By N. Gregory Mankiw
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Extra info for Macroeconomics and the Financial System
Let’s ﬁrst suppose that the bread spoils. In this case, the ﬁrm has paid more in wages but has not received any additional revenue, so the ﬁrm’s proﬁt is reduced by the amount that wages have increased. Total expenditure in the economy hasn’t changed because no one buys the bread. Total income hasn’t changed either—although more is distributed as wages and less as proﬁt. Because the transaction affects neither expenditure nor income, it does not alter GDP. Now suppose, instead, that the bread is put into inventory to be sold later.
How does this transaction affect GDP? The answer depends on what happens to the unsold bread. Let’s ﬁrst suppose that the bread spoils. In this case, the ﬁrm has paid more in wages but has not received any additional revenue, so the ﬁrm’s proﬁt is reduced by the amount that wages have increased. Total expenditure in the economy hasn’t changed because no one buys the bread. Total income hasn’t changed either—although more is distributed as wages and less as proﬁt. Because the transaction affects neither expenditure nor income, it does not alter GDP.
GDP is the total income from the production of bread, which equals the sum of wages and proﬁt—the top half of the circular ﬂow of dollars. GDP is also the total expenditure on purchases of bread—the bottom half of the circular ﬂow of dollars. To compute GDP, we can look at either the ﬂow of dollars from ﬁrms to households or the ﬂow of dollars from households to ﬁrms. These two ways of computing GDP must be equal because, by the rules of accounting, the expenditure of buyers on products is income to the sellers of those products.