Chapter 7: Measuring Domestic Output and National Income

ECO 112 Principles of Macroeconomics

Today’s Roadmap

Key Concepts

Where GDP came from: the Great Depression and the first national income estimates
What GDP measures, and why only final goods count
Value added and the problem of multiple counting
What GDP leaves out, and why output equals income
The expenditures approach: GDP = C + Ig + G + Xn
The income approach, and what NDP, national income, personal income, and disposable income mean
The ladder from GDP down to disposable income
Nominal versus real GDP, and the GDP price index
The shortcomings of GDP as a measure of well-being

What GDP Measures

From Chapter 6 to Chapter 7

Chapter 6 introduced real GDP as the first big summary statistic and promised to build it properly. This chapter does that.

How is GDP defined, and what is left out?
How do we add up millions of different products into one number?
How do we strip out price changes to get real GDP?

National income accounting is the system of tools the government uses to measure the economy’s total output and income. In the United States, the Bureau of Economic Analysis publishes these numbers.

Why Do We Measure the Whole Economy?

GDP is a surprisingly young idea. Before the 1930s, no one produced an official, comprehensive measure of the economy’s total output.

Policymakers relied on scattered clues: railroad shipments, steel output, stock prices, and anecdotes.
Then came the Great Depression. Between 1929 and 1933, U.S. output fell by roughly a quarter, and unemployment climbed to roughly one worker in four (approximate figures).

The pain was obvious. The size of the collapse was not. Leaders could not say how far output had fallen, whether recovery had started, or whether their policies were working.

You cannot manage what you cannot measure.

The Birth of National Income Accounting

In 1932 the U.S. Senate asked the Commerce Department for estimates of the nation’s income.
- Economist Simon Kuznets led the effort. His 1934 report to Congress gave the first comprehensive estimates and showed that national income had fallen by roughly half from 1929 to 1932.

Kuznets also cautioned that a nation’s welfare can scarcely be inferred from its national income alone. We return to that warning at the end of this chapter.
During World War II, governments used the accounts to plan how much of the economy’s output could go to the war effort.
Until 1991 the main measure was GNP (gross national product), which counts output produced by a country’s own residents and firms, wherever in the world they operate. Since 1991 the United States has used GDP, which counts output produced within the country’s borders, whoever owns the resources.

Defining GDP

Gross domestic product (GDP) is the market value of all final goods and services produced within a country in one year.

Market value: every product is valued at its price, so apples and haircuts can be added together.
Final: the product is bought by its end user, not used up to make something else.
Produced: only new production counts.
Within a country: location matters, not the owner’s nationality.
In one year: GDP is a flow, like income per year, not a stock.

Final Goods vs. Intermediate Goods

Final goods and services are bought by their end users for consumption, investment, government use, or export.
Intermediate goods are used up in producing other goods and services, or resold.

The same item can be either. Flour bought by a family to bake at home is a final good. Flour bought by a bakery to make bread is an intermediate good.

Multiple Counting and Value Added

If GDP added up every sale at every stage, the same wheat would be counted again and again. This mistake is multiple counting.

The fix is to count only the value added at each stage: the sale price minus the cost of the intermediate goods bought from the previous stage.

Adding up value added gives exactly the price of the final good.

Example: A Loaf of Bread

A loaf of bread passes through three stages:

A farmer grows wheat and sells it to a mill for $20.
The mill turns it into flour and sells it to a bakery for $50.
The bakery bakes bread and sells it to consumers for $120.

What is the total of all three sales?
What is the value added at each stage?
How much does this production chain add to GDP?

Solution: A Loaf of Bread

Total of all sales: $20 + 50 + 120 = \$190$ (multiple counting)
Value added: farm $20$, mill $50 - 20 = 30$, bakery $120 - 50 = 70$

Sum of value added: $20 + 30 + 70 = \$120$
GDP counts only the $120 final sale.

What GDP Excludes

GDP counts new production. Some large money flows are not production at all:

Financial transactions: buying or selling stocks and bonds only moves ownership of existing assets (recall Chapter 6). The broker’s fee for the service does count.
Secondhand sales: a used car was counted when it was new. Only the dealer’s service margin counts now.
Transfer payments: Social Security, unemployment benefits, and gifts move money without any new good or service being produced.

Why Output Equals Income

Recall the circular flow from Chapter 2.

Households buy final goods from businesses: spending.
Businesses pay households for labor, land, capital, and entrepreneurship: income.

Every dollar spent on output becomes someone’s income. So:

\[ \text{GDP (output)} = \text{Total spending} = \text{Total income} \]

That is why there are two ways to measure GDP.

