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Chapter 20
The Measurement of
National Income
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In this chapter you will learn
1. how the concept of value added solves the problem of
“double counting” when measuring national income.
2. the income approach and the expenditure approach to
measuring national income.
3. the difference between real and nominal GDP and the
meaning of the GDP deflator.
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In this chapter you will learn
4. about the many important omissions from official measures
of GDP.
5. why real per capita GDP is a good measure of average
“material” living standards but an incomplete measure of
overall “well-being.”
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20.1 NATIONAL OUTPUT
AND VALUE ADDED
Production occurs in stages — most firms produce outputs
that are other firms’ inputs
- intermediate products
- final products
Each firm’s contribution to total output is its value added
= revenues - non-labour costs
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Summing value added avoids the problem of double counting
when measuring total output.
Total value added in the economy is called Gross Domestic
Product (GDP).
APPLYING ECONOMIC CONCEPTS 20-1
Value Added Through Stages of
Production
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20.2 NATIONAL INCOME ACCOUNTING:
THE BASICS
Three methods for measuring national income (output):
• total value added from domestic production
• total expenditures on domestic output
• total income generated by domestic production
Because of the circular flow of income, these three measures
yield the same total — GDP.
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Start with a very simple economy
Domestic Households
Factor income:
wages, rents, profits
Domestic Firms
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Revenue from
sales of final G & S
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How does household income actually get used up?
Domestic Households
Savings
Imports
Consumption
Taxes
Factor income:
wages, rents, profits
Domestic Firms
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Revenue from
sales of final G & S
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Do any other agents buy final G & S from Cdn firms?
Domestic Households
Investment
Consumption
Governments
Foreigners
(Exports)
Factor income:
wages, rents, profits
Domestic Firms
Revenue from
sales of final G & S
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GDP from the Expenditure Side
Consider adding up the expenditures needed to purchase the
final output produced in any given year.
There are four broad expenditure categories:
- consumption
- investment
- government purchases
- net exports
Actual consumption expenditure (Ca) includes expenditure
on all final goods during the year.
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Actual investment expenditure (Ia) is expenditure on the
production of goods not for present consumption, including:
• inventories
• plant and equipment
• residential housing
Actual government purchases (Ga) are the purchases of
currently produced goods and services by the government
- excluding transfer payments.
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Actual net exports (NXa) is the difference between exports and
imports: NXa = (Xa - IMa)
Exports are purchases of Canadian-produced goods and
services by foreigners. We subtract imports because they are
not produced in Canada.
Since total domestic output must equal total expenditure on
domestic output, we have:
GDP = Ca + Ia + Ga + NXa
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Ca + Ia + Ga + (Xa - IMa)
= GDP
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Does the accounting identity
GDP = Ca + Ia + Ga + (Xa - IMa)
imply that everything that firms produce each
year is automatically sold to customers?
NO! INVENTORIES!
INVENTORIES!
INVENTORIES!
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GDP from the Expenditure Side: 2005
Category
Consumption
Government purchases
Investment
Net exports
Statistical discrepancy
Total
$billion
% of GDP
$761.9
55.7
254.4
18.6
297.6
21.7
54.3
4.0
0.7
0.0
$1368.9
100.0
Source: Statistics Canada website: www.statcan.ca. Go to “Canadian Statistics” and click on “Economic
Conditions” and then “National accounts.”
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GDP from the Income Side
GDP is also the sum of factor incomes and other claims on
the value of output.
Factor incomes include:
- wages
- rent, interest, and profits
net domestic
income
Non-factor payments include:
- indirect taxes (net of subsidies)
- depreciation of existing physical capital
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GDP from the income side is therefore equal to:
GDP = Net domestic income +
Indirect taxes (less subsidies) +
Depreciation
EXTENSIONS IN THEORY 20-1
Arbitrary Decisions in National
Income Accounting
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GDP from the Income Side: 2005
Billions of $
% of GDP
678.9
49.6%
61.2
4.5%
293.1
21.4%
1033.2
75.5%
Factor Incomes
Wages, salaries and supplementary income
Interest and miscellaneous investment income
Business profits (including net income of
farmers and unincorporated businesses)
Net Domestic Income at factor cost
Non Factor Payments
Depreciation
181.4
13.3%
Indirect taxes less subsidies
154.7
11.3%
-0.4
-0.0%
1368.9
100.0 %
Statistical discrepancy
Total
Source: Statistics Canada website: www.statcan.ca. Go to “Canadian Statistics” and click on “Economic
Conditions” and then “National accounts.”
