Measuring National Output and National Income

Gross Domestic Product (GDP)

GDP is the total market value of a country’s output. It is the market value of all final goods and
services produced within a given period of time by factors of production located within a country.

What does GDP exclude?

GDP is concerned only with new, or current, production. Old output is not counted in current GDP
because it was already counted when it was produced. It would be double counting to count sales of
used goods in current GDP.

It also excludes intermediate production since this will lead to double counting.

Moreover, transfer of money for which no goods or services were exchanged for are also excluded
from GDP. Examples would be transfer payments (pensions and welfare benefits).

Sales of stocks and bonds are also not counted in GDP. These exchanges are transfers of ownership
of assets, either electronically or through paper exchanges, and do not correspond to current
production. Moreover, profits from the stock or bond market have nothing to do with current
production, so they are not counted in GDP. However, if you pay a fee to a broker for selling a stock
of yours to someone else, this fee is counted in GDP because the broker is performing a service for
you. This service is part of current production.

Lastly, GDP excludes output produced abroad by domestically owned factors of production

Equality of Income and Expenditure (Circular flow of income)

GDP measures two things at once: the total income of everyone in the economy and the total
expenditure on the economy’s output of goods and services. GDP can perform the trick of measuring
both total income and total expenditure because these two things are really the same. For an
economy as a whole, income must equal expenditure.

An economy’s income is the same as its expenditure because every transaction has two parties: a
buyer and a seller. Every dollar of spending by some buyer is a dollar of income for some seller.

The equality between income and expenditure can be analysed using the circular flow of income
model for a simple economy also known as a two sector economy. In this economy, we have only two
economic agents which are the households and the firms. It is also known as a closed economy
without government. The economic agents interact through the goods market and the factors of
production market. This is illustrated in the diagram below:

We assume that all goods and services are bought by households (consumption) and that
households spend all of their income. In this economy, when households buy goods and services
from firms, these expenditures flow through the markets for goods and services. When the firms in
turn use the money they receive from sales to pay workers’ wages, landowners’ rent, and firm
owners’ profit, this income flows through the markets for the factors of production. Money
continuously flows from households to firms and then back to households.

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GDP measures this flow of money. We can compute it for this economy in one of two ways: by adding
up the total expenditure by households or by adding up the total income (wages, rent, and profit) paid
by firms. Because all expenditure in the economy ends up as someone’s income, GDP is the same
regardless of how we compute it. Hence the circular flow will be in equilibrium when total income
generated equals total expenditure made.

We have up to now assume that households spend all income they received on goods produced by
firm. (Y=C).However, in real life households do not spend all income they received meaning that they
save part of it for future use. As a result:

Y= C+S, where S (savings) represent a withdrawal / leakage (W) from the circular flow since
the money was not re-injected in the circular flow.

On the other hand, we have also assumed that the only expenditures made in the economy are
expenditures by households (C). However, there will also be expenditures by firms in the form of
investment (I). Firms will have to add to their capital stock and this represents an injection in the
circular flow as it comes from outside the circular flow. We can re-write our equilibrium condition as
follows.

Hence it can be said that equilibrium in the circular flow also means that planned injections to be
equal to planned withdrawals.

Equilibrium in a 3 Sector model

A three sector model is also known as a closed economy with government. Total expenditure in the
economy will be made up of consumption, private investment and government expenditure.

E=

For the economy to be in equilibrium, total income must be equal to total expenditure meaning that:

Y=E

On the injections and withdrawals side, injections in the economy will be made up of private
investment and government expenditure. Government expenditure is considered as an injection since
it is an expenditure that has not been generated from within the circular flow.
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J=

On the other hand, withdrawals will be made up of savings as well as taxes. Factors of production will
have to pay taxes on the income received and this will represent a leakage from the circular flow as it
leads to a reduction on the circular flow of income.

Given that when the economy is in equilibrium, injections must be equal to withdrawals, the
equilibrium condition using the injections/withdrawals approach will be as follows:

Equilibrium in a 4 Sector model

Why planned injections must be equal to planned withdrawals?

