
Production occurs in stages — most firms produce outputs
that are other firms’ inputs
- intermediate products
- final products
Each firm’s contribution to total output is its value added
value added = revenues - non-labour costs
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Summing value added avoids the problem of double counting
when measuring total output.
Total value added in the economy is called Gross Domestic
Product (GDP).
APPLYING ECONOMIC CONCEPTS 20-1
Value Added Through Stages of Production
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20.2 National Income Accounting:
The Basics
Three methods for measuring national income (output):
• total value added from domestic production
• total expenditures on domestic output (final output)
• total income generated by domestic production
Because of the circular flow of income, these three measures
yield the same total — GDP.
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Start with a very simple economy
Domestic Households
Factor income:
wages, rents, profits
Domestic Firms
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Revenue from
sales of final G & S
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How does household income actually get used up?
Domestic Households
Savings
Imports
Consumption
Taxes
Factor income:
wages, rents, profits
Domestic Firms
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Revenue from
sales of final G & S
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Do any other agents buy final G & S from Cdn firms?
Domestic Households
Investment
Consumption
Governments
Foreigners
(Exports)
Factor income:
wages, rents, profits
Domestic Firms
Revenue from
sales of final G & S
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GDP from the Expenditure Side
Consider adding up the expenditures needed to purchase the
final output produced in any given year.
There are four broad expenditure categories:
- consumption
- investment
- government purchases
- net exports
Actual consumption expenditure (Ca) includes expenditure
on all final goods during the year.
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Actual investment expenditure (Ia) is expenditure on the
production of goods not for present consumption, including:
• inventories
• plant and equipment
• residential housing
Actual government purchases (Ga) is the purchase of
currently produced goods and services by government
- excluding transfer payments.
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Actual net exports (NXa) is the difference between exports and
imports: NXa = (Xa - IMa)
Exports are purchases of Canadian-produced goods and
services by foreigners. We subtract imports because they are
not produced in Canada.
Since total domestic output must equal total expenditure on
domestic output, we have:
GDP = Ca + Ia + Ga + NXa
This is an accounting identity
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IMa
Ca
Ia
Ga
Xa
Ca + Ia + Ga + (Xa - IMa)
= GDP
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Does the accounting identity
GDP = Ca + Ia + Ga + (Xa - IMa)
imply that everything that firms produce each
year is automatically sold to customers?
NO!
INVENTORIES!
INVENTORIES!
INVENTORIES!
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A second very important word - CURRENT
GDP = Ca + Ia + Ga + (Xa - IMa)
All of the above symbols measure expenditures on real
goods and services – cars, haircuts, cell phones and
cell phone service, etc.
All of the above symbols represent expenditures on
goods and services produced in the CURRENT
period (year)
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Note
exports were 35%
of GDP
Imports were 34%
of GDP
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GDP from the Income Side
GDP is also the sum of factor incomes and other claims on
the value of output.
Factor incomes include:
- wages
- rent, interest, and profits
net domestic
income
Non-factor payments include:
- indirect taxes (net of subsidies)
- depreciation of existing physical capital
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GDP from the income side is therefore equal to:
GDP = Net domestic income +
Indirect taxes (less subsidies) +
Depreciation
EXTENSIONS IN THEORY 20-1
Arbitrary Decisions
in National Income Accounting
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Wages + Rent + Interest + Profits
+ Indirect taxes (less subsidies) + Depreciation
Ca + Ia + Ga + (Xa - IMa)
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What goes into the firm’s revenue must come out as wages,
rent, interest, profits, indirect taxes or depreciation.
The total revenue of all Canadian firms (the total expenditure
on Canadian final goods and services) must equal the total
value of factor payments plus indirect taxes and depreciation.
Therefore an accounting identity it must be true that:
Ca + Ia + Ga + (Xa - IMa) = Wages + Rent + Interest
+ Profits + Indirect taxes (less
subsidies) + Depreciation
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Canada and six other countries form what is called the
“G7” group of advanced industrialized nations. For a
comparison of economic growth in the G7 countries over
the past decade, look for Growth in Canada and Other
G7 Countries in the Additional Topics section of this
book’s MyEconLab.
www.myeconlab.com
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20.3 National Income Accounting:
Some Further Issues
GDP and GNP
A measure of national output closely related to GDP is Gross
National Product (GNP).
The difference between GDP and GNP is the difference
between income produced and income received.
Income produced in Canada
versus income received by Canadians
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GDP is superior as a measure of domestic economic activity.
GNP is superior as a measure of living standards of residents.
A measure of household income is disposable personal
income:
It equals GNP minus:
- any part not actually paid to households
(retained earnings, indirect taxes, etc.)
- personal income taxes
- plus transfer payments received by households
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Real and Nominal GDP
GDP that is valued at constant base-period prices is real
national income.
GDP Deflator =
Nominal GDP
x 100
Real GDP
The GDP deflator is a comprehensive index of prices because
it includes the prices of all goods and services produced in the
country.
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Supplementary slide
GDP Deflator
GDP deflator is just another price index.
The basket of goods is all final goods and services
produced in Canada
How is it calculated?
GDP in 2005 measured in 2005 prices
GDP in 2005 measured in 1997 prices
[1368.9/1157.4] x 100 = 118.3
x 100
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Do the CPI and the GDP
Deflator Move Together?
Broadly, the two price indexes move together,
due to underlying inflationary forces. But
because one tracks consumer prices and the
other tracks the prices of goods produced in
Canada, there will be some differences.
APPLYING ECONOMIC CONCEPTS 20-2
Calculating Nominal and Real GDP
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Omissions from GDP
National income accountants cannot measure economic
activity that takes place outside of regular, legal markets:
• illegal activities
• leisure (consumption of non-work time)
• the underground economy (tax & regulation avoidance)
• home production (non-market activity)
• economic “bads” (pollution)
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Unless the unmeasured economic activity changes rapidly,
changes in GDP will do a reasonable job of measuring
changes in material living standards.
GDP and Living Standards
“Well-being” is a broader concept than material living
standards:
- GDP is not a complete measure of economic wellbeing
- but income is a very important part of well-being
and GDP is a good measure of income.
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How useful are the various measures of GDP?
They are very useful for tracking the year-to-year changes in
the level of economic activity (market activity).
They are useful in tracking changes in economic activity,
productivity, etc. over the longer term in a given country.
But remember, GDP measures only what goes through
markets – what is bought and sold.
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Are they good measures of the level of human wellbeing
(happiness) in a society? Only in a limited sense – material,
market activity, with no consideration of things like pollution.
Are they good measures of the change in the level of
material wellbeing over time? Maybe, but care must be taken
in making such an interpretation. (war, more labour force
participation, degree of marketization, etc.)
Do they provide the basis for comparing the level of material
wellbeing across different countries? Only if the counties are
of very similar in a deeper structural sense (Canada and the
US or France maybe, but not Canada and Nigeria or Bolivia.
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Some recent economic research attempts to uncover
the determinants of individual well-being, or
“happiness”. One of the interesting findings is that
income appears to be less important than several other
aspects of life. See What Makes People Happy? in the
Additional Topics section of this book’s MyEconLab.
www.myeconlab.com
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Copyright © 2011 Pearson Canada Inc.