Chapter 5 The Measurement of National Income

Three ways to measure national income

o Value added
o The expenditure side
o The income side
Some further issues

1. Value added
Obtaining
Production occurs in stages : some
firms produce
used
outputs that are as
inputs by other

firms .

Double
Adding all sales of all firms .

Overestimates GDP .

the values of production of fi_K_ are

Only
included Th the GDP .

Example: Suppose the local baker uses flour that is the output of the flour milling

output. What would happen if we merely added up the values of all output of all
firms?
Farmer value of wheat
: price of wheat ✗ quantity of wheat
=

1- Mill : value of flour =

price of flour ✗
quantity of flour

::÷÷:÷:÷÷:÷:÷::÷-
+

bread 1 time
Wheat 3 times , flour 2 times , .

the value of bread

GDP only includes .
To avoid double counting, economists use the concept of value added. Two ways
to define value added:
1) Value added = sales revenue costs of intermediate goods
FAFF purchased
from firms that are used
other

as inputs in a further stage

of production .

In our example above, what is the value added of wheat farmer, the flour mill, and
the baker?
Farmer's value added = sales revenue of wheat
ÉÉÉs )
here

+ Mill 's value added = sales revenue of flour - costs ofwheat

counti-F.tt
C avoid double

Baker's value added = sales revenue of bread - costs of flour

:÷:÷::I%::::÷÷÷→
( Only final good B included)

does not know / does not

In reality ,
a firm care

sales for final use, or to be further

that their
are

processed by another firm .

 2)
π
to workers
EX. wags paid
owners
profits paid to
Farmer Flour Baker All firms
milling
company
of
costs A. Purchase from Total
intermediate other firms o 1300 interfirm

500Ns500800.00
goods sale
B. Payments to factors value
Total
value added added re
of production to

sales A+B = value of

venue
product

GDP sum ofall value "double

counting"
added in the economy.

So, value added is one measure of national income. To motivate the other two
The Circular Flow of Expenditure and
Income

! sparings
Domestic

T
-> Households

1 #
consumption
P ayments expenditure
for factor

Funagormemtimoo enter
genios
of
Rest
world
the

#
Domestic ④ -

expenditure
Total

generated
produces
④ >

income
GDP measured from expenditure
GDP measured from
income
side side
2. GDP from the Expenditure Side
Total expenditure on final output is the sum of four broad categories of
expenditure:
· Consumption (C)
·
Investment (I)
·
Got. purchases (G)
·
Exports
Net (NX)
Exhaustive list
falls
final output
-
allexpenditure on

into one and only one category.

1) Consumption expenditure (C)
and services sold their final
Expenditureon all
goods to

users.
fresh vegetables, etc.
EX. Non-durable goods:fresh meat,
Durable goods:car, goods, phones, computers,
canned

furniture, appliances, etc,

services:see a doctor, cosmetic procedure, phone plans,
classes, etc.
2) Investment expenditure university
CI)
Expenditure on
goods notfor presentconsumption.

a) Inventories
ofraw materials, goods
stocks in
process, and
held by firms.
finishedgoods
effect
the ofshort-run fluctuations
· To mitigate
and sales.
in production
 b) New plant and equipment goods.
capital
Ex. Computers, machines, buildings.

c) New residential housing

A new durable
house is asset
that provides

housing services for a long period of time.

part ofa
not but itsownership,
part ofthe GDP.
production occurred,
not
no

inthe GDP.
Any resale item
is not

Gross and net investment

met
een

Gross investment placement

needed
the amount to
replace worn-out capital
investment Gross investment
Net
-
depreciation.
men

thevalue
the loss in

by
ofphysical capital
wear
the
and tear in

production process.
3) Government Purchases (G)
Allgotexpenditure on
goods and services, excluding
->

transfer payment.
purchase oil, road work,
weapon, healthcare,
on
Ex.

infrastructure, police, education,

etc.