Consider a 2 sector model, that is, a closed economy without government. The economy is defined to
be in equilibrium when aggregate output (Y) is equal to planned aggregate expenditure (AE).

Equilibrium:

Because AE is, by definition, C + I, equilibrium can also be written:

Equilibrium:

Suppose planned aggregate expenditure is greater than aggregate output:

Y < C+I
When planned spending exceeds output, firms have sold more than they planned to. Inventory
investment is smaller than planned. Planned and actual investments are not equal. It seems
reasonable to assume that firms will respond to unplanned inventory reductions by increasing output.
If firms increase output, income must also increase. When firms try to keep their inventories intact by
increasing production, this will generate more income in the economy as a whole.
This will lead to more consumption. Remember, when income rises, so does consumption. The
adjustment process will continue as long as output (income) is below planned aggregate expenditure
and equilibrium will be restored at a higher level of income where planned injections will be equal to
planned savings.

Suppose now aggregate output is greater than planned aggregate expenditure:

Y > C+I

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When output is greater than planned spending, there is unplanned inventory investment. Firms
planned to sell more of their goods than they sold, and the difference shows up as an unplanned
increase in inventories. In this case, firms will respond by reducing output. As output falls, income
falls, consumption falls, and so on, until equilibrium is restored, with Y lower than before.

Calculating National Income

There are three methods of calculating GDP:

a. Expenditures Approach
b. Income Approach
c. Output Approach

Expenditures Approach

To determine GDP using the expenditures approach, we add up all the spending on final goods and
services that has taken place throughout the year.
Total expenditure is made up of consumption, investment, government expenditure and net exports:

AE=

Since in equilibrium Y (GDP) = AE, it means that Y (GDP) = C+I+G+(X-M). However, it should be
noted that the value of GDP obtained is known as GDP at market prices since final expenditures
include taxes and subsidies. Taxes increase the value of final expenditure whereas subsidies reduce
it.
Adjustments will have to eliminate the taxes and subsidies and convert the GDP at market prices into
GDP at factor cost.

GDP at factor cost = GDP at market prices – Taxes + Subsidies

Income Approach

This way to calculate GDP implies adding up all the income earned by factors of production from
firms in the economy—the wages earned by labor; the interest earned by those who lend their
savings to firms and the government; the rent earned by those who lease their land or structures to
firms; and the profit earned by the shareholders, the owners of the firms’ physical capital. This is a
valid measure because the money firms earn by selling goods and services must go somewhere;
whatever isn’t paid as wages, interest, or rent is profit. And part of profit is paid out to shareholders as
dividends.

Excluded from the accounts the following items:

1. Transfer payments e.g. the state pension paid to retired people; income support paid to families
on low incomes; the unemployment benefits given to the unemployed and other forms of welfare
assistance including child benefit and housing benefit.
2. Private transfers of money from one individual to another.

GDP at factor cost = Wages + Rents + Interest + Profits

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Output Approach

This method adds up the value of all the final goods and services produced in the economy. For
example, if there are 10 sectors in an economy, the final value of goods and services produced in the
economy are added to obtain GDP.
However, it is important that the value of intermediate goods and services are excluded else there will
be double counting. Consider the table below.

Firm R Firm I Firm F All firms

Purchases from other $0 $100 $130 $230 = Total interfirm sales
firms $180 = Value added
Purchases of FOP (Value $100 $30 $50 $410 = Total value of sales
added)
Total $100 $130 $180

In the above example, firm R starts from scratch and produces goods valued at $100; the firm’s value
added is $100. Firm I purchase the output of firm R, processes it and sells it for $130. Its value added
is $30 because the value of the goods and services is increased by $30 because of the firm’s
activities. Firm F, after purchasing the output of firm I, works them into a finished state and sells them
for $180. Its value added is $50. If the output of each firm had been added instead of their value
added, the value of output would have been $410, far in excess of the actual value of $180.

Other Measures of Income

 Gross national product (GNP) is the total income earned by a nation’s permanent residents (called
nationals). It differs from GDP by including income that our citizens earn abroad and excluding
income that foreigners earn here. For example, when a Canadian citizen works temporarily in the
United States, her production is part of U.S. GDP, but it is not part of U.S. GNP. (It is part of
Canada’s GNP.)

