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CHAPTER 6

Measuring Domestic Output and National Income

113

The huge depreciation charge made against private

and social capital each year is called consumption of fixed

capital because it is the allowance for capital that has been

“consumed” in producing the year’s GDP. It is the portion

of GDP that is set aside to pay for the ultimate replace-

ment of those capital goods.

The money allocated to consumption of fixed capital

(the depreciation allowance) is a cost of production and

thus included in the gross value of output. But this money

is not available for other purposes, and, unlike other costs

of production, it does not add to anyone’s income. So it is

not included in national income. We must therefore add it

to national income to achieve balance with the economy’s

expenditures, as in Table 6.3 .

Table 6.3 summarizes the expenditures approach and

income approach to GDP. The left side shows what the

U.S. economy produced in 2005 and what was spent to

purchase it. The right side shows how those expenditures,

when appropriately adjusted, were allocated as income.

tract consumption of fixed capital (depreciation) from GDP.

The result is a measure of net domestic product (NDP) :

NDP  GDP  consumption of fixed capital

( depreciation )

For the United States in 2005:

NDP is simply GDP adjusted for depreciation. It mea-

sures the total annual output that the entire economy—

households, businesses, government, and foreigners—can

consume without impairing its capacity to produce in

ensuing years.

National Income

Sometimes it is useful to know how much Americans

earned for their contributions of land, labor, capital, and

entrepreneurial talent. Recall that U.S. national income

(NI) includes all income earned through the use of

American-owned resources, whether they are located at

home or abroad. It also includes taxes on production and

imports. To derive NI from NDP, we must subtract the

aforementioned statistical discrepancy from NDP and

add net foreign factor income, since the latter is income

earned by Americans.

For the United States in 2005:

QUICK REVIEW 6.1

• Gross domestic product (GDP) is a measure of the total

market value of all final goods and services produced by the

economy in a given year.

• The expenditures approach to GDP sums the total spending

on final goods and services: GDP  C  I

 G  X

• The economy’s stock of private capital expands when net

investment is positive; stays constant when net investment is

zero; and declines when net investment is negative.

• The income approach to GDP sums compensation to

employees, rent, interest, proprietors’ income, corporate

profits, and taxes on production and imports to obtain

national income, and then subtracts net foreign factor

income and adds a statistical discrepancy and consumption

of fixed capital to obtain GDP.

Other National Accounts

Several other national accounts provide additional useful

information about the economy’s performance. We can de-

rive these accounts by making various adjustments to GDP.

Net Domestic Product

As a measure of total output, GDP does not make allow-

ances for replacing the capital goods used up in each year’s

production. As a result, it does not tell us how much new

output was available for consumption and for additions to

the stock of capital. To determine that, we must subtract

from GDP the capital that was consumed in producing the

GDP and that had to be replaced. That is, we need to sub-

We know, too, that we can calculate national income

through the income approach by simply adding up em-

ployee compensation, rent, interest, proprietors’ income,

corporate profit, and taxes on production and imports.

Personal Income

Personal income (PI) includes all income received

whether earned or unearned. It is likely to differ from

national income (income earned) because some income

earned—taxes on production and imports, Social Secu-

rity taxes (payroll taxes), corporate income taxes, and un-

distributed corporate profits—is not received by

households. Conversely, some income received—such as

Social Security payments, unemployment compensation

Billions

Gross domestic product $12,487

Consumption of fixed capital ⴚ1574

Net domestic product $10,913

Billions

Net domestic product $10,913

Statistical discrepancy ⴚ43

Net foreign factor income 34

National income $10,904

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114

payments, welfare payments, disability and education

payments to veterans, and private pension payments—is

not earned. These transfer payments must be added to

obtain PI.

In moving from national income to personal income,

we must subtract the income that is earned but not re-

ceived and add the income that is received but not earned.

For the United States in 2005:

Disposable Income

Disposable income (DI) is personal

income less personal taxes. Personal taxes

include personal income taxes, personal

property taxes, and inheritance taxes.

