1. Measuring Domestic Output
Why Calculate national Income- for 3 reasons, to
Assess the health of the economy by comparing levels of production at regular intervals
Track the long run course of the economy to see if it has grown remained constant or declined
Formulate policies that will safeguard and improve the economy’s health
Primary measure of economy’s performance is its annual total output, aggregate output or GDP

2. Assessing the Economy’s
Performance
National Income Accounting:
Health of the Economy
Comparisons Over Time
Formulation of Public Policy
What Are These Accounting Measures?

3. Aggregate Output or GDP
It is the total market value of all final goods and services produced in a given year.
GDP is a monetary measure without which we can’t compare relative prices of goods and services produced in an economy in different years
For eg which output is greater, 3 computers & 2 sofas or 3 sofas and 2 computers? Price tag?
If prices of sofas go up and of computers go down then year 1 may be better than year 2

4. Measuring GDP
For accurate measurement goods should be counted once and hence only the market value of final goods is included
Intermediate goods are totally ignored. Why?
Because the final price already includes the price of intermediate goods used in them
Including the value of intermediate goods would amount to multiple counting
Avoid counting 2nd hand Sales they don’t create nothing new

5. Multiple Counting Example is exhibit 7.2
Firm A sells $120 worth Sheep ranch to Firm B
It paid $120 for wages rent interest & profit(WRIP)
Firm B Processed wool and sold for $180 to Firm C
It bought for 120 and paid $60 in WRIP
Firm C manufactures suit and sells to wholesaler for $220. It bought for 180 and paid $40 for WRIP
Firm D sold for $270 to Firm E a retailer who sells it for $350 the market price.

6. (1) Stage of Production (2) Sales Value of Materials or Product (3)
TABLE 7.2
Value Added in a Five-Stage Production Process
(1)
Stage of Production
(2)
Sales Value
of Materials
or Product
(3)
Value
Added
$ 0
Firm A, Sheep ranch
120
$ 120 (= $ $ 0)
Firm B, wool processor
180
60 ( = – 120)
Firm C, suit manufacturer
220
40 ( = – 180)
Firm D, clothing wholesaler
270
50 ( = – 220)
Firm E, retail clothier
350
80 ( = – 270)
Total sales values
$ 1140
Value added (total income)
$ 350

7. Value Added
If we add all intermediates the total comes to However production & sale generated only $350.
Alternatively we can add value added at each stage.
Value added is Market value of firms output less value of its inputs. Firm A got 120 as original value
Firm B bought for 120 sold for 180 so VA is $60
Firm C bought for 180 sold for 220 so VA is 40
=350

8. Non production Transactions
GDP excludes NPTs as they have nothing to with generation of final goods and services. For eg
Public transfer payments: social security, welfare payments, veterans payments
Private transfer payments: money given by father to children, or charities
Stock Market transactions: buying and selling of stocks and bonds is swapping bits of paper though broker’s fees is included in GDP!!!!!!!

9. GDP measurement approaches
We just saw two approaches !!!!!!!!!
We looked at final price paid by consumer and
We looked at entire WRIP incomes that were created in making a suit or value added approach
Similarly GDP can be calculated in 2ways
We can look at GDP as sum of all money spent in buying goods: expenditure or output approach
Or we look at GDP as income derived or created from producing it. This is earnings or income or allocation approach

10. Avoid Multiple Counting Intermediate Goods Final Goods Value Added
GROSS DOMESTIC PRODUCT
The total market value of all final goods and services produced in a given year
A Monetary Measure
Avoid Multiple Counting
Intermediate Goods
Final Goods
Value Added

11. Expenditure Approach Income Approach Consumption by Households
Add all that was spent to
buy total output
All final goods produced are
Bought by 3 domestic sectors
Households, businesses or
Government Or foreign buyers
Income Approach
Add up all income that was derived
As income from production of goods
The total receipts acquired from the
sale of the total output are allocated
to the suppliers as Wages, Rents,
Interests and Profits
Consumption by Households
+Investment Expenditure by
Businesses + Govt Purchases
+ Expenditure by foreigners
Or C+Ig+G+Xn
Wages + Rents
+ Interest +Profits
+ Statistical adjustments
Or W+R+I+P+ adjustments

12. + + + + + + + G D = P = GROSS DOMESTIC PRODUCT Consumption Wages
Expenditures Approach
Income Approach
Consumption
by Households
Wages + +
Rents G D P +
Investment
by Businesses = + =
Interest +
Government
Purchases
Profits + +
Expenditures
by Foreigners
Statistical
Adjustments

