Qualities of Effective Central Banks
GDP stands for Gross Domestic Product. It refers to the market value of all goods and services produced within an economy in a given period of time. Equivalently, GDP also refers to the total income earned by each household, company, and government within a given period of time. Therefore, GDP measures the flow of personal income and output in an economy.
GDP = Consumer spending on goods and services (C)
+ Business gross fixed investment (I)
+ Change in inventories (I)
+ Government spending on goods and services (G)
+ Exports – Imports (X − M)
+ Statistical discrepancy
Exam tip: The easiest way to remember this formula is the following:
GDP = C + I + G + (X – M)
GDP = National income (see the next section)
+ Capital consumption allowance (a portion of GDP due to depreciation)
+ Statistical discrepancy
Note that the statistical discrepancy is equal to gross domestic product less gross domestic income.
National income refers to the income received by all factors of production employed in generating the final output. It is calculated as follows:
National Income = Compensation of employees
+ Corporate and government enterprise profits before taxes
+ Interest income
+ Unincorporated net income of businesses
+ Rent
+ Indirect business taxes – subsidies.
Personal income refers to the broad measure of household income. As such, it measures the purchasing power of consumers. It consists of all the income either earned or not earned by households. It can be calculated as follows:
Personal Income = National Income
– Indirect business taxes
– Corporate income taxes
– Undistributed corporate profits
+ Transfer payments.
Personal disposable income refers to personal income minus taxes at a personal level. It measures the amount of net income that remains after households have paid all their tax levies. It also represents the amount households will spend on goods and services or will save to invest.
Therefore, household savings equals personal disposable income (PDI) minus consumption expenditures, interest paid to businesses, and personal transfer payments.
Question
Assume that the national account of a small island for 2018 showed that the government had received $15 million as revenue and spent $2 million on purchases and expenditure. National investment stood at $4 million, while the island recorded $10 million worth of export with a $5 million worth of import. If the consumption expenditure on final goods and services by consumers for that year amounted to $8 million, the GDP for that year is closest to:
A. $19 million
B. $34 million
C. $11 million
Solution
The correct answer is A.
GDP = C + I + G + (X – M)
C = Consumption expenditure = $8 million
I = Investments = $4 million
G = Government purchases = $2 million
E = Exports = $10 million
M = Imports = $5 million
Thus, GDP = 8 + 4 + 2 + (10 – 5) = $19 million