GDP and the Standard

of Living

CHAPTER

21

21.1 GDP, INCOME, AND EXPENDITURE

GDP & GNP Defined

Gross Domestic Product (GDP)
The market value of all the final goods and services
produced within a country in a given time period.
Value Produced

Use market prices to value production.

Gross National Product (GNP)

The market value of all the final goods and services
produced anywhere in the world in a given time
period by the factors of production supplied by the
residents of the country.

21.1 GDP, INCOME, AND EXPENDITURE

What Produced

Final good or service is a good or service that is

produced for its final user and not as a component of
another good or service.

Intermediate good or service is a good or service

that is produced by one firm, bought by another firm,
and used as a component of a final good or service.
GDP includes only those items that are traded in
markets.

21.1 GDP, INCOME, AND EXPENDITURE

Where Produced
Within a country
When Produced
During a given time period.

21.1 GDP, INCOME, AND EXPENDITURE

Circular Flows in the Economy

Consumption expenditure is the expenditure by
households on consumption goods and services.

Investment is the purchase of new capital goods

(tools, instruments, machines, buildings, and other
constructions) and additions to inventories.

21.1 GDP, INCOME, AND EXPENDITURE

Government expenditure on goods and services
is the expenditure by all levels of government on goods
and services.

Net exports of goods and services is the value of

exports of goods and services minus the value of
imports of goods and services.

21.1 GDP, INCOME, AND EXPENDITURE

Exports of goods and services are the items that
firms in Malaysia produce and sell to the rest of the
world.

Imports of goods and services are the items that

households, firms, and governments in Malaysia buy
from the rest of the world.

21.1 GDP, INCOME, AND EXPENDITURE

Total expenditure is the total amount received by
producers of final goods and services.
Consumption expenditure: C
Investment: I
Government expenditure on goods and services: G
Net exports: NX

Total expenditure = C + I + G + NX

21.1 GDP, INCOME, AND EXPENDITURE

Income
Labor earns wages.
Capital earns interest.
Land earns rent.
Entrepreneurship earns profits.
Households receive these incomes.

21.1 GDP, INCOME, AND EXPENDITURE

Expenditure Equals Income

Because firms pay out everything they receive as
incomes to the factors of production, total expenditure
equals total income.
That is:
Y = C + I + G + NX

The value of production equals income equals

expenditure.

21.1 GDP, INCOME, AND EXPENDITURE

Figure 21.1
shows the
circular flow
of income
and
expenditure.
The table
shows the
U.S. data
for 2007.

21.2 MEASURING GDP

The Expenditure Approach

Measures GDP by using data on consumption
expenditure, investment, government expenditure on
goods and services, and net exports.
Table 21.1 on the next slide shows the calculation for
2007.

21.2 MEASURING GDP

Expenditures Not in GDP

Used Goods
Expenditure on used goods is not part of GDP
because these goods were part of GDP in the
period in which they were produced and
during which time they were new goods.
Financial Assets
When households buy financial assets such
as bonds and stocks, they are making loans,
not buying goods and services.

21.2 MEASURING GDP

The Income Approach

Measures GDP by summing the incomes that firms pay
households for the factors of production they hire.

Wages
Interest
Rent
Profits

21.2 MEASURING GDP

Wages
Wages, called compensation of employees in the
national accounts, is the payment for labor services.
It includes net wages and salaries plus fringe
benefits paid by employers such health care
insurance, social security contributions, and pension
fund contributions.

21.2 MEASURING GDP

Interest, Rent, and Profit
Interest, rent, and profit is the sum of the incomes
earned by capital, land, and entrepreneurship.
Interest is the income households receive on loans they
make minus the interest they pay on their borrowing.
Rent includes payments for the use of land and other
rented inputs.

Profit includes the profits of corporations and small

businesses.

21.2 MEASURING GDP

21.2 MEASURING GDP

Net domestic product at factor cost is the sum of
wages, interest, rent, and profit.

Net domestic product at factor cost is not GDP.

We need to make two adjustments to arrive at GDP:
One from factor cost to market prices
One from net product to gross product

21.2 MEASURING GDP

From Factor Cost to Market Price
The expenditure approach values goods at market
prices; the income approach values them at factor cost.
Indirect taxes (such as sales taxes) make market prices
exceed factor cost.
Subsidies (payments by government to firms) make
factor cost exceed market prices.
To convert the value at factor cost to the value at
market prices, we must:
Add indirect taxes and subtract subsidies

21.2 MEASURING GDP

21.2 MEASURING GDP

From Gross to Net
The expenditure approach measures gross product; the
income approach measures net product.
Gross profit is a firms profit before subtracting the
depreciation of capital.
Net profit is a firms profit after subtracting the
depreciation of capital.

Depreciation is the decrease in the value of capital

that results from its use and from obsolescence.

21.2 MEASURING GDP

Income includes net profit, so the income approach
gives a net measure.
Expenditure includes investment. Because some new
capital is purchased to replace depreciated capital, the
expenditure approach gives a gross measure.
To get gross domestic product from the income
approach, we must add depreciation to total income.
After making these two adjustments the income
approach almost gives the same estimate of GDP as
the expenditure approach.

21.2 MEASURING GDP

21.2 MEASURING GDP

Statistical Discrepancy
The income approach and the expenditure approach do
not deliver exactly the same estimate of GDPthere is
a statistical discrepancy.