The Expenditures Approach

GDP = C + Ig + G + Xn

The expenditures approach adds up spending on final goods by four groups:

C: personal consumption expenditures by households
Ig: gross private domestic investment by businesses
G: government purchases
Xn: net exports, exports minus imports

\[ GDP = C + I_g + G + X_n \]

Consumption (C)

Household spending on final goods and services, the largest component of GDP in the United States. Three types:

Durable goods: last three years or more (cars, appliances, furniture)
Nondurable goods: last less than three years (food, clothing, gasoline)
Services: work done for you (haircuts, health care, rent, tuition)

Tuition counts as consumption, not investment, even though it builds human capital (Chapter 6).

Gross Private Domestic Investment (Ig)

Investment in GDP means spending on new capital and changes in inventories. It has three parts:

Spending by businesses on new machinery, equipment, software, and buildings
New residential construction (a newly built house or apartment)
Changes in inventories: unsold output that firms add to their stock counts as investment, because it was produced this year

Buying existing stocks or bonds is not investment. Neither is buying an existing house.

Gross vs. Net Investment

Machines wear out. Depreciation (consumption of fixed capital) is the value of capital used up during the year.

\[ \text{Net investment} = \text{Gross investment} - \text{Depreciation} \]

Net investment above zero: the economy’s capital stock is growing.
Net investment of zero: investment just replaces worn-out capital.
Net investment below zero: the capital stock is shrinking.

Only gross investment (Ig) goes into GDP.

Government Purchases (G) and Net Exports (Xn)

Government purchases (G)

Spending by federal, state, and local governments on final goods and services: roads, teachers’ salaries, military equipment.

Transfer payments are not included, because nothing is produced in exchange.

Net exports (Xn)

\[ X_n = \text{Exports} - \text{Imports} \]

Exports: our production bought by foreigners, so added.
Imports: foreign production bought here, so subtracted (already counted in C, Ig, or G).
Xn can be negative when we import more than we export.

Example: Computing GDP

An economy reports the following (billions of dollars):

Item	Amount
Durable goods purchased by households	900
Nondurable goods purchased by households	2,300
Services purchased by households	5,400
Business spending on machinery and buildings	1,500
New residential construction	700
Increase in business inventories	100
Government purchases of goods and services	2,900
Social Security and other transfer payments	1,600
Exports	1,400
Imports	1,700
Depreciation	1,100
Purchases of existing stocks and bonds	800

Which items do not belong in GDP?
Compute C, Ig, G, and Xn.
Compute GDP.
Compute net investment.

Solution: Computing GDP

Excluded: transfer payments (1,600) and existing stocks and bonds (800). Depreciation is not spending.
$C = 900 + 2{,}300 + 5{,}400 = 8{,}600$
$I_g = 1{,}500 + 700 + 100 = 2{,}300$
$G = 2{,}900$, $X_n = 1{,}400 - 1{,}700 = -300$

$GDP = 8{,}600 + 2{,}300 + 2{,}900 - 300 = 13{,}500$
Net investment: $2{,}300 - 1{,}100 = 1{,}200$

Example: Is It in GDP, and Where?

For each event, say whether it counts in this year’s GDP. If it does, name the component.

A family buys a newly built house.
A student pays college tuition.
A retiree receives a Social Security check.
A firm produces 500 chairs this year but sells only 400.
A city pays for a new bridge.
A person buys shares of stock from another investor.

Yes, Ig (residential construction).
Yes, C (services).
No, a transfer payment.
Yes, Ig: the 100 unsold chairs are an inventory increase, and the 400 sold are counted in C (or another buyer’s category).
Yes, G.
No, an existing financial asset.

Real Data: GDP Components

Series PCEC, GPDI, GCE, NETEXP

Which component is largest, and which is the most jagged from period to period?

Answer: consumption (PCEC) is by far the largest, while investment (GPDI) is much more volatile.

What sign does net exports (NETEXP) have for most of the chart, and what does that mean?

Answer: it is mostly negative, so the country has been importing more than it exports.

Why does a negative Xn not mean the economy is shrinking?

Answer: imports are subtracted only because they are already counted in C, Ig, and G, so they are removed to count only domestic production.

The Income Approach and Other National Accounts

The Income Approach

Since output equals income, GDP can also be measured by adding up the incomes earned producing it. The income approach uses these categories:

Compensation of employees: wages, salaries, and benefits (the largest share)
Rents: payments for the use of land and property
Interest: income from lending money to businesses
Proprietors’ income: earnings of self-employed people and unincorporated businesses
Corporate profits: what corporations earn after paying their other costs
Taxes on production and imports: sales and property taxes, a cost to firms that is not income to households

These six add up to national income (NI). One more item, depreciation, completes the bridge to GDP, because output that merely replaces worn-out capital is still output.

