Level 1 CFA® Exam:
Gross Domestic Product
Gross Domestic Product - Intro for Level 1 CFA Candidatesstar content check off when done
In this lesson, we will define Gross Domestic Product (GDP) and discuss aggregate output, aggregate income, and aggregate expenditure.
Let’s start with some definitions.
Aggregate output is the value of all goods and services produced in an economy.
Aggregate income is the value of income earned by suppliers of factors of production in an economy.
aggregate output = aggregate income
Aggregate expenditure is the value of money spent on goods and services produced in an economy.
If we assume that there is no import or export of goods in an economy, the aggregate expenditure will be equal to both the aggregate output and the aggregate income.
Gross Domestic Product (GDP) is:
- a measure of the volume of the goods and services produced in a specified period of time by production factors located in a country, irrespective of who owns the factors of production.
- the most popular measure of the size of an economy. It only takes into consideration the purchases of newly produced goods and services. GDP does not include such components as the re-sale of products manufactured in preceding periods or transfer payments from the government.
Nominal GDP vs Real GDP
In your exam, you should be able to distinguish between nominal GDP and real GDP. Perhaps you have already watched the Quantitative Methods videos, where we said that the nominal interest rate is equal to the sum of the real interest rate and inflation premium. In the case of nominal and real GDP, the idea is very similar.
Nominal GDP is measured using current prices, that is prices from the period in which the income making up GDP was earned:
Real GDP equals nominal GDP times 100 divided by GDP deflator. So, the GDP deflator equals nominal GDP divided by real GDP times 100.
Nominal GDP is equal to USD 540 million, and GDP deflator amounts to 114 in a given year. What is the value of real GDP?
Real GDP equals nominal GDP times 100 divided by GDP deflator equals USD 540 million times 100 divided by 114, which gives us USD 473.68 million.
Note: If there is inflation in an economy, real GDP is lower than nominal GDP. What is more, the greater the inflation the greater the difference between nominal GDP and real GDP.
Calculating GDP for Level 1 CFA Examstar content check off when done
There are two main approaches to calculating GDP:
- the income approach, and
- the expenditure approach.
In the income approach, GDP is calculated as the total income generated by households and businesses in a country in a specified period of time. In other words, GDP is the sum of amounts earned by production factors.
In the income approach, GDP is calculated using the following formulas that you can use in your level 1 CFA exam:
National income is the total income received by all factors of production. It includes workers' compensation, enterprise profits before taxes, and indirect taxes.
Consumption of fixed capital:
- is a measure of the depreciation of capital stock in a specified time period,
- determines the value of investments necessary to replace the existing capital stock in order to maintain the level of productivity of the capital.
Statistical discrepancies are a consequence of differences in the sources of data used as the basis of calculating GDP in the two approaches.
Expenditure Approachstar content check off when done
According to the expenditure approach, GDP is equal to the total spending on final output.
There are 2 methods of computing GDP using the expenditure approach:
- sum of value added method, and
- value of final output method.
Value added method:
The value added is defined as the difference between an enterprise's receipts from the sale of products and its expenditure on any intermediate goods manufactured by other businesses.
In other words, as the name 'value added method' suggests, it's a measure of how much a business adds to a product at each stage of the production process.
According to the sum of value added method, GDP is equal to the sum of value added in all sectors of an economy.
Value of final output method:
Of course, instead of computing all value added for all products, we can focus only on the value of final products.
According to the value of final output method, we pay attention only to the sum of the total value of the final goods or services.
Note 1: Both methods should give us the same amount of GDP.
Note: 2: Because total expenditure and total income for the entire economy should be equal, GDP calculated with the aid of the 2 approaches we discussed above, namely the income approach and the expenditure approach, should be the same.
CFA Exam: Differences Between National Income, Personal Income, & Disposable Incomestar content check off when done
National income = compensations of employees + profits before taxes + rent + interest income + indirect taxes that are included in the final price - subsidies.
One component of the national income is personal income, which is a measure of the income of households before taxes. The difference between personal income and national income is that personal income includes all the sources of income of households (including transfer payments, such as unemployment benefits) and excludes corporate taxes and corporate income.
Therefore, personal income = national income + transfer payments - corporate income taxes - indirect business taxes - undistributed corporate profits
Finally, personal disposable income is personal income less taxes, so it's a measure of how much money that can be either consumed or saved is actually at households’ disposal:
Level 1 CFA Exam Takeaways: Gross Domestic Productstar content check off when done
- Aggregate output is the value of all goods and services produced in an economy.
- Aggregate income is the value of income earned by suppliers of factors of production in an economy.
- Aggregate expenditure is the value of money spent on goods and services produced in an economy.
- Gross Domestic Product (GDP) is a measure of the volume of the goods and services produced in a specified period of time by production factors located in a country, irrespective of who owns the factors of production.
- Nominal GDP is measured using current prices and real GDP is measured using constant prices.
- There are two main approaches to calculating GDP: the income approach and the expenditure approach.
- There are 2 methods of computing GDP using the expenditure approach: the sum of value added method and the value of final output method.
- Personal disposable income is personal income less taxes.