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Chapter 2
The Measurement and
Structure of the National
Economy

Outline
– Section 2.1: Differentiate among the three approaches to
national income accounting

– Section 2.2: Explain how GDP is measured

– Section 2.3: Measurement of aggregate saving and its

relation to wealth

– Section 2.4: Calculation of real GDP, price indexes, and

inflation

– Section 2.5: Define real and nominal interest rates

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Section 2.1: National Income Accounting

• National Income Accounts: an accounting framework used in measuring
current economic activity
• Three alternative approaches to measuring economic activity
– Product approach: amount of output produced (evaluated at the market
value).
– Income approach: incomes received by producers of output.
– Expenditure approach: amount of spending by purchasers of output.
• Three approaches give the same measurement of economic activity.
– Why?
• Any output produced (product approach) is purchased by someone
(expenditure approach) and results in income to someone (income
approach).
• The fundamental identity of national income accounting:
Total Production= Total Income= Total Expenditure

Section 2.2: Gross Domestic Product

• Gross Domestic Product (GDP) is the broadest measure
of economic activity.

• How is GDP measured?

1. Product Approach
2. Income Approach
3. Expenditure Approach

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Gross Domestic Product

1) PRODUCT (VALUE ADDED) APPROACH

• GDP is the market value of final goods and services newly

produced within a nation during a fixed period of time.

• Market value is the prices at which goods and services are sold.
– Allows adding together different types of products & services
by valuing them at their market prices.
• Ex: An economy that produces 20 trains and 30 ipads. Each
train sells at $150,000 and each ipad sells at $699.
• Total output : 50 versus (150,000*20) + (699*30)=
$3,020,970
• Value Added: The value of output minus the value of the
intermediate goods used to produce that output (output bought
from other producers)

Gross Domestic Product

1) PRODUCT APPROACH Continued
– Problem: ignores items that are not sold in formal markets such
as:
a) home and child care performed within the family without
pay
b) the value of environmental quality (clean air and water)
c) natural resource depletion
d) underground economy
• there is some adjustment to reflect the underground
economy.
e) government services (that aren’t sold in markets) such as
national defense and public education
• valued at their cost of production.

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Gross Domestic Product

1) PRODUCT APPROACH Continued
• Newly produced:
– Counts only things produced in the given period; excludes
things produced earlier.
• Final goods and services (End products of a process)
– Don’t count intermediate goods and services.
• those used up in the production of other goods and
services in the same period that they themselves were
produced
– Considered as final goods and included in GDP
• Capital goods (factories, office buildings, equipment,
software) are final goods since they aren’t used up in the
same period that they are produced
• Inventory investment (increase in inventories of unsold
finished goods, goods in process, and raw materials)
• Valued at cost of production

Gross Domestic Product

1) PRODUCT APPROACH Continued
• GNP vs. GDP
• GNP (gross national product) = output produced by domestically
owned factors of production
• Ex: output that is produced by U.S. employees in other
countries and in U.S.
• GDP = output produced within a nation
• Ex: production within U.S. by either U.S employees or foreign
employees.

• GDP = GNP – NFP

• NFP = net factor payments from abroad
= payments to domestically owned factors located
abroad minus payments to foreign factors located
domestically
• Example: Engineering revenues for a road built
by a U.S. company in Saudi Arabia is part of U.S. GNP (built by a U.S.
factor of production), not U.S. GDP, and is part of Saudi GDP (built in
Saudi Arabia), not Saudi GNP

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Gross Domestic Product

2) EXPENDITURE APPROACH

• GDP measures total spending on final goods and

services produced within a nation during a specified
period of time.

• Y = C + I + G + NX (the income-expenditure identity)

– Y = GDP = total income = total expenditure
– consumption (C),
– investment (I),
– government purchases of goods and services (G),
– net exports (NX)

Gross Domestic Product

2) EXPENDITURE APPROACH Continued
• Consumption: spending by domestic households on final goods and
services (including those produced abroad)
– Consumer durables (cars, TV sets, furniture, major appliances)
– Nondurable goods (food, clothing, fuel)
– Services (education, health care, financial services, transportation)

• Investment: spending for new capital goods (fixed investment) plus

inventory investment (including spending on foreign-produced goods)
– Business (or nonresidential) fixed investment: spending by
businesses on structures (factories, office building), equipment
(computers, machines), and intellectual property products
(software, research and development, or artistic originals)
– Residential fixed investment: spending on the construction of
houses and apartment buildings
– Inventory investment: increases in firms’ inventory holdings

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Gross Domestic Product

2) EXPENDITURE APPROACH Continued
• Government purchases of goods and services: spending by the
government on goods or services; foreign or domestic such as;
– Employee salaries,
– Government investment on capital goods such as highways,
airports, bridges, and water and sewer systems

– Not all government expenditures are for purchases of goods and

services;
• These are not included in GDP
• Transfers such as Social Security payments, Medicare benefits,
unemployment benefits.
• Interest payments on the government debts such as bonds.

