• What is Gross Domestic Product (GDP)?

• How is GDP related to a nation’s total income and spending?

• What are the components of GDP?
• How is GDP corrected for inflation?
• Does GDP measure society’s well-being?

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 Microeconomics vs. Macroeconomics
• Microeconomics:
The study of how individual households and firms make decisions,
interact with one another in markets.
• Macroeconomics:
The study of the economy as a whole.
• We begin our study of macroeconomics with the country’s total
income and expenditure.

MEASURING A NATION’S INCOME 3

 Income and Expenditure
• Gross Domestic Product (GDP) measures total income of
everyone in the economy.
• GDP also measures total expenditure on the economy’s output of
goods & services.

For the economy as a whole,

income equals expenditure
because every dollar a buyer spends
is a dollar of income for the seller.

MEASURING A NATION’S INCOME 4

 The Circular-Flow Diagram
• A simple depiction of the macroeconomy
• Illustrates GDP as spending, revenue, factor payments, and
income
• Preliminaries:
• Factors of production are inputs like labor, land, capital, and natural
resources.
• Factor payments are payments to the factors of production (e.g.,
wages, rent).

MEASURING A NATION’S INCOME 5

 Households:
The Circular-Flow Diagram ▪ own the factors of production,
sell/rent them to firms for income
▪ buy and consume goods & services

Firms Households

Firms:
▪ buy/hire factors of production,
use them to produce goods
and services
▪ sell goods & services
MEASURING A NATION’S INCOME 6
 The Circular-Flow Diagram

Revenue (=GDP) Spending (=GDP)

Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income (=GDP)
profit (=GDP)
MEASURING A NATION’S INCOME 7
 What This Diagram Omits
• The government
• collects taxes, buys goods & services

• The financial system

• matches savers’ supply of funds with borrowers’ demand for loans

• The foreign sector

• trades goods & services, financial assets, and currencies with the country’s
residents

MEASURING A NATION’S INCOME 8

 Gross Domestic Product (GDP) Is…
…the market value of all final goods & services produced
within a country in a given period of time.

Goods are valued at their market prices, so:

▪ All goods measured in the same units
(e.g., dollars in the U.S.)
▪ Things that don’t have a market value are
excluded, e.g., housework you do for yourself.

MEASURING A NATION’S INCOME 9

 Gross Domestic Product (GDP) Is…
…the market value of all final goods & services produced
within a country in a given period of time.

Final goods: intended for the end user

Intermediate goods: used as components
or ingredients in the production of other goods
GDP only includes final goods – they already
embody the value of the intermediate goods
used in their production.
MEASURING A NATION’S INCOME 10
 Gross Domestic Product (GDP) Is…
…the market value of all final goods & services
produced within a country
in a given period of time.

GDP includes tangible goods

(like DVDs, mountain bikes, beer)
and intangible services
(dry cleaning, concerts, cell phone service).

MEASURING A NATION’S INCOME 11

 Gross Domestic Product (GDP) Is…
…the market value of all final goods & services
produced within a country
in a given period of time.

GDP includes currently produced goods,

not goods produced in the past.

MEASURING A NATION’S INCOME 12

 Gross Domestic Product (GDP) Is…
…the market value of all final goods & services
produced within a country
in a given period of time.

GDP measures the value of production that occurs

within a country’s borders, whether done by its own
citizens or by foreigners located there.

MEASURING A NATION’S INCOME 13

 Gross Domestic Product (GDP) Is…
…the market value of all final goods & services
produced within a country
in a given period of time.

Usually a year or a quarter (3 months)

MEASURING A NATION’S INCOME 14

 The Components of GDP
• Recall: GDP is total spending.
• Four components:
• Consumption (C)
• Investment (I)
• Government Purchases (G)
• Net Exports (NX)
• These components add up to GDP (denoted Y):

Y = C + I + G + NX

MEASURING A NATION’S INCOME 15

 Consumption (C)
• is total spending by households on goods &services.
• Note on housing costs:
• For renters,
consumption includes rent payments.
• For homeowners,
consumption includes the imputed rental value of the house, but not
the purchase price or mortgage payments.

