CHAPTER

2
MEASURING NATIONAL INCOME AND
OUTPUT
 LEARNING OUTCOMES

At the end of this chapter, you should be able to:

 Describe the circular flow of income in two-, three- and four-
sector economies
 Identify the concepts of measuring national income
 Measure national income by using the three approaches
 Distinguish between personal income and disposable income
 Distinguish between nominal income, real income, per capita
income, and growth rate
 Describe the uses of national income statistics
 Elaborate on the problems in measuring national income

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 COMPONENTS OF
MACROECONOMICS

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 CIRCULAR FLOW OF INCOME

 Circular flow of income is an economic model

depicting how money flows through the economy.
 It describes the movement of factors of production and
factors of payment.

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 CIRCULAR FLOW OF INCOME (cont.)

 The flow of factors of production from households to firm and the

flow of goods and services from firms to household are matched
by equivalent flows of money—firms paying income to households
(Y) and households paying the firms for consuming the goods and
services (C).
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 CIRCULAR FLOW OF INCOME (cont.)

 The government collects taxes from households and firms.

The government also makes payments. It buys goods and
services from firms, pays wages and interest to households,
and makes transfer payments to households.
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 CIRCULAR FLOW OF INCOME (cont.)

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 METHODS OF MEASURING INCOME

 The accurate meaning of national income is commonly

referred to as the concepts of gross domestic product
(GDP).
 GDP is the total market value of all final goods and
services produced within a given period of time by
factors of production located within a country.
 The GDP can be computed in three ways:
(i) Income approach
(ii) Expenditure approach
(iii) Product or Output approach
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 CONCEPTS OF NATIONAL INCOME

 Gross Domestic Product (GDP)

The total market value of all final goods and services produced within a
given period of time by factors of production located within a country
 Gross National Product (GNP)
The total market value of final goods and services produced by the
residents of a country during a given period of time

GNP = GDP + Net Factor Income from Abroad

Net Factor Income from Abroad: the difference between the income
received from abroad and the income paid abroad

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 CONCEPTS OF NATIONAL INCOME

 Net National Product (NNP)

The value of national income which is adjusted by the value of depreciation
NNP = GNP – Depreciation
 Market Price: the current price in the market through the forces of
demand and supply
 Factor Price: the price of output that is valued based on the cost of
factors of production
 Personal Income (PI)
The real income earned by households before they pay personal income
taxes.
 Disposable Personal Income (DPI)
The value of personal income minus income tax.

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 METHODS OF MEASURING INCOME
(cont.)

 Since the income approach, expenditure approach

and product approach are the three methods of
measuring the same thing, they must thus be
identical.
 This can be expressed as accounting identity:

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 Gross Domestic Product:
Expenditure and Income

Two definitions:
– Total expenditure on domestically-produced
final goods and services.
– Total income earned by domestically-located
factors of production.

Expenditure equals income because

every dollar spent by a buyer
becomes income to the seller.

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 METHODS OF MEASURING INCOME
(cont.)

Income Approach
The income approach measures national income by
looking at the GDP from the sum of incomes received from
the output production.

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 METHODS OF MEASURING INCOME
(cont.)

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 METHODS OF MEASURING INCOME
(cont.)

Expenditure Approach
Expenditure approach measures national income by looking
at the GDP from the perspective of total spending on the final
goods and services.

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 METHODS OF MEASURING INCOME
(cont.)

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 METHODS OF MEASURING INCOME
(cont.)

Output Approach
Under Output or Product or Value Added Approach, national
income is measured by adding up the net value of all the
goods and services produced in the country, sector by sector
during a year.

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 METHODS OF MEASURING
INCOME (cont.)

 Value added:
The value of output minus
the value of the intermediate goods
used to produce that output

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 NOW YOU TRY:
Identifying value-added

 A farmer grows a bushel of wheat

and sells it to a miller for $1.00.
 The miller turns the wheat into flour
and sells it to a baker for $3.00.
 The baker uses the flour to make a loaf of
bread and sells it to an engineer for $6.00.
 The engineer eats the bread.
Compute value added at each stage
of production and GDP

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 Final goods, value added,
and GDP

 GDP = value of final goods produced

= sum of value added at all stages
of production.
 The value of the final goods already includes
the value of the intermediate goods,
so including intermediate and final goods in
GDP would be double-counting.

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 The expenditure components
of GDP
 consumption, C
 investment, I
 government spending, G
 net exports, NX
An important identity:

value of total aggregate

output expenditure
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 Consumption (C)

– durable goods
.

