Chapter 1: Measurement

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 Outline
• Measuring Economic Activity

• GDP, GNP & the Circular Flow

• Price level

• CPI & GDP Deflator

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Gross Domestic Product (GDP)
• Two ways to view GDP
• Total income of everyone in the economy
• Total expenditure on the economy’s output of
goods and services
• Why?
Expenditure equals income because every
dollar a buyer spends becomes income to the
seller

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 The Circular Flow
Income ($)

Labor

Households Firms

Goods

Expenditure ($)

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 Measuring Economic Activity
• Gross Domestic Product (GDP):

GDP is the market value of all final goods and

services produced within an economy in a given
period of time

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 “Value” - at Market Prices
• Use market prices to compute GDP
– Prices reflect relative social valuations –how
much people are willing to pay.
– Allows us to add up apples & oranges.
• Only includes goods & services traded on legal
markets. Doesn’t include:
– Drugs, underground economy
– Value of time in education
– Home production

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“Final Goods” –avoid double counting

• The value of the final goods already includes the

value of the intermediate goods, so including
intermediate and final goods in GDP would be
double counting.

• GDP = Value of finals goods = Total Income

• Income = Sum of value added

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 Value Added: Example
Sells   Price   Income or
Value Added  
Farmer   Wheat   $1.00   $1.00  
Miller   Flour   $2.00   $1.00  
Baker   Bread   $3.00   $1.00  
Ralph’s   Packaged Bread   $6.00   $3.00  
Total:   $12.00   $6.00  

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 “Produced”
• The only measure of income is what is produced
–new stuff available.
• Selling used goods is just an exchange/transfer
between members of society
Sales of: Counted
Old Homes No
New Homes Yes
Stocks No
Real estate and broker fees Yes
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 Other measures of Income: GNP
• Gross Domestic Product (GDP):
Value of all final goods and services produced
within an economy.
• Gross National Product (GNP):
Value of all final goods and services produced
by domestically owned factors of production.
• In other words, GNP measures the total income
earned by nationals.

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 Measuring GNP
• GNP: “Domestically owned”

• Take domestic income (GDP), subtract income

in home country of foreign factors of production
and add overseas income of domestically
owned factors of production.

GNP = GDP + Net Factor Income.

• Note: Factors of production are capital, labor and land.

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 Measuring GNP: Example
• Look at factor income (wages, profit, and rent)
• Example 1: Toyota factory in California
– Total value added: US GDP
– Wages (income of labor): US GNP
– Profits (income of capital): Japan GNP
• Example 2: Apartment in LA owned by Japanese
national
– Rent: US GDP
– Real estate fee (income of labor): US GNP
– Net Rent (income of land/property): Japan GNP

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 GNP vs GDP
• For most (big) countries small difference.
• For some small countries, big difference.
• GDP reflects output, GNP reflects ownership.

GNP ($US) GDP ($US)

US 2010 14.6 trillion 14.6 trillion
Ireland 2010 171.2 billion 206.6 billion
Bangladesh 2010 109.7 billion 100.3 billion

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 Components of GDP
• Consumption, C
• Investment, I
• Government purchases, G
• Net exports, NX

If Y is output/GDP, then

Y = C + I + G +NX
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 Consumption
• Consumption, C
– Purchases of goods and services for the
purpose of use or enjoyment by households.

• Examples:
– Goods: food, clothing, cars, TVs.
– Services: haircuts, doctor visits, dry cleaning,
air travel.

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 Investment (1)
• Investment, I
– Purchases of new physical assets (which we
call capital) for the purpose of producing output
in future years.
– Mostly done by firms, but also by households.
– Includes inventories

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 Investment (2)
• Financial assets such as stocks or bonds are not
investment.
– These are simply transfers/exchanges, and
don’t create output.
• Must be new physical assets
– For example, sales of old houses or
machineries are not included in investment.
Again, these are just transfers

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 Investment (3)
• Investment by households:
– New housing.
– Even though durables such as cars and TVs are
bought for future consumption, these are not
considered investment if done by households.
– Education is considered consumption (households)
or business expense (firms).
• May not make much sense, but…

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 Government
• Government purchases G
– Purchases of newly produced goods and
services by the government.
– G excludes transfer payments
(e.g., unemployment benefits or pensions),
because they do not represent spending on
goods and services.
– For example: roads, bridges, military spending,
or salaries of government employees.

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 Net Exports
• Net exports NX:

NX = Exports – Imports

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 US GDP components, 2011
$US, billions % of GDP
Consumption (C) 10,726 71.1%
Investment (I) 1,916 12.7%
Government 3,301 20.1%
spending (G)
Net exports (NX) -579 -3.8%

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Different ways to measure GDP
• Total expenditure
C+I+G+X–M
• Total income
Wages + Profits = W + π
• Total output/production
– Unsold output goes to inventory.
• The sum of value added at all stages of
production.
• They’re all the same!!!
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 Real vs. Nominal GDP
• Nominal GDP measures the value of goods and
services using current prices
• Real GDP measures the value of goods and
services using constant prices (the prices used
are called base year prices)
• Why use real GDP?
– Nominal GDP not a good measure of economic
well-being. Changes due to prices or quantities?
– Real GDP captures what would have happened
to output if prices had stayed constant.

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 The GDP Deflator
• GDP Deflator = Nominal GDP/Real GDP

• GDP deflator is the amount needed to deflate

nominal GDP to get the real GDP.
Real GDP=Nominal GDP/GDP Deflator

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 Measuring Prices
• Inflation rate: percentage increase in the overall
level of prices.
• One measure of the price level is the GDP
deflator.
• Another measure is the Consumer Price Index
(CPI).
• CPI = Price of a fixed basket of goods in the
current year divided by the price of the same
basket in a base year.

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How the BLS constructs the CPI"
1. "Survey consumers to determine
composition of the typical consumer’s
“basket” of goods"
2. "Every month, collect data on prices of all
items in the basket; compute cost of
basket"
3. "CPI in any month equals"

Cost of basket in that month

100 ×
Cost of basket in base period
 Example: Compute CPI"

Basket: 20 pizzas, 15 comic books"

prices:" For each year, compute"

"Pizza "Comics" § the cost of the basket"
2012 "$10 "$3" § the CPI (use 2012 as
2013 " 11 " 3" the base year)"
2014 " 12 " 4" § the inflation rate from
2015 " 13 " 3" the preceding year"
 Example: Compute CPI"

"Cost of " "Inflation"

"basket " CPI "rate"
2012 "$245 "100.0 "n.a.!
2013 " 265 "108.2 "8.2%"
2014 " 300 "122.4 "13.2%"
2015 " 305 "124.5 "1.7%"
 CPI vs GDP Deflator
• Both measure an “average” price level using
quantities as weights.
• Main difference, CPI uses base year quantities,
GDP deflator uses final year quantities.
• CPI is called a Laspeyres Index, and the GDP
deflator a Paasche Index.
• Your textbook includes a discussion on why
Laspeyres overstates and Paasche understates
inflation.

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 CPI vs GDP Deflator  
14 CPI
from 12 months earlier

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Percentage change

10

0
GDP deflator
-2
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1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
 Sources of Substitution Bias
• The CPI and GDP deflator aim to measure
changes in purchasing power.
• Use of fixed weights causes a substitution
bias.
• Doesn’t take into account that quantities used
as weights are consumers’ choice.
• Laspeyres uses weights chosen in the base
(initial) year. Paasche uses weights chosen in
the final year.
• When relative prices change, I move my
consumption basket away from goods that
become relatively more expensive.
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