Nov 012010

these notes Should not be taken as absolute, just going with jallal’s cause of helping out! they dont include the last section “Limitations of Real GDP”.  dont mind any spelling or grammer mistakes, they’re on purpose lol

Chapter 4

GDP is the final value of goods and services at the market value, which are produced within a country in a specified time period.

GDP not only measures total production of a country but also the total income and total expenditure.  The income of any country shows the relationship between production and living standards.  So when there is an increase in income, the standards of living increases which means we can buy more goods.  But we can’t buy more goods unless more goods are produced, thus the relationship between production and living standards.

GDP and the circular flow of expenditure and Income

In a market we have households (those that provide factors of production), firms (those that buy factors of production use them to make goods and services), governments and the rest of the world.  All of them meet in the factor and goods market.

Households sell land, labor, capital etc in the factor market and firms buy through an income. Using figure 4.1 from the book we see how through the factor market firms are giving an income (Y) which goes directly to households.  This income is in the form of wages or rent for a land.  So while they are producing goods and services they are simultaneously generating income by paying for the inputs of production, which will eventually come back to them in the form of consumption expenditure(C) through the goods market.  Whatever is not sold in goods market i.e. was excess in supply is considered to be bought back by the firm (I) and goes back to the company books under inventory.  Governments also come to the goods market to buy products and services, denoted (G) they may finance their payments through subsides or taxes.  Firms sell internationally and buy internationally also through the goods market (X-M), a firm should look for a positive (X-M) meaning more exports than imports.  Finally, the GDP calculated through the expenditure side (by households, governments and rest of the world) should equal the income side(through factor markets where firms pay for the inputs to factors of production).


Since we are calculating “Gross” Domestic product, domestic product before depreciation of any sorts, we should take investments or profits in gross terms as well. Eg. 2x+y ≠ 2xy, thus gross measure + net measure ≠ GDP.

Measuring US GDP through the Expenditure Approach:

It’s the addition of C+I+G+X-M from fig 4.1 in the book.  According to the book (C) refers to personal consumption expenditure by households on goods and services for their own use.  Goods such as laptops and services such as banking. (I) is the investment either by firms on capital or the excess of inventory and by households through purchasing houses. (G) being the government expenditure on goods it buy for its use in government offices or for the use of the whole nation, e.g. buying weapons.

Measuring GDP through the Income Approach:

Like the expenditure approach the income approach is also the sum of incomes on factors of production.   First one is compensation of employees, the salary a labor or worker receives for his work (services) including fringe benefits and taxes deducted.  Second form of income is net interest, difference of interest received by households on borrowing and paid on loans.  The third one is rental income, which is payment for the use of land or capital.  Fourthly, corporate profits for the firm, from which dividends are paid and the rest goes into retained earnings.  Lastly, proprietor’s income or the owner’s income which includes the same compensations as labor but for the owner only.  The sum of all these incomes results in NET domestic income at factor cost (since it’s calculated at the cost of factors of production).  WE MUST subtract subsidies since it’s not income but a benefit and at the same time ADD indirect taxes, as this is the real market value of goods and services.  This operation gives us NET domestic income at market price.  Now to get to the GROSS measure we must ADD depreciation since corporate profits are calculated by subtracting it.  Thus by adding depreciation we get the GDP thru the income approach.

When comparing GDP’s of different year, it is sometimes better to take into consideration the bias that might lead to an inaccurate comparison.  For example, rise in prices or inflation, fall of interest rates etc.  Thus for comparison purposes we use two types of GDP: 1) Real GDP and 2) Nominal GDP

Real GDP is valued at a base or reference year prices, the idea is to keep the prices constant and use the quantity of production of current year.

Nominal GDP is valued at current year where both prices and quantity are for the same year.

The use of GDP to calculate standard of living over time:  when calculating standard of living over time we need to look at how better off people are compared to a prior time.  Thus we use the term Real GDP per person, which is Real GDP / population.

We can monitor long-term trends by comparing standard of living in 2008 with that in 1950’s.  When using long term comparisons we can also monitor the rate, let’s say in 1950, to see its increase or decrease in 2008, in other words did we grow as planned.  This highlights growth of potential GDP per person and fluctuations of real GDP per person.  Potential GDP is when all the countries land labor and capital is fully employed i.e. full employment.  But this growth may not be as we planned or predicted, because of unemployment etc.  The difference occurring between our potential GDP and what are real GDP is, is called Lucas wedge or output gap.  This is the opportunity cost paid to the economy for not maintaining potential GDP growth constant.  This gap can be a tremendous amount.

We can also monitor Real GDP fluctuations, part of any cycle.  Fluctuations include expansions and recessions.  In terms of GDP, expansion is the increase in GDP where it equals potential and then outgrows it.  GDP at its highest point before it goes into recession is called the peak.  Recession is the phase where GDP decreases, meaning plummeting growth rates.  GDP at its lowest point is the trough.

The use of GDP to calculate standard of living across countries: problems arises here since 1)real GDP of one country would have to be in the same currency as the real GDP of the other country.  For instance, you cant compare riyals with dollars.   2) goods and services in both countries need to be valued equally.  For instance food prices in KSA are general cheaper than what they are in Japan, thus they are valued at a less weight in the GDP than what it would be in Japan.

 Posted by at 9 PM

  One Response to “ECON 103- notes Chapter 4”

  1. Thank you very much Ziad for the valuable information.

 Leave a Reply

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>