Chapter 21 Monitoring the Value of Production: GDP

I. Gross Domestic Product

1. GDP or gross domestic product is the market value of all the final goods and
services produced within a country in a given time period.
2. The items in GDP are valued at their market values, that is, at their prices. So
if 100,000,000 slices of pizza are sold for $3 each, slices of pizza contribute
$300,000,000 to GDP. Using market values means that the total value of
output, that is, GDP will be in the dollars (or whatever the country’s currency
unit might be).
3. A final good is an item that is bought by its final user. It contrasts with an
intermediate good, which is an item that is produced by one firm, bought by
another firm, and used as a component of a final good or service.
4. To avoid double counting, GDP includes only final goods and services (no
intermediate goods and services are directly counted).
5. Only the goods and services produced within a country are counted. A Honda
produced in North Carolina is counted in U.S. GDP.
6. GDP is measured over a period of time, typically a quarter of a year or a year.

A. GDP and the Circular Flow of Expenditure and Income

Figure 21.1 illustrates the circular flow of expenditure and income. The economy
consists of households, firms, governments, and the rest of the world, which trade
in factor markers and goods (and services) markets.

Figure 21.1 The Circular Flow of Expenditure and Income

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 1. The circular flow illustrates the equality of income, expenditure, and the value
of production. The circular flow diagram shows the transactions among four
economic agents—households, firms, governments, and the rest of the
world—in two aggregate markets—goods markets and factor markets.
2. In the goods market, households, firms, governments, and foreigners buy
goods and services. For analytical purposes, we can categorize spending by
these four agents in the calculation of GDP:
a). The total payment for goods and services by households in the goods
markets is consumption expenditure, C.
b). Investment I is expenditure on capital equipment and buildings by firms
and the addition to business inventories. It also includes expenditures on new
homes by households. For example, if Starbucks builds a new store or
Amazon buys robots, these expenditures are counted under business
investment. Also note that inventories refer to the goods that have been
produced by one business but have not yet been sold to consumers and are
still sitting in warehouses and on shelves. The amount of inventories sitting
on shelves tends to decline if business is better than expected or to rise if
business is worse than expected.
c). Governments buy goods and services, called government expenditure or
G, from firms.
d). Firms sell goods and services to the rest of the world, exports or X, and
buy goods and services from the rest of the world, imports or M. Exports
minus imports are called net exports, X  M.
3. In factor markets households receive income from selling the services of
resources to firms. The total income received is aggregate income. It includes
wages paid to workers, interest for the use of capital, rent for the use of land
and natural resources, and profits paid to entrepreneurs.
4. Each of the market transactions that enter into GDP must involve both a buyer
and a seller. That is to say we can measure GDP either from the factor markets
or from the goods market.

B. GDP Equals Expenditure Equals Income

1. Aggregate expenditure equals C + I + G + (X  M). Aggregate expenditure
equals GDP because all the goods and services that are produced are sold to
households, firms, governments, or foreigners. (Goods and services not sold
are included in investment as inventories and hence are “sold” to the
producing firm.)

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 2. Because firms pay out as income everything they receive as revenue from
selling goods and services, aggregate income equals aggregate expenditure
equals GDP.

C. Why is Domestic Product “Gross”?

1. Depreciation is the decrease in the stock of capital that results from wear and
tear and obsolescence. The total amount spent on purchases of new capital and
on replacing depreciated capital is called gross investment. The amount by
which the stock of capital increases is net investment. Net investment = Gross
investment  Depreciation.

2. The “Gross” in gross domestic product reflects the fact that the investment in
GDP is gross investment and so part of it goes to replace depreciating capital.
Net domestic product subtracts depreciation from GDP.

NDP = GDP – depreciation

(國內生產淨額＝國內生產毛額 - 折舊)

II. Measuring U.S. GDP

A. The Expenditure Approach
The expenditure approach (Table 21.1) measures GDP as the sum of consumption
expenditure, C, investment, I, government expenditure on goods and services, G,
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 and net exports of goods and services, (X  M). So GDP = C + I + G + (X  M)
or, in 2020 and in billions of dollars, $14,145 + $3,605 + $3,831 + ($645) =
$20,936.

Table 21.1 GDP: The Expenditure Approach

B. The Income Approach

1. The income approach measures GDP as the sum of compensation of employees
(the blue flow W in figure21.1a below), net interest, rental income, corporate
profits, and proprietors’ income (the blue flow OFI in figure21.1a below). This
sum equals net domestic income at factor costs which are the costs of the
factors of production used to produce final goods. The expenditure approach
discussed above is valued at market prices which differ from factor costs
because of indirect taxes and subsidies.