Definition: The value of all

last a long time
goods and services bought e.g., cars, home
by households. Includes: appliances
– nondurable goods
last a short time
e.g., food, clothing
– services
work done for
consumers
e.g., dry cleaning,
air travel
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 U.S. consumption, 2008

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 Investment (I)

 Spending on goods bought for future use

(i.e., capital goods)
 Includes:
– Business fixed investment
Spending on plant and equipment
– Residential fixed investment
Spending by consumers and landlords on housing units
– Inventory investment
The change in the value of all firms’ inventories

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 Investment vs. Capital

 Note: Investment is spending on new capital.

 Example (assumes no depreciation):
– 1/1/2009:
economy has $500b worth of capital
– during 2009:
investment = $60b
– 1/1/2010:
economy will have $560b worth of capital

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 Government spending (G)

 G includes all government spending on goods

and services.
 G excludes transfer payments
(e.g., unemployment insurance payments),
because they do not represent spending on
goods and services.

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 U.S. Government Spending,
2008

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 NOW YOU TRY:
An expenditure-output puzzle?

Suppose a firm:
 produces $10 million worth of final goods
 only sells $9 million worth

Does this violate the

expenditure = output identity?

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 Why output = expenditure

 Unsold output goes into inventory,

and is counted as “inventory investment”…
…whether or not the inventory buildup was
intentional.
 In effect, we are assuming that
firms purchase their unsold output.

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 GDP:
An important and versatile
concept

We have now seen that GDP measures:

– total income
– total output
– total expenditure
– the sum of value-added at all stages
in the production of final goods

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 GNP vs. GDP

 Gross National Product (GNP): Total income earned by the

nation’s factors of production, regardless of where located
 Gross Domestic Product (GDP): Total income earned by
domestically-located factors of production, regardless of
nationality
GNP – GDP = factor payments from abroad
minus factor payments to abroad
 Examples of factor payments: wages, profits, rent, interest
& dividends on assets

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 NOW YOU TRY:
Discussion Question

In your country,
which would you
want to be bigger,
GDP or GNP?

Why?

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 GNP vs. GDP in select
countries, 2007

 GNP and GDP in millions of current U.S. dollars

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 Other Measures of Income

 National Income = GNP - Depreciation

 National Income = Compensation of Employees
+ Proprietors’ Income + Rental Income +
Corporate Profits + Net Interest + Indirect
Business Taxes

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 Other Measures of Income
(cont.)

 Disposable Personal Income = Personal

Income - Personal Tax and Nontax Payments
 Disposable Personal Income is what
households and noncorporate businesses have
to spend (or save).

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 Real vs. nominal GDP

 GDP is the value of all final goods and services

produced.
 nominal GDP measures these values using
current prices.
 real GDP measure these values using constant
prices.

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 Real GDP controls for
inflation

 Changes in nominal GDP can be due to:

– changes in prices.
– changes in quantities of output produced.
 Changes in real GDP can only be due to
changes in quantities,
**One way to construct real GDP is by using
constant base-year prices.

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 NOMINAL INCOME VS REAL
INCOME

Nominal Income/GDP Real Income/GDP

 Nominal income is the  Real income refers to the
national income that is national income that is
measured in the current measured at a constant
price or in a base year.
price level.  By comparing the value
 Any change in nominal of production in the two
income reflects the years at the same prices,
combined effects of the changes in real
income reflects only the
change in quantity and changes in real output.
change in price level.

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 NOMINAL INCOME VS REAL
INCOME (cont.)

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 NOMINAL INCOME VS REAL
INCOME (cont.)

Per Capita Income

GDP per capita is often used as an indicator of living
standards.
Per capita income refers to average income per head of
population.

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 NOMINAL INCOME VS REAL
INCOME (cont.)

Growth Rate
Growth rate is the percentage change in quantity of
goods and services produced from one to another.

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 Real vs. nominal GDP

n
GDPt =  Pit Qit
i1
n
RGDPt =  PiBQit
i1
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 NOW YOU TRY:
Real & Nominal GDP

 Compute nominal GDP in each year.

 Compute real GDP in each year using 2006 as
the base year.
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 NOW YOU TRY:
Answers

nominal GDP multiply Ps & Qs from same year

2006: $46,200 = $30  900 + $100  192
2007: $51,400
2008: $58,300

real GDP multiply each year’s Qs by 2006 Ps

2006: $46,200
2007: $50,000
2008: $52,000 = $30  1050 + $100  205

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 GDP Deflator

 Inflation rate: the percentage increase in the

overall level of prices
 One measure of the price level: GDP deflator
Definition:

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 NOW YOU TRY:
GDP deflator and inflation rate

 Use your previous answers to compute

the GDP deflator in each year.
 Use GDP deflator to compute the inflation rate from
2006 to 2007, and from 2007 to 2008.
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 NOW YOU TRY:
Answers

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 Measuring Economic Growth

A problem arises when using fixed base-year

weights: Growth will vary depending on base
year chosen.
Rapidly growing sectors with declining relative
prices will be weighted “too much” as base
year becomes further and further in the past.
Opposite for slowly growing sectors.