Disposable income is the amount of in-

come that households have left over after

paying their personal taxes. They are free

to divide that income between consumption

( C ) and saving ( S ):

DI  C  S

For the United States in 2005:

W 6.1

Measuring output

and income

TABLE 6.4 The Relationships between GDP, NDP, NI, PI, and

Dl in the United States, 2005 *

Billions

Gross domestic product (GDP) $12,487

Consumption of fixed capital ⴚ1574

Net domestic product (NDP) $10,913

Statistical discrepancy ⴚ43

Net foreign factor income 34

National income (NI)

†

$10,904

Taxes on production and imports ⴚ917

Social Security contributions ⴚ871

Corporate income taxes ⴚ378

Undistributed corporate profits ⴚ460

Transfer payments ⴙ1970

Personal income (PI) $10,248

Personal taxes ⴚ1210

Disposable income (DI) $ 9038

*Some of the items combine related categories that appear in the more detailed

accounts.

†

In the 2003 comprehensive revision of the NIPA, the Bureau of Economic Analysis

redefined national income to include revenue from taxes on production and imports.

Previously, it had excluded these indirect business taxes.

that show first the allocations of GDP and then the adjust-

ments needed to derive NDP, NI, PI, and DI.

The diagram illustrates the adjustments necessary to

determine each of the national income accounts. For ex-

ample, net domestic product is smaller than GDP because

consumption of fixed capital flows away from GDP in de-

termining NDP. Also, disposable income is smaller than

personal income because personal taxes flow away from PI

(to government) in deriving DI.

Note the three domestic sectors of the economy:

households, government, and businesses. The household

sector has an inflow of disposable income and outflows of

consumption spending and saving. The government sec-

tor has an inflow of revenue in the form of types of taxes

and an outflow of government disbursements in the form

of purchases and transfers. The business sector has inflows

of three major sources of funds for business investment

and an outflow of investment expenditures.

Finally, note the foreign sector (all other countries) in

the flow diagram. Spending by foreigners on U.S. exports

adds to U.S. GDP, but some of U.S. consumption, gov-

ernment, and investment expenditures buy imported

products. The flow from foreign markets shows that we

handle this complication by calculating net exports (U.S.

exports minus U.S. imports). The net export flow may be

a positive or negative amount, adding to or subtracting

from U.S. GDP.

*Includes a statistical discrepancy.

Billions

National income $10,904

Taxes on production and imports ⴚ917

Social Security contributions ⴚ871

Corporate income taxes ⴚ378

Undistributed corporate profits ⴚ460

Transfer payments ⴙ1970 *

Personal income $10,248

Billions

Personal income $10,248

Personal taxes ⴚ1210

Disposable income $ 9038

Table 6.4 summarizes the relationships among GDP,

NDP, NI, PI, and DI. (Key Question 8)

The Circular Flow Revisited

Figure 6.3 is an elaborate flow diagram that shows the

economy’s four main sectors along with the flows of ex-

penditures and allocations that determine GDP, NDP, NI,

and PI. The orange arrows represent the spending flows—

C  I

 G  X

—that together measure gross domestic

product. To the right of the GDP rectangle are green arrows

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Investment

expenditures

U.S.

BUSINESSES

U.S.

GOVERNMENT

Consumption of fixed capital

Gross

domestic

product

Net

domestic

product

Compensation of employees

Rents

Interest

Dividends

Proprietors’ income

Corporate income taxes

Undistributed corporate profits

Taxes on production and imports

National

income

Transfer payments

Personal taxes

Social Security contributions

Personal saving

Personal consumption expenditures

Government purchases

Net export

expenditures

ALL OTHER

COUNTRIES

U.S.

HOUSEHOLDS

Personal

income

Dispos-

able

income

Net foreign factor income

FIGURE 6.3 U.S. domestic output and the flows of expenditure and income. This figure is an elaborate circular flow diagram that fits the expenditures and allocations sides of GDP

to one another. The expenditures flows are shown in orange; the allocations or income flows are shown in green. You should trace through the income and expenditures flows, relating them to the five basic

national income accounting measures.

