Measuring a Nation's Income Highlighted Sections The Circular Flow Diagram GDP and GNP Real and Nominal GDP The Circular Flow Diagram - (Back to Top) This is the second time you have seen the circular flow diagram - the first was in chapter 2. The circular flow diagram is crucial to your understanding of macroeconomics because this is the picture economists have in mind when they talk about the economy. The important parts of the circular flow diagram, focused on in chapter 2, are repeated in the following list: Notice that goods & services and resources flow around the economy in one direction, while money flows around the economy in the opposite direction. This is because money is normally exchanged for goods & services, or for resources. Recall that factors of production in the economy are generally lumped into three broad categories: labor, land, and capital. The respective names for the prices of labor, land, and capital are wages, rent and profit. Households (people), in the circular flow, own all the labor, land and capital. In markets for factors of production, households sell the services of labor, land and capital to firms in exchange for wages, rent and profits.   *Many students will observe that economists assume all labor, land and capital is owned by people, yet many firms in the economy own land and capital. This apparent incongruency can be cleared up by noting that all firms are ultimately owned by people, so any land and capital owned by firms is actually owned by the owners of these firms.   In markets for goods & services, households spend their income on products that are produced by firms. The money spent on goods & services is called spending (by households) and income (by firms), but spending and income are the same number.   *Suppose you go to McDonalds and spend $3.99 on a Big Mac Extra Value Meal. You have made an expenditure of $3.99 but, at the same time, McDonalds just made $3.99 in income. Think of expenditures and income as two sides of the same coin.   Households (people) have two functions in the economy. First, they sell their labor, land and capital to firms in order to make income, and second, they spend their income on the goods & services that firms produce. Firms have two functions in the economy. First, they purchase the services of labor, land and capital, and second, they use labor, land and capital to produce goods & services, which they sell to households. In economics, technology is represented by a firm's ability to transform labor, land and capital into goods & services. When firms can produce MORE goods & services than before, while using the SAME amount of labor, land and capital, economists say technology has improved. GDP and GNP - (Back to Top) The two most important measures of economic activity (the size of the economy) are gross domestic product and gross national product. GDP - the market value of all final goods and services produced within a country in a given period of time GNP - the market value of all final goods and services produced by permanent residents of a nation within a given period of time The table below will help you understand the difference between GDP and GNP. The columns of the table measure the output of the factors of production of the US or the UK. The rows of the table measure the output of factors that are located geographically within the US or UK. For example, the upper left (100) cell of the table tells the value of output produced by US factors of production (ie: US labor or capital) that are located within the US. The upper right cell (5) measures the value of output produced by UK factors of production (ie: UK labor or capital) that is located within the US. To measure GDP for the US or the UK, simply add up the value of all output produced IN the US or IN the UK. In other words, sum across the rows of the table to find GDP. To measure GNP for the US or the UK, add up the value of all output produced by US or UK factors of production. In other words, sum down the columns of the table to find GNP. Because expenditures and income in the economy are equal, there are different ways to add up economic activity. GDP as the sum of expenditures - There are four categories of expenditures - consumption, investment, government spending and net exports. GDP as the sum of expenditures is given by:   GDP = C + I + G + NX   GDP as the sum of incomes - Since income must equal expenditures, GDP can also be calculated by summing the income of factors of production (labor, land and capital). GDP as the sum of incomes is given by:   GDP = wages + rent + profits   Real and Nominal GDP - (Back to Top) Over time, the value of GDP tends to rise. Being the sum of expenditures on final goods and services, there are two reasons why GDP could increase - either there are more goods and services being produced, or the prices of goods and services has risen, causing the size of expenditures to rise. If GDP rises because more goods and services are being produced, the economy has gotten larger. If GDP rises because the prices of goods and services has risen, the economy is the same size as before, and has experienced inflation. In reality, GDP increases for BOTH reasons - the goal of this section is to help you see how economists separate the two.   Q: Can you compare GDP from year to year to learn about the size of the economy? A: No. You first have to take into account that prices have changed and negate the effects of inflation.   Q: How do economists negate the effects of inflation? A: By calculating the value of expenditures in different years at constant year prices. nominal GDP - the production of goods and services valued at current prices   To calculate the value of 1997 nominal GDP, sum the value of all expenditures in 1997, using the prices that prevailed in 1997   real GDP - the production of goods and services valued at constant prices   To calculate the value of 1997 real GDP (in constant 1995 prices), sum the value of all expenditures in 1997, using the prices that prevailed in 1995 By choosing a base year, and valuing expenditures at constant prices, economists are able to negate the effects of inflation over time. With inflation out of the picture, real GDP is a measure of the size of economic activity. You should spend some time studying table 2 in your textbook chapter, which demonstrates how to calculate nominal and real GDP.   When economists want to know how large inflation has been, they use the following relationship between nominal and real GDP: GDP deflator - the ratio of nominal to real GDP, times 100. Q: What is the value of the GDP deflator in the base year? A: The value of the GDP deflator in the base year is always going to equal 100. Calculating the nominal GDP for 1995 would mean summing all expenditures from 1995 at the prices that prevailed in 1995. Calculating the real GDP for 1995 (in constant 1995 prices) would ALSO involve summing all expenditures from 1995 at the prices that prevailed in 1995. Nominal and real GDP for the base year MUST be equal. If nominal and real GDP are equal, then the 1995 GDP deflator MUST equal 100.   Suppose that 1997 nominal GDP was $8 trillion, and 1997 real GDP (in constant 1995 prices) was $7.5 trillion. The GDP deflator is: The percentage change in the GDP deflator (from 1995 to 1997) is given by:     Q: What does the 1997 GDP deflator of 106.7 tell economists? A: Inflation in the two year period from 1995 to 1997 was 6.7%   As the ratio of nominal to real GDP, the GDP deflator is a measure of the effect of price changes on the size of GDP - therefore, the GDP deflator is one way economists measure inflation. (Back to top)