Principles of Macroeconomics

(ECON 102)

CH.07 : Measuring
Domestic Output &
National Income
 Agenda

Gross Domestic Product (GDP)

Calculating GDP
•• Expenditure approach
•• Income approach

[Link] Flow

GDP Price Index

Shortcomings of GDP
 Gross Domestic Product (GDP)
The primary measure of the economy’s performance as a whole is
its aggregate output. This is most commonly calculated as Gross
Domestic Product, or GDP.

Gross domestic product (GDP) is the total market value of all

final goods and services produced within a given period by factors
of production located within a country.

From this definition we need to take time

to explain exactly what is definition
means:
 A) total market value of all final goods and services
1- GDP is a monetary measure in that everything is valued in dollars.
All goods and services produced must be converted into dollar
values for GDP to work.

2- To avoid multiple counting of goods, GDP includes only the

market value of final goods and ignores intermediate goods.
Final goods and services:- Goods and services produced for final use.
Intermediate goods: are goods either purchased for resale or for further
processing into final goods (We should Exclusion.
GDP could also avoid multiple counting by counting only the value added at each
stage.
When we find GDP count only final goods and services because If we counted
intermediate goods and services or inputs into another good or service will lead
double-counting.
Value added: is the market value of a firm’s output less the value of the inputs that
the firm purchased from others.
 Value Added in the Production of a Gallon of Gasoline
Stage Of Production Value Of Sales Value Added
(1) Oil drilling $ 3.00 $3.00
(2) Refining 3.30 0.30
(3) Shipping 3.60 0.30
(4) Retail sale 4.00 0.40
Total value added $4.00
Total Sales Value $13.90

In calculating GDP:- we can either sum up the value added at each stage
of production (4.00) or we can take the value of final sales (4.00).

Conclusion:
• Avoid multiple counting
• Market value final goods
• Ignore intermediate goods
• Count value added
 Exercise (1)

Sales Value of
Stage of Production Materials or Product Value Added

Firm A, sheep ranch 120 ???

Firm B, wool producer 180 ???
Firm C, coat manufacturer 220 ????
Firm D, clothing wholesaler 270 ????
Firm E, retail clothier 350 ????
Total Sales Value ????
Value Added (total income) ????

1- Calculate the total sales value?

2-Calculate the value added?
 B) Exclusion of Used Goods & Paper Transactions

Nonproduction transactions must be excluded from GDP since

they have nothing to do with the production of final goods.
1- Purely financial transactions: include such items as public transfer
payments like Social Security, private transfer payments (Christmas
gifts), and stock market transactions.
2- Second-hand sales: are ignored in calculating GDP, as GDP is
concerned only with new, or current, production. Old (previous) output
is not counted in current GDP because it was already counted when it
was produced, to avoid double-counting.

Conclusion:
1- Exclude financial transactions:
• Public transfer payments
• Private transfer payments
• Stock market transactions
2- Exclude second-hand sales:
• Sell used car to a friend
Exercise (2)
1-Which of the following is an example of a final good or service?
A. a computer purchased by Federal Express to track shipments
B. wheat a bakery purchases to make bread
C. coffee beans Starbucks purchases to make coffee
D. lumber purchased by a construction company to
used in building houses
 Calculating GDP
The expenditures approach measures GDP as the sum of all of
the money spent in buying the output. The income approach
looks at GDP in terms of the income derived, or created, from
producing goods and services. In theory, either method should
yield equal results. The expenditures and income approaches are
two different ways to look at the same thing.

