Gross Domestic Product GDP Defined 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 ▪ In a given time period © 2025 Pearson Canada Gross Domestic Product Market Value GDP is a market value—goods and services are valued at their market prices. To add apples and oranges, computers and popcorn, we add the market values to calculate the total value of output in dollars. © 2025 Pearson Canada Gross Domestic Product 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 counting the same value more than once. © 2025 Pearson Canada Gross Domestic Product Produced Within a Country GDP measures production within a country—domestic production. In a Given Time Period GDP measures production during a specific time period, normally a year or a quarter of a year.Gross Domestic Product GDP and the Circular Flow of Expenditure and Income 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 in Figure 4.1 illustrates the equality of income and expenditure. © 2025 Pearson Canada Gross Domestic Product The circular flow diagram shows the transactions among households, firms, governments, and the rest of the world. © 2025 Pearson Canada Gross Domestic Product Households and Firms 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. © 2025 Pearson Canada Gross Domestic ProductGross Domestic Product 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. © 2025 Pearson Canada Gross Domestic Product © 2025 Pearson Canada Gross Domestic Product Governments 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.Gross Domestic Product Rest of the World Firms in Canada sell goods and services to the rest of the world—exports—and buy goods and services from the rest of the world—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. © 2025 Pearson Canada Gross Domestic Product © 2025 Pearson Canada Gross Domestic Product The blue and red flows are the circular flow of expenditure and income. Gross Domestic Product The sum of the red flows equals the blue flow. © 2025 Pearson Canada Gross Domestic Product That is: Y = C + I + G + (X – M) © 2025 Pearson Canada Gross Domestic Product The circular flow shows two ways of measuring GDP. GDP Equals Expenditure Equals Income Total expenditure on final goods and services equals GDP. 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 Domestic Product Why Is Domestic Product “Gross”? “Gross” means before deducting the depreciation of capital. The opposite of gross is net. “Net” means after deducting the depreciation of capital. © 2025 Pearson Canada Gross Domestic Product 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. © 2025 Pearson Canada Gross Domestic Product Gross investment is one of the expenditures included in the expenditure approach to measuring GDP. So total production 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. © 2025 Pearson Canada Measuring Canadian GDP Statistics Canada uses two approaches to measure GDP: ▪ The expenditure approach ▪ The income approach Measuring canda GDP The 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) Table 4.1 on the next slide shows the expenditure approach with 2023 data. © 2025 Pearson Canada © 2025 Pearson Canada Measuring Canadian GDP The 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: 1. Compensation of employees 2. Other factor incomes © 2025 Pearson Canada Measuring Canadian GDP Compensation of employees is the payment for labour services—the sum of all wages plus benefits such as pension contributions, which is shown by the blue flow W. Other factor incomes are a mixture of interest, rent, and profit and include labour income from self-employment. They are included in the blue flow OFI. Measuring Canadian GDP The other factor incomes are net incomes after deducting depreciation. To get them to a gross measure, we must add depreciation. Other factor incomes plus depreciation equals gross income and is included in the blue flow OFI. © 2025 Pearson Canada Measuring Canadian GDP The flows W and OFI sum to gross domestic income at factor cost. GDP measured by the expenditure approach is valued at market prices. So indirect taxes less subsidies is added to gross domestic income to convert factor cost to market price, and the total is called GDP at basic prices. GDP at basic prices never equals GDP at market prices, so, Statistics Canada defines GDP as the average of the two totals and redistributes half of the discrepancy to make the two total equal. Table 4.2 shows the income approach with data for 2023. © 2025 