LECTURE NOTES CHAPTER 7

I. Learning objectives – After reading this chapter, students should be able to:
1. Explain how gross domestic product (GDP) is defined and measured.
2. Describe how expenditures on goods and services can be summed to determine GDP.
3 Explain how GDP can be determined by summing up all of the incomes that were derived
from producing the economy's output of goods and services.
4. Discuss the nature and function of a GDP price index, and describe the difference between
nominal GDP and real GDP
5. List and explain the shortcomings of GDP as a measure of domestic output and wellbeing.
II. 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.

III. 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. (See Table 7.1.)
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.
(Table 7.2 illustrates how including sales of intermediate goods would overstate GDP.)
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.
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 7-3)
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 Versus 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).
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
E. Income Approach to GDP (See Table 7.3): Demonstrates how the expenditures on final
products are allocated to resource suppliers as income.
1. Compensation of employees includes wages, salaries, fringe benefits, salary and
supplements, and payments made on behalf of workers like social security and other
health and pension plans.
 2. Rents: payments for supplying property resources (adjusted for depreciation it is net
rent).
3. Interest: payments from private business to suppliers of money capital.
4. Proprietors’ income: income of incorporated businesses, sole proprietorships,
partnerships, and cooperatives.
5. Corporate profits: After corporate income taxes are paid to government, dividends are
distributed to the shareholders, and the remainder is left as undistributed corporate
profits (also referred to as retained earnings).
6. Taxes on production and imports: general sales taxes, excise taxes, business property
taxes, license fees, and customs duties.
7. The sum of the above entries equals national income: all income earned by Canadian
supplied resources, whether here or abroad, plus taxes on production and imports.
F. Personal income (PI) is income received by households.
G. Disposable income (DI) is personal income less personal taxes.

IV. 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 (PxQ) 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 7-6). 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.
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).
C. Real World Considerations and Data
1. The actual GDP price index in the Canada is called the chain-type annual-weights price
index, and is more complex than can be illustrated here.
2. Once nominal GDP and the GDP price index are established, the relationship between
them and real GDP is clear (see Table 7.5).
 3. The base year price index is always 100, since Nominal GDP and Real GDP use the same
prices. Because the long-term trend has been for prices to rise, adjusting Nominal GDP
to Real GDP involves inflating the lower prices before the base year and deflating the
higher prices after the base year.
4. Real GDP values allow more direct comparison of physical output from one year to the
next, because a “constant dollar” measuring device has been used. (The purchasing
power of the dollar has been standardized at the base year level -- currently 2007)

V. Shortcomings of GDP
A. GDP doesn’t measure some very useful output because it is unpaid (homemakers’ services,
parental child care, volunteer efforts, and 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.
VI. The LAST WORD: Value Added and GDP
A. GDP is compiled by Statistics Canada . There are three ways to compile GDP.
1. The expenditure approach, which tallies earnings that are generated by productive activity,
2. The Income approach, which tallies earnings that are generated by productive activity.
3. The value added approach., which sums the value added (output less intermediate
consumption of goods and services) of all industries in Canada.