CHAPTER 2

Measuring economic activity: Gross

domestic product and unemployment

LEARNING OBJECTIVES (LO)

After reading this chapter, you should be able to answer the following questions.
2.1 How do economists define an economy’s output?
2.2 Can you explain the production, expenditure and income methods for measuring GDP to analyse economic
activity?
2.3 How do economists define and compute nominal GDP and real GDP?
2.4 Is there a relationship between real GDP and economic wellbeing?
2.5 How are the unemployment rate, the participation rate and the costs of unemployment calculated?

SET TING THE SCENE

China’s economic growth slowed to 6.7 per cent in the second quarter of the year . . . down from 6.8 per cent in the first quarter
of the year to its slowest pace since 2016 (Chalmers 2018).
Australia’s GDP growth slipped to 2.4 per cent over 2017.
It is a step-down from the annualised rate of 2.8 per cent recorded in the third quarter, and weaker than market expectations.
It also means that there was no acceleration from 2016 when GDP also grew at 2.4 per cent.
‘Growth this quarter was driven by the household sector, with continued strength in household income matched by growth
in household consumption,’ said Australian Bureau of Statistics chief economist Bruce Hockman (Letts 2018).

News reports like these fill the airwaves and the internet— that a doctor depends on a patient’s vital signs—pulse, blood
some TV and radio stations and some websites and blogs pressure and temperature—to make an accurate diagnosis.
carry nothing else. In fact, all kinds of people are interested To understand economic developments and to be able to give
in how the economy is performing. The average person hopes useful advice to policymakers, business people and financial
to learn something that will be useful in a business decision, investors, an economist simply must have up-to-date, accurate
a financial investment or a career move. The professional data. Political leaders and policymakers also need economic
economist depends on economic data in much the same way data to help them in their decisions and planning.

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22 PART 1 ISSUES IN MACROECONOMICS

Setting The Scene continued

Interest in measuring the economy, and attempts to do Measuring economic activity might sound like a
so, date back as far as the mid-seventeenth century when Sir straightforward and uncontroversial task, but that is not the
William Petty (1623–87) conducted a detailed survey of the case. Indeed, the basic measure of a nation’s output of goods
land and wealth of Ireland. The British Government’s purpose and services—the GDP—has been criticised on many grounds.
in commissioning the survey was to determine the capacity Some critics have complained that GDP does not adequately
of the Irish people to pay taxes to the Crown. But Petty used reflect factors such as the effect of economic growth on
the opportunity to measure a variety of social and economic the environment or the rate of resource depletion. Because
variables and went on to conduct pioneering studies of wealth, of problems like these, they charge, policies based on GDP
production and population in several other countries. He was a statistics are likely to be flawed. Unemployment statistics
firm believer in the idea that scientific progress depends first have also been the subject of some controversy. By the end
and foremost on accurate measurement, an idea that today’s of this chapter, you will understand how official measures of
economists endorse. output and unemployment are constructed and used and will
Not until the twentieth century, though, did economic have gained some insight into debates over their accuracy. In
measurement come into its own. World War II was an particular, you will understand how the statistics are defined
important catalyst for the development of accurate economic and measured, and you will be able to discuss the strengths
statistics because its outcome was thought to depend on the and limitations of the definitions as well as the measurement
mobilisation of economic resources. Two economists, Simon difficulties that governments face when turning the definitions
Kuznets in the United States and Richard Stone in the United into actual, published estimates. You will see, for example, what
Kingdom, developed comprehensive systems for measuring a goes into the calculation of a nation’s GDP and, importantly,
nation’s output of goods and services, which were of great help what is left out. So next time you hear or read about the most
to Allied leaders in their wartime planning. Kuznets and Stone recent economic statistics, you will avoid misinterpreting them.
each received a Nobel Prize in economics for their work, which Understanding the strengths and limitations of economic
became the basis for the economic accounts used today by data is the first critical step towards becoming an intelligent
almost all the world’s countries. user of economic statistics, as well as a necessary background
In this chapter and the next, we will discuss how economists for careful economic analysis in the chapters to come.
measure three basic macroeconomic variables that arise
References
frequently in analyses of the state of the economy: the gross
Chalmers, S 2018, ‘China’s economic growth cools to its slowest pace
domestic product (or GDP), the rate of unemployment and the since 2016 amid trade tariff tensions’, ABC News, 17 July 2018, [Link].
rate of inflation. The focus of this chapter is on the first two of [Link]/news/2018-07-16/china-economic-growth-cools-to-its-slowest-pace-
these statistics, GDP and the unemployment rate, which both since/10000038.
measure the overall level of economic activity in a country. The Letts, S 2018, ‘Australia’s economy grew by 2.4 per cent in 2017, below
expectations’, ABC News, 7 March 2018, [Link]/news/2018-03-07/
third statistic, the inflation rate, covered in the next chapter,
gdp-q4-2017/9522450.
measures how fast prices change in a country.

