Week 2 · Chapter

Chapter 2 — Measuring Output: Gross Domestic Product

Principles of Macroeconomics Free sample edition

The module's primary reading · ~35–45 minutes · Objective 2 (measure an economy's output with gross domestic product by the expenditure approach (C + I + G + NX), decide what counts and what does not, distinguish real from nominal GDP, and compute and interpret the GDP deflator) · Read it first this week; the lecture, the tutorial, the quiz, and the Model Workshop all build on it.

In plain language

Every year an economy makes millions of different things, from haircuts to houses. This week you learn how economists add all of it up into one number, gross domestic product, or GDP (the market value of everything newly made inside a country in a year). You will add up spending in four groups, decide which sales count and which do not, and learn why a bigger number does not always mean more stuff was made. The key move is to separate nominal values (measured at today's prices) from real values (measured at fixed prices), so that higher prices are not mistaken for more output. In one small example this week, the dollar total grows 21 percent while the amount of stuff made grows only 10 percent.

Why you already care about this

Think about the last headline you saw that said "the economy grew." Somebody had to measure the economy to say that. You read numbers like this all the time. A store owner checks whether this month's sales beat last month's. A family notices the grocery bill went up 10 dollars a week. A city council asks whether the local economy is bigger than it was last year.

Each of those questions has the same trap inside it. If sales went up, did the store sell more, or did it charge more? If the grocery bill rose, is the family eating more, or are prices higher? GDP is where economists first learn to pull those two stories apart.

In this chapter you will work with an illustrative economy whose spending adds up to 1,100 billion dollars. You will also follow a tiny economy that makes only pizzas and coffees. Its GDP grows from 300 dollars to 363 dollars, yet its output grows by only 10 percent. By the end, you will see exactly where the rest went.

By the end of this chapter you will be able to:

state what GDP measures and what each word in its definition rules in or out;
compute GDP from consumption, investment, government purchases, and net exports;
decide whether a given sale counts in GDP, and say why;
compute nominal GDP and real GDP by hand for a small economy;
compute the GDP deflator and use it to split nominal growth into real growth and inflation.

Carry this sentence with you: count the loaf, not the flour — and price it at base-year prices.

Where we are

Already covered: Week 1, The Macro Perspective, taught you to see the economy as a whole, to read the production possibilities frontier, and to trace the circular flow of spending and income between households and firms.
This week: how to measure an economy's output with GDP, what counts, and how to strip price changes out with real GDP and the GDP deflator.
How they connect: the circular flow says every dollar spent on new output is a dollar of income, so adding up spending is a way to measure the whole economy's output.
Where we're going next: Week 3, Measuring Inflation & Unemployment, builds a second price index, the Consumer Price Index, and measures who is out of work.

Week 1 is the one this chapter leans on. Recall the circular-flow model: households buy goods and services from firms in product markets, and firms pay households for labor and other inputs in factor markets. Every dollar one side spends is a dollar of income to the other. That loop is why spending is a good yardstick. Add up what everyone spent on new output, and you have also added up the income that output created.

1. Define GDP: one price tag on a year of production

Picture a farmers' market at the end of a busy market day. You could describe it by listing everything sold: 40 jars of honey, 250 tomatoes, 12 quilts. That list is accurate, but you cannot add honey to quilts. To add them, you need a common unit. Prices give you one. A jar of honey that sells for 8 dollars and a quilt that sells for 120 dollars can both be counted in dollars, and dollars add up.

GDP does the same thing for a whole country. Here is the course's definition, word for word.

Gross domestic product (GDP) is the market value of all final goods and services produced within a country during a given period, such as a year.

Each phrase in that definition does a job.

Market value means each item is counted at the price it sells for. That is how apples and haircuts end up in one number.
Final means only goods and services bought by their last user. Section 3 explains why.
Produced means newly made in this period. Something made years ago and sold again today was already counted once.
Within a country means the location of production, not the owner. A factory inside the country counts, whoever owns it.
During a given period means GDP is a flow, like the water through a pipe each minute. It is not a pile that has built up over time.

