C h a p t e r
5 MEASURING GDP AND
ECONOMIC GROWTH*
Key Concepts ♦ Net exports (NX ) — exports (X, sales of U.S.
goods and services abroad) minus imports (M, pur-
chases of foreign good and services).
Gross Domestic Product Aggregate expenditure, C + I + G + NX, equals aggre-
Gross domestic product, GDP, is the market value of gate production, GDP, and also equals aggregate in-
all the final goods and services produced within in a come, Y. This equality is the basis for measuring GDP.
country in a given time period. ♦ National saving equals saving by households and
♦ A final good or service is an item that is bought by businesses plus government saving: S + (T − G ).
its final user during a specified time period. In con- ♦ Borrowing from the rest of the world equals M − X.
trast, an intermediate good is an item produced by Investment is financed by national saving plus borrow-
one firm, bought by another and used as a compo-
ing from the rest of world, I = S + (T − G ) + M − X.
nent of a final good or service. Intermediate goods
are not directly included in real GDP. A flow is a quantity over a unit of time. A stock is a
quantity that exists at a moment in time. Wealth and
The circular flow of income and expenditure shows real
capital are stocks; saving and investment are flows.
and monetary flows in the economy. The circular flow
involves: ♦ Wealth, the value of things that people own, is a
stock; income, what people earn, is a flow.
♦ Four economic sectors — households, firms, gov-
ernments, and the rest of the world. ♦ Saving is the amount of income remaining after
spending on consumption. Saving is a flow that
♦ Three major markets — factor markets, goods mar-
adds to wealth.
kets, and financial markets.
♦ Capital, the amount of plant, equipment, and in-
In these markets people make their economic decisions
ventories used to produce other goods, is a stock.
by choosing the amounts of key economic variables:
♦ Depreciation (also called capital consumption) is
♦ Consumption expenditures (C ) — total house-
the decrease in the capital stock because of wear and
hold spending on consumption goods and services.
tear and obsolescence. Gross investment is the total
♦ Investment (I ) — firms’ purchase of new plants, amount of investment. Net investment is gross in-
equipment, buildings, and additions to inventories. vestment minus depreciation. Net investment is the
♦ Government purchases (G ) — government flow that is the amount by which the capital stock
spending on goods and services. Net taxes (T ) are changes.
taxes paid to the government minus transfer pay- Gross domestic product includes depreciation and so
ments received from governments and minus inter- on the income side includes firms’ gross profit (before
est payments on the government’s debt. subtracting depreciation) and on the expenditure side
includes gross investment. Net domestic product ex-
cludes (subtracts) depreciation so it includes firms’ net
profits and net investment.
* This is Chapter 21 in Economics.
77
, 78 CHAPTER 5 (21)
Measuring U.S. GDP Measuring Economic Growth
In 2003, U.S. GDP equaled $10,847 billion. The economic growth rate is the percentage change in
♦ The expenditure approach measures GDP by adding the quantity of goods and services produced from one
final expenditures, C + I + G + NX. Of these expen- year to the next. It equals the growth rate of real GDP.
ditures, personal consumption expenditure is the Real GDP is used for economic welfare comparisons,
largest, at about 71 percent. Gross private invest- for making international comparisons of output, and
ment is about 15 percent, government purchases of for business cycle forecasting.
goods and services is about 19 percent, and net ex- Economic welfare is a comprehensive measure of gen-
ports is about –5 percent. eral economic well being. Real GDP is an imperfect
♦ The income approach adds the compensation of em- measure of economic welfare because real GDP:
ployees, net interest, rental income, corporate prof- ♦ Over adjusts for inflation — many quality im-
its and proprietors’ income to give net domestic in- provements that lead to higher prices are counted as
come at factor cost. Indirect taxes and depreciation only price hikes.
are added and subsidies subtracted to obtain GDP. ♦ Omits household production — all household pro-
duction is omitted.
Real GDP and the Price Level ♦ Omits the underground economy — the under-
ground economy (transactions hidden from the
Real GDP is the value of final goods and services pro-
government) is not included.
duced in a given year when valued at constant prices.
