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Measuring the Economy’s Output
CHAPTER 5
MEASURING THE ECONOMY’S OUTPUT
CHAPTER OVERVIEW
News headlines frequently report the status of the nation’s economic conditions, but to many citizens the
information is confusing or incomprehensible. This chapter acquaints students with the basic language
of macroeconomics and national income accounting. GDP is defined and explained. Then, the
differences between the expenditure and income approaches to determining GDP are discussed and
analyzed in terms of their component parts. The income and expenditure approaches are developed
gradually from the basic expenditure-income identity, through tables and figures.
The importance of investment is given considerable emphasis, including the nature of investment, the
distinction between gross and net investment, the role of inventory changes, and the impact of net
investment on economic growth. On the income side, non-income charges—depreciation and indirect
business taxes—are covered in detail because these usually give students the most trouble.
Other measures of economic activity are defined and discussed, with special emphasis on price indexes.
The purpose and procedure of deflating and inflating nominal GDP are carefully explained and
illustrated. Finally, the shortcomings of current GDP measurement techniques are examined. Global
comparisons are made with respect to size of national GDP and size of the underground economy.
The Last Word looks at the value added approach to measuring GDP.
WHAT’S NEW
The chapter is updated and is more tightly focused than the previous edition. As reflected in the title
change, there is now less emphasis on the price level.
A “Consider This” box has been added to help students understand the difference between the stock and
flow variables of gross investment, depreciation, and the stock of capital (moved from the previous
edition website “Analogies, Anecdotes, and Insights”).
The term “GDP deflator” is new, as is the discussion of the chain weighted index to arrive at real GDP.
Two sections were moved from their positions the last edition. “The Consumer Price Index” section now
appears in the Chapter 6 discussion of inflation. In the “Shortcomings of GDP,” the section on “Per
Capita Output” was moved to the Chapter 6 discussion of measures of economic growth.
There is a new “The Last Word” on measuring GDP by the value added approach.
Data have been updated and web-based questions have been revised.
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INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to understand:
1.
2.
3.
4.
What gross domestic product (GDP) is, and how to measure it.
Other measures of a nation’s production of goods and services.
The distinction between nominal GDP and real GDP.
The shortcomings of GDP as a measure of domestic output and well-being.
COMMENTS AND TEACHING SUGGESTIONS
1.
National income accounts are detailed and can be very time consuming for students. Some
instructors choose to treat them selectively. Decide what priorities are most important and plan
accordingly.
2.
Encourage students to look for news items on Chapter 5 concepts. Students could be asked to
keep a weekly journal summarizing reports or follow a particular measure like unemployment.
Political cartoons are often about macroeconomic issues. Keeping a collection of them; asking
students to contribute enlivens the classroom and builds understanding.
3.
Use of the circular flow diagrams in this section may be helpful. The national income accounts are
built on the identity of income and output. Once a good is produced it generates a like amount of
income; this is clearly and visually demonstrated in the sum of the transactions in the product and
resource markets.
4.
Discuss the difference between “stock” concepts and “flows.” The national accounts are measured
over a period of time, so GDP and the related aggregates are all flow concepts. A “stock” is a
measure of a variable at a point in time. Consider these pairs of terms: income and wealth; saving
and savings; deficit and debt. Contrast the income statement of a firm with the firm’s balance
sheet. The CONSIDER THIS … Stock Answers about Flows box will help illustrate the
difference.
5.
For discussion: Why is a hurricane or an earthquake good for the economy? How does a divorce
add to GDP? How can the depletion of a natural resource add to GDP?.
6.
Ask students how they think a researcher might get information about the size of the
underground economy. Obviously a drug dealer is not going to include sales information on his
tax return. Discuss how the presence of the underground economy might influence tax structure
and policies.
STUDENT STUMBLING BLOCK
1. There is a lot of memorization required to learn the various measures used in the national
accounts. In the interest of time, you might choose to have your students focus on the
expenditures approach to calculating GDP. It will prove to be the most useful in understanding
the analysis in subsequent chapters which use C + I + G + Xn formulation frequently.
2. Special Problems: Investment is a word that all of the students in the class think they understand.
The meaning of the term in ordinary conversation interferes with their ability to acquire a new
definition and use that new definition consistently.
