Gross Domestic Product
National income accounts keep track of the flows of money
between different sectors of the economy.
Keeps track of spending of consumers, sales of producers, business
investment spending, government purchases, and a variety of other
flows of money between different sectors of the economy.
National income accounting is a method of measuring the flows of
income and expenditures in the economy over a period of time.
National income accounts serve the same purpose for the economy as
a whole as does the income statement of a business firm.
I know, this is about as interesting as watching cheese gel, but there’s a
point to all this, as the basic ideas behind the national accounts can be
shown through the circular flow diagram.
Look at this awesome simple market economy
CFD. We’ve got two different decision-makers in
a market economy: households and businesses.
Product market. Where goods and services (g/s)
are bought and sold.
Households buy g/s—demand/monetary flow.
Businesses sell g/s—supply/physical flow.
Price determined by free market.
Consumer expenditures constitute sales
receipts for businesses.
Factor market. Where resources are bought and
Businesses buy factors—demand/monetary
Households sell factors—supply/physical flow.
Price determined by free market.
Businesses’ payments for resources constitute
business costs and resource owners’ income.
Now look at this even more awesome CFD.
Bunch of things going on here.
First off, notice we’ve added two more actors:
the government and the rest of the world.
Second, notice that there’s a third market: the
Much of what we’ve seen in the simple CFD,
however, also applies here.
Firms buy the factors of production (land,
labor, capital) from the households, revenue
from which comes in the form of wages,
profits, interest, and rent.
In addition to that income, households also
get some income through government
transfers, payments that government makes
without expecting a g/s.
Households take part of their income and
put it towards savings in the financial
Government’s going to take a chunk of that
household income in the form of taxes.
The rest of household income goes to
consumer spending, which goes straight to
the product market.
Government has to buy products too, so
they’ll also buy from the product market.
Firms will buy physical capital related to
production from the product market, called
Firms will also build up inventories of goods
and raw materials to help keep their business
The rest of the world will buy goods and
services through exports and imports.
In the financial market, banks will take in the
savings from households and use that to
financial loans and stock issues.
Banks will make loans to governments and
firms, as well as stock issues of corporations.
Banks will also work with the rest of the world
and loan money out to foreign businesses,
and assisting with the buying and selling of
Awesome, Mr. Bordelon. Why do I care?
Well, three reasons, really.
Because I said so, and it can and will show
up on a test and possibly the AP Exam.
Because there’s a basic idea here. The
flow of money into each market equals the
flow of money coming out. For example,
with household income, the amount of
wages, profit, interest, rent, and transfer
payments coming in equals consumer
spending, private saving, and taxes.
Take a look at the product market again,
and notice the number of flows going in.
net exports (exports – imports)
These four categories of expenditures
represent the gross domestic product of
Gross Domestic Product
Gross Domestic Product (GDP) is the total value of all final goods
and services produced in a country in a given year.
total value—market value of production, not production alone
final g/s—g/s sold to the end user
produced in an economy (country)—territory
in a given year—calendar year
AP Note: This is one of the few definitions you actually have to have
down by heart. On the macro exam, on virtually every graph, it can
help save your life and score points.
Three Ways to Measure: value-added, expenditure, income
This table helps demonstrate all three ways
to calculate GDP, and we’ll start with the
In the value-added method, the idea is to
calculate GDP by adding up the value of
all final g/s produced in the economy, with
the exception of intermediate goods.
Why? In macroeconomics, our definitions
are often strict, meant to include and
exclude. Here, GDP refers to “final” g/s,
and that means we can’t count goods
that are categorized as intermediate.
Why? Math, baby.
Looking at the bottom row of this table, we
see this basic exclusion of intermediate goods:
value added = value of sales – cost of
American Ore produces $4,200 worth of
value, based on wages, interest, rent and
profits. That ore will be sent on to
American Steel. There is no intermediate
goods here, the ore itself would be that
value added = $4,200 - $0 = $4,200
American Steel will also add value in
wages, interest, rent and profits, but
notice that their total expenditures are
more than double of American Ore.
That’s because it bought the iron ore at
$4,200. However, the value added is only
$4,800. This is because the ore is an
intermediate good and not counted
value added = $9,000 - $4,200 = $4,800
The final step is when the steel goes to
American Motors, which makes the
final product of the car, sold at
$21,500. Total expenditures are
$21,500, which we would expect given
the factor payments used to make the
car with the addition of $9,000 worth of
steel. However, we’re only interested
in the value added. So we subtract
the total expenditure (sale) from the
value of the intermediate goods.
value of sales = $21,500 - $9,000 = $12,500
What would have happened if we had
included the intermediate goods after
The value of the ore would be counted
three times—mining, refining, production.
The value of the steel would be counted
twice—refining and production. This would
give us an inflated number for GDP.
And that’s bad.
So total amount of value added at each
stage for GDP is $21,500. Keep that
number in mind as we go through the other
GDP = C + I + G + NX
C is for consumer spending, may also see it
as consumption spending. Durable and
I is for investment spending. Final
purchases of machinery, equipment, and
tools. All construction. Inventories.
Changes in business inventory. If output
is more than sales, then inventories will
build up. If businesses sell more than
they make, this becomes a negative
G is for government spending.