Nominal GDP is the value of the final goods and ser- ♦ Omits health and life expectancy — neither peo-
vices produced in a given year valued at the prices that ple’s health nor life expectancy are indicated by real
prevailed in that same year. GDP.
The base year prices method, which is the traditional ♦ Omits leisure time — the value of leisure time is
method of calculating real GDP, values the quantities not included.
produced in each year using the prices of the base year. ♦ Omits environmental quality — the consequences
The chain-weighted output index method, which is of adverse and beneficial environmental changes are
the new method of calculating real GDP, uses the omitted.
prices of two adjacent years to calculate the real GDP ♦ Ignores political freedom and social justice — the
growth rate. extent of political freedom or social justice within a
♦ The chain-weighted output index first calculates the nation is not measured.
value of GDP for this year and last year, using Making international comparisons of real GDP can be
prices from last year and then calculates the growth tricky because the real GDP of one country must be
rate of GDP between the two years. converted into the other nation’s currency. Using ex-
♦ Next the chain-weighted index calculates the value change rates for such conversions might understate the
of GDP for this year and last year, using prices from real GDP in less developed nations. However, use of
this year and again calculates the growth rate of purchasing power parity prices might give a more accu-
GDP between the two years. rate comparison.
♦ The two growth rates are averaged. This average is Though real GDP probably overstates the size of fluc-
used to scale up last year’s real GDP by multiplying tuations in total production and economic welfare, it is
last year’s real GDP by the average. a reasonably good indicator of the phase of the business
The price level is the average level of prices. One cycle, e.g., expansion, peak, and so on.
measure is of the price level is the GDP deflator,
which is an average of current year prices as a percent-
age of base-year prices. The GDP deflator equals Helpful Hints
(Nominal GDP ÷ Real GDP) × 100.
1. GDP, AGGREGATE EXPENDITURE, AND AGGRE-
GATE INCOME : Some of the most important re-
5 MEASURING GDP AND
ECONOMIC GROWTH*
Key Concepts ♦ Net exports (NX ) — exports (X, sales of U.S.
goods and services abroad) minus imports (M, pur-
chases of foreign good and services).
Gross Domestic Product Aggregate expenditure, C + I + G + NX, equals aggre-
Gross domestic product, GDP, is the market value of gate production, GDP, and also equals aggregate in-
all the final goods and services produced within in a come, Y. This equality is the basis for measuring GDP.
country in a given time period. ♦ National saving equals saving by households and
♦ A final good or service is an item that is bought by businesses plus government saving: S + (T − G ).
its final user during a specified time period. In con- ♦ Borrowing from the rest of the world equals M − X.
trast, an intermediate good is an item produced by Investment is financed by national saving plus borrow-
one firm, bought by another and used as a compo-
ing from the rest of world, I = S + (T − G ) + M − X.
nent of a final good or service. Intermediate goods
are not directly included in real GDP. A flow is a quantity over a unit of time. A stock is a
quantity that exists at a moment in time. Wealth and
The circular flow of income and expenditure shows real
capital are stocks; saving and investment are flows.
and monetary flows in the economy. The circular flow
involves: ♦ Wealth, the value of things that people own, is a
stock; income, what people earn, is a flow.
♦ Four economic sectors — households, firms, gov-
ernments, and the rest of the world. ♦ Saving is the amount of income remaining after
spending on consumption. Saving is a flow that
♦ Three major markets — factor markets, goods mar-
adds to wealth.
kets, and financial markets.
