Lecture 2

1.

Principles of Economics
Dr. Shahab Sharfaei, PhD.
Metropolitan University

2.

Lecture 2
MEASURING A NATION’S INCOME

3.

Levels of Well-being
◦ Subjective well-being refers to the way in which people evaluate
their own happiness.
◦ Objective well-being refers to measures of the quality of life and
uses indicators such as educational attainment, measures of
the standard of living, life expectancy.
◦ Countries with higher national incomes have better education,
better housing etc.

4.

II. The Economy’s Income and
Expenditure

5.

The Economy’s Income And Expenditure
When judging whether the economy is doing well or poorly, it is
natural to look at the total income that the economy is earning.

6.

For An Economy As A Whole, Total
Income Must Equal Total Expenditure
Total income must equal expenditure because:
◦ Every transaction has a buyer and a seller.
◦ Every euro of spending by some buyer is a euro of income for
some seller.
◦ The equality of income and expenditure can be illustrated with
the circular-flow diagram.

7.

Figure 1. The Circular-Flow Diagram

8.

Circular Flow of Income
o
Households buy goods and services from firms; firms use this money to pay
for resources purchased from households.
o
When households receive income, some of the income is saved (S) providing
funds for financial institutions. Some is taxed (T). The taxes can be used by
the government in making purchases (G) such as education, health and
infrastructure.
o
Some products and services may be purchased from other countries as
imports (M) and some services and products may be sold abroad as exports
(X).
o
Some businesses will invest (I) in new capital.

9.

IX. The Measurement of Gross
Domestic Product

10.

Defining the Gross Domestic Product
Gross domestic product (GDP) is a measure of the income and
expenditures of an economy.
It is the total market value of all final goods and services produced
within a country in a given period of time.

11.

GDP is the Market Value….
GDP is the market value of all final goods and services
produced within a country in a given period of time.
1)
“GDP is the market value…”
◦ Output is valued at market prices.
2)
“. . . of all final . . .”
◦ It records only the value of final goods, not intermediate goods (the value is
counted only once).
3)
“. . . goods and services . . .”
◦ It includes both tangible goods (food, clothing, cars) and intangible services
(haircuts, house cleaning).

12.

GDP is the Market Value….
1)
“. . . produced . . .”
◦ It includes goods and services produced in the period we’re considering,
not transactions involving goods produced in the past.
2)
“ . . . within a country . . .”
◦ It measures the value of production within the geographic confines of a
country.
3)
“. . . in a given period of time.”
◦ It measures the value of production that takes place within a specific
interval of time, usually a year or a quarter (three months).

13.

The Components of GDP
GDP includes all items produced in the economy and sold legally
in markets.
What Is Not Counted in GDP?
◦ GDP excludes most items that are produced and consumed at home
and that never enter the marketplace.
◦ It excludes items produced and sold illicitly, such as illegal drugs.

14.

The Components of GDP
GDP (Y) is the sum of the following:
◦ Consumption (C)
◦ Investment (I)
◦ Government Purchases (G)
◦ Net Exports (NX)
Y = C + I + G + NX

15.

The Components of GDP
Consumption (C):
◦ The spending by households on goods and services, with the
exception of purchases of new housing.
Investment (I):
◦ The spending on capital equipment, inventories, and structures,
including new housing.
Government Spending (G):
◦ The spending on goods and services by local and central
governments.

16.

The Components of GDP
Net Exports (NX):
o Exports minus imports.
GDP per capita is gross domestic product (GDP) divided by the
population of a country to give a measure of national income per head.

17.

XI. Real versus Nominal GDP

18.

Why Total Spending can Rise from Year to
Year
1. The economy may be producing a larger output of goods and services.
2. Goods and services could be selling at higher prices.
Economists want to know if output has changed when measuring GDP
growth.
◦
Real GDP values the production of goods and services at constant prices. It
takes changes in price over time into account.
◦
GDP at constant prices uses prices that existed in the base year.
◦
Nominal GDP values the production of goods and services at current prices.
Calculated by multiplying output by prices.

19.

A Numerical Example
An accurate view of the economy requires adjusting nominal to
real GDP by using the GDP deflator.
Assume an economy produces only two goods – apples and
potatoes.
◦ Table 1, on the next slide, shows the quantities of the two goods
produced and their prices in the years 2019, 2020 and 2021.

20.

Table 1. Data example
for calculating the real
and nominal GDP
Part of the rise in GDP shown below is attributable to the increase in the quantities of
apples and potatoes and part to the increase in the prices of apples and potatoes. To take
out the effect of changes in prices we use real GDP .

21.

The GDP Deflator
The GDP deflator is a measure of the price level calculated as the
ratio of nominal GDP to real GDP times 100.
It tells us the rise in nominal GDP that is attributable to a rise in
prices rather than a rise in the quantities produced.
GDP deflator =
Nominal GDP
100
Real GDP

22.

Calculating the GDP deflator
For year 2019, nominal GDP is €200, and real GDP is €200, so
the GDP deflator is 100.
We now need the nominal GDP and the real GDP for the other
two years to complete our calculations (see table1).

23.

XII. The Limitations of GDP as a
Measure of Well-being

24.

What GDP can tell us.
GDP is the best single measure of the economic well-being of a
society.
◦ GDP per person tells us the mean income and expenditure of the
people in the economy.
◦ Higher GDP per person indicates a higher standard of living.
GDP is not a perfect measure of the happiness or quality of life,
however.
◦ It is an average and does not tell us about groups of similar
individuals.

25.

What GDP Omits to tell us
Some things that contribute to well-being are not included in GDP.
◦ The value of leisure.
◦ The value of a clean environment.
◦ The distribution of income.
◦ The value of almost all activity that takes place outside of markets,
such as the value of the time parents spend with their children and the
value of volunteer work.

26.

XIII. International Differences in
GDP and the Quality of Life

27.

International Differences in GDP and the
Quality of Life
GDP data is used as a way of comparing well-being across
different countries.
Rich and poor countries have vastly different levels of GDP per
person.
◦ Countries with low GDP per person tend to have more infants with low
birth weight, higher rates of infant mortality, higher rates of maternal
mortality, higher rates of child malnutrition and less common access to
safe drinking water.

28.

Summary
1) Because every transaction has a buyer and a seller, the
total expenditure in the economy must equal the total
income in the economy.
2) Gross Domestic Product (GDP) measures an economy’s
total expenditure on newly produced goods and services
and the total income earned from the production of
these goods and services.
3) GDP is the market value of all final goods and services
produced within a country in a given period of time.

29.

Summary
4)
GDP is divided among four components of expenditure:
consumption, investment, government purchases, and net
exports.
5)
Nominal GDP uses current prices to value the economy’s
production. Real GDP uses constant base-year prices to value
the economy’s production of goods and services.
6)
The GDP deflator—calculated from the ratio of nominal to real
GDP—measures the level of prices in the economy.

30.

Summary
7) GDP is a good measure of economic well-being
because people prefer higher to lower incomes.
8) It is not a perfect measure of well-being because some
things, such as leisure time and a clean environment,
aren’t measured by GDP.

31.

Literature
Mankiw, N. “Principles of Economics“: chapter 23 (Measuring a
Nation’s Income