 Net national product (NNP) is the total income of a nation’s residents (GNP) minus losses from
depreciation. Depreciation is the wear and tear on the economy’s stock of equipment and
structures, such as trucks rusting and computers becoming obsolete. Depreciation is also known
as capital consumption.

 Personal income is the income that households and non corporate businesses receive. Unlike
national income, it excludes retained earnings, which is income that corporations have earned but
have not paid out to their owners. It also subtracts indirect business taxes (such as sales taxes),
corporate income taxes, and insurance contributions. In addition, personal income includes the
interest income that households receive from their holdings of government debt and the income
that households receive from government transfer programs, such as welfare and Social Security.

 Disposable personal income is the income that households and non corporate businesses have
left after satisfying all their obligations to the government. It equals personal income minus
personal taxes plus welfare payments.

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 Real versus Nominal GDP
Nominal GDP refers to GDP at current prices, that is, the actual quantity of goods produced multiplies
by the actual prices.

Hence nominal GDP can rise because of:

a) An increase in the quantity of goods and services produced in the economy; and/or
b) An increase in the price level.

When studying changes in the economy over time, economists want to separate these two effects. In
particular, they want a measure of the total quantity of goods and services the economy is producing
that is not affected by changes in the prices of those goods and services.

To do this, economists use a measure called real GDP. Real GDP answers a hypothetical question:
What would be the value of the goods and services produced this year if we valued these goods and
services at the prices that prevailed in some specific year in the past? By evaluating current
production using prices that are fixed at past levels, real GDP shows how the economy’s overall
production of goods and services changes over time.

In other words real GDP takes into account only changes in output and not changes in the price level.
The real GDP is calculated as follows:

Real GDP =

Where GDP deflator is

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 Uses of national income statistics

 National income statistics are important in the formulation and assessment of macroeconomic
policy. It is clearly important to know current output and patterns of expenditure when formulating
policies to achieve the macroeconomic objectives. For example national income statistics provide
information on the level of investment in the country. Trends can be formulated to know whether
investments have been rising or declining and appropriate measures taken based on the
observations.

 National income statistics are used to monitor changes in real income. This is important because
changes in real income have an important bearing on changes in standard of living. A higher real
income usually means a higher standard of living as people can enjoy more goods and services

 National income statistics are used to make international comparisons between the home
country’s economic performance and that of other countries. A relatively slow growth of real
income is a strong indication that the country is doing less well than it might. The country with the
higher real income will be able to spend more on merit and public goods which in turn will
enhance standard of living.

 Economists use the statistics to develop models of the economy and make forecasts about the
future. Businesses can also use the statistics to make forecasts about future demand.

 Real income per head is also used to calculate the rate at which the economy is growing. The
government can then decide whether the rate is satisfactory or not and take appropriate economic
decisions.

Standard of Living

The standard of living is a measure of the material welfare of the inhabitants of a country. The
baseline measure of the standard of living is real national output per head of population or real GDP
per capita. This is the value of national output divided by the resident population. Other things being
equal, a sustained increase in real GDP increases a nation’s standard of living providing that output
rises faster than the total population. 

Limitations of using GDP to measure Standard of Living

When GDP increases it does not necessarily mean that standard of living is rising. There are two
reasons why this is so. One is that GDP statistics do not accurately measure the true value of output
produced in an economy. The other is that the welfare of a population is closely related to the many
dimensions of economic and human development, which GDP is unable to measure. It follows that
GDP can be quite misleading when used as a measure of welfare.

Within the country

1. Changes in price level : Nominal GDP does not give a good picture of standard of living
because it does not take into account changes in price level. GDP may have increased over
time because of changes in price and not because of changes in output. As a result there has
been no increase in standard of living. To overcome this problem, real GDP is used.

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 2. Changes in population: The population of a country does not remain static overtime. It
increases as well as decreases. It goes without saying that the output when population
increases will be higher. Hence using real GDP to measure standard of living without
accounting for changes in population would be misleading. Therefore, real GDP per head
would be a better measure of standard of living.