Figure 21.1a The Circular Flow of Expenditure and Income

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 2. To obtain GDP, indirect taxes (which are taxes paid by consumers when they
buy goods and services) minus subsidies plus depreciation are included.
a). An indirect tax is a tax such as a sales tax or a tax on gasoline. Market
price includes indirect taxes, so exceeds factor cost. For example, if the sales
tax is 7 percent, you pay $1.07 when you buy a $1 chocolate bar. The factor
cost of the chocolate bar including profit is $1. The market price is $1.07.
b). A subsidy is a payment, such as a farm subsidy, by the government to a
producer. Subsidies make market price less than factor cost.
c). Total expenditure is a gross number because it includes gross investment.
Therefore, we have to add deprecations to the income approach to let it equal
the expenditure approach.
3. Finally any discrepancy between the expenditure approach and income
approach is included in the income approach as “statistical discrepancy.”
4. GDP from the income approach:

GDP = Compensation of employees + Net interest + Rental income + Corporate

profits + Proprietors’ income + (Indirect taxes - Subsidies) + Depreciation

Table 21.2 GDP: The Income Approach

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III. Real GDP and the Price Level
A. Calculating Real GDP
Nominal GDP calculation (using the data in Table 5.3 and 5.4)

Table 5.4 GDP Data for 2003

Item Quantity Price
Balls 160 $0.5
Bats 22 $22.5

Nominal GDP in 2002

Expenditure on balls =100 balls x $1 =$100
Expenditure on bats =20 bats x $5 =$100
Nominal GDP in 2002 = $100+$100 =$200

Nominal GDP in 2003

Expenditure on balls =160 balls x $0.5 =$80
Expenditure on bats =22 bats x $22.5 =$495
Nominal GDP in 2003 = $80+$495 =$575

1. Real GDP is the value of final goods and services produced in a given year
when valued at constant prices.
2. The first step in calculating real GDP is to calculate nominal GDP, which is
the value of goods and services produced during a given year valued at the
prices that prevailed in that same year.
a) The old method of calculating real GDP was to value each year’s
output at the prices of a base year—the base year prices method.

For example: if we use 2002 as the base year. By definition, real GDP
equals nominal GDP in the base year. So real GDP in 2002 is $200. From

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 Table 5.5, we know that the value of the 2003 quantities at the 2002 prices
is calculated as follows:
Expenditure on balls =160 balls x $1 =$160
Expenditure on bats =22 bats x $5 =$110
Value of the 2003 quantities at 2002 price = $160+$110 =$270
Therefore, $270 would be recorded s real GDP in 2003

(Note that in the U.S. today, the base year is 2000.)

3. The new method of calculating real GDP, which is called the chain-weighted
output index method, uses the prices of two adjacent years (like the data in
Tables 5.3 and 5.4 to calculate the real GDP growth rate. This calculation has
several steps:
a). Value last year’s production and this year’s production at last year’s prices
and then calculate the growth rate of this number from last year to this year
as is done in Table 5.5.
b). Value last year’s production and this year’s production at this year’s
prices and then calculate the growth rate of this number from last year to this
year as is done is Table 5.6.
c). Calculate the average of the two growth rates in a) and b). This average
growth rate is the growth rate of real GDP from last year to this year.
d). Repeat the previous three steps for each pair of adjacent years, linking
real GDP back to the base year’s prices. The base year is currently 2000.

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 Using the above information as an example:
Step 1:
Nominal GDP in 2002
Expenditure on balls =100 balls x $1 =$100
Expenditure on bats =20 bats x $5 =$100
Nominal GDP in 2002 = $100+$100 =$200
Step 2:
Nominal GDP in 2003
Expenditure on balls =160 balls x $0.5 =$80
Expenditure on bats =22 bats x $22.5 =$495
Nominal GDP in 2003 = $80+$495 =$575
Step 3:
The value of the 2003 quantities at the 2002 prices is calculated as follows:
Expenditure on balls =160 balls x $1 =$160
Expenditure on bats =22 bats x $5 =$110
Value of the 2003 quantities at 2002 price = $160+$110 =$270
Step 4:
The value of the 2002 quantities at the 2003 prices is calculated as follows:
Expenditure on balls =100 balls x $0.5 =$50
Expenditure on bats =20 bats x $22.55 =$450
Value of the 2002 quantities at 2003 price = $50+$450 =$500
Step 5:
We now have two comparisons between 2002 and 2003.
At the 2002 prices, the value of production increased from $200 in 2002 to $270
in 2003. The increase in value is $70, and the percentage increase is
($70/$200)x100, which is 35 percent.
Step 6:
At the 2003 prices, the value of production increased from $500 in 2002 to $575
in 2003. the increase in value is $75, and the percentage increase is
($75/$500)x100, which is 15 percent.
Step 7:
The method of calculating real GDP uses the average of these two percentage
increases. The average of 35 percent and 15 percent is (35+15)/2, which

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 equals 25 percent. Real GDP is 25 percent greater in 2003 than in 2002. Real
GDP in 2002 is $200, so real GDP in 2003 is $250.