13. Expenditure Approach
Personal Consumption Expenditure also called consumption expenditures by households
The term covers all expenditures on durable consumer goods (Cars, ACs Refrigerators etc), non durable goods (Bread, Milk Toothpaste etc) and consumer expenditures for services (doctors lawyers barbers mechanics etc)
It is denoted by C while calculating GDP

14. Expenditure Approach Gross Private Domestic Investment (Ig) includes
All final purchases of machinery equipment & tools by business enterprises
All construction (residential & commercial)
Changes in inventories for production or as unconsumed output (goods available for sale)
It does not include non investment transactions like transfer of paper assets or resale of tangible assets (investment deals with new capital assets)
Note: Gross Investment Ig includes depreciation

15. - = Gross Investment Depreciation Net Investment EXPENDITURES APPROACH
Increased
Consumption
and
Government
Spending
Stock of
Capital
Stock of
Capital
January 1
Year’s GDP
December 31

16. Expenditure Approach
Government Purchases or G is 3rd category of expenditures & includes consumption and investment by government.
Government incurs expenditure on goods & services in providing public service (education etc)
Govt also spends money on social capital like highways and new schools which have long life.
Govt purchases (Federal Provincial and Local) include all government expenditure on all final goods & direct purchases of resources including labor but exclude transfer payments

17. Expenditure Approach Net Exports or Xn means “Exports less Imports”
Money is spent on purchase of imported goods & on those goods produced locally & exported abroad therefore Xn avoids overstatement of production
Putting All together
GDP = C + Ig + G + Xn

18. Income Approach Items that make up national income
-Compensation of Employees
-Rents
-Interest
-Proprietors’ income
-Corporate Profits
Statistical Adjustments required
Indirect Business taxes are added back
depreciation is added back and finally also add
Net Foreign factor income earned in the country

19. Net Foreign Factor Income
Net foreign factor income is the difference between factor payments received from the foreign sector by domestic citizens and factor payments made to foreign citizens for domestic production. This is also the key difference between GDP and GNP.
Net foreign factor income actually represents a two-part adjustment between gross domestic product and national income.

20. Net Foreign Factor Income
Suppose that a foreign citizen is employed in the domestic economy. For example, suppose that Auklonavic, a citizen of Russia works in an assembly plant located in Shady Valley, U.S.A and If Aukla earns $15,000 in a given year for his productive efforts in the U.S. Wacky Willy factory
Auklonavic’s productive efforts is included in gross DOMESTIC product, but not gross NATIONAL product. His income falls under the heading of factor payments made to foreign citizens for domestic production.

21. Net Foreign Factor Income
Also Suppose that Edgar, a citizen of the United States of America, works in Russia and earns $20000 there.
His productive efforts are included in gross NATIONAL product, but not gross DOMESTIC product and his income falls under the heading of factor payments received from the foreign sector by domestic citizens.

22. Net Foreign Factor Income
Since Auklonavic earned $15,000 in USA and Edgar earned $20,000 in Russia therefore Net Factor Foreign Income is:-
$ $15000 = +5000
However the GDP of USA is $5,000 less than the GNP of USA.

23. Value Added in a Five-Stage Production Process
TABLE 7.2
Value Added in a Five-Stage Production Process
Receipts: Expenditures Approach
Allocations: Income Approach
Personal consumption expenditure (C)… $ 7304
Compensation of employees ………………………….. $ 5977
Gross private domestic investment (Ig) $ 1593
Rents………………………………………………………………… 142
Government purchases (G) ………………………… $ 1593
Interest……………………………………………………………… 684
Net exports (Xn) ……………………………………………… $ -424
Proprietor’s income…………………………………………… 757
Corporate income taxes……………………………………
Dividends…………………………………………………………… 434
Undistributed corporate profits…………………………. 141
National income………………………………………… $ 8348
Indirect business taxes………………………………………. 695
Consumption of fixed capital……………………………… 1393
Net foreign factor income earned in the U.s……… 10
Gross domestic product………………..…………… $ 10,446
Gross domestic product………………………… $ 10,446

24. Net Domestic Product = GDP – Consumption of fixed capital
or – 1393 = 9053
National Income = NDP – (NFFI + Indirect Business Taxes)
Or (10+695) = 8348
Personal Income = NI –(SS contributions + Corp taxes + RE) Transfer Payments
Or Personal Income = ( ) =8929
Disposable Income = Personal Income – personal taxes
Or – 1113 = 7816

