Chapter Twenty – Measuring GDP and Economic Growth
Will our economy expand more rapidly next year or will it sink into a “double-dip” recession? To assess
the state of the economy and to make big decisions about business expansion, firms use forecasts of
GDP. What exactly is GDP? How do we use GDP to tell us how rapidly our economy is expanding or
whether our economy is in a recession? How do we take the effects of inflation out of GDP to reveal the
growth rate of our economic well-being? And how do we compare economic well-being across
Gross domestic product
GDP or gross domestic product is the market value of all final goods and services produced in a country
in a given time period. This definition has four parts: Market value, final goods and services, produced
within a country and in a given time period.
Market value - GDP is a market value which is when goods and services are valued at their market
prices. To add apples and oranges, computers and popcorn, we add the market values so we have a
total value of output in dollars.
Final goods and services - GDP is the value of the final goods and services produced. A final good (or
service) is an item bought by its final user during a specified time period. A final good contrasts with an
intermediate 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. Excluding the value of intermediate goods and services avoids
Produced within a country - GDP measures production within a country, in other words, domestic
In a given time period - GDP measures production during a specific time period, normally a year or a
quarter of a year.
GDP measures the value of production, which also equals total expenditure on final goods and total
income. The equality of income and value of production shows the link between productivity and living
standards. The circular flow diagram illustrates the equality of income and expenditure. The circular flow
diagram shows the transactions among households, firms, governments, and the rest of the world.
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, and
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. 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 not part of the
circular flow of expenditure and income.
Firms in Canada sell goods and services to the rest of the world called exports and buy goods and
services from the rest of the world called 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. The
sum of the red flows equals the blue
flow. That is: Y = C + I + G + X – M
The circular flow shows two ways of
measuring GDP. By aggregate
expenditure or aggregate income.
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. Firms
pay out all their receipts from the sale
of final goods, so income equals
expenditure, Y = C + I + G + (X – M).
“Gross” means before deducting the depreciation of capital. The opposite of gross is net. “Net” means
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 is 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. Gross investment is one
of the expenditures included in the expenditure approach to measuring GDP, so total product is a gross
measure. Gross profit, which is a firm’s profit before subtracting depreciation, is one of the incomes
included in the income approach to measuring GDP, so total product is a gross measure. Measuring Canada’s GDP
The Bureau of Economic Analysis uses two approaches to measure GDP: The expenditure approach and
the income approach.
Expenditure approach - The 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 - The 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, other labour income and all other factor incomes. The
payment for labour services is the sum of gross