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Chapter 8
Measuring
the Economy’s
Performance
Introduction
Gross domestic product is the statistic
most often used to indicate the
economy’s overall performance. What is
included and what is omitted from GDP?
Slide 8-2
Learning Objectives
 Describe the circular flow of income
and output
 Define gross domestic product (GDP)
 Understand the limitations of using
GDP as a measure of national welfare
Slide 8-3
Learning Objectives
 Explain the expenditure approach to
tabulating GDP
 Explain the income approach to
computing GDP
 Distinguish between nominal GDP and
real GDP
Slide 8-4
Chapter Outline
 The Simple Circular Flow
 National Income Accounting
 Two Main Methods of Measuring GDP
 Other Components of National Income
Accounting
Slide 8-5
Chapter Outline
 Distinguishing Between Nominal and
Real Values
 Comparing GDP Throughout the World
Slide 8-6
Did You Know That...
 Decisions on how to categorize
business expenses will affect the
relative size of an increase or a
decrease in economic activity?
 Statisticians measuring our national
economic performance strive for
consistency in constructing their
measures across time?
Slide 8-7
National Income Accounting
 National Income Accounting
– A measurement system used to estimate
national income and its components
Slide 8-8
The Simple Circular Flow
Figure 8-1
Slide 8-9
The Simple Circular Flow
Figure 8-1
Slide 8-10
The Simple Circular Flow
Figure 8-1
Slide 8-11
The Simple Circular Flow
Figure 8-1
Slide 8-12
The Simple Circular Flow
 Two observations
– In every economic exchange, the seller
receives exactly the same amount that
the buyer spends.
– Goods and services flow in one direction
and money payments flow in the other.
Slide 8-13
The Simple Circular Flow
 Profits explained
– Question
• Why is profit a cost of production?
– Answer
• Profits are the return entrepreneurs receive
for the risk they incur when organizing
productive activities
Slide 8-14
The Simple Circular Flow
 Product Markets
– Transactions in which
households buy goods
Slide 8-15
The Simple Circular Flow
 Final Goods and
Services
– Goods and services
that are at their final
stage of production
and will not be
transformed into yet
other goods or services
Slide 8-16
The Simple Circular Flow
 Factor Markets
– Transactions in
which businesses
buy resources
Slide 8-17
The Simple Circular Flow
 Total Income
– The yearly amount
earned by the
nation’s factors of
production
Slide 8-18
The Simple Circular Flow
 Question
– Why must total income
be identical to the dollar
value of total output?
 Answer
– Every transaction
simultaneously involves
an expenditure and a
receipt
Slide 8-19
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
Slide 8-20
National Income Accounting
 Observations
– GDP measures the dollar value of final
output
– GDP measures the dollar value of final
goods and services produced per year
by factors of production located within
a nation’s borders
Slide 8-21
National Income Accounting
 Stress of final output
– What is a final good?
•
•
•
•
•
•
Wheat?
Steel?
Oil?
Bread?
Automobile?
Gasoline?
Slide 8-22
National Income Accounting
 Intermediate Goods
– Goods used up entirely in the production
of final goods
Slide 8-23
Sales Value and Value Added
at Each Stage of Donut Production
Stage of Production
Stage 1: Fertilizer and Seed
Dollar Value of Sales
$.03
$.03
Stage 2: Growing
.06
Stage 3: Milling
.12
Stage 4: Baking
.30
Stage 5: Retailing
.45
Total dollar value of all sales
Value Added
$.96
$.03
$.06
$.18
$.15
Total value added
$.45
Slide 8-24
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.
Slide 8-25
National Income Accounting
 Financial transactions
– Securities
• Stocks and bonds
– Government transfer payments
• Social Security
• Unemployment compensation
– Private transfer payments
• Individual gifts
• Corporate gifts
Slide 8-26
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
Slide 8-27
Recognizing GDP Limitations
 GDP’s limitations
– Excludes non-market production
– Different countries have different legal
versus illegal activities
– Quality of life is not measured
– GDP poorly measures a nation’s wellbeing
Slide 8-28
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
Slide 8-29
Two Main Methods
of Measuring GDP
Expenditure Approach
Slide 8-30
E-Commerce Example:
Using the Internet to Reduce Business
Inventory Levels
 With access to internet auctions, firms find it
easier to follow a just-in-time inventory
practice.