LO 2.1 2.1 MEASURING ECONOMIC ACTIVITY: GROSS DOMESTIC

PRODUCT AND UNEMPLOYMENT
Rising long-run living standards and the avoidance of extremes in short-run macroeconomic performance (two
indicators of good macroeconomic performance) are usually judged in the context of a nation’s gross domestic
gross domestic product product (GDP). It seems a very simple concept: GDP refers to the final value of goods and services that are
(GDP) produced in an economy over a particular period. More formally, GDP is defined as the market value of the
The market value of the
final goods and services final goods and services produced in a country during a given period. This is usually taken to be a quarter (three
produced in a country months) or a year.
during a given period.
GDP is one of the most keenly monitored of all macroeconomic indicators. Later in this book, we show you
how GDP influences macroeconomic outcomes such as the rate of unemployment and the ability of households
to purchase goods and services. Countries with relatively high levels of GDP per person also tend to be countries

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 Measuring economic activity: Gross domestic product and unemployment CHAPTER 2 23

BACKGROUND BRIEFING 2.1

Australia’s historical GDP experience

Figure 1.3 in Chapter 1 shows how Australia’s GDP evolved since 1820. The figure shows what is known
as ‘real GDP’; this involves an adjustment to the raw GDP figures to remove distortions introduced by
inflation (we will deal with this concept in more detail later in this chapter).
The most obvious feature of these data is the tremendous increase in GDP over the period. Most of
the increase occurred in the years after the cessation of World War II hostilities (real GDP increased
by around 180% over the period from 1901 to 1939; over the period from 1946 to 2011 real GDP
increased by around 993%). This is a common experience for industrialised countries; most nations that
we would now regard as being relatively well-off owe their prosperity to the historically unprecedented
increases in their respective GDPs after World War II.
Looking carefully at the graph reminds us that economic growth is not smooth, particularly when
we narrow the time frame over which the economy is studied. The Great Depression of the late 1920s
and early 1930s is clearly visible as a reduction in real GDP over that period. One manifestation
of the Great Depression was that the economy produced far fewer goods and services than had
previously been the case. And, as you can see from the graph, this was associated with a massive
fall in GDP. Although in our lifetimes, we have seen nothing even remotely like the Great Depression,
economic downturns are still with us. As the graph reveals, the early 1980s and early 1990s
were both periods in which there were significant pauses in real GDP growth in Australia. These
periods were recessions and, although small relative to the Great Depression, were associated with
significant increases in unemployment and economic hardship. You can also detect the slowdown in
economic activity associated with the Great Recession in 2009. Understanding why the economy is
prone to these short-run slowdowns, and why other periods are more prosperous, is an important
part of macroeconomics.

with high standards of living, not just in material terms but also in broader influences on the quality of life such
as life expectancy and access to cultural facilities and opportunities.
Economists’ interest in GDP extends across two different time dimensions: the long run and the short run.
Over reasonably short periods of time, say one to four years, GDP can fluctuate quite markedly, growing relatively
strongly at times (economic expansions) and relatively sluggishly at other times (economic contractions).
Macroeconomists call these fluctuations the business cycle. However, over longer periods of time—decades business cycle
and even centuries—most countries experience reasonably steady growth in their GDP. Understanding this Short-run fluctuations
in GDP.
phenomenon is the subject matter of growth economics. In this book, we examine both the business cycle and
long-run growth. Different forces are believed responsible for the short-run fluctuations in GDP that comprise
the business cycle and the long-run factors leading to sustained GDP growth. For this reason, macroeconomists
usually separate the analysis of short-run business cycle fluctuations from long-run growth issues, and we follow
this practice in this book.

2.1.1!!GDP: THE FINE PRINT

Let us take the definition of GDP apart and examine each of its parts separately. The first key phrase in the
definition is ‘market value’.

Market value
To be able to talk about concepts like the ‘aggregate output’ or ‘aggregate production’—as opposed to the
production of specific items—economists need to aggregate the quantities of the many different goods and
services into a single number. We do so by adding up the market values of the different goods and services the
economy produces. A simple example will illustrate the process.

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24 PART 1 ISSUES IN MACROECONOMICS

EXAMPLE 2.1 – ORCHARDIA’S GDP: PART I

In the imaginary economy of Orchardia, total production is four apples and six bananas. To find the
total output of Orchardia we could add the number of apples to the number of bananas and conclude
that the total output is 10 pieces of fruit. But what if this economy also produced three pairs of
shoes? There really is no sensible way to add apples and bananas to shoes.
Suppose we know that apples sell for $0.25 each, bananas for $0.50 each and shoes for $20.00
a pair. Then the market value of this economy’s production, or its GDP, is equal to:

(4 apples × $0.25/apple) + (6 bananas × $0.50/banana) + (3 pairs of shoes × $20.00/pair) = $64.00

Notice that when we calculate total output this way, the more expensive items (the shoes) receive
a higher weighting than the cheaper items (the apples and bananas). In general, the amount people
are willing to pay for an item is an indication of the economic benefit they expect to receive from it.
For this reason, higher-priced items should count for more in a measure of aggregate output.