Worked example — reading the definition on four sales. Run each phrase as a test.

A family pays a plumber to fix a leak this year. It is a final service, newly produced, inside the country. It counts.
A bakery buys flour to bake bread for sale. The flour is not final; the bakery uses it up. It does not count on its own.
A collector buys a painting made decades ago. It was not produced this period. It does not count.
A factory inside the country makes bikes this year, and its owners live abroad. Production happened inside the country. It counts.

So two of the four sales enter this year's GDP, and the other two are left out by a specific word in the definition.

Misconception check. Students often think GDP adds up every sale in the economy. It does not. It adds up the value of new final production. A resale, an intermediate purchase, or a purely financial trade can involve a lot of money changing hands without anything new being made. The cure: before you count a sale, ask, "Was something new and final made here, this period?"

2. Add up the spending: four groups of buyers

Now imagine sorting every purchase of new output into four bins by who bought it. Households buy groceries and phones. Businesses buy machines and new buildings. Governments buy roads and pay teachers. Buyers in other countries buy goods made here, while people here buy goods made abroad. That sorting is the expenditure approach.

The expenditure approach is measuring GDP by adding up all spending on new final goods and services in four groups: consumption, investment, government purchases, and net exports. As a formula, GDP = C (consumption) + I (investment) + G (government purchases) + NX (net exports).

Here is what each letter stands for.

Consumption (C) is household spending on new goods and services, such as groceries, rent, phones, and haircuts.
Investment (I) is business spending on new machines and buildings, plus new homes and additions to inventories. It does not mean buying stocks or bonds.
Government purchases (G) are what all levels of government spend on goods and services, including the pay of public employees.
Exports (X) are goods and services made here and sold to buyers in other countries.
Imports (IM) are goods and services made in other countries and bought here. We write IM, never M, because M stands for the money supply.
Net exports (NX) are exports minus imports. As a formula, NX (net exports) = X (exports) − IM (imports).

Why subtract imports? Some of the household, business, and government spending in C, I, and G went to goods made in other countries. Those goods were not produced here. Subtracting IM takes them back out, so only domestic production is left.

Worked example — the illustrative expenditure account. This account is constructed for this course, not real data. All values are in billions of dollars.

Spending in the illustrative expenditure account, in billions of dollars
Component	Symbol	Value
Consumption	C	700
Investment	I	200
Government purchases	G	250
Exports	X	100
Imports	IM	150

Find net exports first. NX = X − IM = 100 − 150 = −50. Imports are larger than exports, so net exports are negative. That is a trade deficit.
Add the four parts. GDP = C + I + G + NX = 700 + 200 + 250 + (−50).
Combine. 700 + 200 + 250 = 1,150, and 1,150 − 50 = 1,100.

In words: this economy produced 1,100 billion dollars of final goods and services this year. The trade deficit of 50 billion dollars made GDP smaller than the 1,150 billion dollars households, businesses, and government spent.

Misconception check. Students often add a trade deficit to GDP, writing 700 + 200 + 250 + 50 = 1,200. The minus sign is easy to drop. The cure: compute NX = X − IM first, on its own line, and carry its sign. When imports are larger than exports, NX is negative, and a negative number makes the total smaller.

In practice (your tools). In Google Sheets, type the five values into cells B2 through B6 in the order C, I, G, X, IM. In B7, type =B5-B6 to get net exports, which shows −50. In B8, type =B2+B3+B4+B7 to get GDP, which shows 1,100. Change an export or import value and watch GDP move with it. A Desmos calculator line such as 700+200+250+(100-150) gives the same 1,100.

3. Decide what counts: final goods and value added

Picture a loaf of bread on a kitchen counter. Before it got there, a farm grew wheat, a mill ground it into flour, and a bakery baked the loaf. Three businesses each sold something. If you added up all three sales, you would count the wheat three times: once as wheat, again inside the flour's price, and again inside the bread's price.

That is the reason GDP counts only final goods.

