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1. Chapter 3
Measuring gross
domestic product

2. Learning objectives
• Interpret circular flow models of a simple economy
• Distinguish between consumption goods and
capital goods
• Outline the three different approaches to measuring
gross domestic product (GDP)
• Identify the principal components of GDP
• Distinguish between real and nominal GDP
• Appreciate the uses and shortcomings of the GDP
measure

3. The circular flow diagram: a model of the
macroeconomy
A circular flow diagram illustrates the flow of funds
through the economy
A TWO-SECTOR CIRCULAR FLOW MODEL

4. The circular flow diagram: a model of the
macroeconomy
• This two-sector circular model shows how firms and
households interact in markets and how funds flow
through the economy
• Owners of factors of production (households) supply
and sell inputs to firms and earn income (wage)
• Firms create output and earn income as they sell the
outputs in the market
• Households use their earned income to buy outputs in
the market
• Income, goods and services and spending are
connected

5. Measuring GDP
Gross Domestic Product (GDP) is the most commonly
used measure of total output of goods and services
produced in the economy over a period of time.
Formal Definition:
GDP = the market value of all final goods and services
produced in the domestic economy over a given period of
time.
The Australian Bureau of Statistics (ABS) keeps a set of
accounts called the National Accounts from which it
calculates GDP.

6. Measuring GDP
Q. How do you add different goods together?
GDP is a single number, but it measures the production
of many different things like cars, insurance and CDs.
A. Use market value because all goods are measured
in the same unit ($).
Example:
In the economy of country A, production consists of 10
CDs and 20 bus trips. If each CD has a price of $25 and
a bus trip is $10, how much is the GDP of country A?
GDP = (10 × $25) + (20 × $10) = 250 + 200 = $450

7. • This method adds up the production of each firm
or industry in the economy
• In this method we must avoid the double-
counting of intermediate goods and only count
the value added in production
• Value added is the value of a firm’s production
minus the value of intermediate goods
• An intermediate good is a good that undergoes
further processing before it is sold
1 The production approach to measuring GDP

8. Value added in coffee from beans to espresso
Example: Double counting occurs when the value
of growing and picking beans is
included once at the coffee growing
stage of production and then again at
the roasting stage of production.

9. Total spending is divided into four categories:
• Consumption
• Investment
• Government expenditure
• Net exports (exports minus imports)
2 The spending approach to measuring GDP

10. Consumption (C):
The first category, consumption (C), includes
purchases of final goods and services by individuals or
households. In the Australian national accounts, this
item is called household expenditure, or private final
consumption expenditure.
2 The spending approach to measuring GDP

11. 2 The spending approach to measuring GDP
CONSUMPTION AS A SHARE OF GDP

12. 2 The spending approach to measuring GDP
CONSUMPTION AS A SHARE OF GDP

13. • Investment (I) consists of purchases of final goods
by firms as well as construction (including housing)
and inventory investment. Investment takes the form
of newly produced capital goods
• Note: spending by governments on capital goods is
not included in this grouping; it is included under
government spending
2 The spending approach to measuring GDP

14. • Business fixed investment: investment expenditure by
businesses on physical capital, such as factories and
equipment
• Inventory investment: a change in the inventory from one
date to another.
• Inventory investment is positive when goods produced in
the current period are not sold to final users. This causes
inventory levels to rise. The National Accounts treats these
goods as purchased by firms off themselves in the period in
which they are produced.
• Inventory investment is negative when the inventory levels
of firms are lower at the end of the current period than they
were at the beginning.
• Disinvestment: refers to negative investment
2 The spending approach to measuring GDP

15. • Residential investment: purchases of new houses and
apartments
• Depreciation: the decrease in an asset’s value over
time. For physical capital, it is the amount by which
physical capital wears out over a period of time
• Net investment: gross investment minus depreciation
• Gross investment: the total amount of investment,
including that which goes to replacing worn-out capital
• Be sure to understand what macroeconomists mean by
“investment” compared to what “investment” means in
everyday use.
2 The spending approach to measuring GDP

16. 2 The spending approach to measuring GDP
INVESTMENT AND CONSUMPTION AS A SHARE OF GDP

17. • Government expenditure (G): purchases by federal,
State/Territory and local governments of new goods
and services.
• G includes government consumption spending,
government spending on capital goods and changes
in the inventories of public authorities.
• Not all items in the government’s budget are counted
as part of government expenditure. Welfare and
retirement payments made by the government are not
counted as part of these purchases
2 The spending approach to measuring GDP

