182
WHAT’S NEW IN THE SEVENTH EDITION:
There is a new
In the News
box on “Measuring Macroeconomic Well-Being” and tables have been
updated.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ why an economy’s total income equals its total expenditure.
➢ how gross domestic product (GDP) is defined and calculated.
➢ the breakdown of GDP into its four major components.
➢ the distinction between real GDP and nominal GDP.
➢ whether GDP is a good measure of economic well-being.
CONTEXT AND PURPOSE:
Chapter 10 is the first chapter in the macroeconomic section of the text. It is the first of a two–chapter
sequence that introduces students to two vital statistics that economists use to monitor the
macroeconomy—GDP and the consumer price index. Chapter 10 develops how economists measure
production and income in the macroeconomy. The following chapter, Chapter 11, develops how
10
MEASURING A NATION’S
INCOME
Chapter 10/Measuring a Nation’s Income ❖ 183
KEY POINTS:
• Because every transaction has a buyer and a seller, the total expenditure in the economy must equal
the total income in the economy.
• Gross domestic product (GDP) measures an economy’s total expenditure on newly produced goods
and services and the total income earned from the production of these goods and services. More
precisely, GDP is the market value of all final goods and services produced within a country in a given
period of time.
• GDP is divided among four components of expenditure: consumption, investment, government
purchases, and net exports. Consumption includes spending on goods and services by households,
with the exception of purchases of new housing. Investment includes spending on new equipment
and structures, including households’ purchases of new housing. Government purchases include
spending on goods and services by local, state, and federal governments. Net exports equal the value
of goods and services produced domestically and sold abroad (exports) minus the value of goods and
services produced abroad and sold domestically (imports).
• GDP is a good measure of economic well-being because people prefer higher incomes to lower
incomes. But it is not a perfect measure of well-being. For example, GDP excludes the value of
leisure and the value of a clean environment.
CHAPTER OUTLINE:
I. Review of the Definitions of Microeconomics and Macroeconomics
II. The Economy’s Income and Expenditure
A. To judge whether or not an economy is doing well, it is useful to look at Gross Domestic Product
(GDP).
Regardless of whether microeconomics is taught before macroeconomics or vice
versa, students need to be reminded of the differences between the two areas of
study. Begin by defining the two terms and contrasting and comparing their focus.
184 ❖ Chapter 10/Measuring a Nation’s Income
1. GDP measures the total income of everyone in the economy.
2. GDP measures total expenditure on an economy’s output of goods and services.
B. For an economy as a whole, total income must equal total expenditure.
a. Households buy goods and services from firms; firms use this money to pay for resources
purchased from households.
b. In the simple economy described by this circular-flow diagram, calculating GDP could be
done by adding up the total purchases of households or summing total income paid by
firms.
Figure 1
Students have heard of GDP and they are often interested in learning more about
what it is. The basic point that you must get across is that GDP is a measure of
both
aggregate production and aggregate income in a nation over a period of one year.
You can demonstrate this by using the circular-flow diagram and explaining that
production generates income, which provides the purchasing power that generates
the demand for the products.
Chapter 10/Measuring a Nation’s Income ❖ 185
III. The Measurement of Gross Domestic Product
A. Definition of gross domestic product (GDP): the market value of all final goods and
services produced within a country in a given period of time.
B. “GDP Is the Market Value . . .”
1. To add together different items, market values are used.
2. Market values are calculated by using market prices.
C. “. . . Of All . . .”
1. GDP includes all items produced and sold legally in the economy.
2. The value of housing services is somewhat difficult to measure.
3. GDP does not include illegal goods or services or items that are not sold in markets.
a. When you hire someone to mow your lawn, that production is included in GDP.
b. If you mow your own lawn, that production is not included in GDP.
D. “. . . Final . . .”
1. Intermediate goods are not included in GDP.
2. The value of intermediate goods is already included as part of the value of the final good.
To put GDP in terms that students may understand better, explain to them that GDP
represents the amount of money one would need to purchase one year’s worth of
the economy’s production of all final goods and services.
Make sure that students realize that investment goods (such as structures and
vehicles used in production) are not intermediate goods. Investment goods represent
products purchased for final use by business firms.
Have a contest and see which student can come closest in guessing the level of GDP
for the United States last year.
186 ❖ Chapter 10/Measuring a Nation’s Income
3. Goods that are placed into inventory are considered to be “final” and included in GDP as a
firm’s inventory investment.
a. Goods that are sold out of inventory are counted as a decrease in inventory investment.
E. “. . . Goods and Services . . .”
1. GDP includes both tangible goods and intangible services.
F. “. . . Produced . . .”
1. Only current production is counted.
2. Used goods that are sold do not count as part of GDP.
G. “. . . Within a Country . . .”
1. GDP measures the production that takes place within the geographical boundaries of a
particular country.