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3. Changes in business inventory is an entry that represents the difference between what has been
produced and what is sold. Although this entry is very small compared to total GDP, it is one of
the most important indicators of future business activity. It has an important role in the income
determination models presented later in the text.
4. Many of the exclusions from the GDP accounts involve financial transactions that transfer the
ownership of existing assets. The sale of stock in a corporation is a transfer of part ownership of
existing assets. New stock issues only dilute the share of ownership and are excluded as well.
The sale of corporate bonds also represents a purely financial transaction. Corporations that are
seeking to expand use the proceeds of these sales to purchase capital equipment or engage in new
construction, and this is included in GDP. To also include the purchase of the securities would
be an example of double counting. However, services are provided when these transactions are
processed, the value of which should be included in GDP.
5. Sales of secondhand goods are also excluded; however parts of the transactions may need to be
counted. The used car dealership that buys a car for $1000 and resells it for $3000 has created
$2000 worth of output, even if the entire sum is profit to the entrepreneur.
6. Remind the students that entries beginning with the word net could be negative and have been in
the case of net exports for many years in U.S.
LECTURE NOTES
I.
Assessing the Economy’s Performance
A. National income accounting measures the economy’s performance by measuring the flows of
income and expenditures over a period of time.
B. National income accounts serve a similar purpose for the economy, as do income statements
for business firms.
C. Consistent definition of terms and measurement techniques allows us to use the national
accounts in comparing conditions over time and across countries.
D. The national income accounts provide a basis for of appropriate public policies to improve
economic performance.
II.
Gross Domestic Product
A. GDP is the monetary measure of the total market value of all final goods and services
produced within a country in one year.
1. Money valuation allows the summing of apples and oranges; money acts as the common
denominator.
2. GDP includes only final products and services; it avoids double or multiple counting, by
eliminating any intermediate goods used in production of these final goods or services.
3. GDP is the value of what has been produced in the economy over the year, not what was
actually sold.
B. GDP Excludes Non-production Transactions
1. GDP is designed to measure what is produced or created over the current time period.
Existing assets or property that sold or transferred, including used items, are not counted.
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2. Purely financial transactions are excluded.
a. Public transfer payments, like social security or cash welfare benefits.
b. Private transfer payments, like student allowances or alimony payments.
c. The sale of stocks and bonds represent a transfer of existing assets. (However, the
brokers’ fees are included for services rendered.)
3. Second-hand sales are excluded, they do not represent current output.
C. Two Ways to Look at GDP: Spending and Income.
1. What is spent on a product is income to those who helped to produce and sell it.
2. This is an important identity and the foundation of the national accounting process.
D. Expenditures Approach (See Table 5-3)
1. GDP is divided into the categories of buyers in the market; household consumers,
businesses, government, and foreign buyers.
2. Personal Consumption Expenditures—(C)—includes durable goods, nondurable goods
and services.
3. Gross Private Domestic Investment—(Ig)
a. All final purchases of machinery, equipment, and tools by businesses.
b. All construction (including residential).
c. Changes in business inventory.
i. If total output exceeds current sales, inventories build up.
ii. If businesses are able to sell more than they currently produce, this entry will be a
negative number.
d. Net Private Domestic Investment—(In).
i.
Each year as current output is being produced, existing capital equipment is
wearing out and buildings are deteriorating; this is called depreciation or capital
consumption allowance.
ii. Gross Investment minus depreciation (capital consumption allowance) is called
net investment.
iii. If more new structures and capital equipment are produced in a given year than
are used up, the productive capacity of the economy will expand.
iv. When gross investment and depreciation are equal, a nation’s productive
capacity is static.
v. When gross investment is less than depreciation, an economy’s production
capacity declines.
vi. CONSIDER THIS … Stock Answers about Flows
4. Government Purchases (of consumption goods and capital goods) – (G)
a. Includes spending by all levels of government (federal, provincial and local).
b. Includes all direct purchases of resources (labour in particular).
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Measuring the Economy’s Output
c. This entry excludes transfer payments since these outlays do not reflect current
production.