 The ratio of inventories to sales in
manufacturing has dropped since 1990.
 How does this change affect the investment
component of GDP?
Slide 8-31
Two Main Methods
of Measuring GDP
 Income Approach
– A way of measuring national income by
adding up income received by all factors
of production
Slide 8-32
Two Main Methods
of Measuring GDP
Income Approach
Slide 8-33
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
Slide 8-34
Two Main Methods
of Measuring GDP
 Deriving GDP by the expenditure
approach
– Gross Private Domestic Investment (I)
• The creation of capital goods, such as
factories and machines, that can yield
production and hence consumption in the
future
Slide 8-35
Two Main Methods
of Measuring GDP
 Deriving GDP by the expenditure
approach
– Government Expenditures (G)
• State, local, and federal
• Valued at cost
Slide 8-36
Two Main Methods
of Measuring GDP
 Deriving GDP by the expenditure
approach
– Net Exports (Foreign Expenditures)
Net exports (X) = total exports - total imports
Slide 8-37
Two Main Methods
of Measuring GDP
 Mathematical representation using the
expenditure approach
GDP = C + I + G + X
Slide 8-38
GDP and Its Components
Figure 8-4
Slide 8-39
Two Main Methods
of Measuring GDP
 Depreciation and net domestic product
– Deducting for depreciation (capital
consumption allowance)
• Reduction in the value of capital goods over a
one-year period due to physical wear and tear,
and also to obsolescence
NDP = GDP - depreciation
Slide 8-40
Two Main Methods
of Measuring GDP
 GDP = C + I + G + X
 NDP = C + I + G + X - depreciation
 Net Investment = I - depreciation
– Domestic investment minus an estimate of the
wear and tear on the existing capital stock
 NDP = C + net I + G + X
Slide 8-41
Two Main Methods
of Measuring GDP
 Deriving GDP by the income approach
Slide 8-42
Deriving GDP
by the Income Approach
 Gross Domestic Income (GDI)
– The sum of all income—wages, interest,
rent, and profits—paid to the four factors
of production
Slide 8-43
Two Main Methods
of Measuring GDP
 Gross Domestic Income (GDI)
– Wages
– Interest
– Rent
– Profits
Slide 8-44
Two Main Methods
of Measuring GDP
 Gross domestic product equals gross
domestic income plus indirect business
taxes and depreciation.
 These last items are called nonincome
expense items.
Slide 8-45
Gross Domestic Product
and Gross Domestic Income, 2005
(in billions of 2005 dollars per year)
Figure 8-5
Source: U.S. Department of Commerce. First quarter preliminary data annualized.
Slide 8-46
Other Components
of National Income Accounting
 National Income (NI)
– The total of all factor payments to
resource owners
 Personal Income (PI)
– The amount of income that households
actually receive before they pay personal
income taxes
Slide 8-47
Other Components
of National Income Accounting
 Disposable Personal Income (DPI)
– Personal income after personal income
taxes have been paid
Slide 8-48
Going from GDP
to Disposable Income, 2005
Source: U.S. Department of Commerce, and author’s estimates
Table 8-2
Slide 8-49
Distinguishing Between Nominal
and Real Values
 Nominal Values
– Measurements in terms of the actual
market prices at which goods are sold;
expressed in current dollars
Slide 8-50
Distinguishing Between Nominal
and Real Values
 Real Values
– Measurements after adjustments have
been made for changes in the average
of prices between years; expressed in
constant dollars
Slide 8-51
Example: Correcting GDP
for Price Index Changes
 Correcting GDP for price index changes
– Nominal (current) dollars GDP
– Real (constant) dollars GDP
nominal GDP
x 100
Real GDP =
price level*
*Price level: measured by the GDP deflator
Slide 8-52
Example: Correcting GDP
for Price Index Changes
Table 8-3
Source: U.S. Department of Commerce, Bureau of Economic Analysis,
and author’s estimates
Slide 8-53
Distinguishing Between Nominal
and Real Values
 Questions
– Why is the price index greater than 100
for 2002?
