Summary of Notes from Chapter 5 and Practice Questions
1. Every transaction has a buyer and a seller, the total expenditure in the economy must equal the total
income in the economy.
2. Gross domestic product (GDP) measures an economy’s total expenditure on newly produced goods
and services and the total income earned from the production of these goods and services. More
precisely, GDP is the market value of all final goods and services produced within a country in a given
period of time.
3. GDP is divided among four components of expenditure: consumption, investment, government
purchases, and net exports. Consumption includes spending on goods and services by households,
with the exception of purchases of new housing. Investment includes spending on new equipment
and structures, including households’ purchases of new housing. Government purchases include
spending on goods and services by local, provincial, and federal governments. Net exports equal the
value of goods and services produced domestically and sold abroad (exports) minus the value of
goods and services produced abroad and sold domestically (imports).
4. Nominal GDP uses current prices to value the economy’s production of goods and services. Real GDP
uses constant base▯year prices to value the economy’s production of goods and services. The GDP
deflator―calculated from the ratio of nominal to real GDP―measures the level of prices in the
5. GDP is a good measure of economic well▯being because people prefer higher incomes to lower
incomes. But it is not a perfect measure of well▯being. For example, GDP excludes the value of
leisure and the value of a clean environment.
I. Review of the Definitions of Microeconomics and Macroeconomics
A. Definition of microeconomics : the study of how households and firms make
decisions and how they interact in markets.
B. Definition of macroeconomics: the study of economy-wide phenomena,
including inflation, unemployment, and economic growth.
II. The Economy’s Income and Expenditure
A. To judge whether or not an economy is doing well, it is useful to look at Gross Domestic
1. GDP measures the total income of everyone in the economy.
1 2 ☞ Chapter 5/Measuring A Nation’s Income
2. GDP measures total expenditure on an economy’s output of goods and services.
B. For an economy as a whole, total income must equal total expenditure.
1. If someone pays someone else $100 to mow a lawn, the expenditure on the
lawn service ($100) is exactly equal to the income earned from the production of
the lawn service ($100).
2. We can also use the circular flow diagram from Chapter 2 to show why total
income and total expenditure must be equal.
Figure 5.1 Chapter 5/Measuring A Nation’s Income ☞ 3
. Households buy goods and services from firms; firms use their revenue
from sales to pay wages to workers, rent to landowners, and profit to
b. In the simple economy described by this circular flow diagram,
calculating GDP could be done by adding up the total purchases of
households or summing total income paid by firms.
c. Note that this simple diagram is somewhat unrealistic as it omits saving,
taxes, government purchases and investment purchases by firms.
Regardless, each transaction always has a buyer and a seller, therefore,
total expenditure in the economy must be equal to total income.
III. The Measurement of Gross Domestic Product
A. Definition of gross domestic product (GDP) : the market value of all final goods
and services produced within a country in a given period of time.
B. “GDP is the Market Value . . .”
1. To add together different items produced, market values are used.
2. Market values are calculated by using market prices.
C. “. . . of All . . .”
1. GDP includes all items produced and sold legally in the economy.
2. The value of housing services is somewhat difficult to measure.
a. If housing is rented, the value of the rent is used to measure the value
of the housing services.
b. For housing that is owned (or mortgaged), the government estimates
the rental value and uses this figure to value the housing services.
3. GDP does not include illegal goods or services that are sold in markets, nor items
produced and consumed at home. 4 ☞ Chapter 5/Measuring A Nation’s Income
a. When you hire someone to mow your lawn, that production is included
b. If you mow your own lawn, that production is not included in GDP.
D. “. . . Final . . .”
1. Intermediate goods are not included in GDP.
2. The value of intermediate goods is already included as part of the value of the
3. Goods that are placed into inventory are considered to be “final” and included in
GDP as a firm’s inventory investment.
a. Goods that are sold out of inventory are counted as a decrease in
b. The goal is to count the production when the good is finished, which is
not necessarily the same time that the product is sold.
E. “. . . Goods and Services . . .”
1. GDP includes both tangible goods and intangible services.
F. “. . . Produced . . .”
1. As mentioned above, current production is counted.
2. Used goods that are sold do not count as part of GDP.
G. “. . . Within a Country . . .”
1. GDP measures the production that takes place within the geographical
boundaries of a particular country.
2. If a British citizen works temporarily in Canada, the value of his output is
included in GDP for Canada. If a Canadian owns a firm in Haiti, the value of the
production of that firm is not included in Canadian GDP. Chapter 5/Measuring A Nation’s Income ☞ 5
H. “. . . in a Given Period of Time.”
1. The usual interval of time used to measure GDP is a year or a quarter (three