Even after adjusting nominal GDP for changes in population and price level, it still suffers from
some serious limitations which are as follows:

 GDP does not include non marketed output : GDP measures the value of goods and services
that are traded in the market place and that generate incomes for the factors of production. Yet
some output is not sold in the market and does not generate any income; this is called non-
marketed output. For example, the work of the housewife is not accounted for by GDP. In
developing countries GDP tends to be very high and therefore GDP is understated significantly.

 GDP does not include output sold in informal markets : An informal market exists whenever a
buying and selling transaction is unrecorded. For example, in Mauritius, many of the hawkers are
working illegally and therefore their output is not recorded. They do not report the income they
received.

 GDP does not take into account quality improvements in goods and services : The quality of
many products improves over time, yet this is not taken into account in calculating the value of
aggregate output. Technological advances often permit improved products to be sold at lower
prices. This process offers significant benefits to consumers, which do not show up in GDP
figures. The exclusion of quality improvements means that GDP understates society’s welfare.

 Leisure and working hours: An increase in real GDP might have been achieved at the expense
of leisure time if workers are working longer hours. Hence, despite earning higher salaries,
workers are having less time for recreational activities which is not reflected in GDP.

 GDP does not take into account increased life expectancy : Increased life expectancy is
another benefit of technological improvements and higher income levels that has contributed
enormously to the welfare of societies, but is not accounted for in GDP figures.

 GDP does not account for the value of negative externalities: Virtually all countries contribute
to environmental degradation, as a result of which welfare is reduced. This is not reflected in GDP
figures.

 GDP does not take into account the depletion of natural resources: The depletion of natural
resources around the world reduces welfare yet is also not taken into consideration by standard
national income accounting.

 GDP does not take into account composition of output: Whether a country produces military
goods or merit goods or any other type of goods, GDP includes the value of all without any
distinctions regarding the degree to which they contribute to the welfare of the population.
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 Economic development and human development involve increasing production of social services
and merit goods that contribute to higher levels of living. One country may have a lower per capita
GDP than another, but higher levels of social service and merit goods provision than the other.

 GDP provides no information on the distribution of income: How equally or unequally income
and output are distributed over the entire population is another key factor underlying society’s
welfare. Is the wealth if the nation concentrated in relatively few hands or relatively equally
distributed? Are inequalities increasing or decreasing? The measure of GDP per capita cannot
answer any of these questions because it only provides an indication of average output per
person, and is therefore in this respect, too, inconclusive and misleading as a basis of welfare
comparisons.

 GDP does not account for quality of life factors: A society’s welfare depends upon a number
of non economic factors such as the crime rate, a sense of security and peace arising from
relations with other countries, well functioning institutions, stress levels from working conditions,
the degree of political freedom and many others. GDP cannot account for any of these. As a result
welfare may be higher or lower depending on the particular situation prevailing in the country with
respect to each of these factors.

Comparisons between countries

National income data can be used to make cross-country comparisons. This requires converting GDP
data into a common currency (normally the dollar or the Euro). The country with the higher real GDP
per capita is said to have the highest standard of living.
However, cross country comparisons also suffer from the limitations enumerated above as well as
from additional limitations such as:

 GDP and differing price levels: Goods and services can sell for vastly different prices in different
countries. This means that a given amount of a currency can buy more goods in low price country
than in a high price country. If international comparisons of GDP does not account for differing
price levels across countries, we will get a highly misleading picture of welfare.

 Movement in exchange rates: National income figures of different countries are expressed in
different currencies and for the purpose of comparison; the figures are converted into a single
currency. However, using the exchange rate as a basis of conversion is not always satisfactory
because it fluctuates. Fluctuations in exchange rate is not an indication of changing living
standards although GDP may be changing.

