1

MacroLecture2
GDP, Income, and Expenditure
Lecture Highlights
GDP: definition and explain why the value of
production, income, and expenditure are the
same for an economy
Calculating GDP
Nominal versus Real GDP
Limitations of Real GDP as a measure of the
standard of living
2
How does your standard of living compare
with that of your parents when they were your
age?
Who is better off. You or a student in Beijing,
China.
We defined the standard of living as the level
of consumption of goods and services that
people enjoy, measured by average income
per person.
3
Gross Domestic Product (GDP)
- the market value of all the final goods and
services produced within a country in a given
time period.
4
Contd.
What produced?
To calculate GDP, we value all the final goods and
services.
Final good or service: a good or service that is
produced for its final user and not as a component
of another good or service.
Intermediate good or service: a good or service that is
produced by one firm, bought by another firm, and
used as a component of a final good/ service e.g. a
Proton Savvy is a final good, but a Goodyear tyre on
the Savvy is an intermediate good.
5
Contd.
Where produced?
Only goods and services that are produced
within a country as part of that countrys
GDP.
When produced?
GDP measures the value of production during a
given time period.
6
Types of expenditure
Consumption expenditure
Investment
Government purchases of goods and
services
Net exports of goods and services
7
Contd.
Consumption expenditure - the expenditure
by households on consumption goods and
services e.g. expenditures on ice cream,
chocolate bars, dry cleaning services.
Investment the purchase of new capital
goods (tools, instruments, machines,
buildings, and other constructions) and
additions to inventories.
8
Contd.
Government purchases of goods and
services purchases by all levels of
government of goods and services from
firms.
Net exports of goods and services the
value of exports of goods and services minus
the value of imports of goods and services
9
Contd.
Total expenditure = C + I + G + NX
C = consumption expenditure
I = investment
G = government expenditure
NX = net exports
Income labor earns wages, capital earns
interest, land earns rent, and
entrepreneurship earns profits.
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Expenditure equals income
Because firms payout everything they receive as
incomes to the factors of production, total
expenditure equals total income. That is,
Y = C + I + G + NX
The value of production is the cost of production,
which equals income. From the viewpoint of
purchases of goods and services, the value of
production is the cost of buying it, which equals
expenditure.
The value of production equals income expenditure
approach.
11
The circular flow of income,
expenditure
Households
Firms
Governments
Goods markets
Factor markets
Financial markets
Rest of world
C I G NX
NT
G
C I
NX
Y
Y
12
Measuring GDP
There are 2 approaches:
Expenditure approach
Income approach
The expenditure approach measures GDP by
adding together consumption expenditure ,
investment (I), government purchases (G),
and net exports (NX).
13
Contd.
amount in 2009
Item symbol billions of dollars % of GDP
________________________________________
Consumption C 9996 70.7
Investment I 1559 11.0
Govt.purchases G 2927 20.7
Net exports NX - 339 - 2.4
GDP Y 14133
14
Expenditures not in GDP
Used goods expenditure on used goods is
not part of GDP because these goods were
part of GDP in the period in which there were
produced.
Financial assets when households buy
financial assets such as bonds and stocks,
they are making loans, not buying goods and
services.
15
Contd.
The Income approach
The national income accounts divide incomes
into 5 categories:
Compensation of employees
Net interest
Rental income
Corporate profits
Proprietors income
16
Contd.
Compensation of employees the payment
for labor services (net wages & salaries plus
fringe benefits paid by employers)
Net interest the interest households receive
on loans they make minus the interest
households pay on their own borrowing.
Rental income the payment for the use of
land and other rented input.
17
Contd.
Corporate profits the profits of corporations.
Proprietors income proprietors are people
who run their own businesses. Their income
is a mixture of the previous 4 items.
18
Contd.
item amount in 2009 ($billion)
____________________________________
Compensation of employees 7733
Interest, rent, and profit
(net operating surplus) 3358
NDP at factor cost 11091
+ indirect taxes less subsidies 963
+ depreciation (capital consumption) 1865
GDP (income approach) 13919
+ statistical discrepancy 214
GDP (expenditure approach) 14133
From net to gross
The income approach measures net product
and the expenditure approach measures
gross product. The difference is depreciation,
which is the decrease in the value of capital
that results from its use and from
obsolescence. To get GDP from the income