5. Net Exports—(Xn)
a. All spending on goods produced in Canada must be included in GDP, whether the
purchase is made here or abroad.
b. Often goods purchased and measured in Canada are produced elsewhere (Imports).
c. Therefore, net exports, (Xn) is the difference: (exports minus imports) and can be
either a positive or negative number depending on which is the larger amount.
6. Summary: GDP = C + Ig + G + Xn
III.
Other National Accounts (see Table 5.5)
A. Gross national product (GNP) is equal to GDP minus net investments from non-residents.
B. Net domestic product (NDP) is equal to GNP minus depreciation allowance (consumption of
fixed capital).
C. Net national income (NNI) is income earned by Canadian -owned resources here or abroad.
Adjust NDP by subtracting indirect business taxes less subsidies.
D. Personal income (PI) is income received by households. To calculate, take NNI minus
undistributed corporate profits, and add government transfer payments.
E. Disposable income (DI) is personal income less personal taxes.
IV.
Circular Flow Revisited (see Figure 5-2)
A. Compare to the simpler model presented in earlier chapters. Now both government and
foreign trade sectors are added.
B. Note that the inside covers of the text contain a useful historical summary of national income
accounts and related statistics.
V.
Nominal versus Real GDP
A. Nominal GDP is the market value of all final goods and services produced in a year.
1. GDP is a (P  Q) figure including every item produced in the economy. Money is the
common denominator that allows us to sum the total output.
2. To measure changes in the quantity of output, we need a yardstick that stays the same
size. To make comparisons of real output, a dollar must keep the same purchasing
power.
3. Nominal GDP is calculated using the current prices prevailing when the output was
produced but real GDP is a figure that has been adjusted for price level changes.
B. The adjustment process in a one-good economy (Table 5-6). Valid comparisons can not be
made with nominal GDP alone, since both prices and quantities are subject to change. Some
method to separate the two effects must be devised.
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1. One method is to first determine a price index, (see equation 1) and then adjust the
nominal GDP figures by dividing by the price index (in hundredths) (see equation 1).
2. An alternative method is to gather separate data on the quantity of physical output and
determine what it would sell for in the base year. The result is Real GDP. The GDP
deflator is implied in the ratio: Nominal GDP/Real GDP. Multiply by 100 to put it in
standard index form (see equation 3).
VI.
Shortcomings of GDP
A. GDP doesn’t measure some very useful output because it is unpaid (homemakers’ services,
parental child care, volunteer efforts, home improvement projects).
B. GDP does not measure improvements in product quality or make allowances for increased
leisure time.
C. GDP doesn’t measure improved living conditions as a result of more leisure.
D. GDP makes no value adjustments for changes in the composition of output or the distribution
of income.
1. Nominal GDP simply adds the dollar value of what is produced; it makes no difference if
the product is a semi-automatic rifle or a jar of baby food.
2. Per capital GDP may give some hint as to the relative standard of living in the economy;
but GDP figures do not provide information about how the income is distributed.
E. The Underground Economy
1. Illegal activities are not counted in GDP.
2. Legal economic activity may also be part of the “underground,” usually in an effort to
avoid taxation.
F. GDP and the environment.
1. The harmful effects of pollution are not deducted from GDP (oil spills, increased
incidence of cancer, destruction of habitat for wildlife, the loss of a clear unobstructed
view).
2. GDP does include payments made for cleaning up the oil spills, and the cost of health
care for the cancer victim.
G. Per Capita GDP (GDP per person) is a better measure of standard of living than total GDP.
H. Non-economic Sources of Well-Being like courtesy, crime reduction, etc., are not covered in
GDP.
ANSWERS TO END-OF-CHAPTER QUESTIONS
5-1
In what ways are national income statistics useful?
National income accounting does for the economy as a whole what private accounting does for
the individual business. A firm measures its flows of income and expenditures to assess its
operations over some time period in order to gauge its economic health.
The national income accounting system permits us to measure the level of production in the
economy at some particular time and explain why it is at that level. By comparing national
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accounts over a number of years, we can track the long-run course of the economy and see
whether it has grown, been steady, or stagnated. Information supplied by national accounts
provides a basis for designing and applying public policies to improve the performance of the
economy. Without national accounts, economic policy would be guesswork. National income
accounting allows us to assess the health of an economy and formulate policies to maintain and
improve that health.