Transfer payment:CPP, EI, CERB

Not 1 exchange for goods and
paymentnotin
services.
4) Net Exports (M)
Exports
= -

Imports
(X -
IM)

Therefore, measured from the expenditure side, GDP is equal to the total
expenditure of domestically produced output.
GDP Ca latGat
=
+
Na

a:actual (Xa IMa -

> service becoming

is

o
- more important

decumulation
- negative investment
↓ stocks offinished goods

levels of
X and
->

30% ofGDP
o& IM are
-

trade deficit
3. GDP from the Income Side
1) Factor incomes
Wages and Salaries All pre-tax labor take
earnings:
-

home income tax withheld, pension & I

pay,
contributions, etc.

labor).
partofvalue ofproduction paid
to

Interest bank deposits.

- reached
Interest on

earned loans to firms.

(↓
Interest on

Other investment income.

dividends owners.
paid
to
out as

Business profits -
->
retained earnings held by firms
rent
EX, corporate profits,

for the use ofcapital

payments
Net domestic income at factor cost

2.a
and salaries
=
wages
Interest
↓

+ business profits
used
cluding the value of outputthatis
as replacementinvestment.
2) Non-factor payments
Indirect taxes and subsidies
· Taxes on production and sales of
goods and services.
Ex. HST, GST, excise tax.

·
subsidies to
firms:negative taxes
be subtracted
need to

o
Depreciation

From the income side,

salonia,
GDP factor income (wages and
=

interest, business profits)

+non-factor payments
Cindirecttax-subsidies, depreciation).

+
↑
I
Statistical discrepancy

&theoretically
↳
spenditure side GDP from
=

income side
both measured with
slighterror.
In practice, are

total.
is needed so
they
that come to the same

Some Further Issues

1) Real and Nominal GDP
EX. Nominal GDP by 6% 2017.
in

RealGDP by 4% in 2017.

2) The GDP deflator

ominal
GDPthe year X100
=

same

* It is
a price Index,
Example: Suppose we have the data for a hypothetical economy as follows
Quantity produced Prices
Wheat Steel (tonnes) Wheat Steel
(bushels) ($/bushel) ($/tonne)
Year 1 100 20 10 50
Year 2 110 16 12 55

Calculate nominal GDP, real GDP (using year-2 prices), and GDP deflator.
Nominal GDP:
Year 1 $10 x
100
= +
$50x20 = $2000
Year 2 $12
=
110
x +
$55x16 = $2200

Real GDP:
Year 1 $12x100
= +
$55 x 20 = $2300

Year 2 =

16
$12x110 $55 x + =
$2200
base nominal GDP real GDP
For year, =

GDP deflator:

Year 1
2000x100
=
86.96
=

Year 2 = 2200 100

x
= 100
$2200

GDP deflator vs. CPI

CPI:consumer goods
all goods and services produced
GDP deflator:
·
prices of
the
in economy.
index.
· mostcomprehensiveprice
do necessarily more together
They not

effecton
EX. would price ofcoffee, larger CPI.
 3) Omissions from GDP
Activities that
use real resources and generateincome
included the
in GDP.
but arenot
Illegal Activities
Ex. illegal drugs, illegal gambling
dollars.
couldbe multi-billion

The Underground Economy

transactions, but
are
reported
not
perfectly legal
for tax purposes.
12% -
15% ofGDP)

Home Production, Volunteering, and Leisure

market activities
A
Home production:repair your own car, "Housework":cooking,

laundry, etc.
value not
is included in

Leisure is
marketed,
not
its

the GDP.

Ex:pollution, traffic congestion

standards.
GDP will overstate the improvementin living
Do the Omissions Matter?
the omissions.
1. difficult correct
to
major
very
the
be inaccurate but
2. The
level ofGDP may
GDP is
good changes
indication of in
change in a

economic activity.
tax policies depend on output.
market
3. Inflation and
will lead to policy errors.
non-market activities
Including