Two Ways to Add Up the Same GDP

Expenditures approach

Add up spending on final goods and services:

\[ GDP = C + I_g + G + X_n \]

Income approach

Add up the incomes earned producing them:

\[ \begin{aligned} NI &= \text{Compensation} + \text{Rents} + \text{Interest} \\ &\quad + \text{Proprietors' income} + \text{Corporate profits} \\ &\quad + \text{Taxes on production and imports} \end{aligned} \]

\[ GDP = NI + \text{Depreciation} \]

Same output, counted from two sides. Spending on the economy’s output is exactly the income the economy generates. (Two small adjustments, the statistical discrepancy and net foreign factor income, are ignored in this course’s examples.)

Example: Adding Up Income to GDP

Here is the income side of the same economy whose spending we added up earlier (billions of dollars):

Compensation of employees: 7,800
Rents: 300
Interest: 500
Proprietors’ income: 1,000
Corporate profits: 1,900
Taxes on production and imports: 900
Depreciation: 1,100

Compute national income.
Compute GDP by the income approach.
How does it compare with GDP by the expenditures approach?
What share of national income is compensation of employees?

Solution: Adding Up Income to GDP

$NI = 7{,}800 + 300 + 500 + 1{,}000$ $1{,}900 + 900 = 12{,}400$

$GDP = 12{,}400 + 1{,}100 = 13{,}500$

The expenditures approach gave $13{,}500$ too. Two approaches, one answer.
Compensation share of NI: $7{,}800 / 12{,}400 \approx 62.9\%$

Four More Measures: What They Mean and Why They Matter

Measure	What it means	Why it matters
Net domestic product (NDP)	GDP minus depreciation: output left over after replacing capital that wore out	GDP overstates what the economy can add to its living standards, because some output only replaces worn-out machines and buildings
National income (NI)	All income earned by the owners of resources (wages, rents, interest, profits), plus taxes on production and imports	Shows how the economy’s output is divided among workers, landowners, lenders, and business owners
Personal income (PI)	Income households actually receive before paying personal taxes	Some income earned in production never reaches households (retained profits, corporate taxes, payroll contributions), while transfers reach them without being earned
Disposable income (DI)	Personal income minus personal taxes	What households can actually spend or save, so it drives consumption, the largest part of GDP

Each measure answers a different question: how much was produced, how much was produced net of wear, how much was earned, how much did households receive, and how much can they spend?

From GDP to Disposable Income

Each step subtracts or adds something to move from total output to what households can spend.

Step	What changes
GDP	Starting point
Net domestic product (NDP)	Subtract depreciation
National income (NI)	Equal to NDP here (the two small adjustments are zero)
Personal income (PI)	Subtract income earned but not received: taxes on production and imports, social insurance contributions, corporate income taxes, undistributed profits. Add transfer payments.
Disposable income (DI)	Subtract personal taxes

Example: The Ladder

An economy has these values (billions of dollars):

GDP: 13,500
Depreciation: 1,100
Taxes on production and imports: 900
Social insurance contributions: 1,000
Corporate income taxes: 400
Undistributed corporate profits: 500
Transfer payments: 1,500
Personal taxes: 1,400

Assume the statistical discrepancy and net foreign factor income are zero.

Find NDP, national income, personal income, and disposable income.

Solution: The Ladder

NDP: $13{,}500 - 1{,}100 = 12{,}400$

NI: equal to NDP, $12{,}400$

PI: $12{,}400 - (900 + 1{,}000 + 400 + 500)$ $+ 1{,}500 = 11{,}100$

DI: $11{,}100 - 1{,}400 = 9{,}700$

Disposable income is what households can spend or save.

Real Data Idea: Nominal vs. Real GDP

Series GDP and GDPC1

Why does the nominal GDP line rise faster than the real GDP line?

Answer: nominal GDP rises with both output and prices, while real GDP removes the price increases.

Could nominal GDP rise while real GDP falls?

Answer: yes, if prices rise by more than output falls.

Which series should you use to judge whether the economy is growing?

Answer: real GDP, because it isolates changes in actual output.

Nominal vs. Real GDP

Why Nominal GDP Can Mislead

Nominal GDP is GDP measured at the prices of the year in which the output is produced. It changes for two reasons:

The quantity of output changes.
Prices change.

Only the first tells us the economy is producing more. If every price doubled and output stayed the same, nominal GDP would double, but nobody would be better off.

Real GDP measures output using the prices of a fixed base year, so only quantities change from year to year.

Example: Nominal and Real GDP

A tiny economy produces three things. Year 1 is the base year.

Product	Price, Year 1	Quantity, Year 1	Price, Year 2	Quantity, Year 2
Bicycles	$200	10	$240	11
Haircuts	$20	100	$25	104
Loaves of bread	$2	500	$3	500

Compute nominal GDP in each year.
Compute real GDP in Year 2 using Year 1 prices.
Find the growth rate of nominal GDP and of real GDP.