5-2
Explain why an economy’s output is also its income?
Everything that is produced is sold, even if the “selling,” in the case of inventory, is to the
producing firm itself. Since the same amount of money paid out by the buyers of the economy’s
output is received by the sellers as income (looking only at a private-sector economy at this
point), “an economy’s output is also its income.”
5-3
(Key Question) Why do national income accountants include only final goods in measuring total
output GDP in a particular year? Why don’t they include the value of stocks and bonds bought
and sold? Why don’t they include the value of used furniture?
They are excluded because the dollar value of final goods includes the dollar value of
intermediate goods. If intermediate goods were counted, then multiple counting would occur.
The value of steel (intermediate good) used in autos is included in the price of the auto (the final
product).
This value is not included in GDP because such sales and purchases simply transfer the
ownership of existing assets; such sales and purchases are not themselves (economic) investment
and thus should not be counted as production of final goods and services.
Used furniture was produced in some previous year; it was counted as GDP then. Its resale does
not measure new production.
5-4
What is the difference between gross investment and net investment?
Gross investment less depreciation is net investment. Depreciation is the value of all the physical
capital—machines, equipment, buildings—used up in producing the year’s output.
5-5
Why are changes in inventories included as part of investment spending? Suppose inventories
declined by $1 billion during 2001. How would this affect the size of gross private domestic
investment and gross domestic product in 2001? Explain.
Anything produced by business that has not been sold during the accounting period is something
in which business has invested—even if the “investment” is involuntary, as often is the case with
inventories. But all inventories in the hands of business are expected eventually to be used by
business—for instance, a pile of bricks for extending a factory building—or to be sold—for
instance, a can of beans on the supermarket shelf. While in the hands of business both the bricks
and the beans are equally assets to the business, something in which business has invested.
If inventories declined by $1 billion in 2000, $1 billion would be subtracted from both gross
private domestic investment and gross domestic product. A decline in inventories indicates that
goods produced in a previous year have been used up in this year’s production. If $1 billion is not
subtracted as stated, then $1 billion of goods produced in a previous year would be counted as
having been produced in 2000, leading to an overstatement of 2000’s production.
5-6
Use the concepts of gross and net investment to distinguish between an expanding, a static, and
a declining economy. “In 1933 net investment was minus $324 million. This means in that
particular year the economy produced no capital goods at all.” Do you agree? Explain: “Though
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Measuring the Economy’s Output
net investment can be positive, negative, or zero, it is quite impossible for gross investment to be
less than zero.”
When gross investment exceeds depreciation, net investment is positive and production capacity
expands; the economy ends the year with more physical capital than it started with. When gross
investment equals depreciation, net investment is zero and production capacity is said to be
static; the economy ends the year with the same amount of physical capital. When depreciation
exceeds gross investment, net investment is negative and production capacity declines; the
economy ends the year with less physical capital.
The first statement in wrong. Just because net investment was a minus $324 million in 1933 does
not mean the economy produced no new capital goods in that year. It simply means depreciation
exceeded gross investment by $324 million. So the economy ended the year with $324 million
less capital.
The second statement is correct. If only one $20 spade is bought by a construction firm in the
entire economy in a year and no other physical capital is bought, then gross investment is $20—a
positive amount. This is true even if net investment is highly negative because depreciation is
well above $20. If not even this $20 spade has been bought, then gross investment would have
been zero. But gross investment can never be less than zero.
5-7
Define net exports. Explain how Canada’s exports and imports each affect domestic production.
Suppose foreigners spend $7 billion on Canadian exports in a given year and Canadians spend $5
billion on imports from abroad in the same year. What is the amount of Canada’s net exports?
Explain how net exports might be a negative amount.
Net exports are a country’s exports of goods and services less its imports of goods and services.
Canada’s exports are as much a part of the nation’s production as are the expenditures of its own
consumers on goods and services made in Canada. Therefore, Canada’s exports must be counted
as part of GDP. On the other hand, imports, being produced in foreign countries, are part of those
countries’ GDPs. When Canadians buy imports, these expenditures must be subtracted from
Canada’s GDP, for these expenditures are not made on Canada’s production.