H. “. . . in a Given Period of Time.”
1. The usual interval of time used to measure GDP is a year or a quarter (three months).
2. When the government reports GDP, the data are generally reported on an annual basis.
3. In addition, data are generally adjusted for regular seasonal changes (such as Christmas).
I. In addition to summing expenditure, the government also calculates GDP by adding up total
income in the economy.
1. The two ways of calculating GDP almost exactly give the same answer.
Students sometimes have trouble understanding that the production of a foreign firm
operating in the United States is part of U.S. GDP. Help them make the connection by
using the circular–flow diagram. Show them that, even if it is a foreign firm, the firm’s
workers are living in the United States and buying clothes, groceries, and other
goods in the United States. Thus, the workers in the foreign firm operating in the
United States are fueling the domestic economy.
Chapter 10/Measuring a Nation’s Income ❖ 187
J.
FYI: Other Measures of Income
A. Gross National Product (GNP) is the total income earned by a nation’s permanent residents.
B. Net National Product (NNP) is the total income of a nation’s residents (GNP) minus losses from
depreciation (wear and tear on an economy’s stock of equipment and structures).
C. National income is the total income earned by a nation’s residents in the production of goods and
services.
1. National income differs from NNP by excluding indirect business taxes and including business
subsidies.
IV. The Components of GDP
A. GDP (
Y
) can be divided into four components: consumption (
C
), investment (
I
), government
purchases (
G
), and net exports (
NX
).
B. Definition of consumption: spending by households on goods and services, with the
exception of purchases of new housing.
C. Definition of investment: spending on capital equipment, inventories, and structures,
including household purchases of new housing.
1. GDP accounting uses the word “investment” differently from how we use the term in
everyday conversation.
= + + +
Y C I G NX
Students will ask why GDP is called “
Y
.”
Remind them that in equilibrium GDP
expenditures must be equal to income. The “
Y
” stands for income because the letter
“
I
” is used for investment.
It can be a challenge to teach all of these definitions without putting your students to
sleep. Concentrate on the measures that will mean the most to students as the
semester progresses.
188 ❖ Chapter 10/Measuring a Nation’s Income
3. In GDP accounting, investment means purchases of investment goods such as capital
equipment, inventories, or structures.
D. Definition of government purchases: spending on goods and services by local, state,
and federal governments.
E. Definition of net exports: spending on domestically produced goods by foreigners
(exports) minus spending on foreign goods by domestic residents (imports).
F.
Case Study: The Components of U.S. GDP
1. Table 1 shows these four components of GDP for 2012.
2. The data for GDP come from the Bureau of Economic Analysis, which is part of the
Department of Commerce.
V. Real Versus Nominal GDP
A. There are two possible reasons for total spending to rise from one year to the next.
1. The economy may be producing a larger output of goods and services.
B. When studying GDP over time, economists would like to know if output has changed (not prices).
C. Thus, economists measure real GDP by valuing output using a fixed set of prices.
D. A Numerical Example
Table 1
Make sure that you point out Table 1. Call attention to the importance of
consumption and the negative number in the net exports column.
Make sure that you do this example or a similar numerical example in class. If you
feel comfortable improvising, let the students pick two goods and then make up an
example with them.
Spend some time in class distinguishing between government purchases and transfer
payments. Point out that transfer payments are actually negative taxes representing
payments from the government to individuals (with no good or service provided in
return) rather than payments from individuals to the government. Define net taxes
as the difference between taxes and transfers.
Chapter 10/Measuring a Nation’s Income ❖ 189
1. Two goods are being produced: hot dogs and hamburgers.
Year
Price of
Hot Dogs
Quantity of
Hot Dogs
Price of
Hamburgers
Quantity of
Hamburgers
2. Definition of nominal GDP: the production of goods and services valued at current
prices.
3. Definition of real GDP: the production of goods and services valued at constant
prices.
Let’s assume that the base year is 2013.
E. Because real GDP is unaffected by changes in prices over time, changes in real GDP reflect
changes in the amount of goods and services produced.
Table 2
Emphasize that when there is inflation, nominal GDP can increase while real GDP
actually declines. Make sure that students understand that real GDP will be used as a
proxy for aggregate production throughout the course.
Make sure that it is clear to students how to calculate these numbers so that they
can compute nominal GDP and real GDP on their own.
190 ❖ Chapter 10/Measuring a Nation’s Income
F. The GDP Deflator
1. Definition of GDP deflator: a measure of the price level calculated as the ratio of
nominal GDP to real GDP times 100.
2. Example Calculations
G.