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 Chain-Weighted Real GDP

 Over time, relative prices change, so the base

year should be updated periodically--which BEA
used to do.
 In essence, chain-weighted real GDP
updates the base year every years,
so it is more accurate than fixed base-year GDP.

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 Consumer Price Index (CPI)

 A measure of the overall level of prices

 Uses:
– tracks changes in the typical household’s
cost of living
– adjusts many contracts for inflation
– allows comparisons of dollar amounts over time

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 How we construct the CPI

1. Survey consumers to determine composition of

the typical consumer’s “basket” of goods
2. Every month, collect data on prices of all items
in the basket; compute cost of basket
3. CPI in any month equals

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 Understanding the CPI (cont.)

Et Q P iB it
CPI  = i1
n
EB
Q P iB iB
i1

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 Why the CPI may overstate
inflation
 Substitution bias: The CPI uses fixed weights, so it
cannot reflect consumers’ ability to substitute toward
goods whose relative prices have fallen.
 Introduction of new goods: The introduction of
new goods makes consumers better off and, in
effect, increases the real value of the dollar. But it
does not reduce the CPI, because the CPI uses
fixed weights.
 Unmeasured changes in quality: Quality
improvements increase the value of the dollar, but
are often not fully measured.
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 CPI vs. GDP Deflator

Prices of capital goods:

– included in GDP deflator (if produced domestically)
– excluded from CPI
Prices of imported consumer goods:
– included in CPI
– excluded from GDP deflator
The basket of goods:
– CPI: fixed
– GDP deflator: changes every year
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 Categories of the
population(un-employment

 employed
working at a paid job
 unemployed
not employed but looking for a job
 labor force
the amount of labor available for producing
goods and services; all employed plus
unemployed persons
 not in the labor force
not employed, not looking for work
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 The Household Survey: Two
important labor force
concepts
 unemployment rate
percentage of the labor force that is unemployed
 labor force participation rate
the fraction of the adult population
that “participates” in the labor force

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 The Establishment Survey

 The BLS obtains a second measure of

employment by surveying businesses,
asking how many workers are on their payrolls.
 Neither measure is perfect, and they
occasionally diverge due to:
– treatment of self-employed persons
– new firms not counted in establishment survey
– technical issues involving population inferences
from sample data

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 USES OF NATIONAL INCOME

(1) Standard of living indicators

Standard of living reflects the individuals’ welfare because
it shows how much goods and services can be consumed by
each individual in a country. It can be measured by GDP per
capita.

(2) Government planning and policies

The available statistics of national income can guide the
policy makers in planning for the future. From the national
income data, the government can view the historical trends
and performance of economic sectors.

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 USES OF NATIONAL INCOME (cont.)

(3) Sectoral contributions

An economy consists of various economic activities. Hence,
with the available statistics of national income data, the study of
the economic sectors can tell us the relative importance of
various parts of the economy and whether these change with
time relatively. It is also useful in the context of the analysis of
specific problems of an economy.

(4) International comparisons

With the national income statistics, we not only can compare
the absolute size of one economy relative to another, but
compare how well-off the average individual is in each country.

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 PROBLEMS OF MEASURING
NATIONAL INCOME

(1) Problems of non-monetized sector

The existence of a large number of non-monetized activities
in these countries, especially in the agricultural sector makes
the computation of the national income more difficult.

(2) Underground economy

Official GDP estimates may not take into account the
underground economy, in which transactions contributing to
production, such as illegal trade and tax-avoiding activities,
are unreported, causing GDP to be underestimated.

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 PROBLEMS OF MEASURING
NATIONAL INCOME (cont.)
(3) Non-market transactions
There are many productive works done in the economy but they are
not paid. Food grown in backyard plots, home repairs, clothes made
at home, and any other do-it-yourself goods and services that people
make or do for themselves, their families or their friends are not
counted in GDP.

(4) Problems of expertise and modern machinery

The lack of professionals such as statisticians, researchers,
programmers and analysts is a major problem in third world countries.

(5) Problems of double counting

Double counting in national income will appear when both values of
final goods and intermediate goods are included.

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 Chapter Summary

 Gross Domestic Product (GDP) measures both total

income and total expenditure on the economy’s
output of goods & services.
 Nominal GDP values output at current prices;
real GDP values output at constant prices. Changes
in output affect both measures,
but changes in prices only affect nominal GDP.
 GDP is the sum of consumption, investment,
government purchases, and net exports.

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 Chapter Summary

 The overall level of prices can be measured

by either:
– the Consumer Price Index (CPI),
the price of a fixed basket of goods purchased by
the typical consumer, or
– the GDP deflator,
the ratio of nominal to real GDP
 The unemployment rate is the fraction of the labor
force that is not employed.

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