Amit Rajaraman

Lecture 20

More often though, to measure the performance of an economy, we use the Gross Domestic Product (GDP). It measures two things – the total income of everyone in the country and the total expenditure on the economy’s output of goods and services. This is because both of these quantities are equal – an economy’s income is the same as its expenditure. This is made clear by the circular flow diagram we studied earlier.

GDP is the market value of all final goods and services produced within a country in a given period of time.

  • We use market prices to measure the amount people are paying for different goods.
  • GDP attempts to include all goods and services. If someone is renting out a house, then the tenant’s expenditure/landlord’s income will be counted. But even if someone owns the house they are staying in, we try to include it in the GDP by estimating its rental value. Some products, such as vegetables grown and consumed at home, illegally sold drugs, etc that never enter the market place, are difficult to include in the GDP however.
  • GDP includes both tangible goods (food, clothing) and intangible services (haircuts, housecleaning).
  • GDP includes goods and services currently produced, we do not include transactions involving items produced in the past.
  • GDP measures the production within the geographical confines of a country. If an Indian citizen works temporarily in Canada, then their production is considered in Canada’s GDP. If a Canadian citizen owns a factory in India, then the production of the factory is part of India’s GDP.
  • The GDP measures the value of production within a specific interval, usually a quarter (three months) or a year.

Intermediate goods are goods used up entirely in the production of final goods.
Value added is the dollar value of an industry’s sales minus the value of the intermediate goods used in production.

The difference between the GDP calculated using the income and expenditure methods is called statistical discrepancy (it arises due to imperfect data sources).

There are several transactions that have nothing to do with final goods. As a result, we exclude things like stocks/bonds (securities), social security, unemployment compensation (government transfer payments), individual gifts, corporate gifts (private transfer payments) etc. We also exclude the transfer of second-hand goods (we have already made the purchase and it has been included in the value), household production, and legal/illegal underground transactions.
That is, we only want to count the sales of final goods that occur through the market.

Therefore, we measure the GDP as the sum of the

  • national income:
    • compensation of employees
    • proprietor’s income
    • corporate profits
    • net interest
    • rental income
  • depreciation
  • indirect taxes minus subsidies
  • net factor payments to the rest of the world

Gross private domestic investment consists of

  • the creation of capital goods such as factories/machines that can yield production (and thus consumption). This also includes changes in business inventories and repairs made to machines and buildings.
  • producer durables or capital goods (life span more than three years)
  • fixed investments (purchases by a business of newly produced producer durables or capital goods)
  • inventory investments (changes in stocks of finished goods and goods in process, as well as changes in raw materials)