115

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Figure 6.3 shows that flows of expenditures and in-

come are part of a continuous, repetitive process. Cause

and effect are intermingled: Expenditures create income,

and from this income arise expenditures, which again flow

to resource owners as income.

tion as an identical hamburger that sold for 50 cents

in 1970.

The way around this problem is to deflate GDP when

prices rise and to inflate GDP when prices fall. These ad-

justments give us a measure of GDP for various years as if

the value of the dollar had always been the same as it was

in some reference year. A GDP based on the prices that

prevailed when the output was produced is called unad-

justed GDP, or nominal GDP . A GDP that has been de-

flated or inflated to reflect changes in the price level is

called adjusted GDP, or real GDP .

Adjustment Process in a One-

Product Economy

There are two ways we can adjust nominal GDP to reflect

price changes. For simplicity, let’s assume that the econ-

omy produces only one good, pizza, in the amounts indi-

cated in Table 6.5 for years 1, 2, and 3. Suppose that we

gather revenue data directly from the financial reports of

the pizza businesses to measure nominal GDP in various

years. After completing our effort, we will have deter-

mined nominal GDP for each year, as shown in column 4

of Table 6.5 . We will have no way of knowing to what ex-

tent changes in price and/or changes in quantity of output

have accounted for the increases or decreases in nominal

GDP that we observe.

GDP Price Index How can we determine real GDP

in our pizza economy? One way is to assemble data on the

price changes that occurred over various years (column 2)

and use them to establish an overall price index for the

entire period. Then we can use the index in each year to

adjust nominal GDP to real GDP for that year.

A price index is a measure of the price of a specified

collection of goods and services, called a “market basket,”

in a given year as compared to the price of an identical

(or highly similar) collection of goods and services in a

TABLE 6.5 Calculating Real GDP (Base Year ⴝ Year 1)

(4)

(2) Unadjusted,

(1) Price of (3) or Nominal, (5)

Units of Pizza Price Index GDP, Adjusted, or

Year Output per Unit (Year 1 ⴝ 100) (1) ⴛ (2) Real, GDP

1 5 $10 100 $ 50 $50

2 7 20 200 140 70

3 8 25 250 200 80

4 10 30 ___ ___ ___

5 11 28 ___ ___ ___

QUICK REVIEW 6.2

• Net domestic product (NDP) is the market value of GDP

minus consumption of fixed capital (depreciation).

• National income (NI) is all income earned through the use

of American-owned resources, whether located at home or

abroad. Since 2003, NI has included taxes on production and

imports.

• Personal income (PI) is all income received by households,

whether earned or not.

• Disposable income (DI) is all income received by households

minus personal taxes.

Nominal GDP versus Real GDP

Recall that GDP is a measure of the market or money

value of all final goods and services produced by the econ-

omy in a given year. We use money or nominal values as a

common denominator in order to sum that heterogeneous

output into a meaningful total. But that creates a problem:

How can we compare the market values of GDP from year

to year if the value of money itself changes in response to

inflation (rising prices) or deflation (falling prices)? After

all, we determine the value of GDP by multiplying total

output by market prices.

Whether there is a 5 percent increase in output with

no change in prices or a 5 percent increase in prices with

no change in output, the change in the value of GDP will

be the same. And yet it is the quantity of goods that get

produced and distributed to households that affects our

standard of living, not the price of the goods. The ham-

burger that sold for $2 in 2000 yields the same satisfac-

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117

reference year. That point of reference, or benchmark, is

known as the base period or base year. More formally,

Price price of market basket

index in specific year

in given



price of same market



100 (1)

year

basket in base year

By convention, the price ratio between a given year and

the base year is multiplied by 100 to facilitate computa-

tion. For example, a price ratio of 2/1 ( 2) is expressed as

a price index of 200. A price ratio of 1/3 ( .33) is ex-

pressed as a price index of 33.

In our pizza-only example, of course, our market bas-

ket consists of only one product. Column 2 of Table 6.5

reveals that the price of pizza was $10 in year 1, $20 in

year 2, $25 in year 3, and so on. Let’s select year 1 as our

base year. Now we can express the successive prices of the

contents of our market basket in, say, years 2 and 3 as

compared to the price of the market basket in year 1:

Price index, year 2



$20

____

$10

 100  200

Price index, year 3



$25

____

$10

 100  250

For year 1 the index has to be 100, since that year and the

base year are identical.