Statistical discrepancy is the discrepancy between

the expenditure approach and income approach
estimates of GDP, calculated as the GDP expenditure
total minus the GDP income total.

21.2 MEASURING GDP

21.2 MEASURING GDP

GDP and Related Measures of Production and

Income
Gross national product (GNP) is the market value of
all the final goods and services produced anywhere in the
world in a given time period by the factors of production
supplied by residents of the country.
Msia GNP =Msia GDP + Net factor income (Y) from abroad**
(**Y received from other countries - Y paid to other countries)

21.2 MEASURING GDP

Real GDP and Nominal GDP

Real GDP is the value of the final goods and services
produced in a given year expressed in the prices of the
base year.

Nominal GDP is the value of the final goods and

services produced in a given year expressed in the
prices of that same year.

21.2 MEASURING GDP

Calculating Real GDP

The goal of calculating real GDP is to measure the
extent to which total production has increased
Real GDP removes the influence of price changes from
the nominal GDP numbers.
To focus on the principles and keep the numbers easy
to work with, well calculate real GDP for an economy
that produces only one consumption good, one capital
good, and one government service.

21.2 MEASURING GDP

Table 21.3 shows the calculation with 2000 (base year)
and 2008.
To find the total expenditure in 2000 multiply the
quantity of each item produced in 2000 by its price in
2000.
Then sum the expenditures to find nominal GDP in
2000.

Nominal
GDP in
2000 is
$100
million.
Because
2000 is the
base year,
real GDP
in 2000 is
also $100
million.

21.2 MEASURING GDP

In part (b) of Table 21.3, we calculate nominal GDP in
2008.
Again, we calculate nominal GDP by multiplying the
quantity of each item produced by its price and then
sum the expenditures to find nominal GDP in 2008.

Nominal
GDP in
2000 is
$100
million.
Nominal
GDP in
2008 is
$300
million.

21.2 MEASURING U.S. GDP

Nominal GDP in 2000 is $100 million and in 2008 it is $300
million.
Nominal GDP in 2008 is three times its value in 2000.
But by how much has the quantity of final goods and
services produced increased?

21.2 MEASURING U.S. GDP

The increase in real GDP will tell by how much the
quantity of good and services has increased.
Real GDP in 2008 is what the total expenditure would
have been in 2008 if prices had remained the same as
they were in 2000.
To calculate real GDP in 2008 multiply the quantities
produced in 2008 by the price in 2000 and the sum
these expenditures to find real GDP in 2008.
Part (c) of Table 21.3 shows the details.

Real GDP
in 2000 is
$100
million.
Real GDP
in 2008 is
$160
million
only 1.6
times real
GDP in
2000.

21.3 THE USE AND LIMITATIONS OF REAL GDP

We use estimates of real GDP for two main purposes:
To compare the standard of living over time
To compare the standard of living among countries

The Standard of Living Over Time

To compare living standards we calculate real GDP per
person (GDP per capita / income per capita)- real
GDP divided by the population.

21.3 THE USE AND LIMITATIONS OF REAL GDP

In 1967, real GDP in the United States was $3,485 billion
and the population of the United States was 198.7
million.
Real GDP per person = $3,485 billion 198.7 million
Real GDP per capita in US = $17,536
GDP per capita (current price) in Malaysia
2011= US$9977.32

21.3 THE USE AND LIMITATIONS OF REAL GDP

Long-Term Trend
Figure 21.3 shows
the long-term trend
in U.S. real GDP per
person.
Real GDP per person
doubled in the 36
years from 1967 to
2002.

21.3 THE USE AND LIMITATIONS OF REAL GDP

Short-Term Fluctuations
Fluctuations in the pace of expansion of real GDP is
called the business cycle.
The business cycle is a periodic irregular up-and down
movement of total production and other measure of
economic activity.
The four stages of a business cycle are expansion,
peak, recession, and trough.

21.3 THE USE AND LIMITATIONS OF REAL GDP

The shaded periods

show the
recessions
periods of falling
production that
lasts for at least six
months.

21.3 THE USE AND LIMITATIONS OF REAL GDP

Standard of Living Across Countries

To compare living standards across countries, we must
convert real GDP into a common currency and common
set of prices, called purchasing power parity.
Purchasing power parity in Msia in 2008 = US$14,206

Goods and Services Omitted from GDP

Household production
Underground production
Leisure time
Environment quality

21.3 THE USE AND LIMITATIONS OF REAL GDP

Household Production
Real GDP omits household production, it
underestimates the value of the production of
many people, most of them women.
Underground Production
Hidden from government to avoid taxes and
regulations or illegal.
Because underground economic activity is
unreported, it is omitted from GDP.

21.3 THE USE AND LIMITATIONS OF REAL GDP

Leisure Time
Our working time is valued as part of GDP, but our
leisure time is not.
Environment Quality

Pollution is not subtracted from GDP.

We do not count the deteriorating atmosphere as a
negative part of GDP.
If our standard of living is adversely affected by
pollution, our GDP measure does not show this
fact.

21.3 THE USE AND LIMITATIONS OF REAL GDP

Other Influences on the Standard of Living

Health and Life Expectancy
Good health and a long life do not show up directly
in real GDP.
Political Freedom and Social Justice
A country might have a very large real GDP per
person but have limited political freedom and
social justice.
A lower standard of living than one that had the
same amount of real GDP but in which everyone
enjoyed political freedom.