Solution: Nominal and Real GDP

Nominal Year 1: $2{,}000 + 2{,}000 + 1{,}000 = 5{,}000$
Nominal Year 2: $2{,}640 + 2{,}600 + 1{,}500 = 6{,}740$
Real Year 2: $200(11) + 20(104) + 2(500) = 5{,}280$

Nominal growth: $(6{,}740 - 5{,}000)/5{,}000 = 34.8\%$
Real growth: $(5{,}280 - 5{,}000)/5{,}000 = 5.6\%$

Most of the nominal increase was higher prices, not more output.

The GDP Price Index

A price index compares the cost of a fixed basket of output in the current year with its cost in the base year:

\[ \text{Price index} = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100 \]

The base year always has an index of 100. The GDP price index (or GDP deflator) covers everything produced in the economy.

In our example, Year 2: $6{,}740 / 5{,}280 \times 100 \approx 127.7$. Prices are about 27.7 percent higher than in the base year.

Deflating Nominal GDP

To convert nominal GDP into real GDP in base-year dollars, divide by the price index (in hundredths):

\[ \text{Real GDP} = \frac{\text{Nominal GDP}}{\text{Price index} / 100} \]

This is called deflating. If prices rose since the base year, dividing shrinks the nominal number back down to what it would be at base-year prices.

Example: Deflating

	Nominal GDP (billions)	GDP price index
Year A	$4,200	105
Year B	$4,830	115

Compute real GDP in each year.
Compute the growth rate of nominal GDP and of real GDP from Year A to Year B.
Explain the difference between the two growth rates.

Solution: Deflating

Real A: $4{,}200 / 1.05 = 4{,}000$
Real B: $4{,}830 / 1.15 = 4{,}200$

Nominal growth: $630/4{,}200 = 15\%$
Real growth: $200/4{,}000 = 5\%$

Prices rose about 9.5 percent between the years, which explains the gap.

Real Data: The GDP Price Deflator

Series GDPDEF

What is the base year for this index, and what value does it take there?

Answer: the base year is 2017 and the index is about 100 in that year.

What does the line’s upward slope tell you?

Answer: the overall price level of domestic output has risen over time, which is inflation.

If the index today is above 100, is real GDP smaller or larger than nominal GDP?

Answer: smaller, because deflating divides nominal GDP by a number greater than 1.

Shortcomings of GDP

GDP Is Not a Measure of Well-Being

GDP is an excellent measure of output. It was never designed to measure how well people live. Its main gaps:

Nonmarket activities
The underground economy
Leisure
Environmental damage and other negative externalities
Quality improvements and free digital products
Distribution of income

Nonmarket Activities and the Underground Economy

Nonmarket activities: household production, childcare by a parent, home cooking, and volunteering create value but involve no market sale, so they are left out. If a family hired someone to do the same work, GDP would rise.
Underground economy: cash-only work and illegal activity go unreported to avoid taxes or the law. Real output takes place, but it is not measured.

Leisure and the Environment

Leisure: if people work fewer hours and enjoy more free time, that is a gain in well-being, but GDP may fall.
Negative externalities: pollution and congestion are costs that fall on others. GDP counts the production that causes them and generally does not subtract the damage. Spending to clean up the damage can even raise GDP.

Quality and “Free” Digital Products

Today’s phone is far more capable than one from a decade ago. Statisticians use hedonic adjustments to try to account for quality changes, but the fit is imperfect.
Many digital services (search, maps, social media) are free to users. They generate little or no measured revenue, so their benefit to users is mostly missing from GDP.

Discussion: Would You Trust GDP?

Consider two countries with the same GDP per person.

In Country X, people work long hours, air quality is poor, and much care work is unpaid at home.
In Country Y, people work shorter hours, air is clean, and care work is done through paid services.

Which country would you rather live in? Which do you think GDP overstates or understates?

What other information would you want before comparing them?

Distribution

GDP per person is an average. Recall the mean versus median discussion from Chapter 6.

Two countries can have the same GDP per person but very different income distributions.
If most gains go to high earners, the typical household may barely benefit.

GDP says nothing about who receives the output.

A side note: gross output is a broader statistic that includes sales at every stage of production, unlike GDP, which counts only final goods.

Wrap Up

GDP is the market value of final goods and services produced in a country in a year. Value added avoids multiple counting.
GDP excludes financial asset trades, secondhand sales, and transfers.
Expenditures approach: $GDP = C + I_g + G + X_n$. Income approach: the incomes earned producing that output.
From GDP to disposable income: subtract depreciation, taxes on production and imports, and personal taxes, and adjust for corporate items and transfers.
Nominal GDP mixes output and prices. Real GDP $=$ nominal GDP $/$ (price index $/100$).
GDP misses nonmarket work, leisure, environmental damage, and distribution.

Looking ahead: Chapter 8 uses real GDP to study economic growth, and Chapter 9 uses it to study business cycles, unemployment, and inflation.