EXAMPLE 2.2 – ORCHARDIA’S GDP: PART II

Suppose Orchardia were to produce three apples, three bananas and four pairs of shoes at the same
prices as in the preceding text. What is its GDP now?
Now the Orchardian GDP is equal to:

(3 apples × $0.25/apple) + (3 bananas × $0.50/banana) + (4 pairs of shoes × $20.00/pair) = $82.25

Notice that the Orchardian GDP is higher in Example 2.2 than in the previous example, even though
two of the three goods (apples and bananas) are being produced in smaller quantities than before.
The reason is that the good whose production has increased (shoes) is much more valuable than the
goods whose production has decreased (apples and bananas).

CONCEPT CHECK 2.1

Suppose Orchardia produces the same quantities of the three goods as originally at the same prices. In addition, it produces five
oranges at $0.30 each. What is the GDP of Orchardia now?

Market values provide a convenient way to add together, or aggregate, the many different goods and services
produced in a modern economy. A drawback of using market values is that not all economically valuable goods
and services are bought and sold in markets. For example, the unpaid work of a homemaker, although it is of
economic value, is not sold in markets and so is not counted in GDP. However, paid housekeeping and childcare
services, which are sold in markets, do count. This distinction can create some pitfalls, as Example 2.3 shows.

EXAMPLE 2.3 – WOMEN’S LABOUR FORCE PARTICIPATION AND GDP MEASUREMENT

The percentage of adult Australian women working outside the home has increased in the past
five decades, from around 40 per cent in 1966 to over 70 per cent in 2017 (see Figure 2.1). These
figures are known as the ‘female labour force participation rate’. They are calculated by looking at
the proportion of adult women who are either in employment or who are unemployed but actively

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 Measuring economic activity: Gross domestic product and unemployment CHAPTER 2 25

seeking work. This trend has led to a substantial increase in the demand for paid childcare and
housekeeping services, as families require more help at home. How have these changes affected
measured GDP?
The entry of many women into the labour market has raised measured GDP in two ways. First,
the goods and services that women produce in their new jobs have contributed directly to increasing
GDP. Second, the fact that paid workers took over previously unpaid housework and childcare duties
has increased measured GDP by the amount paid to those workers. The first of these two changes
represent a genuine increase in economic activity, but the second reflects a transfer of existing
economic activities from the unpaid sector to the market sector. Overall, the increase in measured
GDP associated with increased participation in the labour force by women probably overstates the
actual increase in economic activity.

80

70

60
Per cent

50

40

30

20
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017

Year

Figure 2.1 Female labour force participation, Australia

Source: OECD 2018, ’LFS by sex and age – indicators’, [Link]

With a few exceptions, like goods and services provided by government agencies, GDP is calculated
by adding up market values. (As market prices for publicly provided goods and services do not exist,
economic statisticians add to the GDP the costs of providing those goods and services as rough measures
of their economic value. For example, to include public education in the GDP, the statisticians add to
GDP the salaries of teachers and administrators, the costs of textbooks and supplies and the like. Similarly,
the economic value of the national defence establishment is approximated, for the purposes of measuring
GDP, by the costs of defence: the pay earned by soldiers and sailors, the costs of acquiring and maintaining
weapons and so on.) However, not all goods and services that have a market value are counted in GDP. As
we will see next, GDP includes only those goods and services that are the end products of the production
process, called ‘final goods and services’. Goods and services that are used up in the production process are
not counted in GDP.

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26 PART 1 ISSUES IN MACROECONOMICS

THINKING AS AN ECONOMIST 2.1

What explains the trend illustrated in Figure 2.1?

In a world governed only by economic principles—without social conventions, customs or traditions—

homemaking tasks like cleaning, cooking and child-rearing would be jobs like any other. As such, they
comparative advantage would be subject to the principle of comparative advantage: those people (either men or women) who are
Everyone does best when relatively more efficient in performing homemaking tasks would specialise in them, freeing people whose
each person concentrates
on the activities for which comparative advantage lies elsewhere to work outside the home; homemaking tasks would be done by
their opportunity cost is those with the lowest opportunity cost in those tasks. In such a world, to see a woman with a medical
lowest. degree doing housework would be very unusual—her opportunity cost of doing housework would be too
opportunity cost high; in this case, the opportunity cost is the forgoing of opportunities to practise medicine.
The value of the next-best Of course, we do not live in a world driven only by economic considerations. Traditionally, the social
alternative to taking a
particular action. custom has severely limited the economic opportunities of women (and in some societies still does).
However, social restrictions on women have weakened considerably over the past century, particularly in
the industrialised countries, as a result of the increased educational attainment of women, the rise of the
feminist movement and other factors. As traditional social restraints on women have loosened, domestic
arrangements have moved in the direction dictated by comparative advantage—to an increasing degree,
homemaking tasks are now performed by paid specialists, while the majority of women (and men) work
outside the home.