The index numbers tell us that the price of pizza

rose from year 1 to year 2 by 100 percent { [(200 

100)/100]  100} and from year 1 to year 3 by 150 per-

cent { [(250  100)/100]  100}.

Dividing Nominal GDP by the Price In-

dex

We can now use the index numbers shown in col-

umn 3 to deflate the nominal GDP figures in column 4.

The simplest and most direct method of deflating is to ex-

press the index numbers as hundredths—in decimal

form—and then to divide them into corresponding nomi-

nal GDP. That gives us real GDP:

Real GDP



nominal GDP

________________________

price index (in hundredths)

(2)

Column 5 shows the results. These figures for real GDP

measure the market value of the output of

pizza in years 1, 2, and 3 as if the price of

pizza had been a constant $10 throughout

the 3-year period. In short, real GDP

reveals the market value of each year’s

output measured in terms of dollars that

have the same purchasing power as dollars

had in the base year.

To test your understanding, extend

Table 6.5 to years 4 and 5, using equations

1 and 2. Then run through the entire deflat-

ing procedure, using year 3 as the base pe-

riod. This time you will have to inflate some

of the nominal GDP data, using the same

procedure as we used in the examples.

An Alternative Method

Another way to establish real GDP is to gather separate data

on physical outputs (as in column 1) and their prices (as in

column 2) of Table 6.5 . We could then determine the mar-

ket value of outputs in successive years if the base-year price

($10) had prevailed . In year 2, the 7 units of pizza would have

a value of $70 ( 7 units  $10). As column 5 confirms, that

$70 worth of output is year 2’s real GDP. Similarly, we could

determine the real GDP for year 3 by multiplying the

8 units of output that year by the $10 price in the base year.

Once we have determined real GDP through this

method, we can identify the price index for a given year

simply by dividing the nominal GDP by the real GDP for

that year:

Price index

(in hundredths)



nominal GDP

_____________

real GDP

(3)

Example: In year 2 we get a price index of 200—or, in

hundredths, 2.00—which equals the nominal GDP of

$140 divided by the real GDP of $70. Note that equation

3 is simply a rearrangement of equation 2. Table 6.6 sum-

marizes the two methods of determining real GDP in our

single-good economy. (Key Question 11)

Real-World Considerations

and Data

In the real world of many goods and services, of course,

determining GDP and constructing a reliable price index

are far more complex matters than in our pizza-only

W 6.2

Real GDP and

price indexes

O 6.1

GDP price index

TABLE 6.6 Steps for Deriving Real GDP from Nominal GDP

Method 1

1. Find nominal GDP for each year.

2. Compute a GDP price index.

3. Divide each year’s nominal GDP by that year’s price index

(in hundredths) to determine real GDP.

Method 2

1. Break down nominal GDP into physical quantities of output and

prices for each year.

2. Find real GDP for each year by determining the dollar amount that

each year’s physical output would have sold for if base-year prices

had prevailed. (The GDP price index can then be found by dividing

nominal GDP by real GDP.)

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economy. The government accountants must assign a

“weight” to each of several categories of goods and ser-

vices based on the relative proportion of each category in

total output. They update the weights annually as expen-

diture patterns change and roll the base year forward year

by year using a moving average of expenditure patterns.

The GDP price index used in the United States is called

the chain-type annual-weights price index —which hints at its

complexity. We spare you the details.

Table 6.7 shows some of the real-world relationships

between nominal GDP, real GDP, and the GDP price in-

dex. Here the reference year is 2000, where the value of

the index is set at 100. Because the price level has been ris-

ing over the long run, the pre-2000 values of real GDP

(column 3) are higher than the nominal values of GDP for

those years (column 2). This upward adjustment acknowl-

edges that prices were lower in the years before 2000, and

thus nominal GDP understated the real output of those

years in 2000 prices and must be inflated to show the cor-

rect relationship to other years.