MEASURING A NATION’S INCOME 16

 Investment (I)
• is total spending on goods that will be used in the future to
produce more goods.
• includes spending on
• capital equipment (e.g., machines, tools)
• structures (factories, office buildings, houses)
• inventories (goods produced but not yet sold)

Note: “Investment” does not

mean the purchase of financial
assets like stocks and bonds.
MEASURING A NATION’S INCOME 17
Government Purchases (G)
• is all spending on the goods & services purchased by
government
at the federal, state, and local levels.
• G excludes transfer payments, such as
Social Security or unemployment insurance benefits.
They are not purchases of goods services.

MEASURING A NATION’S INCOME 18

 Net Exports (NX)
• NX = exports – imports
• Exports represent foreign spending on the economy’s goods &
services.
• Imports are the portions of C, I, and G
that are spent on goods & services produced abroad.
• Adding up all the components of GDP gives:

Y = C + I + G + NX

MEASURING A NATION’S INCOME 19

 U.S. GDP and Its Components, 2007
billions % of GDP per capita

Y $13,841 100.0 $45,825

C 9,734 70.3 32,228

I 2,125 15.4 7,037

G 2,690 19.4 8,905

NX –708 –5.1 –2,344

MEASURING A NATION’S INCOME 20

 ACTIVE LEARNING 1
GDP and its components
In each of the following cases, determine how much GDP
and each of its components is affected (if at all).
A. Debbie spends $200 to buy her husband dinner
at the finest restaurant in Boston.
B. Sarah spends $1800 on a new laptop to use in her
publishing business. The laptop was built in China.
C. Jane spends $1200 on a computer to use in her editing
business. She got last year’s model on sale for a great
price from a local manufacturer.
D. General Motors builds $500 million worth of cars,
but consumers only buy $470 million worth of them.
 ACTIVE LEARNING 1
Answers
A. Debbie spends $200 to buy her husband dinner
at the finest restaurant in Boston.
Consumption and GDP rise by $200.

B. Sarah spends $1800 on a new laptop to use in her

publishing business. The laptop was built in China.
Investment rises by $1800, net exports fall
by $1800, GDP is unchanged.

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 ACTIVE LEARNING 1
Answers
C. Jane spends $1200 on a computer to use in her
editing business. She got last year’s model on sale for
a great price from a local manufacturer.
Current GDP and investment do not change, because
the computer was built last year.
D. General Motors builds $500 million worth of cars, but
consumers only buy $470 million of them.
Consumption rises by $470 million,
inventory investment rises by $30 million,
and GDP rises by $500 million.

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 Real versus Nominal GDP
• Inflation can distort economic variables like GDP, so we have two
versions of GDP:
One is corrected for inflation, the other is not.
• Nominal GDP values output using current prices. It is not
corrected for inflation.
• Real GDP values output using the prices of a base year. Real GDP
is corrected for inflation.

MEASURING A NATION’S INCOME 24

 EXAMPLE:
Pizza Latte
year P Q P Q
2005 $10 400 $2.00 1000
2006 $11 500 $2.50 1100
2007 $12 600 $3.00 1200

Compute nominal GDP in each year:

Increase:
2005: $10 x 400 + $2 x 1000 = $6,000
37.5%
2006: $11 x 500 + $2.50 x 1100 = $8,250
2007: $12 x 600 + $3 x 1200 = $10,800 30.9%

MEASURING A NATION’S INCOME 25

 EXAMPLE:
Pizza Latte
year P Q P Q
2005 $10 400 $2.00 1000
2006 $11 500 $2.50 1100
2007 $12 600 $3.00 1200
Compute real GDP in each year,
using 2005 as the base year:
Increase:
2005: $10 x 400 + $2 x 1000 = $6,000
20.0%
2006: $10 x 500 + $2 x 1100 = $7,200
16.7%
2007: $10 x 600 + $2 x 1200 = $8,400
MEASURING A NATION’S INCOME 26
 EXAMPLE:
Nominal Real
year GDP GDP
2005 $6000 $6000
2006 $8250 $7200
2007 $10,800 $8400
In each year,
• nominal GDP is measured using the (then) current prices.
• real GDP is measured using constant prices from the base year
(2005 in this example).

