4/4/2023

ECO 121: ELEMENTARY MACROECONOMICS

LECTURE 2: MEASURING ECONOMIC ACTIVITY

Winford Masanjala

Learning Objectives
LO2 Explain how economists define an economy’s output.
LO2 Apply the production, expenditure and income methods
for measuring GDP to analyze economic activity.
LO3 Define and compute nominal GDP and real GDP.
LO4 Discuss the relationship between real GDP and economic
well-being.

1
 4/4/2023

MEASURING NATIONS INCOME

• The Gross Domestic Product (GDP) is the commonest measure

of nations output.

• It can be measured and defined using Production or Expenditure.

Imagine a closed economy with two economic agents

• Households
• Firms

The Economy has two markets

CIRCULAR • Market for Goods and Service (Commodity Markets)
FLOW DIAGRAM • Market for Factors of Production (Factor Markets)
(IN A CLOSED
• In factor markets, households sell factors while firms buy.
ECONOMY) • For labour firms pay wages
• For capital firms pay profits
• For land firms pay rent

• In Commodity markets
• Firms sell goods and service and receive revenue
• Households pay for Goods and Service (expenditure)

2
 4/4/2023

CIRCULAR
FLOW DIAGRAM
(IN A CLOSED
ECONOMY)

GDP is the sum of

• incomes received by
firms for goods and
services or

• income received by
households for
factors of
production.

CIRCULAR FLOW (OPEN ECONOMY)

Overseas Income (H) 14
Income (Q) 550

Depreciation (D) -19

Net Taxes (T)
20 Net Lending to Overseas (L) -21
Savings (S)
40

G. Deficit (B)
5 25
G. Spending (G)
Exports (X) 25

Investment (I) 75

Consumer Expenditure (C) 475

Imports (M) 50
Transfers to Overseas (O) 10

Date: Monday / 01 / October / 2019 Advancing social justice, promoting decent work 6

3
 4/4/2023

PRODUCTION APPROACH

PRODUCTION APPROACH

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

4
 4/4/2023

Market Value …
Every economy produces a myriad goods and services
• GDP adds together the different kinds of products into a single measure
of the value of economic activity.
• To aggregate the products we need to find their value in money terms.

Let 𝑄𝑖 =Quantity of good i produced, and

𝑃𝑖 =Price of good i.
𝑁
Then
𝐌𝐚𝐫𝐤𝐞𝐭 𝐕𝐚𝐥𝐮𝐞 = ෍ 𝑃𝑖 ∗ 𝑄𝑖
𝑖=1

Market Value …

Ex. The Economy of Chikanda produces two goods (tobacco and maize)

Quantity Price
(Tonnes) (US$/Tonne)
Tobacco 100 250
Maize 250 50

𝐺𝐷𝑃𝐶ℎ𝑖𝑘𝑎𝑛𝑑𝑎 = 𝑄𝑇 ∗ 𝑃𝑇 + 𝑄𝑀 ∗ 𝑃𝑀

𝐺𝐷𝑃𝐶ℎ𝑖𝑘𝑎𝑛𝑑𝑎 = 100 x 250 + 250 x 50 = $37,500

5
 4/4/2023

Market Value …
Pro: Market values provide a convenient way to aggregate the many
different goods and services produced in a modern economy.

Con: Not all economically valuable goods and services are bought
and sold in markets.
1. Market value understates GDP because non marketed activities are
not included e.g. home making

2. In developing countries like Malawi, there is a large informal sector

whose transactions are neither regulated nor tracked by Government

… final …
Goods are of two types:
• Intermediate goods (or inputs) are goods that are used by another
individual to produce other goods.
• Final goods are those consumed by the ultimate user.

• Only final goods enter GDP

• If intermediate goods are included it amounts to double counting.
• The value of intermediate goods will be included in the value of the
final product.

6
 4/4/2023

… final …

What if the good is neither intermediate nor final e.g. capital

good?

• Capital Goods are long-lived goods used in the production of

other goods e.g. machines/factories.

• By convention, newly produced capital goods are considered

final goods.

… goods and services …

GDP includes both

• Goods which are tangible e.g. food, clothing, cars, and
• Services which are intangible e.g. haircut, house cleaning, doctor
services or guard services.

