Measuring the Economy’s Performance: Macroeconomic Study Notes

Measuring the Economy’s Performance

Introduction

Economists use gross domestic product (GDP) as the fundamental measure of an economy’s overall performance. GDP quantifies the market value of final goods and services produced within a nation’s borders during a specific period, typically one year. Adjusting for the average level of prices enables straightforward comparisons of aggregate production over time. However, GDP has limitations, and alternative measures are sometimes considered.

Learning Objectives

• Describe the circular flow of income and output

• Define gross domestic product (GDP) and explain its limitations

• Explain the expenditure and income approaches to tabulating GDP

• Discuss the key components of national income

• Distinguish between nominal GDP and real GDP

The Simple Circular Flow

Concept and Principles

The circular flow of income model illustrates the movement of money, resources, and goods/services in an economy. It is based on two principles:

• In every economic exchange, the seller receives exactly the same amount that the buyer spends.

• Goods and services flow in one direction, while monetary payments flow in the opposite direction.

Diagram: Circular Flow of Income and Product

The circular flow diagram shows:

• Product markets: Where households buy final goods and services from businesses.

• Factor markets: Where businesses buy resources (labor, land, capital, entrepreneurship) from households.

• Total income: Wages, rents, interest, and profits paid to households.

Profits as a Cost of Production

• Profits are the return entrepreneurs receive for the risk they incur when organizing productive activities.

National Income

• National income is the yearly amount received by the nation’s resource owners (factors of production), including wages, rent, interest payments, and profits.

Final Goods and Services

• Final goods and services are those at their last stage of production and will not be transformed into other goods or services. For example, bread is a final good, while wheat is usually an intermediate good.

Markets

• Product markets: Households buy goods.

• Factor markets: Businesses buy resources.

Equality of Output and Income

• The dollar value of total output must equal total income. Every transaction involves both an expenditure and a business receipt.

National Income Accounting

Definition of GDP

Gross domestic product (GDP) is the total market value of all final goods and services produced during a year by factors of production located within a nation’s borders.

Key Observations

• GDP measures the dollar value of final goods and services.

• GDP measures the dollar value of final output produced per year by factors of production.

• GDP measures the final output produced within a nation’s borders.

Final vs. Intermediate Goods

• Final goods: Goods ready for consumption (e.g., bread, automobile).

• Intermediate goods: Goods used up entirely in the production of final goods (e.g., wheat, steel).

Value Added

Value added is the dollar value of an industry's sales minus the value of intermediate goods used in production.

Table: Value Added at Each Stage of Donut Production

Stage of Production	Dollar Value of Sales	Value Added
1: Fertilizer and seed	$0.03	$0.03
2: Growing	$0.07	$0.04
3: Milling	$0.12	$0.05
4: Baking	$0.30	$0.18
5: Retailing	$0.45	$0.15
Total	$0.97	$0.45

Additional info: The sum of value added at each stage equals the retail price of the final good.

Gross Output (GO)

• Gross output (GO): The total market value of all goods and services produced during a year, including all business-to-business expenditures. GO includes double counting across all stages of production.

Excluded Transactions

• Financial transactions: Securities (stocks, bonds), government transfer payments (Social Security, unemployment), private transfer payments (gifts).

• Transfer of secondhand goods: Sale of used goods.

• Other excluded transactions: Household production, legal and illegal underground transactions.

Limitations of GDP

• Excludes nonmarket production.

• Not a direct measure of human well-being.

Two Main Methods of Measuring GDP

Expenditure Approach

The expenditure approach computes GDP by adding up the dollar value at current market prices of all final goods and services.

• Consumption expenditures (C): Durable goods (lifespan > 3 years), nondurable goods (lifespan < 3 years), services.

• Gross private domestic investment (I): Creation of capital goods, changes in inventories, repairs, and investment in future production.

• Government expenditures (G): State, local, and federal spending, valued at market prices.

• Net exports (X): Net exports = total exports - total imports.

GDP Formula (Expenditure Approach):

$GDP = C + I + G + X$

Net Domestic Product (NDP)

• Depreciation: Reduction in the value of capital goods due to wear and tear and obsolescence.