– Why is the price index less than 100 for
1996?
– Why is real GDP greater than nominal
GDP for 1996 and less than nominal GDP
for 2002?
Slide 8-54
Nominal and Real GDP
Figure 8-6
Source: U.S. Department of Commerce
Slide 8-55
Distinguishing Between Nominal
and Real Values
 Per capita GDP
– Adjusting for population growth
real GDP
Per capita real GDP =
population
Slide 8-56
Nominal and Real GDP
 The Bureau of Economic Analysis now uses
a chain-weighted measure of real GDP.
 This means that changes in the prices and
output levels of a certain good will contribute
to overall changes in GDP to the extent that
the good accounts for a significant share of
overall economic activity.
Slide 8-57
Distinguishing Between Nominal
and Real Values
 A new chain-weighted measure of the
growth in real GDP
– Prior to 1996
• U.S. Department of Commerce Bureau of
Economic Analysis (BEA) used a fixed weight
measure for real GDP
Slide 8-58
Distinguishing Between Nominal
and Real Values
 A new chain-weighted measure of the
growth in real GDP
– 1996
• BEA converted to a chain-weighted real GDP
that measures GDP by considering relative
price and share changes
Slide 8-59
Example: Real GDP
Really Lightens Up
 The value of real GDP has increased
dramatically over the past century.
 The physical weight of GDP has increased
only slightly over this time frame.
 Think about the contributions of
pharmaceuticals, software, and other
information goods.
Slide 8-60
Distinguishing Between Nominal
and Real Values
 Question
– Is real per capita GDP a good indicator of
social well-being?
Slide 8-61
Distinguishing Between Nominal
and Real Values
 Some issues
– The distribution of output
– Changes in leisure time
– Increased traffic congestion
– Air pollution
– Crime
– Housework
Slide 8-62
Comparing GDP
Throughout the World
 Example
– France
• $1.25 = 1 euro
• Per capita income = 23,168.80 euros
– France per capita income in terms of
dollars equals
23,168.80 x 1.25 = $28,961.
Slide 8-63
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
Slide 8-64
International Example:
Purchasing Power Parity Comparisons of Incomes
Table 8-4
Source: World Bank
Slide 8-65
Issues and Applications:
Does More GDP Make People Happier?
 Social scientists attempt to measure general
levels of personal satisfaction, and to
compare them on an international basis.
 There is a positive correlation between selfreported measures of life satisfaction and
per capita real GDP.
 Some economists point to this as evidence
that GDP is a good proxy measure for
overall well-being.
Slide 8-66
Summary Discussion
of Learning Objectives
 The circular flow of income and output
– In every economic transaction, receipts exactly
equal expenditures
– Goods and services flow in one direction and
money payments flow in the other
 Gross Domestic Product (GDP)
– The total market value of a nation’s final output of
goods and services produced in a year using
factors of production located within its borders
Slide 8-67
Summary Discussion
of Learning Objectives
 The limitations of using GDP as a
measure of national welfare
– Excludes non-market transactions
– Does not measure national well-being
 The expenditure approach to tabulating
GDP
– GDP = C + I + G + X
Slide 8-68
Summary Discussion
of Learning Objectives
 The income approach to computing GDP
– The sum of wages, rent, interest, profit,
depreciation, and indirect business taxes
 Distinguishing between nominal GDP and
real GDP
– Nominal GDP is the value of newly produced
final output in the current year measured in
current market prices.
– Real GDP adjusts nominal GDP into constant
dollars by correcting for price level changes.
Slide 8-69
End of
Chapter 8
Measuring
the Economy’s
Performance