Pearson Canada © 2025 Pearson Canada Measuring Canadian GDP Nominal GDP and Real GDP Real GDP is the value production in a given year when valued at the prices of a reference base year. Currently, the reference base year is 2012 and we describe real GDP as measured in 2012 dollars. Nominal GDP is the value production in a given year valued at the prices that prevailed in that same year. Nominal GDP is just a more precise name for GDPMeasuring Canadian GDP Calculating Real GDP Table 4.3(a) shows the quantities produced and the prices in 2012 (the base year). Nominal GDP in 2012 is $100 million. Because 2012 is the base year, both real GDP and nominal GDP are $100 million. © 2025 Pearson Canada Measuring Canadian GDP Table 4.3(b) shows the quantities produced and the prices in 2023. Nominal GDP in 2023 is $462 million. Nominal GDP in 2023 is 4.6 times its value in 2012. © 2025 Pearson Canada Measuring Canadian GDP In Table 4.3(c), we calculate real GDP in 2023. The quantities are those of 2023, as in part (b). The prices are those in the base year (2012) as in part (a). The sum of these expenditures is real GDP in 2023, which is $300 million. © 2025 Pearson Canada The Uses and Limitations of Real GDP Economists use estimates of real GDP for two main purposes: ▪ To compare the standard of living over time ▪ To compare the standard of living across countriesThe Uses and Limitations of Real GDP The Standard of Living Over Time Real GDP per person is real GDP divided by the population. Real GDP per person tells us the value of goods and services that the average person can enjoy. By using real GDP, we remove any influence that rising prices and a rising cost of living might have had on our comparison. © 2025 Pearson Canada The Uses and Limitations of Real GDP Long-Term Trend A handy way of comparing real GDP per person over time is to express it as a ratio of some reference year. For example, in 1961, real GDP per person was $20,000 and in 2023, it was $60,000. So real GDP per person in 2023 was 3 times its 1961 level—that is, $60,000 ÷ $20,000 = 3. © 2025 Pearson Canada The Uses and Limitations of Real GDP Two features of our expanding living standard are: ▪ The growth of potential GDP per person ▪ Fluctuations of real GDP around potential GDP Potential GDP is the value of real GDP when all the economy’s labour, capital, land, and entrepreneurial ability are fully employed. So potential GDP is the maximum quantity of real GDP that can be produced while avoiding shortages of labour, capital, land, and entrepreneurial ability that would bring rising inflation. © 2025 Pearson Canada The Uses and Limitations of Real GDP Figure 4.4 shows real GDP per person in Canada. Potential GDP per person grows at a steady pace because the quantities of the factors of production and their productivity grow at a steady pace. Real GDP per personfluctuates around potential GDP per person. © 2025 Pearson Canada The Uses and Limitations of Real GDP Real GDP per person in Canada: Doubled between 1961 and 1988 and ... in 2023 was 2.6 times its 1961 value. © 2025 Pearson Canada The Uses and Limitations of Real GDP Productivity Growth Slowdown The growth rate of real GDP per person slowed after 1970. How costly was that slowdown? The answer is provided by a number that we’ll call the Lucas wedge. Lucas wedge is the dollar value of the accumulated gap between what real GDP per person would have been if the 1960s growth rate had persisted and what real GDP per person turned out to be. © 2025 Pearson Canada The Uses and Limitations of Real GDP Figure 4.5 illustrates the Lucas wedge. The red line is actual real GDP per person. The thin black line is the trend that real GDP per person would have followed if the 1960s growth rate of potential GDP had persisted. The shaded area is the Lucas wedge. © 2025 Pearson Canada The Uses and Limitations of Real GDP Real GDP Fluctuations—The Business Cycle A business cycle is a periodic but irregular up-and-down movement of total production and other measures of movement of total production and other measures of economic activity. Every cycle has two phases: 1. Expansion 2. Recession and two turning points: 1. Peak 2. Trough © 2025 Pearson Canada The Uses and Limitations of Real GDP Figure 4.6 illustrates the business cycle. An expansion is a period during which real GDP increases—from a trough to a peak. Recession is a period during which real GDP decreases—its growth rate is negative for at least two successive quarters. © 2025 Pearson Canada The Uses and Limitations of Real GDP The Standard of Living Across Countries Two problems arise in using real GDP to compare living standards across countries: 1. The real GDP of one country must be converted into the same currency units as the real GDP of the other country. 