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Economics 3rd ch05


By John B. Taylor
Stanford University

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Chapter 18 (Macro 5)
Measuring the
Production, Income,
and Spending of
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This chapter introduces GDP and its
components from the perspective of
spending, income, and production. After a
brief introduction to price indexes, nominal
and real GDP are contrasted, and the
limitations of GDP accounting are
discussed. The chapter concludes with
international comparisons of GDP and the
role of exchange rates and purchasing
power parity in making these comparisons.
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Teaching Objectives
• 1. Define and introduce the three approaches to
determining GDP.

2. Discuss the relationship among saving, investment,
and net exports.
3. Distinguish between nominal and real GDP and the
role of price indexes.
4. Provide an introductory discussion of international
comparisons of GDP.

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1. Measuring GDP
• It is most commonly used measure of
economic activity.
• It indicates the dollar value of FINAL goods
and services PRODUCED within the
borders of the DOMESTIC economy during
a period (quarter or year)
• Intermediate goods are excluded to avoid

double counting.

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How to measure GDP?
There are three approaches to the
measurement of GDP:
• spending,
• income,
• and production.

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Spending Approach
• The spending approach divides GDP into
four areas: households (consumption),
businesses (investment), government, and
foreigners (net exports).

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Consumption (C)
• Consumption reflects the spending by
households or individuals for final goods
and services. The numbers are given in
Table 18.2, and the percentage of GDP
represented by consumption is given in
Figure 18.1.

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Figure 18.1
(Macro 5)
as a Share of

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Investment (I)
• Investment reflects the spending of
businesses and includes fixed business
investment, inventory investment, and
residential investment. The numbers are
given in Table 18.2, and the percentage of
GDP represented by consumption and
investment is given in Figure 18.2.

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Figure 18.2
(Macro 5)
Investment and
Consumption as a
Share of GDP

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Government purchases (G)
• Government purchases of goods and services but
not transfer payments make up over $1 trillion of
GDP. Transfer payments are excluded because
they do not reflect current production. The
numbers are given in Table 18.3, and the
percentage of GDP represented by consumption,
investment, and government purchases is given in
Figure 18.3.

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Figure 18.3
(Macro 5)
Investment, and
Consumption as a
Share of GDP

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Net exports (X)
• Net exports (exports and imports), or the
trade balance, is included to account for
imported consumption and investment items
and for items exported from the United
States that are not counted in the
consumption, investment, or government
spending parts of GDP.

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Expression for GDP
• The relation between GDP and its
spending components is the familiar
Y = C + I + G + X equation.
• What is the share of net exports, if the
share of C, I, and G are 68, 18, 18 percent,

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Figure 18.4
(Macro 5)
The Circular Flow of Income and Expenditure

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The income approach
• The income approach divides GDP
according to who receives the income from
the spending flow. In addition to aggregate
income, national income and personal
income are also used as measures of

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Labor, Capital Income and Depreciation

• Labor income includes wages, salary, and fringe benefits,
as given in Table 18.3.
• Capital income (profits, rents, and interest payments) is
also given in Table 18.3.
• Depreciation is included as a reduction in the flow of
income to account for the wearing out of capital, allowing
for a distinction between gross and net investment.
Depreciation is used to get net GDP.

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Taxes and Foreign Income
• Indirect business taxes are taxes that are included in
the selling price of the good or service and so are
removed as a part of income flow from the production
of GDP.
• Net income of foreigners balances out the net effect of
income earned in the United States by citizens of other
countries and income earned by U.S. citizens abroad.
The details are given in Table 20.3. Also included in
this table is the statistical discrepancy between income
and spending that occurs in data collection.

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2. Saving, Investment, and Net Exports
• National saving is defined as income minus
consumption minus government purchases,
or S = Y - C - G .
• In the absence of a change in net exports,
for a country to increase its investment, it
has to increase its saving: S = I + X .
• Saving varies over time for a variety of
reasons, including the age composition of

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Government Dis(saving)
• The government saves or dissaves, as do
individuals, with a resulting budget surplus
or deficit. When the government dissaves,
households and businesses must save more
to obtain the same level of national saving.

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The production approach

• The production approach looks at GDP from
the standpoint of value added by each input
in the production process.
• The three approaches--spending, income,
and production– (should) result in
equivalent values for GDP.

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Figure 18.5 (Macro 5)
Value Added in Coffee: From Beans to Espresso

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3. Real GDP and Nominal GDP
• Since GDP is the dollar value of goods and
services measured in price units, as prices change,
GDP changes without any change in the
underlying production, income, or spending of an
economy. A method must be used to hold the
effect of price increases constant, particularly
when inflation is present to any degree.

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Real GDP
• The adjustment of nominal GDP for the
effects of changes in the price level, or
inflation, results in real GDP. Real GDP
then provides a basis of comparison of
changes in production between points in

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