• NDP Formula: $NDP = GDP - ext{depreciation}$

Income Approach

The income approach measures GDP by summing all components of national income: wages, interest, rent, and profits.

• Gross domestic income (GDI): The sum of all income paid to the four factors of production.

• Components: Wages, interest (received minus paid), rent, profits, nonincome expense items (taxes, subsidies, depreciation).

Table: GDP and GDI Components (Example)

Expenditure Approach	Income Approach
Personal consumption	Wages, salaries
Gross private investment	Interest, rent
Government spending	Profits, taxes, subsidies
Net exports	Depreciation

Other Components of National Income Accounting

National Income (NI)

• National income: Total factor payments to resource owners.

Personal Income (PI)

• Personal income: Income households actually receive before paying personal income taxes.

Disposable Personal Income (DPI)

• Disposable personal income: Personal income after personal income taxes have been paid.

Table: From GDP to Disposable Income (Example)

Item	Amount
Gross domestic product (GDP)	297870
Minus depreciation	-51612
Net domestic product (NDP)	246258
Net U.S. income obtained abroad	+1100
Statistical discrepancy	-1506
National income (NI)	245852
Minus taxes, contributions	-72768
Net transfers and interest receipts	+474348
Personal income (PI)	247432
Minus personal income taxes	-41089
Disposable personal income (DPI)	206343

Distinguishing Between Nominal and Real Values

Nominal vs. Real GDP

• Nominal GDP: Value of output measured at current market prices (money values).

• Real GDP: Value of output measured in constant dollars, adjusted for changes in the average level of prices.

Constant Dollars

• Constant dollars: Expressed in terms of real purchasing power using a particular year as the base.

Correcting GDP for Price Index Changes

• Real GDP formula: $ext{Real GDP} = rac{ ext{Nominal GDP}}{ ext{Price Index}} imes 100$

Table: Correcting GDP for Price Index Changes

Nominal GDP (billions)	Price Index (base year=2017)	Real GDP (billions, constant 2017 dollars)
182950	97.315	187996
188049	98.240	191417
206565	102.291	201939
252140	104.008	206921
284154	125.036	272580

Per Capita Real GDP

• Per capita real GDP: Real GDP per person. $ext{Per capita real GDP} = rac{ ext{Real GDP}}{ ext{Population}}$

Foreign Exchange Rate and Purchasing Power Parity

• Foreign exchange rate: The price of one currency in terms of another.

• Purchasing power parity (PPP): Adjustment in exchange rate conversions to account for differences in the true cost of living across countries.

Table: Comparing GDP Internationally

Country	GDP (PPP, US$)	GDP (Exchange Rate, US$)
United States	76,339	76,399
Germany	63,150	48,433
United Kingdom	54,603	45,850
France	55,493	40,964
Italy	51,865	34,158
Japan	45,573	33,815
China	36,485	15,345
India	21,476	12,720
Brazil	17,822	8,918
Russia	14,653	4,788

Alternative Measures of Economic Performance

• Genuine Progress Indicator (GPI): Accounts for elements that counter environmental and human harms associated with increased production.

• Better-Life Index (BLI): Emphasizes material living conditions and other determinants of quality of life.

• Human Development Index (HDI): Emphasizes people’s abilities alongside income-based measures of living standards.

Summary of Key Concepts

Circular Flow of Income and Output

• In every transaction, the seller receives the same amount the buyer spends.

• Goods and services flow in one direction; monetary payments flow in the other.

• Households purchase final output using income from selling labor, land, capital, and entrepreneurship.

• Income equals the value of output.

GDP Definition and Limitations

• GDP is the total market value of final output produced within a year using domestic factors of production.

• GDP measures production flow, not wealth.

Expenditure and Income Approaches

• Expenditure approach: $GDP = C + I + G + X$

• Income approach: $GDP = ext{wages} + ext{interest} + ext{rent} + ext{profits}$

Key Components of National Income

• National income

• Personal income

• Disposable personal income

Nominal vs. Real GDP

• Nominal GDP: Value of output at current prices.

• Real GDP: Value of output in constant dollars, adjusted for price changes.

• Real GDP formula: $ext{Real GDP} = rac{ ext{Nominal GDP}}{ ext{Price Index}} imes 100$