approach, we must add depreciation to total
income.
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Statistical discrepancy
The expenditure approach and income approach do not
deliver exactly the same estimate of GDP. If a taxi driver
doesnt report all his tips, they get missed in the income
approach. But we can traced them by the expenditure
approach when he spends his income. So the sum of
expenditures might exceed the sum of incomes the
discrepancy between the expenditure approach and the
income approach is called the statistical discrepancy it
is calculated as the GDP expenditure total minus the
GDP income total.
20
21
Valuing the output of
industries
To measure the value of production of an
industry, we count only the value added by
that industry.
Value added is the value of a firms
production minus the value of the
intermediate goods it buys from other firms.
22
Contd.
The value of the bread (the final good) is equal to the sum of all values added.
0 0.5 1.0 1.5
$1.50
0.70 0.80
.2
0.2 0.5
consumer
baker
miller
farmer
Value added
Intermediate goods
Final expenditure
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Nominal GDP versus Real GDP
In 2001, GDP was $10,082 bil. In 2002, GDP
was $10,377 bil. Because GDP in 2002 was
greater than in 2001, one or two things must
have happened.
We produced more goods and services.
We paid higher prices for our goods and
services.
24
Contd.
Producing more goods and services contributes to
an improvement in our standard of living.
Paying higher prices means that our cost of living
has increased but our standard of living has not.
We measure the increase in production by a number
called real GDP.
Real GDP is the value of the final goods and
services produced in a given year when valued at
constant prices.
Nominal GDP the value of the final goods and
services produced in a given year valued at the
prices that prevailed in the same year.
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Nominal GDP calculation
GDP data for 2002
Item Qty Price
________________________
Apples 100 $1.00
Oranges 200 $0.50
_________________________
Expenditure on apples = 100 X $1 = $100
Expenditure on oranges = 200 X $0.50 = $100
Nominal GDP in 2002 = $100 + $100 = $200
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Contd.
GDP data for 2003
Item Qty Price
____________________________
Apples 160 $0.50
Oranges 220 $2.25
____________________________
Expenditure on apples = 160 X $0.50 = $80
Expenditure on oranges = 220 X $2.25 = $495
Nominal GDP in 2003 = $80 + $495 = $575
27
Real GDP calculation
To calculate real GDP, we choose one year,
called the base year, against which to
compare the other years.
Suppose 2002 as the base year. Real GDP
equals nominal GDP in the base year. So
real GDP in 2002 is $200.
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Traditional Real GDP
calculation
Calculating real GDP values the qty produced in each year at the
prices of the base year.
2003 quantities and 2002 prices
Item Qty Price
___________________________
Apples 160 $1.00
Oranges 220 $0.50
___________________________
Expenditure on apples = 160 X $1.00 = $160
Expenditure on oranges = 220 X $0.50 = $110
Value of the 2003 quantities at 2002 prices = $270
Using the traditional method, $270 would be recorded as real GDP
in 2003.
29
New Method of Calculating Real
GDP
The new method compares the quantities produced in 2002 and
2003 by using not only 2002 prices but also the 2003 prices. It
then averages the two sets of numbers.
Calculate the value of 2002 quantities at 2003 prices
2002 quantities and 2003 prices
Item Qty Price
Apples 100 $0.50
Oranges 200 $2.25
__________________________
Expenditure on apples = 100 X $0.50 = $50
Expenditure on oranges = 200 X $2.25 = $450
Value of the 2002 quantities at 2003 prices = $500
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Contd.
We have two comparisons between 2002 and 2003. at the 2002
prices, the value of production increased from $200 (2002) to
$270 (2003). The increase value is $70.
The percentage increase = 70/200 X 100 = 35%.
At the 2003 prices, the value of production increased from $500
(2002) to $575 (2003). The increase value is $75.
the percentage increase = 75/500 X 100 = 15%
The new method of calculating real GDP uses the average of
these two percentage increase:
The average is.
(35% + 15%)/2 = 25%
Real GDP is 25% greater in 2003 than in 2002
Real GDP in 2002 is $200
Real GDP in 2003 is $200(1.25) = $250
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Chain Linking
The calculation that weve just described is repeated
each year. Each year is compared with its preceding
year.
So, in 2002, the calculation are repeated but using
the prices and quantities of 2003 and 2004.
Real GDP 2004 = real GDP 2003 increased by the
calculated percentage change in real GDP 2004.
Suppose that real GDP 2004 is calculated to be
20% greater than in 2003.
real GDP 2003 = $250
real GDP 2004 = $250 (1.2) = $300
32
Contd.
year real GDP chain-linked percentage change

