Chapter 4: Monitoring the Value of Production 

11 January 2019 
ECON 2200 Lecture - Week 2
 
 
Gross Domestic Product (GDP​) → The market value of all final goods and services 
produced in a country in a given time period 
● Market value 
○ Goods and services are valued at their market prices 
○ To add apples & oranges, computers & popcorn, we add market values 
so we have a total value of output in dollars 
● Final goods and services 
○ An item bought by its final user during a specified time period 
○ Contrasts with an i​ ntermediate good​, which is an item that is produced 
by one firm, bought by another firm and used as a component of a 
final good or service 
● Produced within a country 
○ Domestic production 
● In a given time period 
 
Household and Firms 
Households sell and firms buy the services of labour, capital, and land in factor markets.
● For these factor services, firms pay income to households:
○ Wages for labour services
○ Interest for the use of capital
○ Rent for the use of land
○ A fourth factor of production, entrepreneurship, receives profit.

In the figure, the blue flow,​Y​, shows total income paid by firms to households.
 

 
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Firms sell and households buy consumer goods and services in the ​goods market​.
● Consumption expenditure​ is the total payment for consumer goods and
services, shown by the red flow labelled ​C.​
● Firms buy and sell new capital equipment in the goods market and put unsold
output into inventory.
● The purchase of new plant, equipment, and buildings and the additions to
inventories are investment, shown by the red flow labelled ​I​.

 
 
Governments​ → ​Buy goods and services from firms and their expenditure on goods and
services is called ​government expenditure
● Government expenditure is shown as the red flow ​G
● Governments finance their expenditure with taxes and pay financial transfers to
households, such as unemployment benefits, and pay subsidies to firms.
● These financial transfers are ​no​t part of the circular flow of expenditure and
income.

 
 

 
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Rest of the World → F ​ irms in Canada sell goods and services to the rest of the world—
exports​—and buy goods and services from the rest of the world—​imports​.
● The value of exports (​X​) minus the value of imports (​M)​ is called ​net exports​, the
red flow ​X​−​M​.
● If net exports are ​positive​, the net flow of goods and services is from Canadian
firms to the rest of the world.
● If net exports are ​negative​, the net flow of goods and services is from the rest of
the world to Canadian firms.

 
The blue and red flows are the circular flow of expenditure and income 
Sum of red flows = blue flow 
● Y​ = C
​ ​ + ​I​ + ​G​ + X
​ ​ - ​M 
 
The circular flow shows two ways of measuring GDP 
● GDP = Expenditure equals Income 
○ Y ​(GDP) = C ​ ​ + ​I​ + G
​ ​ + ​X​ - ​M 
● Aggregate income equals the total amount paid for the use of factors of
production: wages, interest, rent, and profit.

Why is domestic product “gross”?

● Gross → ​before​ deducting the depreciation of capital
● Net → opposite of gross; ​after​ deducting the depreciation of capital
● Depreciation → is the decrease in the value of a firm’s capital that results from
wear and tear and obsolescence.
● Gross investment → the total amount spent on purchases of new capital and on
replacing depreciated capital.
● Net investment → is the increase in the value of the firm’s capital.
○ Net investment = Gross investment − Depreciation

 
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Measuring Canadian GDP

● The Bureau of Economic Analysis uses two approaches:
○ Expenditure Approach
○ Income Approach

Expenditure Approach​ → measures GDP as the sum of the red flow: consumption
expenditure, investment, government expenditure on goods and services, and net
exports.
● GDP = ​C​ + ​I​ + ​G​ + (​X​ − ​M​)

Income Approach​ → measures GDP by summing the incomes that firms pay
households for the factors of production they hire.
● Two broad categories are
○ Wages, salaries, and other labour income
○ Other factor incomes

 
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The payment for labour services is the sum of net wages plus benefits such as pension
contributions and is shown by the blue flow W
● Other factor incomes include a mixture of interest, rent, and profit and include
some labour income from self-employment
● They are included in the blue flow OFI

The sum of all factor incomes is net domestic income at factor cost Two adjustments
must be made to get GDP:
1. Indirect taxes less subsidies are added to get from factor cost to market prices
2. Depreciation is added to get from net domestic income to gross domestic
income.

Nominal GDP and Real GDP

● Real GDP​ → value of final goods and services produced in a given year when
valued at the prices of a reference base year
○ Currently, the reference base year is 2007 and we describe real GDP as
measured in 2007 dollars
● Nominal GDP​ → is the value of goods and services produced during a given
year valued at the prices that prevailed in that same year
○ Nominal GDP is just a more precise name for GDP

The Uses and Limitations of Real GDP

● Economists use estimates of real GDP for two main purposes:
○ To compare the standard of living over time
○ To compare the standard of living across countries

Standard Living Over Time → Real GDP per person is real GDP divided by population
● Real GDP per person tells us the value of goods and services that the average
person can enjoy
● By using real GDP, we remove any influence that rising prices and a rising cost
of living might have had on our comparison
● Long-Term Trend:
○ Express as a ratio of some reference year
○ For example, in 1969, real GDP per person was $19,000 and in 2010, it
was $38,000. So real GDP per person in 2010 was double its 1969 level:
■ $38,000 / $19,000 = 2
● Two features of our expanding living standard are:
○ The growth of potential GDP per person
○ Fluctuations of real GDP around potential GDP
● Potential GDP​ → value of real GDP when all economy’s labour, capital, land
and entrepreneurial ability are fully employed

 
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Potential GDP grows at a steady pace because the quantities of the factors of
production and their productivity grow at a steady pace
● Real GDP fluctuates around potential GDP

Real GDP Fluctuations - The Business Cycle

● Business Cycle ​→ periodic but irregular up-and-down movement of total
production and other measures of economic activity
○ Two phases: Expansion & Recession
○ Two turning points: Peak and Trough

Expansion​ → period during which real GDP increases (from a trough to a peak)
Recession​ → period during which real GDP decreases (growth rate is negative for at
least two successive quarters)

The Standard of Living Across Countries

● Two problems arise in using real GDP to compare living standards across
countries:
○ The real GDP of one country must be converted into the same currency
units as the real GDP of the other country

 
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■ Problematic because prices of particular products in one country

may be less/more in the other country (ex. USA and China)
○ The goods and services in both countries must be valued at the same
prices

Limitations of Real GDP → some factors that influence the standard of living and are
not a part of GDP are:
● Household production
● Underground economic activity
● Health and life expectancy
● Leisure time
● Environmental quality
● Political freedom and social justice

Chained-Dollar Real GDP​ → 3 Steps used by Stats Canada

1. Value production in the prices of adjacent years
2. Find the average of 2 percentage changes
3. Link (chain) to the reference year

 
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