If Canadian exports are $7 billion and imports are $5 billion, then Canada’s net exports are +$2
billion. If the figures are reversed, so that Canadians export $5 billion and import $7 billion, then
net exports are -$2 billion—a negative amount. For this to come about, Canadians must either
decrease their holdings of foreign currencies by $2 billion, or borrow $2 billion from
foreigners—or do a bit of both. (Another option is to sell back to foreigners some of the previous
Canadian investments abroad.)
5.8
(Key Question) Following is a list of domestic output and national income figures for a given
year. All figures are in billions. Calculate GDP by both the expenditure and income methods.
The answers derived by each approach should be the same.
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Measuring the Economy’s Output
Personal consumption expenditures
Capital consumption allowances (depreciation)
Interest and miscellaneous investment income
Net income of farms and unincorporated business
Net exports
Profits of corporation and government enterprises before taxes
Wages, salaries, and supplementary labour income
Indirect business taxes (less subsidies)
Government current purchases of goods and services
Net investment (net capital formation)
Taxes less subsidies on factors of production
$120
20
10
17
+13
42
113
11
40
30
10
GDP = $223
5-9
Using the following national income accounting data, compute (a) GDP, (b) GNP, (c) NDP, (d)
NNI, (e) PI, (f) DI. All figures are in billions.
Wages, salaries, and supplementary labour income
Canadian exports of goods and services
Capital consumption allowances
Government current purchases of goods and services
Indirect taxes less subsidies
Net investment (net capital formation)
Government transfer payments
Canadian imports of goods and services
Personal taxes
Personal consumption expenditures
Net investments from non-residents
Undistributed corporate profits
$194.2
17.8
11.8
59.4
14.4
52.1
13.9
16-5
40.5
219.1
2.2
10
(a) GDP= $343.7; (b) GNP = $341.5; (c) NDP = $329.7; (d) NNI = $315.3; (e) (PI) = $319.2; (f)
DI = $278.7
5-10
Why do national income accountants compare the market value of the total outputs in various
years rather than actual physical volumes of production? Explain. What problem is posed by any
comparison over time of the market values of various total outputs? How is this problem
resolved?
If it is impossible to add oranges and apples, as the saying goes, it is surely even more impossible
to add oranges and, say, computers. If the production of oranges increases by 100 percent and
that of computers by 10 percent, it does not make any sense to add the 100 percent to the 10
percent, then divide by 2 to get the average and say total production has increased by 55 percent.
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Measuring the Economy’s Output
Since oranges and computers have different values, the quantities of each commodity are
multiplied by their values or prices. Adding together all the results of the price times quantity
figures leads to the aggregate figure showing the total value of all the final goods and services
produced in the economy. Thus, to return to oranges and computers, if the value of orange
production increases by 100 percent from $100 million to $200 million while that of computers
increases 10 percent from $2 billion to $2.2 billion, we can see that total production has
increased from $2.1 billion (= $100 million + $2 billion) to $2.4 billion (= $200 million + $2.2
billion). This is an increase of 14.29 percent [= ($2.4 billion - $2.1 billion)/$2.1 billion)]—and
not the 55 percent incorrectly derived earlier.
However, comparing market values over time of various total outputs does have the disadvantage
that prices change. If the market value in year 2 is 10 percent greater than in year 1, we cannot
say the economy’s production has increased 10 percent. It depends on what has been happening
to prices; on whether the economy has been experiencing inflation or deflation.
To resolve this problem, statisticians deflate (in the case of inflation) or inflate (in the case of
deflation) the value figures for the total output so that only “real” changes in production are
recorded. To do this, each item is assigned a “weight” corresponding to its relative importance in
the economy. Housing, for example, is given a high weight because of its importance in the
average budget. A book of matches would be given a very low weight. Thus, the price of housing
increasing by 5 percent has a much greater effect on the price index used to compare prices from
one year to the next than would the price of a book of matches increasing by 100 percent.
In Canada, the base year for the current GDP price index is 1992; that is, the price level index is
set at 100 for 1992. If, then, it is calculated that the average level of prices has increased by 3.8
percent by 1993, the nominal (price-unadjusted) GDP figure for 1993 will be divided by 1.038 to
deflate the 1993 GDP so that it may be expressed in real terms, that is, in terms of the constant
dollars of the base year, 1992.