♦ Capital, the amount of plant, equipment, and in-
In these markets people make their economic decisions
ventories used to produce other goods, is a stock.
by choosing the amounts of key economic variables:
♦ Depreciation (also called capital consumption) is
♦ Consumption expenditures (C ) — total house-
the decrease in the capital stock because of wear and
hold spending on consumption goods and services.
tear and obsolescence. Gross investment is the total
♦ Investment (I ) — firms’ purchase of new plants, amount of investment. Net investment is gross in-
equipment, buildings, and additions to inventories. vestment minus depreciation. Net investment is the
♦ Government purchases (G ) — government flow that is the amount by which the capital stock
spending on goods and services. Net taxes (T ) are changes.
taxes paid to the government minus transfer pay- Gross domestic product includes depreciation and so
ments received from governments and minus inter- on the income side includes firms’ gross profit (before
est payments on the government’s debt. subtracting depreciation) and on the expenditure side
includes gross investment. Net domestic product ex-
cludes (subtracts) depreciation so it includes firms’ net
profits and net investment.
* This is Chapter 21 in Economics.
77
, 78 CHAPTER 5 (21)
Measuring U.S. GDP Measuring Economic Growth
In 2003, U.S. GDP equaled $10,847 billion. The economic growth rate is the percentage change in
♦ The expenditure approach measures GDP by adding the quantity of goods and services produced from one
final expenditures, C + I + G + NX. Of these expen- year to the next. It equals the growth rate of real GDP.
ditures, personal consumption expenditure is the Real GDP is used for economic welfare comparisons,
largest, at about 71 percent. Gross private invest- for making international comparisons of output, and
ment is about 15 percent, government purchases of for business cycle forecasting.
goods and services is about 19 percent, and net ex- Economic welfare is a comprehensive measure of gen-
ports is about –5 percent. eral economic well being. Real GDP is an imperfect
♦ The income approach adds the compensation of em- measure of economic welfare because real GDP:
ployees, net interest, rental income, corporate prof- ♦ Over adjusts for inflation — many quality im-
its and proprietors’ income to give net domestic in- provements that lead to higher prices are counted as
come at factor cost. Indirect taxes and depreciation only price hikes.
are added and subsidies subtracted to obtain GDP. ♦ Omits household production — all household pro-
duction is omitted.
Real GDP and the Price Level ♦ Omits the underground economy — the under-
ground economy (transactions hidden from the
Real GDP is the value of final goods and services pro-
government) is not included.
duced in a given year when valued at constant prices.
Nominal GDP is the value of the final goods and ser- ♦ Omits health and life expectancy — neither peo-
vices produced in a given year valued at the prices that ple’s health nor life expectancy are indicated by real
prevailed in that same year. GDP.
The base year prices method, which is the traditional ♦ Omits leisure time — the value of leisure time is
method of calculating real GDP, values the quantities not included.
produced in each year using the prices of the base year. ♦ Omits environmental quality — the consequences
The chain-weighted output index method, which is of adverse and beneficial environmental changes are
the new method of calculating real GDP, uses the omitted.
prices of two adjacent years to calculate the real GDP ♦ Ignores political freedom and social justice — the
growth rate. extent of political freedom or social justice within a
♦ The chain-weighted output index first calculates the nation is not measured.
value of GDP for this year and last year, using Making international comparisons of real GDP can be
prices from last year and then calculates the growth tricky because the real GDP of one country must be
rate of GDP between the two years. converted into the other nation’s currency. Using ex-
♦ Next the chain-weighted index calculates the value change rates for such conversions might understate the
of GDP for this year and last year, using prices from real GDP in less developed nations. However, use of
this year and again calculates the growth rate of purchasing power parity prices might give a more accu-
GDP between the two years. rate comparison.
♦ The two growth rates are averaged. This average is Though real GDP probably overstates the size of fluc-
used to scale up last year’s real GDP by multiplying tuations in total production and economic welfare, it is
last year’s real GDP by the average. a reasonably good indicator of the phase of the business
The price level is the average level of prices. One cycle, e.g., expansion, peak, and so on.
measure is of the price level is the GDP deflator,
which is an average of current year prices as a percent-
age of base-year prices. The GDP deflator equals Helpful Hints
(Nominal GDP ÷ Real GDP) × 100.
1. GDP, AGGREGATE EXPENDITURE, AND AGGRE-
GATE INCOME : Some of the most important re-