A) Expenditure approach
• A method of computing
GDP that measures the total
amount spent on all final
goods and services during a
given period.
 There are four main categories of expenditure
1) Personal consumption expenditures (C):consumption is the
largest component of GDP and represents household spending
on the following,
- Durable goods: Goods that last a relatively long time, such
as cars .
- Nondurable goods: Goods that are used up fairly quickly
such as food & gasoline
- Services : The things we buy that do not involve the
production of physical things such as legal and medical
services and education.
2) Gross private domestic investment (Ig):is total investment
in capital that is the purchase of plants, equipment, inventory,
and new residential structures by the business sector. And
include,
- Nonresidential investment: Expenditures by firms for
machines, tools, plants, and so on.
- Residential investment: Expenditures by households and
firms on new houses and apartment buildings.
- Change in business inventories: The amount by which
firms’ inventories change during a period.
 Inventories: are the goods that firms
produce now but intend to sell later.
Depreciation :-The amount by which
an asset’s value falls in a given period.
Gross investment:- The total value of
all newly produced capital goods (plant,
equipment, housing, and inventory)
produced in a given period.
net investment:- Gross investment
minus depreciation.
3) Government purchases or government consumption
expenditures and gross investment (G) :-
• It includes expenditures for goods and services that the
government uses in providing public services.
• It includes expenditures for publicly owned capital such as
for schools or roads.
• It excludes government transfer payments such as Social
Security because they simply transfer government receipts
to certain households and does not generate any sort of
production.

4) Net exports (Xn): net spending by the rest of the world, or

exports (X) minus imports (M);
• Xn= exports (X) - imports (M)
GDP = C + Ig + G + Xn
 Exercise (3)

Durable goods 1,218.8

Nondurable goods 2,563.0
Services 7,337.7
Nonresidential 1,616.6
Residential 382.4
Change in business inventories 60.6
Expenditures by federal 1,214.2
Expenditures by State and local governments 1,849.4
Exports 2,179.7
Imports 2,746.3

Calculate (GDP) ??
 The Answer
Personal consumption expenditures (C) 11,119.5
Durable goods 1,218.8
Nondurable goods 2,563.0
Services 7,337.7
Gross private domestic investment (l) 2,059.5
Nonresidential 1,616.6
Residential 382.4
Change in business inventories 60.6
Government consumption 3,063.6
and gross investment (G)
Federal 1,214.2
State and local 1,849.4
Net exports (EX – IM) −566.7
Exports (EX) 2,179.7
Imports (IM) 2,746.3
Gross domestic product 15,676.0
 Exercise (4)
Personal consumption expenditures SAR 12,272
Gross private domestic investment SAR 3,021
Government purchases SAR 3,183
Exports SAR 2,169
Imports SAR 2,698

Calculate (GDP) ??
 The Answer

Calculate (GDP) ??

[Link]
 Calculating GDP .. Cont.
B) Income approach
1
This approach allocates
expenditures as income to those National income (NI) =
responsible for producing the • employee compensation
output. ✔ wages and salaries
✔ supplements like benefits
Step 01: National income (NI) • rents
The major component is national • interest
income, which is made up of • proprietor’s income
employee compensation, rents, • corporate profits
interest, proprietor’s income, ✔ Corporate income taxes
corporate profits, and taxes on ✔ Dividends
production and imports. ✔ Undistributed profits
• taxes on production and imports.
[Link]
❑ Notes:

• The largest share is employee compensation which includes wages and

salaries paid by both businesses and government as well as supplements
such as benefits paid by employers on behalf of employees.

• Under the income approach, all expenditures on final goods and services
flow as income to either private citizens or the government. To move
from national income to GDP, several adjustments must be made.

Step 02: from National income (NI) to Net domestic product (NDP)
• The first adjustment is for net foreign factor income. This is income
Americans gain from supplying resources abroad, which would be taken
out, and then income that foreigners gain from supplying resources to the
U.S. would be added.
• The next adjustment comes from what is called a statistical
discrepancy, which basically is just a balancing amount.
 2
Net domestic product (NDP) =
National income (NI) - Net foreign factor income + Statistical discrepancy

National income (NI) = NDP + Net foreign factor income - Statistical discrepancy
 Second 03: from NDP to Gross domestic product (GDP)
The final adjustment factor is the useful life of private capital equipment
that extends well beyond the year in which they were produced. The cost
of the equipment must be allocated over its useful life.