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Wages + Rent + Interest + Profits
+ Indirect taxes + Depreciation
Ca + Ia + Ga + (Xa - IMa)
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What goes into the firm’s revenue must come out as wages,
rent, interest, profits, indirect taxes or depreciation.
The total revenue of all Canadian firms (the total expenditure
on Canadian final goods and services) must equal the total
value of factor payments plus indirect taxes and depreciation.
Therefore as accounting identities it must be true that:
Ca + Ia + Ga + (Xa - IMa) = Wages + Rent + Interest
+ Profits + Indirect taxes
+ Depreciation
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20.3 NATIONAL INCOME ACCOUNTING:
SOME EXTRA ISSUES
GDP and GNP
A measure of national output closely related to GDP is Gross
National Product (GNP).
The difference between GDP and GNP is the difference
between income produced and income received.
Income produced in Canada
versus income received by Canadians
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GDP is superior as a measure of domestic economic activity.
GNP is superior as a measure of living standards of residents.
A more “refined” measure is disposable personal income:
It equals GNP minus:
- any part not actually paid to households
- personal income taxes
- plus transfer payments received by households
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Real and Nominal GDP
GDP that is valued at constant base-period prices is real
national income.
GDP Deflator =
Nominal GDP
x 100
Real GDP
The GDP deflator is a very comprehensive index of prices
because it includes the prices of all goods and services
produced in the country.
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Do the CPI and the GDP
Deflator Move Together?
Broadly, the two price indexes move together,
due to underlying inflationary forces. But
because one tracks consumer prices and the
other tracks the prices of goods produced in
Canada, there will be some differences.
APPLYING ECONOMIC CONCEPTS 20-2
Calculating Nominal and Real GDP
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Output and Well Being
The rise in real GDP over the past century has had two main
causes:
1. The increase in the amount of land, labour, and capital
used in production, and
2. An increase in the amount of output produced per unit of
input.
Per capita output is the amount of output per person — it is
computed by dividing GDP by total population. It measures
the average output (and income) per person (but tells us
nothing about how that income is distributed across people).
GDP per capita in 2005 was $42,548
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A better way of assessing average living standards is to consider
measures of productivity. For example, GDP divided by the number
of employed persons tells us the average output per employed
person. This is one measure of labour productivity.
GDP divided by the total number of hours worked measures output
per hour of labour input, and provides a second measure of labour
productivity.
GDP per worker in 2005 was $79,868
GDP per hour worked in 2005 was $45.99
Changes in overall living standards are better reflected by changes
in productivity than by changes in GDP per capita.
GDP and related measures of national income must be interpreted
with their limitations in mind. What are these limitations?
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Omissions from GDP
National income accountants cannot measure economic
activity that takes place outside of regular, legal markets:
• illegal activities
• Leisure (consumption of non-work time)
• the underground economy (tax & regulation avoidance)
• home production (non-market activity)
• economic “bads” (pollution)
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Unless the unmeasured economic activity changes rapidly,
changes in GDP will do a reasonable job of measuring
changes in material living standards.
GDP and Living Standards
“Well-being” is a broader concept than material living
standards:
- GDP is not a complete measure of economic wellbeing
- but income is a very important part of well-being
and GDP is a good measure of income.
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How useful are the various measures of GDP?
They are very useful for tracking the year-to-year changes in
the level of economic activity (market activity).
They are useful in tracking changes in economic activity,
productivity, etc. over the longer term in a given country.
But remember, GDP measures only what goes through
markets – what is bought and sold.
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How useful are the various measures of GDP?
Are they good measures of the level of human wellbeing
(happiness) in a society? Only in a limited sense – material,
market activity, with no consideration of things like pollution.
Are they good measures of the change in the level of
material wellbeing over time? Maybe, but care must be taken
in making such an interpretation. (war, more labour force
participation, degree of marketization, etc.)
Do they provide the basis for comparing the level of material
wellbeing across different countries? Only if the counties are
of very similar in a deeper structural sense (Canada and the
US or France maybe ok but Canada and Nigeria or Bolivia
probably not.
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