• Net exports: exports minus imports

– Imports are subtracted from GDP, as they represent goods
produced abroad, and were included in consumption, investment,
and government purchases

Gross Domestic Product

3) INCOME APPROACH
• GDP= income generated by production (including profits and taxes paid to the
government)
• National Income =
+ Employee Compensation: Wages and benefits
+ Proprietor’s Income: Income of the self-employed
+ Individual Rental Income: Rent earned from land or building
+ Corporate Profits: Corporate Revenue - (wages + interest + rents + other costs)
+ Net Interest: Interest earned - Interest paid by individuals
+ Taxes on production and imports: Sales taxes, customs duties,…
+ Business current transfer payments: donations, insurance payments,…
+ Current surplus of government enterprises: profits of businesses owned by the
government such as water, electricity, trash companies, mass transit firms
• Net National Product= National income + statistical discrepancy
• Gross National product (GNP)= Net national product + depreciation (the value of
capital that wears out in the period)
• GDP= GNP – net factor payments (NFP)

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Gross Domestic Product

3) INCOME APPROACH Continued
• Private disposable income = Y (or GDP) + NFP + payments
to the private sector from the government sector (transfers
(TR) and interest earned on government debt (INT)) –
taxes paid to government (T)
= Y (or GDP)+ NFP + TR + INT – T

• Government’s net income

= T – TR – INT
• Private disposable income + government’s net income
= GDP + NFP = GNP

GNP vs. GDP in select countries, 2007

GNP – GDP
Country GNP GDP
(% of GDP)
Philippines $157,087 $144,062 9.0%
Japan $4,530,191 $4,384,255 3.3%
China $3,229,841 $3,205,507 0.8%
United States $13,827,201 $13,751,400 0.6%
Canada $1,318,304 $1,329,885 –0.9%
South Africa $274,141 $283,007 –3.1%
New Zealand $125,936 $135,667 –7.2%
Peru $98,625 $107,297 –8.1%
GNP and GDP in millions of current U.S. dollars
Source: World Development Indicators, World Bank.

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Question 1
ABC computer company has a $20 million factory in Silicon Valley. During
the current year, ABC builds $2 million worth of computer components.
ABC’s costs are $1 million for labor, $100,000 for interest on debt, and
$200,000 for taxes.

ABC sells all its output to XYZ Supercomputer. Using ABC’s components, XYZ
builds 4 supercomputers at a cost of $800,000 each ($500,000 worth of
components, $200,000 in labor cost, and $100,000 in taxes per computer).
XYZ has a $30 million worth of factory.

XYZ sells 3 of the supercomputers for $1million each to businesses. At

year’s end, it had not sold the 4th computer. The unsold computer is carried
on XYZ’s books as an $800,000 increase in inventory.
a) Calculate the GDP using all the three approaches.
b) Repeat part a) but now assume that in addition to its other costs, ABC
paid $500,000 for imported computer chips.

Solution

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Section 2.3: Saving and Wealth

• National wealth = sum of all households’, firms’, and
governments’ wealth within the nation
• Wealth= assets minus liabilities

• An important determinant of national wealth is saving rate

by individuals, businesses, and government
• Saving rate = saving/current income
• Saving= current income-current spending
– We are interested in “spending” to meet current
needs.
• One dollar increase in national saving increases national
wealth by one dollar.
– Savings is a flow, wealth is a stock

Stocks vs. Flows

A stock is a
quantity measured Flow Stock
at a point in time.
E.g.,
“A person’s wealth is
$600,000 in 2014. ” Wealth
in 2015 is 650,000.

A flow is a quantity measured per unit of time.

E.g., “A person’s annual saving is $50,000 during 2015.”