2.1.2!!FINAL GOODS AND SERVICES

Many goods are used in the production process. Before a baker can produce a loaf of bread, grain must be
grown and harvested, then the grain must be ground into flour and, together with other ingredients, baked into
bread. Of the three major goods that are produced during this process—the grain, the flour and the bread—only
the bread is used by consumers. Because producing the bread is the ultimate purpose of the process, the bread
final goods or services is called a ‘final good’. In general, final goods or services are the end products of a process, the products or
Goods or services services that consumers actually use. The goods or services produced on the way towards making the final
consumed by the ultimate
user—because they are product—here, the grain and the flour—are called intermediate goods or services.
the end products of the Since GDP measures only those items that are of direct economic value, only final goods and services are
production process, they
are counted as part of GDP. included in GDP. Intermediate goods and services are not included. To illustrate, suppose that the grain from
the previous example has a market value of $0.50 (the price the milling company paid for the grain). The grain
intermediate goods or is then ground into flour, which has a market value of $1.20 (the price the baker paid for the flour). Finally, the
services
Goods or services used up flour is made into a loaf of bread, worth $2.00 at the local store. In calculating the contribution of these activities
in the production of final to GDP, would we want to add together the values of the grain, the flour and the bread? No, because the grain
goods and services and
therefore not counted as
and flour are intermediate goods, valuable only because they can be used to make bread. Therefore, in this
part of GDP. example, the total contribution to GDP is $2.00, the value of the loaf of bread, the final product.
Example 2.4 illustrates the same distinction but this time with a focus on services.

EXAMPLE 2.4 – THE HAIRDRESSER AND THEIR ASSISTANT

Your hairdresser charges $30 for a haircut. In turn, the hairdresser pays their assistant $6 per
haircut in return for sharpening the scissors, sweeping the floor and other chores. For each haircut
given, what is the total contribution of the hairdresser and their assistant, taken together, to GDP?
The answer to this problem is $30: the price, or market value, of the haircut. The haircut is
counted in GDP because it is the final service: the one that actually has value to the final user. The
services provided by the assistant have value only because they contribute to the production of the
haircut; thus they are not counted in GDP.

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 Measuring economic activity: Gross domestic product and unemployment CHAPTER 2 27

We have established the rule that only final goods and services are counted in GDP. Intermediate goods and
services, which are used up in the production of final goods and services, are not counted. In practice, this rule
is not easy to apply, because the production process often stretches over several periods. To illustrate, recall
the earlier example of the grain that was milled into flour, which in turn was baked into a loaf of bread. The
contribution of the whole process to GDP is $2.00, the value of the bread (the final product). Suppose, though,
that the grain and the flour were produced near the end of 2018 and the bread was baked early the next year, in
2019. In this case, should we attribute the $2.00 value of the bread to the GDP for the year 2018 or to the GDP
for the year 2019?
Neither choice seems quite right since part of the bread’s production process occurred in each year. Part
of the value of the bread should probably be counted in the year 2018 GDP and part in the year 2019 GDP.
But how should we make the split? To deal with this problem, economists determine the market value of final
goods and services indirectly, by adding up the value added by each firm in the production process. The value
added by any firm equals the market value of its product or service minus the cost of inputs purchased from
other firms. As we will see, summing the value added by all firms (including producers of both intermediate value added
and final goods and services) gives the same answer as simply adding together the value of final goods and For any firm, the market
value of its product or
services. However, the value-added method eliminates the problem of dividing the value of a final good or service minus the cost
service between two periods. of inputs purchased from
other firms.
To illustrate this method, let us revisit the example of the loaf of bread, which is the result of multiple stages of
production. We have already determined that the total contribution of this production process to GDP is $2.00,
the value of the bread. Let us show now that we can get the same answer by summing value added. Suppose that
the bread is the ultimate product of three corporations: ABC Grain Company produces the grain, General Flour
produces the flour and Hot ’n’ Fresh Baking produces the bread. If we make the same assumptions as before
about the market value of the grain, the flour and the bread, what is the value added by each of these three
companies?
ABC Grain Company produces $0.50 worth of grain, with no inputs from other companies, so ABC’s value
added is $0.50. General Flour uses $0.50 worth of grain from ABC to produce $1.20 worth of flour. The value
added by General Flour is thus the value of its product ($1.20) less the cost of purchased inputs ($0.50), or
$0.70. Finally, Hot ’n’ Fresh Baking buys $1.20 worth of flour from General Flour and uses it to produce
$2.00 worth of bread. So the value added by Hot ’n’ Fresh is $0.80. These calculations are summarised in
Table 2.1.
You can see that summing the value added by each company gives the same contribution to GDP—$2.00—
as the method based on counting final goods and services only. Basically, the value added by each firm
represents the portion of the value of the final good or service that the firm creates in its stage of production.
Summing the value added by all firms in the economy yields the total value of final goods and services, or
GDP.
You can also see how the value-added method solves the problem of production processes that bridge two
or more periods. Suppose that the grain and flour are produced during 2018 but the bread is not baked until
2019. Using the value-added method, the contribution of this production process to the year 2018 GDP is the
value added by the grain company plus the value added by the flour company, or $1.20. The contribution of the
production process to the year 2019 GDP is the value added by the baker, which is $0.80. Thus part of the value
of the final product, the bread, is counted in the GDP for each year, reflecting the fact that part of the production
of the bread took place in each year.