MEASURING A NATION’S INCOME 27

 EXAMPLE:
Nominal Real
year GDP GDP
2005 $6000 $6000
37.5% 20.0%
2006 $8250 $7200
30.9% $8400 16.7%
2007 $10,800
• The change in nominal GDP reflects both prices and
quantities.

▪ The change in real GDP is the amount that

GDP would change if prices were constant
(i.e., if zero inflation).
Hence, real GDP is corrected for inflation.
MEASURING A NATION’S INCOME 28
Nominal and Real GDP in the U.S.,
1965-2007
Billions
$12,000

$10,000
Real GDP
$8,000 (base year
$6,000
2000)

$4,000
Nominal
$2,000 GDP
$0
1965 1970 1975 1980 1985 1990 1995 2000 2005 29
 The GDP Deflator
• The GDP deflator is a measure of the overall level of prices.
• Definition:

nominal GDP
GDP deflator = 100 x
real GDP

▪ One way to measure the economy’s inflation rate is to

compute the percentage increase in the GDP deflator
from one year to the next.

MEASURING A NATION’S INCOME 30

 EXAMPLE:
Nominal Real GDP
year GDP GDP Deflator
2005 $6000 $6000 100.0
14.6%
2006 $8250 $7200 114.6
2007 $10,800 $8400 128.6
12.2%

Compute the GDP deflator in each year:

2005: 100 x (6000/6000) = 100.0

2006: 100 x (8250/7200) = 114.6

2007: 100 x (10,800/8400) = 128.6

MEASURING A NATION’S INCOME 31

 ACTIVE LEARNING 2
Computing GDP
2007 (base yr) 2008 2009
P Q P Q P Q
Good A $30 900 $31 1,000 $36 1050
Good B $100 192 $102 200 $100 205

Use the above data to solve these problems:

A. Compute nominal GDP in 2007.
B. Compute real GDP in 2008.
C. Compute the GDP deflator in 2009.
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GDP and Economic Well-Being
• Real GDP per capita is the main indicator of the average
person’s standard of living.
• But GDP is not a perfect measure of
well-being.
• Robert Kennedy issued a very eloquent
yet harsh criticism of GDP:

MEASURING A NATION’S INCOME 33

 Gross Domestic Product…
“… does not allow for the health of our
children, the quality of their education,
or the joy of their play. It does not
include the beauty of our poetry or
the strength of our marriages, the
intelligence of our public debate or
the integrity of our public officials.
It measures neither our courage, nor our wisdom,
nor our devotion to our country. It measures everything,
in short, except that which makes life worthwhile, and it
can tell us everything about America except why we are
proud that we are Americans.”
- Senator Robert Kennedy, 1968 34
 GDP Does Not Value:
• the quality of the environment
• leisure time
• non-market activity, such as the child care a parent provides his or
her child at home
• an equitable distribution of income

MEASURING A NATION’S INCOME 35

 Then Why Do We Care About GDP?
• Having a large GDP enables a country to afford better schools, a
cleaner environment,
health care, etc.
• Many indicators of the quality of life are positively correlated with
GDP. For example…

MEASURING A NATION’S INCOME 36

 GDP and Life Expectancy in 12 countries
Indonesia
Japan
China
Life expectancy (years)
U.S.
Mexico Germany
Brazil
Pakistan
Russia
India
Bangladesh

Nigeria

Real GDP per capita 37

 GDP and Literacy in 12 countries
China Russia U.S.
Germany Japan
Mexico

(% of population)
Adult Literacy Brazil
Indonesia

Nigeria

India

Pakistan

Bangladesh

Real GDP per capita 38

 GDP and Internet Usage in 12 countries

Japan
U.S.

(% of population)
Internet Usage

Germany

Brazil
Indonesia
Mexico
Pakista
Russia
n
China
Nigeria India

Bangladesh Real GDP per capita 39

SUMMARY
• Gross Domestic Product (GDP) measures a country’s total income and
expenditure.
• The four spending components of GDP include: Consumption,
Investment, Government Purchases, and Net Exports.
• Nominal GDP is measured using current prices. Real GDP is measured
using the prices of a constant base year and is corrected for inflation.
• GDP is the main indicator of a country’s economic well-being, even
though it is not perfect.

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