25. U.S. GDP, NDP, NI, PI, & DI, 2002 OTHER NATIONAL ACCOUNTS
Gross Domestic Product (GDP) $10,446
Consumption of fixed capital -1,393
Net Domestic Product (NDP) $9,053
Net foreign factor income earned in the U.S
Indirect business taxes
National Income (NI) $8,348
Social security contributions
Corporate income taxes
Undistributed corporate profits
Transfer payments ,683
Personal Income (PI) $8,929
Personal Taxes ,113
Disposable Income (DI) $7,816

26. Exports $ Exp Approach
Dividends Inc Approach
Consumption of fixed capital Inc Approach
Wages and salaries Inc Approach
Government purchases Exp Approach
Rents Inc Approach
Indirect business taxes Inc Approach
Wage and salary supplements Inc Approach
Gross private domestic investment Exp Approach
Corporate income taxes Inc Approach
Transfer payments Not included in either
Interest Inc Approach
Properties’ income Inc Approach
Personal consumption expenditures Exp Approach
Imports Exp Approach
Social security contributions Not included in either
Undistributed corporate profits Inc Approach
Personal taxes Not included in either
Net foreign factor income earned in the U.S Inc Approach

27. Nominal PPP GDP Per Capita Norway $ 84543 $ 52238 Sweden 47465 37775
Denmark
Japan
United States
Switzerland
Indonesia
Austria
Pakistan
India
Sri lanka
Bangladesh

28. Nominal V/s Real GDP
A GDP based on the prices that prevailed when the output was produced is called Nominal GDP
A GDP that has been deflated when prices rose and inflated when prices fell is called Adjusted GDP or Real GDP

29. Year (1) Units of Outputs (2) Price of Pizza Per Units (3) Price Index
TABLE 7.5
Calculating Real GDP
Year
(1)
Units of
Outputs
(2)
Price of
Pizza
Per Units
(3)
Price Index
(Year 1 = 100
(4)
Unadjusted,
Or Nominal,
GDP
(1) * (2)
(5)
Adjusted, or
Real, GDP 1 5
$10
100
$50 2 7 20
200
140 70 3 8 25
250 80 4 10 30
____
300 28
280

30. TABLE 7.6
Steps for Deriving Real GDP from Nominal GDP
Method 1
Find nominal GDP for each year.
2. Compute a GDP price index.
3. Divide each year’s nominal GDP by that year’s price index (in hundredths) to determine real GDP.
Method 2
Break down nominal GDP into physical quantities of output and price for each year.
2. Find real GDP for each year by determining the dollar amount that year’s physical output would have sold for if base-year prices had prevailed. (The GDP price index can then be found by dividing nominal GDP by real GDP)

31. = = = x 100 NOMINAL GDP vs. REAL GDP An Alternative Method
Adjustment Process
GDP Price Index
Price Index
in a given
year =
Price of market basket
in specific year
Price of same market
basket in base year
x 100
Real GDP =
Nominal GDP
Price Index
(in hundredths)
An Alternative Method
Price Index
(in hundredths) =
Nominal GDP
Real GDP

32. Nominal GDP, Billions of $
TABLE 7.7
Nominal GDP, Real GDP, and GDP Price Index, Selected year
(1)
Year
(2)
Nominal GDP, Billions of $
(3)
Real GDP, Billions of $
(4)
GDP Price Index* (1996 = 100)
1975
1635.2
4084
____
1980
2795.6
57.054
1985
4213.0
5717.1
73.69
1990
5803.2
6707.9
1995
7400.5
98.10
1996
7813.2
100.00
2002
9439.9
110.66

33. SHORTCOMINGS OF GDP Nonmarket Activities Leisure
Improved Product Quality
The Underground Economy
GDP and the Environment
Composition and Distribution of Output
Noneconomic Sources of Well-Being

34. Inflation Rise in the general level of prices
Reduces the purchasing power of money
The measure of inflation is Consumer Price Index
CPI is a “market basket” that has some 300 goods & services purchased by urban consumer
GDP price index discussed in last class is a much broader measure as it includes capital goods too
CPI is based on spending patterns of urban consumers in a specific period compared with base year
Also important are SPI and WPI

35. Measurement of Inflation
In Pakistan CPI is the main measure of price changes at retail level. It covers the retail prices of 374 items in 35 major cities.
Price of most recent market basket in a year
CPI=
Price of the same basket in base year
SPI shows the weekly change of price of selected
53 items of daily use consumed by households
whose monthly income in the base year
ranged from Rs.3000 to Rs P.M
WPI deals with whole sale prices in same fashion