3
Gross domestic product (GDP) =
National income (NI) - Net foreign factor income + Statistical discrepancy
+ consumption of fixed capital

Gross domestic product (GDP) =

Net domestic product (NDP) + consumption of fixed capital

Net domestic product (NDP) =

Gross domestic product (GDP) - consumption of fixed capital
 Exercise (5)
employee compensation 9655
rents 657
interest 524
proprietor’s income 1388
corporate profits 2009
taxes on production and imports 1302
Net foreign factor income 214
consumption of fixed capital 2821
Statistical discrepancy -195

Calculate:
1. National income (NI)
2. Net domestic product (NDP)
3. Gross domestic product (GDP)
 The answer
1- National income (NI) =
employee compensation + rents + interest + proprietor’s income + corporate
profits + taxes on production and imports.

National income (NI) = 9,655+ 657 + 524 + 1,388+ 2,009+ 1,302

National income (NI) = $15,535

2- Net domestic product (NDP) =

National income (NI) - Net foreign factor income + Statistical discrepancy

Net domestic product (NDP) = 15,535- 214+ (-195)

Net domestic product (NDP) = $15,126
 The answer
3- Gross domestic product (GDP) =
Net domestic product (NDP) + consumption of fixed capital

Gross domestic product (GDP) = 15,126 + 2821

Gross domestic product (GDP) = $17,947
Difference between Personal Income (PI) and Disposable Income (DI)?
Personal income includes all income received, regardless of whether it is
earned or unearned, while disposable income is personal income less
personal taxes.

4
Personal Income (PI) =
National income (NI) – (taxes on production and imports + Social security
contributions + Corporate income taxes + Undistributed profits) + Transfer
payments

5
Disposable Income (DI) = Personal Income (PI) - personal taxes

Personal Income (PI) = Disposable Income (DI) + personal taxes

 Exercise (6)
National income 15,535
taxes on production and imports 1,177
Social security contributions 1,203
Corporate income taxes 530
Undistributed profits 591
Transfer payments 3,306
personal taxes 1,945

Calculate:
1. Personal Income (PI)
2. Disposable Income (DI)
 The answer
1- Personal Income (PI) =
National income (NI) – (taxes on production and imports + Social security
contributions + Corporate income taxes + Undistributed profits) + Transfer
payments

Personal Income (PI) = 15,535 – (1,177 + 1,203 + 530 + 591) + (3,306)

Personal Income (PI) = $15,340

2- Disposable Income (DI) = Personal Income (PI) - personal taxes

Disposable Income (DI) = 15,340 – 1,954

Disposable Income (DI) = $13,395
Exercise (7)

Calculate:
1- GDP
2- NI
3-NDP
 (The Answer)

1. GDP (Gross Domestic Product) can be calculated using the

expenditure approach:

GDP = C+I+G+ (X - M)
C = Household Consumption = $304 billion
I = Gross Private Investment = $124 billion
G = Government Purchases = $156 billion
X - M = Net Exports = $18 billion

• Plugging in the values:

GDP = 304 + 124 + 156 + 18 = $602 billion
 (The Answer)

National income (NI) = employee compensation + rents + interest +

Business profits (proprietor’s income + corporate profits) + taxes on
production and imports.

National Income (NI):

• Employees' Compensation = $67 billion
• Rental Income = $75 billion
• Interest Income = $150 billion
• Business Profits = $200 billion
• Indirect Business Taxes = $86 billion

Plugging in the values:

NI = 67 + 75 + 150 + 200 + 86= $578
 (The Answer)
Net domestic product (NDP) =
National income (NI) - Net foreign factor income + Statistical discrepancy

Net domestic product (NDP):

• National income = $578 billion
• Net foreign factor income = $12 billion

Plugging in the values:

NDP = 578 - 12= $566

Gross domestic product (GDP) =

Net domestic product + consumption of fixed capital (depreciation)

Gross domestic product (GDP) = 566+ 36 = $602 billion

3- Circular Flow
 4- GDP Price Index
• GDP measures production at current dollar values which
creates problems because the value of a dollar changes over
time. One hundred years ago, the purchasing power of one
dollar was much different than it is today. To get around
that problem, there are two different GDPs.