NX is for net exports, and is found as X – IM.
This number can be negative if imports
In this case, the expenditure method is
found in the top row, where American
Motors, Inc. sells the car for $21,500.
Again, keep that number in mind.
You may see this also as “factor income
Generally, this can be referred to as
national income (NI), meaning any income
earned by the resources.
Employee compensation: wages, salaries,
Rent: property; net rent is rent adjusted for
Interest: payments from businesses to
suppliers of money capital.
Income of business owners.
Corporate profits: After corporate income
taxes paid to government, dividends
distributed to shareholders, remainder is
undistributed corporate profits.
NI = Wages + Rent + Interest + Profit
This can be found in the last column, under
total factor income, for a total of $21,500.
The $21,500 Question
One of the things we mentioned about the circular flow diagram is
that the inflows have to equal the outflows.
That also means that the methods to calculate them have to come
out the same too. In this case, value-added, expenditure, and
income approaches gave us GDP of $21,500.
In and Out
In. Domestically produced final g/s, including capital goods, new
construction of structures, and changes to inventories.
U.S. final goods
U.S. final services
In and Out
Two AP favorites for exclusion from GDP
Second Hand Sales. Especially houses. Do not count it when it’s sold
because its value has already been accounted for in the year
Purely Financial Transactions
Public: social security, welfare, unemployment, any kind of government
transfer payment. These are not products and would not count in GDP.
Private: stocks, bonds, allowance, and alimony. These are actually legal
obligations and not products and would not count in GDP.
What about the broker’s fee for stocks?
COUNT IT! It’s a final g/s!
Inventory. Stocks of goods and raw materials held to facilitate
Businesses will build up inventories in anticipation of future sales, and
this will count as investment spending in GDP. But why isn’t counted
when it’s sold?
Because we’re focused on the value, not it’s sale price.
Additional inventory is an investment in future sales.
When a good is released from the inventories, its value is subtracted
from the value of inventories and so from GDP.
GDP gives us the value of current production at current prices. We
could be more specific and call this nominal GDP.
Nominal GDP. Total value of all final g/s produced in the economy
during a given year, calculated with the price current in the year in
which the output is produced.
English? Current GDP using current output with current prices.
We could also call this current-dollar GDP or current money GDP.
We use GDP to figure out the size of the macroeconomy.
Using nominal GDP to compare production across years is
misleading, and can often lead to exaggerated results. Part of an
increase in GDP over time represents also an increase in the price of
g/s. So we need to take into account that price change, and that’s
where real GDP comes in.
Real GDP. The total value of all final g/s produced in the economy
during a given year, calculated using the prices of a selected base
English? GDP adjusted for change in price.
Why can’t we just use nominal GDP and be done with it?
If I told you that nominal GDP in 1930 at the start of the Great
Depression was $92.2 billion, dropping from $104.6 billion, truth is, it
wouldn’t make a lot of sense to you. You weren’t alive back then,
you have no understanding of the size of the economy in the 1920s
and 1930s, and there’s no real way for you to put it in context, even
accounting for cosplay and dressing up like a slapper, Zach.
What you do understand is current prices, current spending.
Adjusting for a price change, what if I now told you that real GDP in
1930, the U.S. went from $1.0 trillion to roughly $800 billion? That’s a
more comprehensible set of numbers, and one we’re used to.
What exactly are we doing here? What we’re doing is we’re taking
the production for the year we’re looking at, and putting it in terms
of prices for a year we know and understand, what we’ll call the
That base year changes every couple of years from the
government’s perspective, but it’s a time period in which we
understand the stability and value of our currency.
Calculating Real GDP
(100)($100) + (80)($50) = $14,000
(110)($110) + (80)($100) = $20,100
Now, if we compare nominal GDP, we find that we have a percentage growth between 2010
and 2011 of 43.6%. My God, what an amazing economy! It’s a Christmas miracle!
• NOOO! Equation: [(New number – Old number)/Old Number] x 100%
• This number is utter crap. By the way, this is also how politicians lie with numbers. All of them.
Satan’s little minions, each and every one.
• Solution: Use 2010 prices as a base year and multiply 2011 quantity by those prices.
Calculating Real GDP
(100)($100) + (80)($50) = $14,000
(110)($100) + (80)($50) = $15,000
Now this is more like it. If we look at a percentage change from year to year, we have 7.1%
Why do this? Because we need numbers that we can understand and recognize. 2010, in this
example, is a year we understand, but future years not so much. The base year’s prices give us a
frame of reference to judge from.
One other note, notice that the nominal and real GDP for 2010 is the same. This is because we
are using 2010 prices and quantity. This will always be the case for the base year, that nominal
and real GDP will be equal.
GDP Doesn’t Measure Everything
GDP per capita. GDP divided by the population, average GDP per
person, shows standard of living, what countries can produce, etc.
Happiness doesn’t count: volunteer work, hobbies, raising children,
chores, work around the house, etc.
All of these are things that hurt the economy. So stop doing it. You
don’t hate America, do you?
Unhappiness, however, does: divorce lawyers, security systems,
choosing an assault rifle over butter, natural disasters, plagues,
locusts, the Apocalypse.
All of these are things that contribute to the economy. So…when do we
start firing off the nukes? We should do it from orbit, it’s the only way to