7
 4/4/2023

… Produced Within a Country …

• GDP measures the value of production within the geographic confines

of a country.
• When a Malawian citizen works in South Africa, her production is part
of South African GDP.
• When a British farmer produces tea in Malawi, the production is part of
Malawian GDP.
• Thus, items are included in a nation’s GDP if they are produced
domestically, regardless of the nationality of the producer.

…Produced within a country…

Digression
There is an alternative measure of national output that focuses on
nationality of the producer instead of their geography.
Gross national product (GNP) is the total income earned by a
nation’s permanent residents (called nationals).
• GNP differs from GDP in that it includes income that a country’s
citizens earn abroad and excludes income that foreigners earn here.

8
 4/4/2023

…Produced within a country…

Example
• When a Malawian citizen works in South Africa, her production is part of
South African GDP but Malawian GNP
• When a British farmer produces tea in Malawi, the production is part of
Malawian GDP but British GNP
• Thus, items are included in a nation’s GNP if they are produced citizens
regardless of the location of production

…Produced …in a Given Period of Time.

• GDP measures the value of production that takes place within a specific
interval of time.
• Usually, that interval is a year.
• GDP only includes goods and services currently produced.
• GDP does not include transactions involving items produced in the
past.
• Used goods are excluded because they were already included in the
GDP for the year they were produced

9
 4/4/2023

“. . . Produced . . .during a given period time”

Example:
• When Toyota produces and sells a new car, the value of the car is
included in that year’s GDP.
• But when one person sells a used Toyota car to another person, the
value of the used car is not included in GDP.
Example:
• A 10 year old house is sold for K50m. The owner pays 5% to
surveyor and 1% to lawyer. How much does this transaction
contribute to GDP

…Produced … in a given period …

What if the good is produced across time or countries?
• Use value added to apportion value to time periods or countries
• Value added for any firm is the market value of its product or service
minus the cost of inputs purchased from other firms
• Ex A farmer produces maize valued K1000. A miller buys the maize
and produces flour which he sells at K1500. A baker buys flour at
K1500 and bakes bread sold at K2000.
• If this transaction happens within one year, the value of bread (K2,000)
is included in GDP of that year

10
 4/4/2023

…Produced … In a given period …

If the good is produced across time or countries allocate the value-added

to GDP in the relevant period or country

Producer Value Added

(in Kwacha)
Farmer 1,000
Miller 1500-1000= 500
Baker 2000-1500= 500
Total 2,000

… produced within a country in a given period…

Extreme example: Airbus A320

• Airbus is a European aero-plane manufacturer that assembles planes in Toulouse

France. It uses parts from all over the globe
Wings: Broughton, UK
Center fuselage: Hamburg, Germany
Horizontal Stabilizer: Getafe, Spain
Engines: USA
Rudder: Harbin, China
etc

11
 4/4/2023

The value of these parts enter GDP of the relevant country in the year produced

(China)

(USA)

(Spain)

(UK) (Germany)

EXPENDITURE APPROACH

12
 4/4/2023

THE EXPENDITURE APPROACH

• If all goods that are produced are sold, then the value of goods produced
(production) should equal value of goods bought (expenditure)

• GDP is calculated as the sum of all spending by different spenders

Spender Expenditure
Households Consumption (C) GDP =C + I + G +(EX-IM)
Firms Investment (I)
Government Government spending (G) GDP =C + I + G +NX
Foreigners Net exports (NX)

Consumption Expenditure (C)

Consumption: refers to spending by households on goods and services

except purchase of new housing

Consumption is of three types

1. Consumer Durables: spending on long-lived consumer goods e.g fridges
2. Non-durable Consumption: spending on short-lived goods e.g
food/clothing
3. Services: household spending on intangibles e.g kabaza, salon

13
 4/4/2023

Investment (I)
Investment: refers to spending by firms on final goods and services, primarily
capital goods.
Investment is of three types.
1) Business fixed Investment: Purchase by firms of new capital goods such as
plant and machinery.
2) Residential Investment: refers to value of construction of new homes and
apartments buildings. Even when an individual build a house it is considered
investment.
3) Inventory Investment: The addition of unsold goods to a company’s
inventories.

Government Expenditure (G)

• Government Expenditure: Refers to spending on goods and services by

state, local and national governments.

• When the government pays the salary of a Civil Servant, that salary is
part of government purchases.

• Government spending excludes transfers e.g. pensions

• Transfer payments alter household income, but they do not reflect the
economy’s production

14
 4/4/2023

Net Exports (NX)

Net Exports is the difference between Exports and Imports

• Exports: Domestically produced goods that are sold abroad.
• Imports: Good produce abroad but bought and consumed locally.