• Nominal GDP is based upon the prices that were in effect

when the output was produced. A GDP that has been
deflated or inflated to reflect changes in price levels is
referred to as real GDP.

• In order to calculate real GDP, a base year must be selected

and then the current year’s prices adjusted accordingly.
 GDP Price Index .. Cont.

❑ Nominal GDP is the dollar value of final goods and services

evaluated at current-year prices (Uses current prices).

❑ (Real GDP) is the value of final goods and services evaluated at

base-year prices (corrects for price changes).

❑ The difference between nominal GDP and real GDP comes from
Changes in prices (inflation).

❑ Use price index to determine real GDP.

 GDP Price Index

Price Price of Market Basket

Index in Specific Year
In Given
= Price of Same Basket × 100
Year in Base Year

We use a price index that is equal to the price of a collection of goods and
services in the specific year divided by the price for the same goods and
services in a base year multiplied by 100.

Real Nominal GDP

GDP =
Price Index (in hundredths)

Nominal GDP is then divided by the price index (in hundredths) to determine
real GDP.
 Exercise (8)
Calculating Real GDP (Base Year = Year 1)
(2)
(1) Price of (3) (4) Unadjusted, or (5)
Units of Pizza Price Index Nominal, GDP Adjusted, or Real,
Year Output Per Unit (Year 1 = 100) (1) × (2) GDP
1 5 $10

2 7 20

3 8 25

4 10 30

5 11 28

In this table, nominal GDP and real GDP are calculated based upon the formula.
Years 1 to 3 have been calculated. Complete the table for years 4 and 5.
 Exercise (9)

• This table shows some of the relationships between nominal GDP, real
GDP and the GDP price index over the past decade. Here the base year is
2009 (note that is the year where the index is 100).
• To test your understanding of the relationships, determine the value
of the price index for 1995 and real GDP for 2005 and 2009.
 5- Shortcomings of GDP
❑ While GDP is a reasonably accurate and highly useful
measure of how the economy is performing, it does have
several shortcomings:
1. Nonmarket and domestic activities:- such as housework
and childcare, are not counted in GDP even though they
amount to real production.
2. The value of leisure time, weekends, holidays, etc., is
also not included, but they certainly add value due to the
added satisfaction they provide to workers.
3. Improved product quality: GDP fails to capture the full
value of improvements in product quality. Let’s face it, a
$200 cell phone purchased today is of very different
quality than a cell phone that cost $200 just a decade ago.
 Shortcomings of GDP .. Cont.
4. The underground economy: there is also a huge
underground economy, mainly comprised of illegal activities,
that produces income that is not measured through traditional
GDP methods. Included in this underground economy are
legal activities that provide income that the recipients refuse
to report to the I.R.S. and pay taxes on.

5. Environmental issues and noneconomic sources of

well-being are also problematic in that GDP does not really
have a way to accurately value and report the issues.

5-GDP also has nothing to say about the distribution of

output among individuals in a society.
Gross Output:
Gross output (GO) is a statistic that sums together the dollar
value of the economic activity that takes place at each stage
into which all economic activity can be grouped.

In 2015, GO was $31.5 trillion while GDP was $17.9 trillion.

GO is particularly useful when attempting to gauge the
magnitude of business cycle fluctuations.

During the 2007-2009 recession, real GDP fell 4.2%, while

real GO fell 8.6%. That means total economic activity fell by
more than twice as much as final output which helps to
explain why employment fell so dramatically during and after
the Great Recession.