Final goods and services are goods and services bought by their last user, such as a loaf of bread a family eats or a haircut, rather than used up to make something else for sale.
An intermediate good is a good bought by a business to be used up in making another good for sale, such as the flour a bakery turns into bread; GDP leaves it out because its value is already inside the final good's price.
Double counting is the error of counting an intermediate good once on its own and again inside the price of the final good it went into, which makes measured output too large.

There is a second way to get the same answer. Instead of counting only the final loaf, count what each business added.

Value added is the amount a producer adds at its stage of production: the price of what it sells minus the cost of the intermediate goods it bought; the value added at every stage sums to the price of the final good.

Worked example — the illustrative bread chain. These prices are illustrative, constructed for this course. A farm sells wheat to a mill for 1 dollar. The mill sells flour to a bakery for 2 dollars. The bakery sells a loaf for 5 dollars.

Sales and value added at each stage of the illustrative bread chain, in dollars
Stage	Sells for	Paid for inputs	Value added
Farm (wheat)	1	0	1
Mill (flour)	2	1	1
Bakery (loaf)	5	2	3

Value added at each stage. Farm: 1. Mill: 2 − 1 = 1. Bakery: 5 − 2 = 3.
Sum the value added. 1 + 1 + 3 = 5 dollars.
Compare with the final good. The loaf sells for 5 dollars. The two methods agree.
See the error. Adding every sale gives 1 + 2 + 5 = 8 dollars. That overstates output by 8 − 5 = 3 dollars, the wheat and flour counted a second time.

In words: the bread chain adds 5 dollars to GDP, whether you count the final loaf or add up the value each business created.

What counts, and where

The same tests sort everyday sales. All of these are fresh, illustrative cases.

A family buys a newly built house. It counts, in I, because new residential construction is investment.
A city pays a public-school teacher's salary. It counts, in G, because the government is buying a service, teaching.
A student buys a used laptop from a roommate. It does not count. The laptop was counted in the year it was made.
A worker buys shares of stock. It does not count. Ownership changed hands, but nothing new was produced.
A retiree receives a Social Security check. It does not count. It is a transfer payment.
A transfer payment is a payment from the government to a person that buys no good or service in return, such as a Social Security check or unemployment benefits; it is left out of government purchases and out of GDP.

When the retiree later spends that check on groceries, the groceries count, in C. The check itself is a transfer of money, not a purchase of output.

Misconception check. Students often put a Social Security check into G, because the government wrote the check. But G counts only what the government buys. A Social Security check buys no good or service, so it is a transfer payment and stays out of GDP. The cure: ask, "What did the government get in return?" If it got nothing, it is a transfer.

Pause and reflect — choose one. Pick either prompt; they count the same.

(a) Think of something you bought this week. Was it a final good, or did it go into making something else? Explain in two sentences which part of the GDP definition decides it.
(b) Think of a job you or someone you know has done. Describe one thing that job adds to a final good or service, and say whether it is counted as value added or as a final sale.

4. Separate prices from quantities: real versus nominal GDP

Suppose your favorite taco truck brought in 20 percent more money this year than last year. Good news? It depends. If it sold 20 percent more tacos, the business grew. If it sold the same number of tacos at higher prices, it did not make any more food at all. Dollar totals mix two things: how much was made and what it sold for.

Economists split those two things apart.

Nominal GDP is the value of a period's final goods and services measured at the prices of that same period, so it rises when either output or prices rise.
Real GDP is the value of a period's final goods and services measured at the fixed prices of a chosen base year, so it changes only when the amount of output changes.
The base year is the year whose prices are used to value output in every year when real GDP is computed; in the base year nominal GDP equals real GDP and a price index equals 100.

Worked example — the illustrative two-good economy. This tiny economy, constructed for this course, makes only pizzas and coffees. Values are in dollars.

Quantities and prices in the illustrative two-good economy, base year and year 2
Year	Pizzas	Price of a pizza	Coffees	Price of a coffee
Base year	40	5.00	100	1.00
Year 2	44	5.50	110	1.10

Base-year GDP. 40 × 5 + 100 × 1 = 200 + 100 = 300 dollars. In the base year, nominal GDP and real GDP are the same 300 dollars.
Year-2 nominal GDP, at year-2 prices. 44 × 5.50 + 110 × 1.10 = 242 + 121 = 363 dollars.
Year-2 real GDP, at base-year prices. 44 × 5 + 110 × 1 = 220 + 110 = 330 dollars.