Conversely, the rising price level of the post-2000

years caused nominal GDP figures for those years to over-

state real output. So the statisticians deflate those figures

to determine what real GDP would have been in other

years if 2000 prices had prevailed. Doing so reveals that

real GDP has been less than nominal GDP since 2000.

By inflating the nominal pre-2000 GDP data and de-

flating the post-2000 data, government accountants deter-

mine annual real GDP, which can then be compared with

the real GDP of any other year in the series of years. So

the real GDP values in column 3 are directly comparable

with one another.

Once we have determined nominal GDP and real GDP,

we can fashion the price index. And once we have deter-

mined nominal GDP and the price index, we can calculate

real GDP. Example: Nominal GDP in 2005 was $12,487.1

billion and real GDP was $11,134.8 billion. So the price

level in 2005 was 112.1 ( $12,487.1/$11,134.8  100), or

12.1 percent higher than in 2000. If we knew the nominal

GDP and the price level only, we could find the real GDP

for 2005 by dividing the nominal GDP of $12,487.1 by the

2005 price index, expressed in hundredths (1.1214).

To test your understanding of the relationships be-

tween nominal GDP, real GDP, and the price level, deter-

mine the values of the price index for 1980 in Table 6.7

and determine real GDP for 1990 and 2003. We have left

those figures out on purpose. (Key Question 12)

Shortcomings of GDP

GDP is a reasonably accurate and highly useful measure of

how well or how poorly the economy is performing. But it

has several shortcomings as a measure of both total output

and well-being (total utility).

Nonmarket Activities

Certain productive activities do not take place in any mar-

ket—the services of homemakers, for example, and the

labor of carpenters who repair their own homes. Such ac-

tivities never show up in GDP, which measures only the

market value of output. Consequently, GDP understates a

nation’s total output. There is one exception: The portion

of farmers’ output that farmers consume themselves is es-

timated and included in GDP.

Leisure

The average workweek (excluding overtime) in the United

States has declined since the beginning of the 1900s—

from about 53 hours to about 35 hours. Moreover, the

greater frequency of paid vacations, holidays, and leave

time has shortened the work year itself. This increase in

leisure time has clearly had a positive effect on overall

well-being. But our system of national income accounting

understates well-being by ignoring leisure’s value. Nor

Source: Bureau of Economic Analysis, www.bea.doc.gov .

TABLE 6.7 Nominal GDP, Real GDP, and GDP Price Index,

Selected Years

(2) (3) (4)

(1) Nominal GDP, Real GDP, GDP Price Index

Year Billions of $ Billions of $ (2000 ⴝ 100)

1980 2789.5 5161.7

1985 4220.3 6053.7 69.7

1990 5803.1 81.6

2000 9817.0 9817.0 100.0

2003 10,971.2 106.3

2005 12,487.1 11,134.8 112.1

QUICK REVIEW 6.3

• Nominal GDP is output valued at current prices. Real GDP

is output valued at constant base-year prices.

• The GDP price index compares the price (market value) of

all the goods and services included in GDP in a given year to

the price of the same market basket in a reference year.

• Nominal GDP can be transformed into real GDP by

dividing the nominal GDP by the GDP price index

expressed in hundredths.

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does the system accommodate the satisfaction—the “psy-

chic income”—that many people derive from their work.

Improved Product Quality

Because GDP is a quantitative measure rather than a quali-

tative measure, it fails to capture the full value of improve-

ments in product quality. There is a very real difference in

quality between a $200 cell phone purchased today and a

cell phone that cost the same amount just a decade ago.

Today’s cell phone is digital and has greater memory capac-

ity, a viewing screen, and enhanced capabilities.

Obviously quality improvement has a great effect on

economic well-being, as does the quantity of goods pro-

duced. Although the BEA adjusts GDP for quality im-

provement for selected items, the vast majority of such

improvement for the entire range of goods and services

does not get reflected in GDP.

The Underground Economy

Embedded in our economy is a flourishing, productive

underground sector. Some of the people who conduct

business there are gamblers, smugglers, prostitutes,

“fences” of stolen goods, drug growers, and drug dealers.

They have good reason to conceal their incomes.