18. • Government expenditures on capital goods is also
called public infrastructure investment and refers to
purchases of capital by the government for use as public
goods, which add to the productive capacity of the
economy. Eg roads, ports, buildings etc.
• Transfer payments: payments that transfer spending
power and are not directly associated with the production
of current period output. Examples include
unemployment benefits, retirement payments and family
benefit payments.
• Government expenditure (G) = government outlays −
government transfer payments
2 The spending approach to measuring GDP

19. 2 The spending approach to measuring GDP
GOVERNMENT EXPENDITURE, (PRIVATE) INVESTMENT AND (HOUSEHOLD)
CONSUMPTION AS A SHARE OF GDP

20. • Exports: the total value of the goods and services that
people in one country sell to people in other countries
• Imports: the total value of the goods and services that
people in one country buy from people in other
countries
• Net exports (X): the value of exports minus the value
of imports
• Trade balance: the value of exports minus the value
of imports; another term for net exports
2 The spending approach to measuring GDP

21. • If net exports are positive, the country has a trade
surplus
• If net exports are negative, the country has a trade
deficit
• For example in 2010, exports equaled $1838 billion
and imports equaled $2354 billion. The Australian
trade deficit for 2010 was $516 billion
2 The spending approach to measuring GDP

22. Algebraic summary:
2 The spending approach to measuring GDP
Y ≡ C + I + G + X

23. The income approach: the sum of labour income, capital
income and indirect taxes less subsidies gives a measure
of GDP.
3 The income approach to measuring GDP
AGGREGATE INCOME AND GDP, 2010–2011

24. Labour income: the sum of wages, salaries and
supplements paid to workers. Known in the National
Accounts as “compensation of employees”
3 The income approach to measuring GDP
LABOUR’S SHARE OF TOTAL INCOME, 1998–2011

25. Capital income: the sum of profits, rental payments and
interest payments. Known in the National Accounts as
“Gross Operating Surplus”
3 The income approach to measuring GDP
THE CAPITAL’S SHARE OF TOTAL INCOME, 1998–2011

26. • Mixed income refers to income generated from both
labour and capital
• In the aggregate income table, the first two items
are called factor incomes
• The total of these factor incomes gives GDP at
factor cost
• This is not the same as the GDP figure calculated
from the expenditure approach, which is based on
the market prices of final goods and services
3 The income approach to measuring GDP

27. If the government raised
the GST, GDP measured at
market prices would
suddenly rise. But the
measurement of GDP at
factor cost removes this
misleading increase.
3 The income approach to measuring GDP
HOW DIRECT TAXES INFLATE MARKET PRICES

28. • So GDP calculated by the income approach and the
spending approach will be equal, indirect taxes are
added and subsidies are subtracted from GDP at
factor cost.
• Indirect taxes: taxes, such as the GST, that are
levied on products when they are sold
• Net indirect taxes: indirect taxes minus subsidies
3 The income approach to measuring GDP

29. The circular flow of income and expenditure

30. The circular flow of income and expenditure
revisited
• This figure shows how aggregate expenditure equals
aggregate income
• Consumption (C) is joined by government expenditure
(G), investment (I) and net exports (X) to sum to
aggregate expenditure on the left
• At the top of the figure, this aggregate spending is
received by firms that produce the output and then pay
out aggregate income (Y) in the form of wages, rents,
interest payments and profits
• The government also takes direct taxes from income
and makes transfer payments to households

31. Real GDP and nominal GDP
• Nominal GDP is the value of current period production at
current period prices. However, nominal GDP can mislead
when comparing GDP over time. Why?
GDP is a measure of aggregate output but when prices
rise, ceteris paribus, this increases GDP without an
increase in the quantity of goods and services produced.
Economists therefore want a measure of GDP that
removes the impact of changing prices.
• Real GDP is a measure of the value of all final goods and
services produced in a country during some period of
time, adjusted for changing prices. Real GDP changes
only when quantities produced change.

32. • The traditional method for calculating real GDP is called
the constant price or base year method. It involves
choosing a year, called the “base year”, and uses the
prices of goods and services that year to calculate real
GDP in each year. In doing so the prices of goods and
services are being held constant for each year GDP is
calculated. The value of real GDP now changes only
when quantities produced change.
• A more contemporary method for calculating real GDP is
the “chain weighted” or “chain volume” method – you
can read about this on pages: 378-379 of Littleboy et al.
• For this unit we will stick with the base year method.
Converting nominal GDP into real GDP

33. Converting nominal GDP into real GDP
• Suppose an economy only produces music CDs and
bus trips, and we want to compare this total production
in two different years: 2013 and 2014
• Nominal GDP in 2013 = ($25 × 1000) + ($10 × 2000)
= $45 000
• Nominal GDP in 2014 = ($30 × 1200) + ($15 × 2200)
= $69 000