In words: measured at today's prices, this economy looks 363 dollars big. Measured at base-year prices, it made 330 dollars' worth of output. The gap of 363 − 330 = 33 dollars is price change, not extra pizza or coffee.

In practice (your tools). In Google Sheets, put the year-2 quantities in B2 and B3 (44 and 110), the year-2 prices in C2 and C3 (5.50 and 1.10), and the base-year prices in D2 and D3 (5 and 1). Nominal GDP is =B2*C2+B3*C3, which shows 363. Real GDP is =B2*D2+B3*D3, which shows 330. The only difference between the two formulas is which price column you multiply by.

Misconception check. Students often read a rise in nominal GDP as a rise in output. In the two-good economy, nominal GDP rose from 300 to 363 dollars, which looks like a big jump. But real GDP rose only from 300 to 330. Part of the 363 is higher prices on the same kinds of goods. The cure: never compare output across years until both years are measured at the same base-year prices.

5. Build the GDP deflator: a price index from GDP

Now that you have nominal and real GDP for the same year, you can compare them. Their ratio tells you how much prices have moved since the base year. That comparison has a name.

A price index is a number that compares the overall level of prices in a period with the level in a base year, which is set to 100; a reading of 110 means prices are 10 percent above the base year.
The GDP deflator is a price index for all of the goods and services counted in GDP, computed as nominal GDP divided by real GDP, times 100; it equals 100 in the base year.

Worked example — two deflators that tell one story. Use both illustrative datasets.

The expenditure account. Nominal GDP is 1,100 billion dollars. The same output valued at base-year prices is a real GDP of 1,000 billion dollars. Deflator = (1,100 ÷ 1,000) × 100 = 110.0.
The two-good economy, year 2. Deflator = (363 ÷ 330) × 100 = 110.
The two-good economy, base year. Deflator = (300 ÷ 300) × 100 = 100, as the definition says it must be.

In words: in both datasets, the price level sits 10 percent above the base year. A deflator of 110 tells you that nominal GDP is 10 percent larger than real GDP because prices rose, not because more output was made.

Notice the units. A deflator is a level, so it carries no percent sign: you write 110, not 110%. The percent appears when you describe how far it sits above 100.

In practice (your tools). In the same Google Sheet, type =363/330*100 in an empty cell. It shows 110. If you prefer Desmos, type 363/330*100 on a new line and read the result to its right.

Misconception check. Students often read the deflator as a measure of output, as if 110 meant "the economy grew 10 percent." It is the opposite. The deflator measures prices only; it is the part of nominal GDP that real GDP removes. The cure: say the full sentence each time — "the deflator says prices are 10 percent above the base year" — and keep output growth for real GDP.

6. Check the story: real growth, inflation, and nominal growth

You now have three numbers for the two-good economy: real GDP grew, prices rose, and nominal GDP grew. They should fit together, and they do.

Worked example — splitting 21 percent into two parts. Use the two-good economy's base year and year 2.

Real growth. (330 − 300) ÷ 300 × 100 = 30 ÷ 300 × 100 = 10%. Output grew 10 percent.
Nominal growth. (363 − 300) ÷ 300 × 100 = 63 ÷ 300 × 100 = 21%. The dollar total grew 21 percent.
Inflation, from the deflator. The deflator went from 100 in the base year to 110 in year 2, so prices rose 10 percent.
The check. (1 + real growth) × (1 + inflation) = (1 + nominal growth). Here, (1 + 0.10) × (1 + 0.10) = 1.10 × 1.10 = 1.21, which is 1 + 0.21. The pieces fit: 10% more output at 10% higher prices is 21% more spending.

In words: this economy's output grew 10 percent, and the rest of the 21 percent rise in nominal GDP came from higher prices. Next week's tools for inflation will reuse this exact split.