TABLE 2.1 Value added in bread production

COMPANY REVENUES – COST OF PURCHASED INPUTS = VALUE ADDED

ABC Grain $0.50 $0.00 $0.50
General Flour $1.20 $0.50 $0.70
Hot ’n’ Fresh $2.00 $1.20 $0.80
Total $2.00

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28 PART 1 ISSUES IN MACROECONOMICS

CONCEPT CHECK 2.2

Amy’s card shop receives a shipment of Valentine’s Day cards in December 2018. Amy pays the wholesale distributor of the cards a
total of $500. In February 2019 she sells the cards for a total of $700. What are the contributions of these transactions to GDP in the
years 2013 and 2014?

EXAMPLE 2.5 – A GOOD THAT CAN BE EITHER INTERMEDIATE OR FINAL

What is an intermediate good?
Farmer Chin produces $100 worth of milk. She sells $40 worth of milk to her neighbours and
uses the rest to feed her pigs, which she sells to her neighbours for $120. What is Farmer Chin’s
contribution to the GDP?
The final goods in this example are the $40 worth of milk and the $120 worth of pigs sold to the
neighbours. Adding $40 and $120, we get $160, which is Farmer Chin’s contribution to the GDP.
Note that part of the milk Farmer Chin produced serves as an intermediate good and part as a final
good. The $60 worth of milk that is fed to the pigs is an intermediate good and so it is not counted
in GDP. The $40 worth of milk sold to the neighbours is a final good and so it is counted.

capital good A special type of good that is difficult to classify as intermediate or final is a capital good. A capital good is a
A long-lived good that is long-lived good, which is itself produced and used to produce other goods and services. Factories and machines
used in the production of
other goods and services. are examples of capital goods. Houses and apartment buildings, which produce dwelling services, are also a form
of capital good. Capital goods do not fit the definition of final goods since their purpose is to produce other
goods. On the other hand, they are not used up during the production process, except over a very long period,
so they are not exactly intermediate goods either. For purposes of measuring GDP, economists have agreed to
classify newly produced capital goods as final goods. Otherwise, a country that invested in its future by building
modern factories and buying new machines would be counted as having a lower GDP than a country that
devoted all its resources to producing consumer goods.

2.1.3!!PRODUCED WITHIN A COUNTRY DURING A GIVEN PERIOD

The word ‘domestic’ in the term ‘gross domestic product’ tells us that GDP is a measure of economic activity
within a given country. Thus, only production that takes place within the country’s borders is counted. For
example, Australia’s GDP includes the market value of all food products produced within Australian borders,
even if they are made in foreign-owned processing plants. However, food products produced in New Zealand by
an Australian-based company like SPC Ardmona would not be counted in Australia’s GDP.
What about food products that are produced in Australia from ingredients sourced In New Zealand? The
value-added method introduced earlier could again be used to suggest an answer. Recall that we used this method
to divide the market value of a product that was produced over two years into its contribution to the GDP of each
of the years. Similarly, we can use this method to divide the value of a product that was produced in part in two
different countries into its contribution to each country’s GDP. Revisiting our loaf of bread example, suppose
now that ABC Grain Company produced the grain in New Zealand. General Flour buys $0.50 worth of grain
from ABC in New Zealand, imports it to Australia, and uses it to produce $1.20 worth of flour (in Australia).
Finally, Hot’n’Fresh Baking buys $1.20 worth of flour from General Flour and uses it to produce $2.00 worth of
bread (in Australia). Using the value-added method, Table 2.1 suggests that the total value of the bread, $2.00,
is divided across the two countries’ GDPs: $0.50 is included in New Zealand’s GDP (the value of the grain
produced in New Zealand) and $1.50 is included in Australia’s GDP (the value added in Australia).
We have seen that GDP is intended to measure the amount of production that occurs during a given period,
such as the calendar year. For this reason, only goods and services that are actually produced during a particular
year are included in the GDP for that year. Example 2.6 and Concept Check 2.3 demonstrate this point.

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 Measuring economic activity: Gross domestic product and unemployment CHAPTER 2 29

EXAMPLE 2.6 – THE SALE OF A HOUSE AND GDP

Does the sale of an existing home count in GDP?
A 20-year-old house is sold to a young family for $200 000. The family pays the real estate
agent a 6 per cent commission, or $12 000. What is the contribution of this transaction to GDP?
Because the house was not produced during the current year, its value is not counted in this
year’s GDP. (The value of the house was included in the GDP 20 years earlier, the year the house
was built.) In general, purchases and sales of existing assets, such as old houses or used cars, do
not contribute to the current year’s GDP. However, the $12 000 fee paid to the real estate agent
represents the market value of the agent’s services in helping the family find the house and make
the purchase. Since those services were provided during the current year, the agent’s fee is counted
in current-year GDP.

CONCEPT CHECK 2.3

Lotta Doe sells 100 shares of stock in Benson Buggywhip for $50 per share. She pays her broker a 2 per cent commission for
executing the sale. How does Lotta’s transaction affect the current-year GDP?

