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Chapter 5

# ECO 1102 Chapter Notes - Chapter 5: Economy Car, Retained Earnings, Microeconomics

Department
Economics
Course Code
ECO 1102
Professor
Chapter
5

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WHAT’S NEW IN THE SIXTH EDITION?
The
In the News
box “Does GDP Measure Well-Being?” has been replaced by “Identifying the 1 Percent.”
LEARNING OBJECTIVES
By the end of this chapter, students should understand:
¾ why an economy’s total income equals its total expenditure.
¾ how gross domestic product (GDP) is defined and calculated.
¾ the breakdown of GDP into its four major components.
¾ the distinction between real GDP and nominal GDP.
WHY IS THIS CHAPTER IMPORTANT TO STUDENTS?
Chapter 5 is the first chapter in the macroeconomics section of the text. It is the first of a two-chapter
sequence that introduces students to two vital statistics that economists use to monitor the economy—
GDP and the consumer price index. Chapter 5 develops how economists measure production and income
in the economy. The following chapter, Chapter 6, develops how economists measure the level of prices
in the economy. Taken together, Chapter 5 concentrates on the
quantity
of output in the economy, while
Chapter 6 concentrates on the
price
of output.
The purpose of this chapter is to provide students with an understanding of the measurement
and the use of gross domestic product (GDP). GDP is the single most important measure of the health
and economic performance of the economy. Indeed, it is the most widely reported statistic in every
developed economy.
IF NOTHING ELSE, MY STUDENTS SHOULD LEARN…
1. Every transaction has a buyer and a seller, the total expenditure in the economy must equal the total
income in the economy.
5 MEASURING A NATION’S
INCOME

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Chapter 5/Measuring A Nation’s Income ) 93
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
deflatorcalculated from the ratio of nominal to real GDPmeasures the level of prices in the
economy.
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.
WHAT CAN I DO IN CLASS?
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
Product (GDP).
Students have heard of GDP and they are genuinely interested in learning more
about what it is. The basic point that you must get across is that GDP is a measure
of
both
aggregate production and aggregate income generated within a nation
during a given period of time. You can demonstrate this by using the circular-flow
diagram and explaining that production generates income, which, in turn, results in
the purchasing power that generates the demand for the products.
Regardless of whether microeconomics is taught before macroeconomics or vice-
versa, students need to be reminded of the differences between the two areas of
study. Begin by defining the two terms and contrasting and comparing their focus.

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94 ) Chapter 5/Measuring A Nation’s Income
1. GDP measures the total income of everyone in the economy.
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.
a. Households buy goods and services from firms; firms use their revenue
from sales to pay wages to workers, rent to landowners, and profit to
firm owners.
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.
Fi
g
ure 5.
1
To reinforce the idea that aggregate production is equal to aggregate income, draw a
dollar bill on the chalkboard to represent the value of output for an economy. Divide
the dollar among the various inputs of production including residual profit for
entrepreneurs.