Here is a caveat about that check. It multiplies; it does not add. Adding 10% and 10% gives 20%, which is close but not exact. The gap between 20% and 21% is the price increase on the extra output: 10% of the new 10%. For small rates, adding gives a quick estimate; the product gives the exact answer.

Misconception check. Students often add the two rates and expect nominal growth to equal exactly real growth plus inflation, 10% + 10% = 20%. Then the 21% looks like an error. It is not. The cure: multiply the growth factors, 1.10 × 1.10 = 1.21, and the gap between 20% and 21% appears on its own.

What GDP does not measure

One honest note before you finish. GDP measures the market value of output, not how well people are living. It leaves out unpaid work at home, leisure time, and harm to the environment, among other things. That limitation is real, and you will weigh it in this week's discussion. It does not make GDP useless; it makes GDP a measure of one thing, output, read with care.

Pause and reflect — choose one. Pick either prompt; they count the same.

(a) Name one change that would raise a country's GDP without making people better off, and explain which part of the GDP definition lets it in.
(b) Name one change that would make people better off without raising GDP, and explain which part of the GDP definition leaves it out.

Key terms

Gross domestic product — The market value of all final goods and services produced within a country during a given period, such as a year; it is written GDP. (first used: 1. Define GDP: one price tag on a year of production)
Expenditure approach — Measuring GDP by adding up all spending on new final goods and services in four groups: consumption, investment, government purchases, and net exports. (first used: 2. Add up the spending: four groups of buyers)
Consumption — Household spending on new goods and services, such as groceries, rent, phones, and haircuts; it is written C in the expenditure approach. (first used: 2. Add up the spending: four groups of buyers)
Investment — In GDP accounting, business spending on new capital goods such as machines and buildings, plus new residential construction and additions to inventories; it is written I and does not mean buying stocks or bonds. (first used: 2. Add up the spending: four groups of buyers)
Government purchases — Spending by all levels of government on goods and services, including the pay of public employees; it is written G and leaves out transfer payments. (first used: 2. Add up the spending: four groups of buyers)
Exports — Goods and services produced inside a country and sold to buyers in other countries; they are written X. (first used: 2. Add up the spending: four groups of buyers)
Imports — Goods and services produced in other countries and bought by people, firms, or governments inside the country; they are written IM, never M, which stands for the money supply. (first used: 2. Add up the spending: four groups of buyers)
Net exports — Exports minus imports, written NX; net exports are negative when a country buys more from abroad than it sells abroad, and then they subtract from GDP. (first used: 2. Add up the spending: four groups of buyers)
Final goods and services — Goods and services bought by their last user, such as a loaf of bread a family eats or a haircut, rather than used up to make something else for sale. (first used: 3. Decide what counts: final goods and value added)
Intermediate good — A good bought by a business to be used up in making another good for sale, such as the flour a bakery turns into bread; GDP leaves it out because its value is already inside the final good's price. (first used: 3. Decide what counts: final goods and value added)
Double counting — The error of counting an intermediate good once on its own and again inside the price of the final good it went into, which makes measured output too large. (first used: 3. Decide what counts: final goods and value added)
Value added — The amount a producer adds at its stage of production: the price of what it sells minus the cost of the intermediate goods it bought; the value added at every stage sums to the price of the final good. (first used: 3. Decide what counts: final goods and value added)
Transfer payment — A payment from the government to a person that buys no good or service in return, such as a Social Security check or unemployment benefits; it is left out of government purchases and out of GDP. (first used: 3. Decide what counts: final goods and value added)
Nominal GDP — The value of a period's final goods and services measured at the prices of that same period, so it rises when either output or prices rise. (first used: 4. Separate prices from quantities: real versus nominal GDP)
Real GDP — The value of a period's final goods and services measured at the fixed prices of a chosen base year, so it changes only when the amount of output changes. (first used: 4. Separate prices from quantities: real versus nominal GDP)
Base year — The year whose prices are used to value output in every year when real GDP is computed; in the base year nominal GDP equals real GDP and a price index equals 100. (first used: 4. Separate prices from quantities: real versus nominal GDP)
Price index — A number that compares the overall level of prices in a period with the level in a base year, which is set to 100; a reading of 110 means prices are 10 percent above the base year. (first used: 5. Build the GDP deflator: a price index from GDP)
GDP deflator — A price index for all of the goods and services counted in GDP, computed as nominal GDP divided by real GDP, times 100; it equals 100 in the base year. (first used: 5. Build the GDP deflator: a price index from GDP)