IV. Measuring Economic Growth

A. We use real GDP to calculate the economic growth rate.
1. The economic growth rate is the percentage change in the quantity of goods
and services produced from one year to the next. It equals

Real GDP this year -Real GDP last year

( ) ∙ 100
Real GDP last year

2. We measure economic growth so we can make

a). economic welfare comparisons
b). international welfare comparisons
c). business cycle (景氣循環) forecasts

B. Calculating the Price Level

1. The average level of prices is called the price level.
2. One measure of the price level is the GDP deflator, which is an average of the
current-year prices expressed as a percentage of the base-year prices.
a) The GDP deflator is calculated as
GDP Deflator = (Nominal GDP  Real GDP) *100

C. Deflating the GDP Balloon

1. Nominal GDP can increase because production increases and because prices
rise.
2. Using the GDP deflator we deflate nominal GDP to get real GDP as Figure
21.2 illustrates.

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 Figure 21.2 Deflating the GDP Balloon

V. The Uses and Limitations of Real GDP

Economists use estimates of real GDP for two main purpose:
 To compare the standard of living over time
 To compare the standard of living across countries

A. The Standard of Living Over Time

1. One measure of the standard of living over time is real GDP per person, or
real GDP divided by the population. Real GDP per person tells us the value of
goods and services that the average person can enjoy.
2. The value of real GDP when all the economy’s labor, capital, land, and
entrepreneurial ability are fully employed is called potential GDP. Potential
GDP grows at a steady pace because the quantities of the factors of production
and their productivity grow at a steady pace.

Figure 21.3 Rising Standard of living in the U.S.

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3. The growth rate of real GDP slowed in the productivity growth slowdown after
1970. This slowdown created a Lucas wedge (Figure 21.4). A Lucas wedge is
the dollar value of the accumulated gap between what real GDP per person
would have been if the growth rate had persisted and what real GDP per
person actually turned out to be.

Figure 21.4 The Cost of Slower Growth: The Lucas Wedge

4. Fluctuations in the pace of expansion of real GDP is denoted the business

cycle, periodic but irregular increases and decreases in the total production and
other measures of economic activity. Each cycle is categorized by: trough,
expansion, peak, recession (Figure 21.5).

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 Figure 21.5 The Most Recent U.S. Business Cycle

B. The Standard of Living Across Countries

Real GDP can be used to compare living standards across countries. But two
problems arise in using real GDP to compare living standards:
1. First, the real GDP of one country must be converted into the same currency
unit as the real GDP of the other country.
2. Second, the goods and services in both countries must be valued at the same
prices. Relative prices in countries will differ, so goods and services should be
weighted accordingly. For example, if more prices are lower in China than in
the United States, China’s prices put a lower value on China’s production than
would U.S. prices. If all the goods and services produced in China are valued
using U.S. prices, than a more valid comparison can be made of real GDP in
the two countries. This comparison using the same prices is called purchasing
power parity (PPP) prices (Figure 21.6).

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 Figure 21.6 Two Views of Real GDP in China

C. Limitations of Real GDP

Some of the factors that influence the standard of living are not part of real
GDP. Omitted from GDP are:
1. Household Production: Preparing meals, changing a light bulb and caring for
a child are all examples of household production. The omission of household
production from GDP means that GDP underestimates total production. On
the other hand, as more services, such as childcare, are provided in the
marketplace, the measured growth rate overestimates development of all
economic activity.
2. Underground Economic Activity: If the underground economy is a
reasonably stable proportion of all economic activity, though the level of GDP
will be too low, the growth rate will be accurate.
3. Health and Life Expectancy: Better health and long life are not directly
included in real GDP.
4. Leisure Time: Increases in leisure time lower the economic growth rate, but
we value our leisure time and we are better off with it.
5. Environmental Quality: Pollution does not directly lower the economic
growth rate.
6. Political Freedom and Social Justice: Political freedom and social justice are
not measured by real GDP.

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D. A Broader Indicator of Economic Well-Being:
a). The Human Development Index

Box Figure 1: The Human Development Index

b). Gross National Happiness: The assessment of gross national happiness

(GNH) was designed in an attempt to define an indicator that measures
quality of life or social progress in more holistic and psychological terms
than only the economic indicator of gross domestic product (GDP). There is
no exact quantitative definition of GNH, but elements that contribute to GNH
are subject to quantitative measurement.
c). Genuine Progress Indicator: The genuine progress indicator (GPI) is an
alternative metric system which is an addition to the national system of
accounts that has been suggested to replace, or supplement, gross domestic
product (GDP) as a metric of economic growth. The GPI is used in green
economics, sustainability and more inclusive types of economics commonly
known as "True Cost" economics. GPI is an attempt to measure whether a
country's growth, increased production of goods, and expanding services
have actually resulted in the improvement of the welfare (or well-being) of
the people in the country.
.

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