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Saving and Wealth

• Private saving = private disposable income – consumption
Spvt = (GDP + NFP + TR + INT– T ) – C

• Government saving = net government income – government

purchases of goods and services
Sgovt = (T – TR – INT) – G
• Government budget deficit = Sgovt < 0
• Government budget surplus = Sgovt > 0

• National saving = private saving + government saving

• S = Spvt + Sgovt
S = [Y + NFP + TR + INT –T – C] + [T – TR – INT – G]
S = Y + NFP – C – G
S= GNP – C – G

Saving and Wealth

• The uses of private saving

S = Y + NFP – C – G and Y = C + I + G + NX
S = (C + I + G + NX) + NFP – C – G
S = I + (NX + NFP)
S = I + CA
• Current account balance = CA
CA= pmts received from foreigners- pmts made to
foreigners
CA = NX + NFP

S=Spvt + Sgovt = I + CA
Spvt = I + (- Sgovt ) + CA

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Saving and Wealth

Spvt = I + (- Sgovt ) + CA

The uses-of-saving identity—saving is used in three ways:

• investment (I) : firms borrow from private savers to finance their
investment. (ex: firms sell corporate bonds)
• government budget deficit (Sgovt < 0 ) : when the government runs
budget deficit, it borrows from private savers to pay for their
expenses. (ex: government sells treasury bonds)
• current account balance (CA) : when the CA > 0,
– U.S. receipt of pmts from foreigners > U.S. pmts made to
foreigners.
– So, the foreigners receipt of payments from U.S. are not
sufficient to cover the payments they make to U.S.
– Thus, foreigners borrow from U.S. savers; that is U.S. lends to
foreigners (ex: U.S. savers buy foreign bonds).

Question 2
You are given the following information about an economy:
Gross private domestic investment = 40
Government purchases of goods and services = 30
Gross national product (GNP) = 200
Current account balance = - 20
Taxes = 60
Government transfer payments to the domestic private sector = 25
Interest payments from the government to the domestic private sector = 15
(assume all interest payments by the government go to domestic households)
Factor income received from rest of world = 7
Factor payments made to rest of world = 9

Assuming that government investment is zero, find

a) Consumption
b) National Saving

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Solution

Section 2.4: Real GDP, Price Indexes, and Inflation

• Since GDP is measured in current market values, is an increase in
GDP due to production increasing, or due to prices increasing?
• Nominal GDP—the value of 2009 2015

final goods and services 2009 2009 2015 2015

Product Quantity Price Value Quantity Price Value
evaluated at current-market Eye examinations 80 $40 $3,200 100 $50 $5,000
prices Pizzas 90 11 $990 80 10 $800
Textbooks 15 90 $1,350 20 100 $2,000
• Real GDP—the value of final Nominal GDP $5,540 $7,800
goods and services evaluated
at base-year prices 2009 2015

2009 2009 2015 2009

– Real GDP measures Product Quantity Price Value Quantity Price Value
physical quantity of Eye examinations 80 $40 $3,200 100 $40 $4,000

production. Pizzas 90 11 $990 80 11 $880

Textbooks 15 90 $1,350 20 90 $1,800
– Hold prices constant from Real GDP $5,540 $6,680
the base year Real 2015 GDP in 2009 dollar values 24
$6,680

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Real GDP
• 2009 as the base year, the growth in output is 20.58%
• 2015 as the base year, the growth in output is 21.88%
• Growth of output differs depending on which year is used as the base
year.
2009 2015
2009 2009 2015 2009
Product Quantity Price Value Quantity Price Value
Eye Examinations 80 $40 $3,200 100 $40 $4,000
Pizza 90 11 $990 80 11 $880
Textbooks 15 90 $1,350 20 90 $1,800
Real GDP $5,540 $6,680
% growth of real GDP (6,680-5,540)/5,540 = 20.58%

2009 2015
2009 2015 2015 2015
Product Quantity Price Value Quantity Price Value
Eye Examinations 80 $50 $4,000 100 $50 $5,000
Pizza 90 10 $900 80 10 $800
Textbooks 15 100 $1,500 20 100 $2,000
Real GDP $6,400 $7,800
% growth of real GDP (7,800-6,400)/6,400 = 21.88%

U.S. Nominal and Real GDP, 1990-2012

• Why is real GDP greater than nominal GDP until 2009?
• Why do real GDP and nominal GDP intersect at 2009?

Source: [Link] Nominal GDP and real GDP: 1990-2012

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Price Index

• Economists and policy-makers are interested in the price

levels: a measure of the average prices of goods and services
in the economy.
• Why? Stable prices are desirable because they allow
households and firms to plan for the future appropriately.
• Price levels are measured by price index such as GDP
Deflator or Consumer Price Index (CPI).
– GDP Deflator measures the overall price level of goods &
services included in GDP.
– CPI measures the price level of a basket of consumer
goods & services.