 Taste and needs: Crude income per head of different countries may not satisfactorily indicate
differences in economic welfare because of different taste and needs. Different goods confer a
different degree of benefit or utility to the citizens of different countries. Similarly, an Englishman
may obtain higher income than a Mauritian, but the former may have to spend much more on
heating and warm clothes than the latter so that he may be in no way better off. People of the
World differ widely in their cultural nature, consumption and expenditure patterns, savings habit,
etc…

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 Other measures of Standard of Living

1. Human Development Index (HDI)

Human Development Index measures the overall development of a nation. It is a set of statistics,
which are used to rank the different countries in the world and classify them by level of development.
HDI or The Human Development Index is a comparative measure of factors like life expectancy,
literacy, education and standards of living, well-being, especially child welfare for all countries
worldwide.

In other words, the Index is made up of three equally weighted components. It takes into account real
GDP per head using purchasing power parity, education (literacy rate, years of schooling) and health
(mortality rates, number of doctors, etc…). It gives a single numerical value between 0-1 and the
higher the value the more developed the nation. It gives an indication of health and education level in
the country rather than just incomes.

For the year 2011, Norway was ranked 1 st on the level of development (HDI = 0.943) whereas the
USA was ranked 4th (HDI = 0.91), despite the US having a higher real GDP per head than Norway.
The rank of Mauritius is 77th with an HDI of 0.728

Advantages of using HDI

 measures chosen are easy and cheap to collect
 measures chosen are fairly reliable
 indicates GDP has been used to increase social welfare illustrated through an increase in literacy
rates or access to health care
 GDP rank minus HDI rank as a useful measure for health and education level in the country
 use of education and health as a measure is a sign of successful government policies
 A higher HDI implying a higher literacy rate and better access to health care also means a shift of
PPF or AS curve outwards as a sign of increased potential output without increases in costs, so
HDI rank is a sign of welfare in the future.

Disadvantages of HDI
 an indication of deprivation or poverty would increase the usefulness of HDI
 PPP values change very quickly and are likely to be inaccurate or misleading
 income distribution not taken into account
 still very little sense of quality of life in this measure, for example wars, political oppression, etc are
not taken into account

2. Genuine Progress indicator

The measure was invented by an organization known as Redefining Progress. People working at the
organization believe that conventional measures such as GDP measure the wrong stuff. According to
them things that are added should have been subtracted. Moreover, certain things which do involve
cash movements, are not taken into account.

The objective of the GPI is to measure real progress. GPI starts with a broad measure such as
consumption and from it net foreign lending or borrowing is subtracted. An amount is then subtracted
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if the distribution of income has become more unequal or added if it has become more equal. After
that, social costs such as the costs of crimes, automobile accidents, commuting, family breakdown,
lost leisure time and underemployment are subtracted.

The GPI is then also adjusted for environmental costs such as the depletion of non renewable
resources, the cost of long term environmental damage, cost of ozone layer depletion, lost of
farmlands and wetlands.

Finally, the positives excluded from conventional measures are added to the GPI. They include the
value of housework and parenting, volunteer work, etc…

The GPI has shown that our real progress is only a fraction of what conventional indicators tell us.

3. Measurable Economic Welfare (MEW)

The MEW was developed by Nordhaus and Tobin (1972) to better understand the relationship
between economic growth and welfare.

MEW is calculated by adjusting conventional national income accounts in the areas of:
 A reclassification of government final expenditures into intermediates, consumption and net
investment, and a reclassification of some household expenditures. Education, medicine and
public health expenditures are considered gross investments that raise productivity or yield
household services.

 Consumer durables. The treatment of consumer durables as capital goods turns out to have little
quantitative effect.

 Instrumental or defensive expenditures. Among these expenditures are classified: costs of

commuting to work, and government services such as police, sanitation, road maintenance and
national defence.

 Disamenities of urbanisation. This category which includes the environmental damage costs of
environmental pollution is valued by a “disamenity premium” that is estimated as the income
differential between people living in densely populated locations and people living in rural
locations.

Although the MEW contains aspects of sustainable development (certain defensive expenditures and
the disamenity premium of urbanisation), its coverage and its degree of sophistication are quite
limited.

Conclusion:
Despite its serious limitations, national income accounting has become, since its creation, a tool of
economic analysis and policy making around the world. In fact, GDP has been hailed as one of the
great invention of the 20th century.

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