2. The goods and services in both countries must be valued at the same prices. © 2025 Pearson Canada The Uses and Limitations of Real GDP Using the exchange rate to compare GDP in one country with GDP in another country is problematic because … prices of particular products in one country may be much less or much more than in the other country. The United States and China provide a striking example. For example, using the market exchange rate to value China’s GDP in U.S. dollars leads to an estimate that in 2023, GDP per person in the United States was 5.5 times GDP per person in ChinaThe Uses and Limitations of Real GDP Figure 4.5 illustrates the problem. Using the market exchange rate and domestic prices makes China look like a developing economy. But valuing GDP at purchasing power parity prices, U.S. income per person is only 1.6 times that in China. © 2025 Pearson Canada The Uses and Limitations of Real GDP Limitations of Real GDP Real GDP measures the value of goods and services that are bought in markets. Some of the factors that influence the standard of living and that are not part of GDP are: ▪ Household production ▪ Underground economic activity ▪ Leisure time ▪ Environmental quality © 2025 Pearson Canada The Uses and Limitations of Real GDP The Bottom Line Do we get the wrong message about the level and growth of economic well-being and the standard of living by looking at the growth of real GDP? The influences that are omitted from real GDP are probably large. It is possible to construct broader measures that combine the many influences that contribute to human happiness. Despite all the alternatives, real GDP per person remains the most widely used indicator of economic well-being. © 2025 Pearson Canada Mathematical Note: Chained-Dollar Real GDP Statistics Canada uses a measure of real GDP called chained-dollar real GDP. Three steps are needed to calculate this measure: ▪ Value production in the prices of adjacent years ▪ Find the average of two percentage changes ▪ Link (chain) to the reference yearMathematical Note: Chained-Dollar Real GDP Value Production in Prices of Adjacent Years Part (a) shows the quantities and prices in 2022. Part (b) shows the quantities and prices in 2023. Part (c) the quantities of 2023 valued at 2022 prices. Part (d) the quantities of 2022 valued at prices of 2023. © 2025 Pearson Canada Mathematical Note: Chained-Dollar Real GDP Parts (a) and (c) value the quantities of both years at 2022 prices. That is, valuing the goods and services at 2022 prices, real GDP increased from $280 million to $300 million. © 2025 Pearson Canada Mathematical Note: Chained-Dollar Real GDP Parts (b) and (d) value the quantities in both years at 2023 prices. That is, valuing the goods and services at 2023 prices, real GDP increased from $449 million in 2022 to $462 million in 2023. © 2025 Pearson Canada Mathematical Note: Chained-Dollar Real GDP Find the Average of Two Percentage Changes In part (a), at 2022 prices, production increased by 7.1 percent. In part (b), at 2023 prices, production inproduction increased by 2.9 percent. The average increase in production is 5.0 percent. © 2025 Pearson Canada Mathematical Note: Chained-Dollar Real GDP Link (Chain) to the Base Year To find real GDP in 2023 in base-year prices (2012), we need to know the 1. Real GDP in 2012 2. Average growth rate each year from 2012 to 2023 and from 2012 back to 2010. © 2025 Pearson Canada Mathematical Note: Chained-Dollar Real GDP In the example here we use 2018 as the base year. Starting with real GDP in 2018 of $120 million and the growth rate each year, real GDP in each year since 2018 is calculated as follows: Real GDP in 2019 is 8 percent higher than the $120 million in 2018, which is $130 million. The figure shows the linking of each year to the base year. © 2025 Pearson Canada Mathematical Note: Chained-Dollar Real GDP Notice that the growth rates depend only on prices and quantities produced in adjacent years and … do not depend on which year is the reference base year. Changing the base year changes the level of real GDP in each year, but it does not change the growth rates of real GDP