Most participants in the underground economy, how-

ever, engage in perfectly legal activities but choose ille-

gally not to report their full incomes to the Internal

Revenue Service (IRS). A bell captain at a hotel may re-

port just a portion of the tips received from customers.

Storekeepers may report only a portion of their sales re-

ceipts. Workers who want to hold on to their unemploy-

ment compensation benefits may take an “off-the-books”

or “cash-only” job. A brick mason may agree to rebuild a

neighbor’s fireplace in exchange for the neighbor’s repair-

ing his boat engine. The value of none of these transac-

tions shows up in GDP.

The value of underground transactions is estimated to

be about 8 percent of the recorded GDP in the United

States. That would mean that GDP in 2005 was under-

stated by about $1 trillion. Global Perspective 6.2 shows

estimates of the relative sizes of underground economies

in selected nations.

GDP and the Environment

The growth of GDP is inevitably accompanied by “gross

domestic by-products,” including dirty air and polluted

water, toxic waste, congestion, and noise. The social

costs of the negative by-products reduce our economic

well-being. And since those costs are not deducted from

total output, GDP overstates our national well-being.

Ironically, when money is spent to clean up pollution

and reduce congestion, those expenses are added to

the GDP!

Composition and Distribution

of Output

The composition of output is undoubtedly important for

well-being. But GDP does not tell us whether the mix of

goods and services is enriching or potentially detrimental

to society. GDP assigns equal weight to an assault rifle

and a set of encyclopedias, as long as both sell for

the same price. Moreover, GDP reveals nothing about

the way output is distributed. Does 90 percent of the out-

put go to 10 percent of the households, for example, or is

the output more evenly distributed? The distribution of

output may make a big difference for society’s overall

well-being.

GLOBAL PERSPECTIVE 6.2

The Underground Economy as a Percentage of

GDP, Selected Nations

Underground economies vary in size worldwide. Three factors

that help explain the variation are (1) the extent and complex-

ity of regulation, (2) the type and degree of taxation, and (3)

the effectiveness of law enforcement.

Source : Friedrich Schneider and Dominik H. Enste, “Shadow Economies:

Size, Causes, and Consequences,” Journal of Economic Literature , March

2000, p. 104.

Percentage of GDP

0 5 10 15 20 25 30

Greece

Italy

Spain

Portugal

Belgium

Sweden

Germany

France

Holland

United Kingdom

Japan

United States

Switzerland

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Magical Mystery Tour

The Bureau of Economic Analysis (BEA), an Agency

of the Department of Commerce, Compiles the

NIPA Tables. Where Does It Get the Actual Data?

Discussions of national income accounting often leave the im-

pression that the data for the National Income and Product Ac-

counts magically appear from some mysterious place. Let’s take

a tour to see where economists get their data.

Consumption The BEA derives the

data for the consumption component

of the GDP accounts from four main

sources:

• The Census Bureau’s Retail Trade

Survey , which gains sales informa-

tion from a sample of 22,000 firms.

• The Census Bureau’s Survey of

Manufacturers , which gathers

information on shipments of

consumer goods from 50,000

establishments.

• The Census Bureau’s Service Sur-

vey , which collects sales data from

30,000 service businesses.

• Industry trade sources. For exam-

ple, data on auto sales and air-

craft are collected directly from

auto and aircraft manufacturers.

Investment The sources of the data

for the investment component of GDP

include:

• All the sources above used to determine consumption. Pur-

chases of capital goods are separated from purchases of con-

sumer goods. For example, estimates of investment in

equipment and software are based on manufacturers’ shipments

reported in the Survey of Manufacturers , the Service Survey , and

industry sources.

• Census construction surveys. The Census Bureau’s Housing

Starts Survey and Housing Sales Survey produce the data

used to measure the amount of housing construction, and

the Construction Progress Reporting Survey is the source of

data on nonresidential construction. The BEA determines

changes in business inventories through the Retail Trade

Survey , the Wholesale Trade Survey (of 7100 wholesale

firms), and the Survey of Manufacturing.

Government Purchases The data for government purchases

(officially “government consumption and investment expendi-

tures”) are obtained through the follow-

ing sources:

• The U.S. Office of Personnel Man-

agement, which collects data on

wages and benefits, broken out by

the private and public sector.