2.2 METHODS FOR MEASURING GDP LO 2.2

GDP is a measure of the quantity of goods and services produced by an economy. But any good or service that
is produced will also be purchased and used by some economic agent—a consumer buying Christmas gifts or a
firm investing in new machinery, for example. For many purposes, knowing not only how much is produced, but
who uses it and how, is important. (Goods that are produced but not sold in a period are called ‘inventories’. By
convention, economists regard these unsold goods as having been purchased by the firms that produced them.)
Economic statisticians divide the users of the final goods and services that make up the GDP for any given
consumption expenditure,
period into four categories: households, firms, governments and the foreign sector (i.e. foreign purchasers of or consumption
domestic products). They assume that all the final goods and services that are produced in a country in a given Spending by households
period will be purchased and used by members of one or more of these four groups. Furthermore, the amounts on goods and services
such as food, clothing and
that purchasers spend on various goods and services should be equal to the market values of those goods and entertainment.
services. As a result, GDP can be measured with equal accuracy by either of two methods (see Section 2.2.2 for
investment
discussion of the third method): Spending by firms on
1. adding up the market values of all the final goods and services that are produced domestically final goods and services,
primarily capital goods and
2. adding up the total amount spent by each of the four groups on final goods and services and subtracting housing.
spending on imported goods and services.
government purchases
Corresponding to the four groups of final users are four components of expenditure: consumption Purchases by federal, state
expenditure, investment, government purchases and net exports. That is, households consume, firms invest, and local governments of
final goods and services.
governments make government purchases (consumption and investment) and the foreign sector buys the nation’s Government purchases
exports. Table 2.2 gives the dollar values for each of these components for the Australian economy over the do not include transfer
financial year 2016–17. As the table shows, GDP for Australia in 2016–17 was about $1692 billion, roughly $68 payments, which are
payments made by the
000 per person. The item in Table 2.2 labelled ‘statistical discrepancy’ is a balancing item that ensures that the government in return for
figure for GDP calculated by summing all the expenditures in the economy is equivalent to the figure for GDP which no current goods or
services are received, nor
calculated from adding together the total incomes earned in the economy. We will discuss the use of income to
do they include interest
measure GDP shortly. paid on the government
Detailed definitions of the components of expenditure and their principal subcomponents are in debt.
Table 2.3. As you read through them, refer to Table 2.2 to get a sense of the relative importance of each type net exports
of spending. Exports minus imports.

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30 PART 1 ISSUES IN MACROECONOMICS

TABLE 2.2 Expenditure components of Australian GDP, 2016–17 ($ million, chain volume measures)

Household consumption 993 674

Investment 419 458
Government consumption 321 459
Exports 337 046
Imports −374 571
Statistical discrepancy −5 689
GROSS DOMESTIC PRODUCT 1 691 377
Source: Australian Bureau of Statistics, ‘Australian national accounts: National income, expenditure and product, June 2018’, Cat.
no. 5206.0.

TABLE 2.3 Expenditure components of GDP

COMPONENT DEFINITION SUBCATEGORIES

CONSUMPTION Spending by households on goods and • Durables: Long-lived consumer goods such as cars
services such as food, clothing and and furniture. Note that new houses are not treated as
entertainment. consumer durables but as part of the investment.
• Non-durables: Shorter-lived goods like food and
clothing, and services, everything from haircuts and
taxi rides to legal, financial and educational services.
INVESTMENT Spending by firms on final goods and • Business fixed investment: The purchase by firms of
services, primarily capital goods and new capital goods such as machinery, factories and
housing. office buildings. (Remember that for the purposes of
calculating GDP, long-lived capital goods are treated as
final goods rather than as intermediate goods.) Firms
buy capital goods to increase their capacity to produce.
• Residential investment: The construction of new
homes and apartment buildings. For GDP accounting
purposes, residential investment is treated as an
investment by the business sector, which then sells
the homes to households.
• Inventory investment: The addition of unsold goods to
company inventories—in other words, the goods that a
firm produces but does not sell during the current period
are treated, for accounting purposes, as if the firm
had bought those goods from itself. (This convention
guarantees that production equals expenditure.)
GOVERNMENT Purchases by federal, state and local
EXPENDITURE governments of final goods, such as fighter
planes, and services, such as teaching in
public schools. Government purchases do
not include transfer payments, which are
payments made by the government in return
for which no current goods or services are
received. Examples of transfer payments
(which, again, are not included in government
purchases) are Social Security benefits,
unemployment benefits, pensions paid to
government workers and welfare payments.
Interest paid on the government debt is also
excluded from government purchases.

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 Measuring economic activity: Gross domestic product and unemployment CHAPTER 2 31

COMPONENT DEFINITION SUBCATEGORIES

NET EXPORTS Exports minus imports
Exports are domestically produced final
goods and services that are sold abroad.
Imports are purchases by domestic buyers
of goods and services that were produced
abroad. Imports are subtracted from exports
to find the net amount of spending on
domestically produced goods and services.

2.2.1!!THE NATIONAL INCOME ACCOUNTING IDENTITY

The relationship between GDP and expenditures on goods and services can be summarised by an equation. Let:

Y = GDP, or output
C = consumption expenditure
I = investment
G = government expenditure
NX = net exports

Using these symbols, we can write that GDP equals the sum of the four types of expenditure algebraically as:
Y = C + I + G + NX Equation 2.1

In writing the equation this way, we are assuming that the measures of consumption, investment and government national income accounting
expenditure include expenditure on imported goods and services. As they represent expenditure on the GDP of identity
A mathematical relation
other countries, these imports need to be subtracted from the calculation of domestic GDP. This is why it is net
that shows how GDP
exports, and not just exports alone, that appears in the equation. is equal to the sum
Equation 2.1 is a very important concept in macroeconomics. It is known as the national income accounting of expenditure on
consumption, investment,
identity. As you will see, the national income accounting identity provides the starting point for many important government purchases and
macroeconomic models in common use today. net exports.