36. Measurement of Inflation
Inflation can be measured as
Rate of
inflation
CPI of current year- previous year =
CPI of previous year
For example if the CPI in current year was and in the previous year it was then
Rate of inflation =
X 100 = 1.6%
177.1
Also apply Rule of 70 here which says that time required for a measure to double is 70 divided by that number

37. Price Deflator
The process of converting nominal GDP into real GDP is known as deflation. A price index calculated as the ratio of nominal GDP to real GDP
GDP Deflator = Nominal GDP / Real GDP
Or Real GDP= Nominal GDP/ Price deflator where
Price deflator= prices in base year/ prices in X year
Example: if nominal GDP in 1995 was 150 Billion and in 2004 it was 300 Billion and suppose prices have risen by 50% then real GDP is given by
GDP deflator =300/150 =2. lets do some more ex

38. Hypothetical Economy Nominal GDP in year 1 = 100x2 + 100x4 = 600
Apples Produced
100
150
Chicken Produced
140
Cost of Apples 2 4
Cost of chicken 6
Nominal GDP in year 1 = 100x x4 = 600
Nominal GDP in year 2 = 150x x 6= 1440
Year 2 price index at year 1 prices = (150x2)+(140x4)
=2.966
290
Year 2 price index at year 2 prices = 150x x6
=4.966
290
Where = current years price index

39. Hypothetical Economy contd
GDP Deflator => 2.966X=4.966 x 100
Or X =496.6/2.966 = 167.4%
This is the price level in percentage terms
prevailing in current year relative to the price
level of year 1
Real GDP = 1440 x 100/ = 860
Nominal Growth = 1440 – 600/ 600 = 140%
Real Growth rate = 860 – 600/ 600 = 43%

40. Lets make it simple Nominal GDP year 1 = 100*2 + 100* 4= 600
Real GDP is calculated by multiplying year 2 quantities with year 1 prices. So
Real GDP in year 2 = 150*2+140*4 = 860
GDP Deflator = Nominal GDP / real GDP * 100
Or GDP Deflator = 1440/860 *100 =1.6744
Nominal Growth = /600 = 140%
Real growth = /600 = 43%

41. Purchasing Power Parity
The exchange rate which equalizes the purchasing power of different currencies, given the prices of goods and services in the countries concerned, is referred to as Purchasing Power Parity (PPP)
The purchasing power parity hypothesis suggests that in the long run the market exchange rates and PPP rates should converge

42. Purchasing Power Parity
Note that the implied PPP exchange rate is different for each product, therefore, a basket of goods & services is considered to calculate a single Implied PPP rate for the entire economy

43. GDP nominal and GDP PPP
Japan being a relatively expensive country has a greater Nominal GDP as compared to GDP PPP, therefore, has a GDP (nominal/ PPP) ratio greater than 1
India being a relatively cheap country has a greater GDP PPP as compared to Nominal GDP, therefore, has a GDP (nominal/ PPP) ratio less than 1

44. GDP (Nominal/ PPP) ratio across 30 countries

45. TABLE 17-2: Actual and Purchasing Power Parity Exchange Rates for 2006
Country
Actual exchange rate (current per dollar)
PPP Exchange rate (currency per dollar)
Under ( - )/ over ( + ) valuation
Switzerland
1.253
1.950
+56
United kingdom
0.54
0.66
+22
Japan
116.31
136.39
+17
United states 1
Brazil
2.1738
1.11
-49
Russia
26.305
9.86
-62
China
7.97
1.81
-77
India
22.05
8.803
-80
Mozambique
26,140
5,051
-81
Uganda
1,753
316
-82

46. Comparisons of GDP nominal and GDP PPP
Country
Nominal GDP
GDP PPP
Switzerland
$ 67,246
$ 41,663 UK
36,120
34,920
Japan
42,820
33,805 US
47,284
Brazil
10,816
11,239
Russia
10,437
15,837
China
4,382
7,519
India
1,265
3,339
Mozambique
458
1,010
Uganda
501
1,241
Pakistan
1,050
2,791

47. Big Mac Index Country BM in Local BM in $ Implied PPP of USD
Actual Exchange rate
Under/over valuation against USD %
USA
$3.54
3.54 UK
2.29
3.30
1.55
1.44 -7
Japan
290
3.23
81.9
89.8 -9
Switzerland
6.5
5.6
1.84
1.16 58
Brazil
8.02
3.45
2.27
2.32 -2
Russia 62
1.73
17.5
35.7
-51
China
12.5
1.83
3.53
6.84
-48
Pakistan
255 3
72.03 85
-16
Euro Area
3.42
4.38
1.02
1.28 24