Wages and benefits of government

employees are the single largest

“purchase” by Federal, state, and

local government.

• The previously mentioned Census

Bureau’s construction surveys,

which break out private and public

sector construction expenditures.

• The Census Bureau’s Survey of Gov-

ernment Finance , which provides

data on government consumption

and investment expenditures.

Net Exports The BEA determines net

exports through two main sources:

• The U.S. Customs Service, which

collects data on exports and imports

of goods.

• BEA surveys of potential domestic exporters and importers

of services, which collect data on exports and imports of

services.

So there you have it. Not so magical after all!

Source: Based on Joseph A. Ritter, “Feeding the National Accounts,”

Federal Reserve Bank of St. Louis Review , March–April 2000, pp.

11–20. For those interested, this article also provides information on

the sources of data for the income side of the national accounts.

Last

Word

120

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CHAPTER 6

Measuring Domestic Output and National Income

121

Summary

1. Gross domestic product (GDP), a basic measure of an econ-

omy’s economic performance, is the market value of all final

goods and services produced within the borders of a nation

in a year.

2. Intermediate goods, nonproduction transactions, and sec-

ondhand sales are purposely excluded in calculating GDP.

3. GDP may be calculated by summing total expenditures on

all final output or by summing the income derived from the

production of that output.

4. By the expenditures approach, GDP is determined by add-

ing consumer purchases of goods and services, gross invest-

ment spending by businesses, government purchases, and

net exports: GDP  C  I

 G  X

5. Gross investment is divided into (a) replacement investment

(required to maintain the nation’s stock of capital at its exist-

ing level) and (b) net investment (the net increase in the

stock of capital). In most years, net investment is positive

and therefore the economy’s stock of capital and production

capacity increase.

6. By the income or allocations approach, GDP is calculated as

the sum of compensation to employees, rents, interest, pro-

prietors’ income, corporate profits, taxes on production and

imports minus net foreign factor income, plus a statistical

discrepancy and consumption of fixed capital.

7. Other national accounts are derived from GDP. Net domes-

tic product (NDP) is GDP less the consumption of fixed

capital. National income (NI) is total income earned by a

nation’s resource suppliers plus taxes on production and im-

ports; it is found by subtracting a statistical discrepancy

from NDP and adding net foreign factor income to NDP.

Personal income (PI) is the total income paid to households

prior to any allowance for personal taxes. Disposable in-

come (DI) is personal income after personal taxes have been

paid. DI measures the amount of income available to house-

holds to consume or save.

8. Price indexes are computed by dividing the price of a spe-

cific collection or market basket of output in a particular

period by the price of the same market basket in a base pe-

riod and multiplying the result (the quotient) by 100. The

GDP price index is used to adjust nominal GDP for infla-

tion or deflation and thereby obtain real GDP.

9. Nominal (current-dollar) GDP measures each year’s output

valued in terms of the prices prevailing in that year. Real

(constant-dollar) GDP measures each year’s output in terms

of the prices that prevailed in a selected base year. Because

real GDP is adjusted for price-level changes, differences in

real GDP are due only to differences in production activity.

10. GDP is a reasonably accurate and very useful indicator of a

nation’s economic performance, but it has its limitations. It

fails to account for nonmarket and illegal transactions, changes

in leisure and in product quality, the composition and distri-

bution of output, and the environmental effects of production.

The link between GDP and well-being is tenuous.

Terms and Concepts

national income accounting

gross domestic product (GDP)

intermediate goods

final goods

multiple counting

value added

expenditures approach

income approach

personal consumption expenditures ( C )

gross private domestic investment ( I

)

net private domestic investment

government purchases ( G )

net exports ( X

)

taxes on production and imports

national income

consumption of fixed capital

net domestic product (NDP)

personal income (PI)

disposable income (DI)

nominal GDP

real GDP

price index

Noneconomic Sources of

Well-Being

Finally, the connection between GDP and well-being is

problematic for another reason. Just as a household’s

income does not measure its total happiness, a nation’s

GDP does not measure its total well-being. Many things

could make a society better off without necessarily

raising GDP: a reduction of crime and violence, peace-

ful relations with other countries, people’s greater civil-

ity toward one another, better understanding between

parents and children, and a reduction of drug and alco-

hol abuse.

