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IFT Notes for Level I CFA® Program

R14 Aggregate Output, Prices and Economic Growth

Part 2


 

2.2. The Components of GDP

The following are the major components of GDP based on the expenditure approach:

  • Consumer spending on final goods and services.
  • Gross private domestic investment.
  • Government spending on final goods and services for both current consumption and investment in capital goods.
  • Net exports (exports – imports).

GDP based on expenditure approach = (C + GC) + (I + GI) + (XM)

where:

C = consumer spending on goods and services

I = gross private domestic investment

G = government spending on final goods and services for both current consumption and investment in capital goods = GC + GI

X-M = net exports = exports – imports

The following exhibit is reproduced from the curriculum (Exhibit 6):


Concept 31

Notation: flow of factor of production – solid lines.

Dashed lines – financial flows, including income and taxes.

Note: The section on sectors of an economy in the curriculum is exhaustive. The important terms for each of the sectors are summarized below:

Sectors of an Economy
The Household and Business Sectors (private sector)
Consumption expenditure: C Part of income that households pay to firms for consuming goods and services.
Saving: S Part of income of households is saved.

National savings equals savings by households, businesses, and government.

Investment: I Refers to the purchase of new capital which includes plant, property, equipment, buildings and inventory. It does not include labor.

It is financed by household savings and capital flows from the rest of the world.

Flow between the factor market Labor, capital and land flow from households to firms.

Income flows from firms to households as compensation for labor, interest, rent and profits. Income is spent in three ways:

Consumption (C)

Savings (S) part of which later goes to financial markets.

Taxes (T)

Flow between financial market Part of the savings from households flows to firms that need to raise capital. Firms raise money to invest in inventory and PPE (plants, property and equipment): I
Flow between goods market Consumption expenditure flows to the business sector.

Investment (I) from firms flows through goods back to firms.

The Government Sector
Flow between households and businesses Taxes (T): Government collects taxes from households and businesses. This is the government’s revenue.

Transfer payments: The government makes transfer payments to the unemployed, for health care, etc. This is not included in government expenditure (G) because this is a monetary transfer and nothing is received in return.

Net taxes = T = taxes – transfer payments

Flow between goods market Expenditure (G): Government purchases goods and services from businesses to build roads, schools, and other goods; spends on military, fire protection, security, and other services. This is denoted by G.
Fiscal deficit If G > T, then the government has a fiscal deficit and must borrow from financial markets to fund its spending.
How government purchases (G) differs from government transfer payments? Transfer payments are just a flow of money for social welfare. Whereas, G (expenditure) involves actual spending on goods or services.
The External Sector
Exports: X Value of goods and services sold to foreigners.
Imports: M Portion of domestic consumption (C), government expenditure (G), and investment (I) spent on purchasing goods and services from the rest of the world.
Net exports X-M
Trade deficit If domestic saving is less than domestic investment plus government fiscal balance, then there is a deficit. It also means that the economy is spending more on imports than foreign countries are spending on domestic goods and services.

2.3. GDP, National Income, Personal Income, and Personal Disposable Income

There are two approaches to calculate GDP: expenditure approach and the income approach. Ideally, both the approaches should give the same estimate, but they differ because different data sources are used for each method. The numerical difference between the GDP using the expenditure approach and GDP using the income approach is accounted for as a statistical discrepancy.

GDP based on expenditure approach =  (C + GC) + (I + GI) + (XM)

GDP based on Income Approach = GDP = Gross domestic income (GDI) = Net domestic income + Consumption of fixed capital (CFC) + Statistical discrepancy

Gross domestic income is the income received by all factors of production which are used to produce final output:

Gross domestic income = Compensation of employees + Gross operating surplus + Gross mixed income + Taxes less subsidies on production + Taxes less subsidies on products and imports

where:

  • Compensation of employees = wages and salaries including direct compensation in cash or in kind + employers’ social contributions.
  • Gross operating surplus represents corporate profits of businesses. Businesses includes private corporations, non-profit corporations, and government corporations.
  • Gross mixed income = farm income + non-farm income (excluding rent) + rental income.

Consumption of fixed capital (CFC) is a measure of depreciation of the capital stock. It is the decrease in capital stock because of wear and tear during the production of goods and services. This is also the amount to be spent on replacing the depreciated stock and adding new capital stock. In other words, gross surplus is the sum of profit plus CFC.

Personal income measures the consumers’ ability to make purchases.

Personal income = Compensation of employees + Net mixed income from unincorporated businesses + Net property income

Personal Income = National Income – Indirect business taxes – Corporate income taxes – Undistributed corporate profits (retained earnings) +    Transfer payments (ex: unemployment benefits paid by governments to households)

Household disposable income (HDI) = Household primary income – Net current transfers paid.

Household net saving = HDI – Household final consumption expenditures + Net change in pension entitlements.

Example

What is the GDP and Net domestic income given the following data for 2019?

Account Name Amount
Consumption 300
Statistical discrepancy 10
CFC 30
Government spending on final goods and services for both current consumption and investment in capital goods i.e. GC + GI = G 76
Imports 34
Gross private domestic investment 80
Exports 30

Solution:

GDP for 2019 based on expenditure approach = (C + GC) + (I + GI) + (XM) = = C + G + I + (X-M) = 300 + 76 + 80 + (30 – 34) = 452

GDP based on Income Approach = GDP = Gross domestic income (GDI) = Net domestic income + Consumption of fixed capital (CFC) + Statistical discrepancy

Net domestic income for 2019 = GDP – CFC – Statistical discrepancy = 452 – 30 – 10 = 412

 


Economics Aggregate Output, Prices, and Economic Growth Part 2