2004 $300

2003 $250

2002 $200
Base year
+25%
+20%
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Calculating the GDP calculator
Economists and policy makers are interested
not just in the level of production, as
measured by Real GDP, but also in the price
level. The price level measures the average
prices of goods and services in the economy.
We can use values for nominal GDP and Real
GDP to compute a measure of the price level,
called the GDP deflator.
34
Contd.
GDP deflator an average of current prices
expressed as a percentage of base year prices.
GDP deflator = nominal GDP X 100
___________
real GDP
The GDP deflator is a measure of the price level.
If nominal GDP rises but real GDP remains
unchanged, it must be that prices have risen.
The larger the nominal GDP for a given real GDP, the
higher the prices and the larger is the GDP deflator.
35
Contd.
Calculating the GDP deflator
__________________________________
Year nominal GDP Real GDP GDP def
___________________________________
2002 $200 $200 100

2003 $575 $250 230
___________________________________
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Other measures of Total
Production and Total Income
GDP is the value of final goods and services
produced within Malaysia.
Gross National Product (GNP) is the value of final
goods and services produced by residents of
Malaysia, even if the production takes place outside
Malaysia. Malaysian firms have facilities in foreign
countries, and foreign firms have facilities in
Malaysia. For example, a Malaysian firm has a
factory in Vietnam. Income of this firm is part of
Malaysias GNP but not part of Malaysias GDP. It is
part of Vietnams GDP.
GNP equals GDP plus net factor income received
from or paid to other countries.
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GDP and Related Product and
Income Measures
GDP
+ net factor income from abroad
= GNP
- Depreciation
= NNP
- Statistical discrepancy
= NI
- retained profits + transfer payments
= Personal Income
- Personal income taxes
= Disposable Personal Income
38
Contd.
Consumption expenditure is the largest
component of aggregate expenditure. The
main influences on consumption expenditure
is disposable personal income, which is the
income received by households minus
personal income taxes paid.
39
Goods and services omitted
from GDP
GDP measures the value of goods and
services that are bought in markets. But it
excludes:
Household production
Underground production
Leisure time
Environment quality
40
Contd.
Household production activities like preparing
meals, cleaning the kitchen, cutting the grass,
washing the car are examples of productive
activities that do not involve market transactions and
are not counted as part OF GDP.
Underground production the part of the economy
that is hidden from the view of the government
because people want to avoid taxes and regulations
because the goods and services being produced are
illegal e.g. the production and distribution of illegal
drugs, production that uses illegal workers.
41
Contd.
Leisure time leisure is an economic good. The more leisure we
have, the better off we are. Our working time is valued as part of
GDP, but our leisure time is not. These improvements in our
standard of living are not measured in real GDP.
Environment quality an industrial society produces more
atmospheric pollution than an agricultural society does. For
example an industrial society burns more coals, oil and gas. It
depletes resources, clears forests, and pollutes lakes and rivers.
Industrial activity increases wealth and wealthy people value a
clean environment and are better able to devote resources to
protecting it.
Resources that are used to protect the environment are valued
as part of GDP but pollution is not substracted from GDP.
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Some important identities
A simple economy: two sector economy
Y = the value of output which has neither a government nor foreign
trade
C = consumption
I = investment spending
Output sold can be written in terms of the components of demand
as the sum of consumption and investment spending
Y C + I (1)
All output produced is either consumed or invested.
Firms do sometimes make output that they cannot sell and that
accumulates as inventories on their shelves.
However, we count the accumulation of inventories as part of
investment. Therefore, all output is either consumed or invested.
43
Contd.
The private sector receives, as disposable personal income, the
whole of income Y. that income will be allocated, part will be
spent on consumption, and part will be saved.
Y S + C .. (2)
S = private sector saving
Identities (1) and (2) can be combined:
C + I Y C + S . (3)
Substracting consumption from each part of identity (3), we have
I Y C S .. (4)
Identity (4) shows that in this simple economy investment is
identically equal to saving.
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Reintroducing the government and
foreign trade (4-sector economy)
G = purchases of goods and services by the government
TA = all taxes or gross taxes
TR = transfers to the private sector
NX = net exports (exports minus imports)
Y C + I + G + NX .. (5)
Disposable income (Yd) = income (Y) + TR TA
Or Yd = Y T, T(net taxes) = TA TR
Yd Y + TR TA .. (6)
Yd C + S (7)
Combining identities (6) and (7), we have
C + S Yd Y + TR TA .. (8) or
C Yd S Y + TR TA S .. (8a)
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Contd.
Use the right-hand side of equation (8a) to substitute for C in identity
(5). We obtain
S I (G + TR TA) + NX . (9)
Y = C + I + G + NX
Yd = Y TA + TR
Y = Yd + TA TR
C + I + G + NX Yd + TA TR
C + I + G + NX C + S + TA TR . (10)
I + G + NX S + T, T = TA TR
S I G T + NX or
S I (G T) + (X M)

Budget deficit
Net export


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National saving (S), private saving
(Sp) and government saving (Sg)
Sp = Y + TR TA C
Income (Y) after paying taxes (TA) is called disposable
income (Yd)
Yd = (Y + TR) TA
Government saving (Sg) is given by government tax
receipts minus the purchases of goods and services
Sg = TA TR G
National saving (S) reflects the behavior of both the
private and public sector.
S = Sp + Sg = Y C - G