5-11
(Key Question) Suppose that in 1984 the total output in a single-good economy was 7,000
buckets of chicken. Also suppose that in 1984 each bucket of chicken was priced at $10. Finally,
assume that in 1992 the price per bucket of chicken was $16 and that 22,000 buckets were
purchased. Determine the GDP price index for 1984, using 1992 as the base year. By what
percentage did the price level, as measured by this index, rise between 1984 and 1992? Use the
two methods listed in Table 6-6 to determine real GDP for 1984 and 1992.
Price index for 1984 = 62.5; 60 percent; real GDP for 1984 = $112,000 and real GDP for 1992 =
$352,000.
5-12
Distinguish between a fixed based price index and a chain weighted index. Why can a fixed base
price index exaggerate GDP growth.
5-13
(Key Question) The following table shows nominal GDP and an appropriate price index for a
group of selected years. Compute real GDP. Indicate in each calculation whether you are
inflating or deflating the nominal GDP data.
Year
Nominal GDP,
billions
GDP deflator
(1997= 100)
Real GDP
billions
1929
$6.1
8.6
$ ______
1933
3.5
7.0
$ ______
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Measuring the Economy’s Output
1962
44.8
17.6
$ ______
1974
173.9
32.8
$ ______
1984
449.6
71.8
$ ______
1994
770.9
102.4
$ ______
2002
1154.9
107.5
$ ______
Values for real GDP, top to bottom of the column: $70.9(inflating); $50.0 (inflating); $254.4 (inflating);
$ (inflating); $530.2 (inflating); $626.2 (inflating); $809.8(inflating);$1074.3(deflating).
5-14
Which of the following are actually included in deriving this year’s GDP? Explain your answer
in each case.
a. Interest on a Bell Canada bond
b. Canada Pension payments received by a retired factory worker
c. The services of a painter in painting the family home
d. The income of a dentist
e. The money received by Smith when she sells her economics textbook to a book buyer
f.
The monthly allowance that a college or university student receives from home
g. Rent received on a two-bedroom apartment
h. The money received by Stan when he resells this year’s model Plymouth to Ed
i.
Interest received on corporate bonds
j.
A 2-hour decline in the length of the workweek
k. The purchase of a Quebec Hydro bond
l.
Interest received on corporate bonds
m. The purchase of 100 shares of Nortel common stock
n. The purchase of an insurance policy
(a) Included. Income received by the bondholder for the services derived by the corporation for
the loan of money.
(b) Excluded. A transfer payment from taxpayers for which no service is rendered (in this year).
(c) Excluded. Not a market transaction. If any payment is made, it will be within the family.
(d) Included. Payment for a final service. You cannot pass on a tooth extraction!
(e) Excluded. Secondhand sales are not counted; the textbook is counted only when sold for the
first time.
(f) Excluded. A private transfer payment; simply a transfer of income from one private
individual to another for which no transaction in the market occurs.
(g) Included. Payment for the final service of housing.
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Measuring the Economy’s Output
(h) Excluded. The production of the car had already been counted at the time of the initial sale.
(i) Included. The income received by the bondholders is paid by the corporations for the current
use of the “money capital” (the loan).
(j) 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.
(k) Excluded. A non-investment transaction; it is merely the transfer of ownership of financial
assets. (If Quebec Hydro uses the money from the sale of a new bond to carry out an
investment in real physical assets, that will be counted.)
(l) Included. The increase in inventories could only occur as a result of increased production.
(m) Excluded. Merely the transfer of ownership of existing financial assets.
(n) Included. Insurance is a final service. If bought by a household, it will be shown as
consumption; if bought by a business, as investment—as a cost added to its real investment
in physical capital.
5-15
(The Last Word) Distinguish between (a) the value added approach ; (b) the expenditure
approach; (c) and the income approach to calculating GDP.
The value added approach sums up the value of total output less the value of intermediate goods
and services. The expenditure approach sums up the expenditure on final goods and services. The
income approach tallies earnings of all factors of productions.
Consider This
In 2001 gross investment in Canada totalled $216.5 billion and capital consumption allowance
amounted to $144.3 billion. How much was added to the Canadian capital stock in 2001?
Answer: $72.2 billion.
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