Chapter 5

Measuring a Nation’s Production

and Income

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Learning Objectives

1. Explain the circular flow2. Identify the components of GDP3. Describe the steps from GDP to income4. Calculate real and nominal GDP5. List the phases of the business cycle6. Discuss the relationship of GDP to welfare

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● macroeconomicsThe study of the nation’s economy as a whole; focuses on the issues of inflation, unemployment, and economic growth.

● inflationSustained increases in the average prices of all goods and services.

MEASURING A NATION’SPRODUCTION AND INCOME

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The Circular Flow of Production and Income

FIGURE 5.1The Circular Flow of Production and Income

The circular flow shows how the production of goods and services generates income for households and how households purchase goods and services produced by firms.

5.1 THE “FLIP” SIDES OF MACROECONOMICACTIVITY: PRODUCTION AND INCOME

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● gross domestic product (GDP)The total market value of final goods and services produced within an economy in a given year.

● intermediate goodsGoods used in the production process that are not final goods and services.

5.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT

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● real GDPA measure of GDP that controls for changes in prices.

● nominal GDPThe value of GDP in current dollars.

● economic growthSustained increases in the real GDP of an economy over a long period of time.

R E A L - N O M I N A L P R I N C I P L EWhat matters to people is the real value of money or income—its purchasing power—not the face value of money or income.

5.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT (cont.)

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FIGURE 5.2U.S. Real GDP, 1930–2011

During the Great Depression in the 1930s, GDP initially fell and then was relatively flat. The economy was not growing much.

However, the economy began growing rapidly in the 1940s during Word War II and has grown substantially since then.

SOURCE: U.S. Department of Commerce.

5.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT (cont.)

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The Components of GDP

Economists divide GDP into four broad categories, each corresponding to different types of purchases represented in GDP:

1 Consumption expenditures: purchases by consumers2 Private investment expenditures: purchases by firms3 Government purchases: purchases by federal, state, and local governments4 Net exports: net purchases by the foreign sector (domestic exports minus domestic imports)

5.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT (cont.)

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The Components of GDP

CONSUMPTION EXPENDITURES

● consumption expendituresPurchases of newly produced goods and services by households.

PRIVATE INVESTMENT EXPENDITURES

● private investment expendituresPurchases of newly produced goods and services by firms.

5.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT (cont.)

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The Components of GDP

PRIVATE INVESTMENT EXPENDITURES

Private investment expenditures in GDP consist of three components:

1 First, there is spending on new plants and equipment during the year.2 Second, newly produced housing is included in investment spending.3 Finally, if firms add to their stock of inventories, the increase in inventories during the current year is included in GDP.

5.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT (cont.)

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The Components of GDP

PRIVATE INVESTMENT EXPENDITURES

● gross investmentTotal new investment expenditures.

● depreciationReduction in the value of capital goods over a one-year period due to physical wear and tear and also to obsolescence; also called capital consumption allowance.

● net investmentGross investment minus depreciation.

5.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT (cont.)

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The Components of GDP

GOVERNMENT PURCHASES

● government purchasesPurchases of newly produced goods and services by local, state, and federal governments.

● transfer paymentsPayments from governments to individuals that do not correspond to the production of goods and services. Not included in GDP.

5.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT (cont.)

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The Components of GDP

NET EXPORTS

● importA good or service produced in a foreign country and purchased by residents of the home country (for example, the United States).

● exportA good or service produced in the home country (for example, the United States) and sold in another country.

● net exportsExports minus imports.

5.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT (cont.)

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The Components of GDP

NET EXPORTS

● trade deficitThe excess of imports over exports.

● trade surplusThe excess of exports over imports.

5.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT (cont.)

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Putting It All Together: The GDP Equation

Y = C + I + G + NX

Y = GDP

C = Consumption

I = Investment

G = Government purchases

NX = net exports

GDP = consumption + investment + government purchases + net exports

where

In other words,

5.2 THE PRODUCTION APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING GROSS DOMESTIC PRODUCT (cont.)

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● national incomeThe total income earned by a nation’s residents both domestically and abroad in the production of goods and services.

Measuring National Income

● gross national productGDP plus net income earned abroad.

5.3 THE INCOME APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING NATIONAL INCOME

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Measuring National Income

● personal incomeIncome, including transfer payments, received by households.

● personal disposable incomePersonal income that households retain after paying income taxes.

5.3 THE INCOME APPROACH: MEASURING A NATION’S MACROECONOMIC ACTIVITY USING NATIONAL INCOME (cont.)

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How to Use the GDP Deflator

● GDP deflatorAn index that measures how the prices of goods and services included in GDP change over time.

● chain-weighted indexA method for calculating changes in prices that uses an average of base years from neighboring years.

5.4 A CLOSER EXAMINATION OF NOMINAL AND REAL GDP (cont.)

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● recessionCommonly defined as six consecutive months of declining real GDP.

● peakThe date at which a recession starts.

● troughThe date at which output stops falling in a recession.

● expansionThe period after a trough in the business cycle during which the economy recovers.

5.5 FLUCTUATIONS IN GDP (cont.)

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chain-weighted index

consumption expenditures

depreciation

depression

economic growth

expansion

export

GDP deflator

government purchases

gross domestic product (GDP)

gross investment

gross national product (GNP)

import

inflation

intermediate goods

macroeconomics

national income

net exports

net investment

nominal GDP

peak

personal income

personal disposable income

private investment expenditures

real GDP

recession

trade deficit

trade surplus

transfer payments

trough

value added

K E Y T E R M S