Case Study: Real GDP over Recent History
1. Figure 2 shows quarterly data on real GDP for the United States since 1965.
ALTERNATIVE CLASSROOM EXAMPLE:
The country of ____________ (insert name based on school mascot such as “Pantherville” or
“Owlstown”) produces two goods: footballs and basketballs. Below is a table showing prices
and quantities of output for three years:
Year
Price of
Footballs
Quantity of
Footballs
Price of
Basketballs
Quantity of
Basketballs
Year 1
$10
120
$12
200
Year 2
12
200
15
300
Year 3
14
180
18
275
Using Year 1 as the Base Year:
Real GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3,600
=
Nominal GDP
GDP deflator 100
Real GDP
Make sure that you point out that nominal GDP and real GDP will be equal in the
base year. This implies that the GDP deflator for the base year will always be equal
to 100.
Figure 2
Chapter 10/Measuring a Nation’s Income ❖ 191
3. We can also see that there are times when real GDP declines. These periods are called
recessions.
VI. Is GDP a Good Measure of Economic Well-Being?
A. GDP measures both an economy’s total income and its total expenditure on goods and services.
B. GDP per person tells us the income and expenditure level of the average person in the economy.
C. GDP, however, may not be a very good measure of the economic well-being of an individual.
1. GDP omits important factors in the quality of life including leisure, the quality of the
D.
In the News: The Underground Economy
1. The measurement of GDP misses many transactions that take place in the underground
economy.
2. This article compares the underground economies of the United States and several other
countries.
E.
Case Study: International Differences in GDP and the Quality of Life
1. Table 3 shows real GDP per person, life expectancy, the average years of schooling among
adults, and the percentage of the population that reports being satisfied with the quality of
water they have available.
2. In rich countries, life expectancy is higher, adults have more years of schooling and a greater
percentage of the population reports being satisfied with the quality of water they have
available.
Table 3
Get students involved in a discussion of the merits and problems involved with using
192 ❖ Chapter 10/Measuring a Nation’s Income
F.
In the News: Measuring Macroeconomic Well-Being
1. Some economists wonder if we need a better measure of economic well-being.
2. This article from
The Wall Street Journal
describes some attempts at creating a better
measure of well-being.
Activity 1—GDP and Well-Being
Type: In-class demonstration
Topics: Per capita GDP
Materials needed: None
Time: 15 minutes
Class limitations: Works in any size class
Purpose
This activity examines the usefulness and limits of measures of GDP. Students often have
Instructions
Ask students the following questions. Discuss each before moving to the next question.
1. If GDP is a good measure of well-being, why is Switzerland’s GDP so much lower than
India’s GDP or China’s GDP?
2. What measures would be better to compare the well-being of different countries?
3. How do you expect these direct measures to correlate with per capita GDP?
Common Answers and Points for Discussion
1. GDP itself tells very little; Switzerland’s GDP is much lower than that of India or China,
2. Well-being can be measured directly in a variety of ways. Students often suggest these:
collect and interpret.
3. Although per capita GDP is not a direct measure of well-being, it can be used as a proxy
for direct measures. The wealthiest countries have per capita incomes over 10 times
higher than the poorest.
Chapter 10/Measuring a Nation’s Income ❖ 193
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes:
1. Gross domestic product measures two things at once: (1) the total income of everyone in the
Questions for Review:
1. An economy’s income must equal its expenditure, because every transaction has a buyer and
194 ❖ Chapter 10/Measuring a Nation’s Income
7.
Year
Nominal GDP
Real GDP
GDP Deflator
8. It is desirable for a country to have a large GDP because people could enjoy more goods and
Quick Check Multiple Choice
1. b
Problems and Applications
1. a. Consumption increases because a refrigerator is a good purchased by a household.
Chapter 10/Measuring a Nation’s Income ❖ 195
Calculating real GDP (base year 2013):
2013: ($1 per qt. of milk 100 qts. milk) + ($2 per qt. of honey 50 qts. honey) = $200
b. Calculating the percentage change in nominal GDP:
Percentage change in nominal GDP in 2014 = [($400 – $200)/$200] 100 = 100%.
c. Economic well-being rose more in 2014 than in 2015, since real GDP rose in 2014 but not
5. a. Calculating Nominal GDP:
b. Calculating Real GDP:
c. Calculating the GDP deflator:
Year 3: $30/$20 100 = 150
196 ❖ Chapter 10/Measuring a Nation’s Income
6.
Year
Nominal GDP
(billions)
GDP Deflator
(base year: 2005)
2012
$15,676
115.4
8. a. GDP is the market value of the final good sold, $180.
9. In countries like India, people produce and consume more food at home that is not included
10. a. The increased labor-force participation of women has increased GDP in the United States,
Chapter 10/Measuring a Nation’s Income ❖ 197