34. Converting nominal GDP into real GDP
• Production (in 2013 prices) in 2013
= ($25 × 1000) + ($10 × 2000) = $45 000
• Production (in 2013 prices) in 2014
= ($25 × 1200) + ($10 × 2200) = $52 000
• Keeping prices constant at 2013 levels, or using
2013 as ‘the base year’, we see that the increase
in production is from $45 000 in 2013 to $52 000
in 2014, an increase in real terms of 16 per cent
By contrast the % change in nominal GDP
between 2013 and 2014 was 53%
• Economic growth refers to the % change in
real GDP over a period of time.

35. Real GDP versus nominal GDP over time
• Typically, real GDP increases much less than nominal
GDP because real GDP is adjusted for rising prices
• Most of the increase in nominal GDP is due to rising
prices. The chart shows real GDP in 2009–10 dollars

36. Real GDP versus nominal GDP over time

37. Shortcomings of the GDP measure
Real GDP per capita has shortcomings as an indicator of wellbeing in a
society. Items are omitted, such as:
• Unpaid activity or activity not subject to a legal market process, such as
work and production in the home. Some exceptions are made such as farm
output consumed on farms and imputed rents of owner-occupied dwellings.
•Leisure activity – going for a walk rather than working will probably cause
GDP to fall but your wellbeing to rise. The consumption of leisure is omitted
from GDP unless it involves a purchase in the market, such as a cinema
ticket etc.
•The underground economy: illegal transactions are not recorded in the
National Accounts. In Australia the size of the underground economy is
estimated to be 15% of GDP.
•Quality improvements – difficult to adjust for.

38. Shortcomings of the GDP measure
•Real GDP per capita does not tell us anything about the
actual distribution of real GDP among people.
There are other aspects of the wellbeing of individuals that
are not counted in GDP like:
•Vital statistics on the quality of life – over time some other
indicators of quality of life have improved with increases in
real GDP such as average life expectancy, educational
attainment, and child mortality. However, other indicators
have deteriorated as real GDP has increased like the
incidence of diabetes and obesity. chi
•Environmental quality

39. Inflation:
The increase in the overall price level over time
Inflation rate:
• The annual percentage rate of change in the price
level, as measured, for example, by the CPI
• Economists use the consumer price index (CPI) to
measure the price level and inflation
• The CPI for any period measures the cost of living
during a particular period of time
Inflation

40. Measures of Inflation – Consumer price index
Consumer price index (CPI): is the cost of purchasing a
fixed collection – a “market basket” – of consumer goods
and services in a given year divided by the cost of
purchasing the same collection in some base year.
How the CPI is constructed:
•Suppose the government of Australia has chosen 2000 as
the base year
•Assume a typical Australian family only purchases three
items – rents an apartment, fish and chips and a holiday

41. Measures of Inflation – Consumer price index
Monthly household budget of the typical family in 2000 (base year) Cost (in 2000)
Rent (three-bedroom apartment) $500
Fish and chips (60 at $2 each) $120
Holiday $60
Total expenditure $680
Cost of buying the market basket in 2000, which
is the base year.

42. Suppose that in 2010, the prices of these items
have risen. By how much did the family’s cost of
living increase between 2000 and 2010?
Measures of Inflation – Consumer price index
Cost of buying (base-year) basket of goods and services in 2010 Cost (in 2010)
Rent (three-bedroom apartment) $630
Fish and chips (60 at $2.50 each) $150
Holiday $70
Total expenditure $850

43. Measures of Inflation – Consumer price index
• The tables demonstrate that if the typical family
wanted to consume the same basket of goods and
services in the year 2010 as they did in 2000, they
would have to spend $850 per month, or $170 more
than their total expenditure in 2000

44. Measures of Inflation – Consumer price index
• The CPI in any given year is computed using the
following formula:
CPI=
Costofbase-yearbasketofgoodsandservicesincurrentyear
Costofbase-yearbasketofgoodsandservicesinbaseyear
CPIinyear2010=
$850
$680
=1.25
• The cost of living in the year 2010 is 25 per cent
higher than in 2000

45. Measures of Inflation – GDP deflator
• If nominal GDP grows faster than real GDP this is due to
inflation.
• If nominal GDP increases less than real GDP this due to
deflation – a situation where the price level is falling over
time.
• Its possible to derive a measure of the general price
level using nominal and real GDP and from this a
measure of inflation:
GDP deflator = nominal GDP/real GDP
The % change in the GDP deflator from year to year is
a measure of inflation.
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