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PART TWO

Macroeconomic Measurement and Basic Concepts

122

Study Questions

1. In what ways are national income statistics useful?

2. Explain why an economy’s output, in essence, is also its

income.

KEY QUESTION Why do economists include only final

goods in measuring GDP for a particular year? Why don’t

they include the value of the stocks and bonds bought and

sold? Why don’t they include the value of the used furniture

bought and sold?

4. What is the difference between gross private domestic

investment and net private domestic investment? If you

were to determine net domestic product (NDP) through

the expenditures approach, which of these two measures of

investment spending would be appropriate? Explain.

5. Why are changes in inventories included as part of invest-

ment spending? Suppose inventories declined by $1 billion

during 2006. How would this affect the size of gross private

domestic investment and gross domestic product in 2006?

Explain.

6. Use the concepts of gross investment and net investment to

distinguish between an economy that has a rising stock of

capital and one that has a falling stock of capital. “In 1933

net private domestic investment was minus $6 billion. This

means that in that particular year the economy produced no

capital goods at all.” Do you agree? Why or why not? Ex-

plain: “Though net investment can be positive, negative, or

zero, it is quite impossible for gross investment to be less

than zero.”

7. Define net exports. Explain how U.S. exports and imports

each affect domestic production. Suppose foreigners spend

$7 billion on U.S. exports in a specific year and Americans

spend $5 billion on imports from abroad in the same year.

What is the amount of the United States’ net exports? Ex-

plain how net exports might be a negative amount.

KEY QUESTION Below is a list of domestic output and na-

tional income figures for a certain year. All figures are in

billions. The questions that follow ask you to determine the

major national income measures by both the expenditures

and the income approaches. The results you obtain with the

different methods should be the same.

Personal consumption expenditures $245

Net foreign factor income 4

Transfer payments 12

Rents 14

Statistical discrepancy 8

Consumption of fixed capital (depreciation) 27

Social Security contributions 20

Interest 13

Proprietors’ income 33

Net exports 11

Dividends 16

a. Using the above data, determine GDP by both the ex-

penditures and the income approaches. Then determine

NDP.

b. Now determine NI in two ways: first, by making the re-

quired additions or subtractions from NDP; and second, by

adding up the types of income and taxes that make up NI.

c. Adjust NI (from part b ) as required to obtain PI.

d. Adjust PI (from part c ) as required to obtain DI.

9. Using the following national income accounting data,

compute ( a ) GDP, ( b ) NDP, and ( c ) NI. All figures are in

billions.

Compensation of employees $194.2

U.S. exports of goods and services 17.8

Consumption of fixed capital 11.8

Government purchases 59.4

Taxes on production and imports 14.4

Net private domestic investment 52.1

Transfer payments 13.9

U.S. imports of goods and services 16.5

Personal taxes 40.5

Net foreign factor income 2.2

Personal consumption expenditures 219.1

Statistical discrepancy 0

10. Why do national income accountants compare the

market value of the total outputs in various years rather

than actual physical volumes of production? What

problem is posed by any comparison over time of the

market values of various total outputs? How is this

problem resolved?

11.

KEY QUESTION Suppose that in 1984 the total output

in a single-good economy was 7000 buckets of chicken.

Also suppose that in 1984 each bucket of chicken was

priced at $10. Finally, assume that in 2000 the price per

bucket of chicken was $16 and that 22,000 buckets

were produced. Determine the GDP price index for

1984, using 2000 as the base year. By what percentage

did the price level, as measured by this index, rise be-

tween 1984 and 2000? Use the two methods listed in

Table 6.6 to determine real GDP for 1984 and 2000.

Compensation of employees 223

Taxes on production and imports 18

Undistributed corporate profits 21

Personal taxes 26

Corporate income taxes 19

Corporate profits 56

Government purchases 72

Net private domestic investment 33

Personal saving 20

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