EXAMPLE 2.7 – MEASURING GDP BY PRODUCTION AND BY EXPENDITURE

An economy produces 1 000 000 cars valued at $15 000 each. Of these, 700 000 are sold to consumers, 200 000 are
sold to businesses, 50 000 are sold to the government and 25 000 are sold abroad. No cars are imported. The cars left
unsold at the end of the year are held in inventory by the car producers. Find GDP in terms of (a) the market value of
production and (b) the components of expenditure. You should get the same answer both ways.

PRODUCTION METHOD EXPENDITURE METHOD

UNITS PRODUCED VALUE OF EXPENDITURE
(CARS) PRODUCTION COMPONENT UNITS SOLD VALUE OF EXPENDITURE
1 000 000 1 000 000 × Consumption 700 000 700 000 × $15 000
$15 000 = $15 billion = $10.5 billion
Investment 200 000 (sold to business) (200 000 × $15 000) + (25 000
25 000 (unsold inventory) × $15 000) = $3.375 billion
Government 50 000 50 000 × $15 000
purchases = $0.75 billion
Net exports 25 000 25 000 × $15 000
= $0.375 billion
GDP $15 billion $15 billion

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32 PART 1 ISSUES IN MACROECONOMICS

CONCEPT CHECK 2.4

Extending Example 2.7, suppose that 25 000 of the cars purchased by households are imported rather than domestically produced.
Domestic production remains at 1 000 000 cars valued at $15 000 each. Once again, find GDP in terms of (a) the market value of
production and (b) the components of expenditure.

2.2.2!!GDP AND THE INCOMES OF CAPITAL AND LABOUR

GDP can be thought of as either a measure of total production or as a measure of total expenditure—either
method of calculating the GDP gives the same final answer. There is yet a third way to think of the GDP, which
is as the incomes of capital and labour.
Whenever a good or service is produced or sold, the revenue from the sale is distributed to the workers and
the owners of the capital involved in the production of the good or service. Thus, except for some technical
adjustments that we will ignore, GDP also equals labour income plus capital income. Labour income (equal
to about 75% of GDP) comprises wages, salaries and the incomes of the self-employed. Capital income
(about 25% of GDP) is made up of payments to owners of physical capital (e.g. factories, machines, office
buildings) and intangible capital (e.g. copyrights, patents). The components of capital income include items
such as profits earned by business owners, the rents paid to owners of land or buildings, interest received
by bondholders in non-financial private firms and the royalties received by the holders of copyrights or
patents. Both labour income and capital income are to be understood as measured prior to payment of taxes;
ultimately, of course, a portion of both types of income is captured by the government in the form of tax
collections.
A related concept is gross national income. This is defined as income earned by all citizens of a country
regardless of where those citizens live. GDP and gross national income can differ if many of a country’s citizens
work elsewhere and the citizens of other countries work domestically.
A useful way of summarising the relationships between the expenditure, production and income approaches
circular flow of income to measuring GDP is a concept known as the circular flow of income. To illustrate this concept we will use
The economy’s national a very simple, stylised representation of an economy known as the two-sector model. This is a scaled-down
income that can be
equivalently measured version of the economy, in which only firms and households are assumed to exist. The government is absent
using the production, and there are no exports and imports. There is, of course, no such economy in the real world. Nonetheless,
expenditure or income
approaches. economists often work with a simplified model such as this as it enables key fundamental characteristics of the
economy to be highlighted in a way that would not be possible if all of the complexities of an actual economy
two-sector model were also considered.
A simplified model of the
economy in which there Figure 2.2 shows a representation of how households and firms interact in a two-sector model. These
are only households and interactions are associated with various flows that take place between the two sectors. The first set of flows
firms.
relates to production. Households send a flow of factors of production to firms. In this simple economy,
these factors of production are of two types. The first is labour services: the hours of work supplied by
households to firms. The second relates to the services from capital: firms are assumed to rent the plant
and equipment needed to produce goods and services from households. Firms use these factors of output
to produce goods and services which, in turn, are sold to households. The revenue produced by these sales
enables firms to pay for their use of labour and capital services. These payments represent a flow of income
to households.
The circular flow highlights why economists regard production, income or expenditure as equivalent means to
describe the same concept, GDP. Firms, by producing and then selling output, generate income for households,
who use the income to purchase the goods and services produced by firms. In this simple closed system, income,
expenditure and production are three different words describing the same concept.
Economies, in reality, are much more complex than the simple representation illustrated by the circular flow
of income. When the respective values of production, expenditure and income flows are measured over a period,
they are never exactly equivalent. Background Briefing 2.2 discusses one reason why this is so, the failure to
record properly many economic transactions.