Note:
• An increase in Exports increases Net Export and hence increase GDP.
• An increase in Imports decreases Net Exports and hence decrease GDP.

In the final analysis

Since GDP = C + I + G + NX

An increase in any component directly increases GDP.

A reduction in any component will also a decrease in GDP

But…
• While an increase in Exports increases Net Export and hence increase GDP.
• An increase in Imports decreases Net Exports and, in turn, decrease GDP.

15
 4/4/2023

Do we get the same GDP using two different

methods?
Exercise: An economy produces 1,000,000 cars valued at $15,000 each.
700,000 are sold to consumers,
200,000 are sold to businesses,
50,000 are sold to the government
25,000 are sold abroad.
No cars are imported.
The cars left unsold at the end of the year are held in inventory by the car producers.

Find GDP in terms of

(a) The market value of production, and
(b) The components of expenditure.

Do we get the same GDP using two different

methods?
• The market value of the production of cars in this economy is

𝐌𝐚𝐫𝐤𝐞𝐭 𝐕𝐚𝐥𝐮𝐞 = ෍ 𝑃𝑖 ∗ 𝑄𝑖
𝑖=1

⟹ 1,000,000 cars * $15,000/car = $15 billion.

16
 4/4/2023

Expenditure Method

C= 700,000 cars* $15,000 = $10.5 bn.

G= 50,000 cars* $15,000 = $0.75 bn
NX =Exports-Imports
=Exports (25,000 cars* $15,000= $0.375 bn) - Imports (0) = $0.375 bn.
I= Business Fixed Investment+ Inventory Investment
=200,000 cars*$15,000+ 25,000*15,000
=$3billion+$0.375 billion = $3.375
GDP = C+I+G+NX = $10.5 bn+$0.75bn+$0.375 + $3.375 =$15 billion

INCOME APPROACH

17
 4/4/2023

The Income Approach

• In this approach, GDP is the sum of incomes received by primary factors
of production.
• Recall from the Circular Flow

Factor of Production Income

Labor Wages
Capital Profit
Land Rent

GDP = Wages + Profit + Rent = Labor Income + Capital Income

The Three Faces of GDP

𝑪
+
𝑰 𝑳𝒂𝒃𝒐𝒖𝒓 𝑰𝒏𝒄𝒐𝒎𝒆
𝑴𝒂𝒓𝒌𝒆𝒕 = + = +
𝑽𝒂𝒍𝒖𝒆 𝑮 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆
+
𝑵𝑿

18
 4/4/2023

The Three Faces of GDP

REAL VS NOMINAL GDP

19
 4/4/2023

REAL VS NOMINAL GDP

• Recall that GDP measures the total spending on goods and services in all
markets in the economy.
• If GDP rises from one year to the next, at least one of two things must be
true:
1. The economy is producing a larger output of goods and services, or
2. Goods and services are being sold at higher prices.

• Economists are interested in isolating the impact of changes in quantity

of goods from price increases.

NOMINAL vs REAL GDP

• NOMINAL GDP: Measure of GDP in which quantities produced are

measured or valued at current year prices.

• Changes in nominal GDP from one year to the next capture changes to
either quantities produced or prices or both

20
 4/4/2023

NOMINAL vs REAL GDP

• REAL GDP: Measure of GDP in which the quantities are valued at prices
of a base year
• Issue: What would be the value of the goods and services produced
this year if prices had not changed since some specific year in the past
(called base year)
• Economists value goods and services at the prices that prevailed in
the base year
• Real GDP measures physical volume while Nominal GDP measures
monetary value

NOMINAL vs REAL GDP

Tobacco Price Maize Price

2015 100 250 150 50
2021 120 280 200 75

Let’s assume that 2015 is the base year.