Summary

GDP is the market value of all final goods and services produced within a country in a period.
By spending, GDP = C + I + G + NX, and net exports NX = X − IM.
A trade deficit makes NX negative, so it subtracts from GDP.
Count final goods or value added, never both; leave out used goods, financial trades, and transfer payments.
Nominal GDP uses each year's prices; real GDP uses base-year prices.
The GDP deflator = (nominal GDP ÷ real GDP) × 100, and it equals 100 in the base year.
Check any pair of rates with (1 + real growth) × (1 + inflation) = (1 + nominal growth).
GDP measures output, not well-being.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

An illustrative island economy reports, in millions of dollars: consumption 60, investment 15, government purchases 20, exports 10, and imports 25. Compute net exports and GDP, and say in words what the sign of net exports means.
Sort each illustrative sale: a family hires a painter to paint their kitchen; a car dealer sells a five-year-old pickup truck; a state pays a nurse at a public hospital; a retiree receives a monthly pension check from the government; a builder finishes a new apartment building. Which count in this year's GDP, and in which component?
In an illustrative coffee chain, a farm sells beans to a roaster for 4 dollars, the roaster sells the roasted beans to a café for 7 dollars, and the café sells the drinks made from them for 15 dollars. Find the value added at each stage and the total, and find how much a "sum every sale" total would overstate output.
An illustrative economy makes only bikes and books. In the base year it makes 10 bikes at 100 dollars and 50 books at 10 dollars. In year 2 it makes 12 bikes at 105 dollars and 60 books at 10.50 dollars. Compute nominal and real GDP for year 2, the GDP deflator, real growth, and nominal growth, and check them against each other.

Answers (worked reasoning — read after attempting)

Net exports first: NX = X − IM = 10 − 25 = −15. Then GDP = C + I + G + NX = 60 + 15 + 20 + (−15). Since 60 + 15 + 20 = 95, GDP = 95 − 15 = 80 million dollars. The negative sign means the island imported more than it exported, a trade deficit, so imports pull GDP below what was spent at home. If you got 130, you added imports instead of subtracting them.
The painter's work counts, in C: it is a new final service a household bought. The used pickup does not count; it was counted the year it was made, though the dealer's service on the sale would count. The nurse's pay counts, in G: the government is buying a service. The pension check does not count; it is a transfer payment, and nothing was bought. The new apartment building counts, in I, because new residential construction is investment.
Value added: the farm adds 4 dollars, the roaster adds 7 − 4 = 3 dollars, and the café adds 15 − 7 = 8 dollars. The total is 4 + 3 + 8 = 15 dollars, the price of the final drinks. Summing every sale gives 4 + 7 + 15 = 26 dollars, which overstates output by 26 − 15 = 11 dollars, the beans counted again inside each later price.
Base-year GDP: 10 × 100 + 50 × 10 = 1,000 + 500 = 1,500 dollars. Year-2 nominal GDP: 12 × 105 + 60 × 10.50 = 1,260 + 630 = 1,890 dollars. Year-2 real GDP, at base-year prices: 12 × 100 + 60 × 10 = 1,200 + 600 = 1,800 dollars. Deflator: (1,890 ÷ 1,800) × 100 = 105, so prices are 5 percent above the base year. Real growth: (1,800 − 1,500) ÷ 1,500 × 100 = 20%. Nominal growth: (1,890 − 1,500) ÷ 1,500 × 100 = 26%. Check: 1.20 × 1.05 = 1.26, which is 1 + 0.26, so 20% more output at 5% higher prices is 26% more spending.

Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, and the quiz — and next week the Consumer Price Index adds a second price index, built by a fixed-basket method.

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