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• Since nominal and real GDP will be the same in the base year,
the GDP deflator will be 100 in the base year.
GDP Deflator and Inflation

Nominal GDP in period t

GDP deflator in period t  100
Real GDP in period t

• Since nominal and real GDP will be the same in the base year,
the GDP deflator will be 100 in the base year.
• Inflation rate : Percentage increase in the price level from one
year to the next.
− Percentage Change in GDP Deflator

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Inflation Rate in the U.S.

• Inflation is measured as the annual percentage change in the GDP Deflator.
• Inflation rose quite highly during the 1960s and 1970s.
• Inflation declined from 2005 to 2009 and from 2012 to 2014.
Figure 1: Inflation rate in the U.S. (1960-2014)

Source: Implicit price deflator for GDP, U.S. Bureau of Economic Analysis, downloaded from FRED
database, Federal Reserve Bank of St. Louis, [Link]/fred2/series/GDPCTPI

Question 3

Oranges Price of Shirts Price of

Year
Produced Oranges Produced Shirts

2009 1,800 $0.90 110 $35

2010 2,000 $1.2 112 $37
2011 2,200 $1.4 115 $39

Consider the data shown above for Vicuna, a country that

produces only two products: oranges and shirts. Using 2009
as the base year, calculate the price level change (inflation)
from 2010 to 2011.

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Solution

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CPI and Inflation

To calculate the CPI in a given year, we need:
• A basket of goods
• The cost to purchase the basket of goods in a base year
• The prices in the current year

Expenditures for consumer basket in the current year

CPI  100
Expenditures for consumer basket in the base year

• CPI index is used to adjust wages, and government benefits such as

social security benefits for inflation.
• Inflation rate: Percentage increase in the price level from one year to
the next.
− Percentage Change in Consumer Price Index (CPI)
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Consumer Price Index

• The Bureau of Labor Statistics creates a basket of goods in eight
categories. About 75% of the basket is housing, food, and transportation.

The CPI market basket, December 2012

Measuring Inflation
Computing CPI and Inflation Rate
Base Year (1999) 2014 2015
Expenditures Expenditures
(on base-year (on base-year
Product Quantity Price Expenditures Price quantities) Price quantities)
Eye
examinations 1 $50.00 $50.00 $100.00 $100.00 $85.00 $85.00

Pizzas 20 10.00 200.00 15.00 300.00 14.00 280.00

Books 20 25.00 500.00 25.00 500.00 27.50 550.00

TOTAL $750.00 $900.00 $915.00

Formula Applied to 2014 Applied to 2015

Expenditures in the current year  $900   $915 

CPI = 100   100  120    100  122
Expenditures in the base year  $750   $750 

 122  120 
Inflation rate:   100  1.7%
 120  34

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Nominal Interest Rate versus Real Interest Rate

You loan $1,000

If the interest rate is 6%, the loan will be paid back in a year as
=(1,000)+(1,000*0.06)=$1,060.

• Interest rate: a rate of return promised by a borrower to a lender

• This 6% is the nominal interest rate: the stated interest rate on a loan.
• Nominal interest rate: rate at which the nominal value of an asset
increases over time

• If there is no inflation with $1,060 you can purchase 6% more goods than
you did with your initial $1,000. The return on your asset is 6%.
• If inflation is 6%, the goods that cost you $1,000 will now cost you
$1,060. Thus, your $1,060 is not worth more money than $1,000. The
return on your asset is 0%.

• We can adjust for inflation by calculating the real interest rate.

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Nominal Interest Rate versus Real Interest Rate

• Real interest rate: rate at which the real value of an asset increases over
time.
Real Interest Rate  Nominal Interest Rate (i) - Inflation Rate ()

• If prices rise by 2% from this year to next, then your real interest rate on
the loan is only 4%. This more accurately reflects the cost of borrowing
and lending money.

• Borrowing and lending decisions are made on the expected real interest
rates.
• Actual inflation rate is not known until the year is over.
Expected Real Interest Rate  Nominal Interest Rate (i) - Expected Inflation Rate ( e )

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Question 4
Hy Marks buys a one-year government bond on January 1,
2015 for $500. He receives principal plus interest totaling
$545 on January 1, 2016. Suppose that the CPI is 200 on
January 1, 2015 and 214 on January 1, 2016. This increase in
prices is more than Hy had anticipated; his guess was that the
CPI would be 210 at the beginning of 2016.

• Find the: Nominal interest rate, inflation rate, real interest

rate, Hy’s expected inflation rate, and Hy’s expected real
interest rate.

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Solution

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