In that case 2015 prices will be used to calculate real GDP

21
 4/4/2023

NOMINAL vs REAL GDP

Nominal GDP Note

𝐺𝐷𝑃15 = 100 ∗ 250 + 150 ∗ 50 = 32,500 1. In the base year real GDP
equals Nominal GDP
𝐺𝐷𝑃21 = 120 ∗ 280 + 200 ∗ 75 = 48,600
2. In the other years,
Real GDP nominal GDP is generally
higher than real GDP.
𝐺𝐷𝑃15 = 100 ∗ 250 + 150 ∗ 50 = 32,500
3. For every year difference
𝐺𝐷𝑃21 = 120 ∗ 250 + 200 ∗ 50 = 40,000 between real and nominal
GDP reflects price changes

NOMINAL vs REAL GDP

• Changes in prices from the base year to any year are calculated using the GDP
deflator
• GDP deflator is a measure of the price level calculated as the ratio of nominal GDP
to real GDP times 100

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃𝑡
𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟𝑡 = x100
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃𝑡

• The Deflator is a measure of economy-wide average price changes since the base year

22
 4/4/2023

NOMINAL vs REAL GDP

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃15 32,500

𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟15 = 𝑥100 = 𝑥100 = 100
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃15 32,500

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃21 48,600

𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟21 = 𝑥100 = 𝑥100 = 121.50
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃21 40,000

REAL vs NOMINAL GDP

Summary

1. The GDP Deflator is always equal to 100 in the base year because real
GDP and nominal GDP are equal.

2. Note that between 2015 and 2021 nominal GDP rose by 49.54 %.
This change captured changes in both quantities produced and prices

3. The deflator shows that 21.5 % of the increase in nominal GDP

between 2015 and 2021 was on account of increases in price.

23
 4/4/2023

MALAWI GDP by SECTOR (Billion Kwacha)

SECTOR 2019 2020 2021 2022*

Agriculture, Forestry and Fishing 1,590.4 1,644.2 1,705.9 1,721,1

Wholesale & Retail Trade 909.6 908.8 938.4 925.1
Manufacturing 847.6 883.2 919.8 913.6
Real Estate Services 463.7 478.0 499.5 509.2
Financial & Insurance Activities 430.7 451.2 479.5 506.3
Information & Communication 407.8 431.9 461.5 469.8
Health & Social Work 430.4 418.4 427.4 437.7
Transportation & Storage 337.3 314.0 331.9 335.4
Education 308.1 293.5 301.1 315.9
Construction 230.4 238.9 245.5 258.2
… … … … …
Sum of All Industries 6,770.6 6,867.7 7,131.8 7,244,8
Plus: taxes less subsidies 434.6 394.67 461.7 440.6
GDP at constant 2017 prices 7,205.2 7,262.4 7,593.5 7,685. 4

Malawi Sectoral Shares of GDP (%)

SECTOR 2019 2020 2021 2022*
Agriculture, Forestry and Fishing 22.1 22.6 22.5 22.4
Wholesale & Retail Trade 12.6 12.5 12.4 12
Manufacturing 11.8 12.2 12.1 11.9
Financial & Insurance Activities 6.0 6.2 6.3 6.6
Real Estate Services 6.4 6.6 6.6 6.6
Information & Communication 5.7 5.9 6.1 6.1
Health and Social Work 6 5.8 5.6 5.7
Transportation & Storage 4.7 4.3 4.4 4.4
Education 4.3 4 4 4.1
Construction 3.2 3.3 3.2 3.4
… … … … …
Sum of All Industries 94 94.6 93.9 94.3
Plus: taxes less subsidies 6.0 5.4 6.1 5.7
GDP at constant 2017 prices 100.00 100.00 100.00 100.00

24
 4/4/2023

Is real GDP a good indicator of well-being?

No. GDP per capita is not a good measure of well-being because it excludes
some dimensions that contribute to wellbeing e.g.
1. Amount of leisure enjoyed
2. Useful but non-marketed activities e.g. the value of goods and services
produced at home.
3. Activities in the underground economy
4. Quality of the environment e.g Zomba vs Lilongwe
5. General Quality of life e.g. low crime
6. GDP ignores distributional considerations (Poverty and Inequality)

Is real GDP a good indicator of well-being?

Yes. Kinda.
1. GDP per capita is correlated with availability of Goods and Service
• Citizens of a country with a high GDP per capita are likely to have more
and better goods and services (after all, that is what GDP measures).

2. GDP per capita is linked to better health and education outcomes.

• Countries with high GDP per capita have higher life expectancy, low
infant mortality, low U-5 mortality, higher female literacy rates, higher
gross enrolment rates and progression rate

25
 4/4/2023

Key Concepts

Base year Gross National Product (GNP)

Capital Good Intermediate Goods Or Services
Consumption Investment
Consumption Expenditure Market Value
Final Goods or Services Net Exports
Government Purchases Nominal GDP
GDP Deflator Real GDP
Gross Domestic Product (GDP) Value Added

26