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 Measuring economic activity: Gross domestic product and unemployment CHAPTER 2 33

Households supply factors of production to firms

Firms pay households for use of factors of production

Households purchase goods and services from firms

Firms produce output, which is supplied to households

Figure 2.2 The circular flow of income

Note: The circular flow of income in a two-sector economy traces the flows of income, expenditure and production of resources between households and firms.

BACKGROUND BRIEFING 2.2

The underground economy

One problem with the official estimates of GDP is that they exclude what for many countries may be a
significant form of economic activity, the ‘underground economy’. This term refers to economic transactions
that are not recorded in the official statistics, often because they represent illegal activity and/or they
are a result of an attempt to avoid taxes. A cash payment to a tradesperson for which a receipt is not
issued is one form of underground economic activity—such an arrangement may suit the tradesperson
as the payment would not be counted as income for the purposes of assessing taxable income. Criminal
transactions, such as the proceeds from drug sales, are also part of the underground economy.
How significant is the underground economy? A report by the Australian Bureau of Statistics (ABS
2012) attempted the task of quantifying the underground economy. This is a difficult task. By their
nature, transactions in the underground economy may be difficult to detect using anything other than
very indirect means. For example, audits conducted by the taxation department can be used to infer
the degree of under-reporting of income. Expenditure data on commodity groups, used to calculate the
amount owing to the government through Australia’s goods and services tax (GST), can be matched
against production data to again estimate the degree of under-reporting.
The ABS research concluded that the size of the underground economy might be lower than many
people realise, requiring adjustments to GDP of no more than 3 per cent. This is well down on other
estimates. For example, a well-known study by the World Bank (Schneider, Buehn & Montenegro 2010)
concluded the underground economy in Australia was around 15 per cent of official GDP. However, the
World Bank study used a very different methodology to that adopted by the ABS, a reminder of how
difficult it can be to agree on a definitive way of quantifying highly complex economic phenomena.
References
Australian Bureau of Statistics (ABS) 2013, ‘Information paper: The non-observed economy and Australia’s GDP, 2012’, Cat no.
5204.0.55.008, [Link]/ausstats/[email protected]/Latestproducts/5204.0.55.008Main%20Features22012?opendocument&tab
name=Summary&prodno=5204.0.55.008&issue=2012&num=&view=.
Schneider F, Buehn A, Montenegro C 2010, ‘Shadow economies all over the world: New estimates for 162 countries from 1999 to
2007’, The World Bank, [Link]
421&menuPK=64166093&entityID=000158349_20101014160704.

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34 PART 1 ISSUES IN MACROECONOMICS

!! RECAP
Expenditure components of GDP

GDP can be expressed as the sum of expenditures on domestically produced final goods and services. The
four types of expenditure that are counted in the GDP, and the economic groups that make each type of
expenditure, are as follows:

TYPE OF WHO MAKES THE

EXAMPLES
EXPENDITURE EXPENDITURE?
Consumption Households Food, clothes, haircuts, new cars
Investment Business firms New factories and equipment, new houses, increases
in inventory stocks
Government purchases Governments New school buildings, new military hardware, salaries
of soldiers and government officials
Net exports, or exports Foreign sector Exported manufactured goods, legal or financial
minus imports services provided by domestic residents to foreigners

GDP also equals labour income plus capital income.

LO 2.3 2.3 NOMINAL GDP VERSUS REAL GDP

As a measure of the total production of an economy over a given period, such as a particular year, GDP is useful
in comparisons of economic activity. For example, GDP data for the year 2017, broken down by state, could be
used to compare aggregate production in South Australia and Victoria during that year. However, economists
are interested in comparing levels of economic activity not only in different locations but over time as well.
Using GDP to compare economic activity at two different points in time may give misleading answers, as the
following example shows. Suppose for the sake of illustration that the economy produces only pizzas and pasta.
The prices and quantities of the two goods in the years 2013 and 2018 are shown in Table 2.4. Also shown is
nominal GDP, obtained by multiplying the quantity of each commodity by its current price, and then adding the
values derived to get an overall measure of the value of commodities produced in this economy.

TABLE 2.4 Prices and quantities in 2013 and 2018

QUANTITY OF PIZZAS PRICE OF PIZZAS QUANTITY OF PASTA PRICE OF PASTA NOMINAL GDP
2013 10 $10 15 $5 $175
2018 20 $12 30 $6 $420

Comparing the GDP for the year 2018 to the GDP for the year 2013, we might conclude that it is 2.4 times
greater ($420/$175). But look more closely at the data given in Table 2.4. Can you see what is wrong with this
conclusion? The quantities of both pizzas and pasta produced in the year 2018 are exactly twice the quantities
produced in the year 2013. If economic activity, as measured by actual production of both goods, exactly doubled
over the six years, why do the calculated values of GDP show a greater increase?
The answer, as you can also see from the table, is that prices, as well as quantities, rose between 2013 and
2018. Because of the increase in prices, the market value of production grew more over those six years than
the physical volume of production. So in this case, GDP is a misleading gauge of economic growth, since the
physical quantities of the goods and services produced in any given year, not the dollar values, are what determine
people’s economic wellbeing. Indeed, if the prices of pizzas and pasta had risen 2.4 times between 2013 and

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