National Income Accounting

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
 Measuring the Economy

 Measurement of aggregate economic activity helps

answer such questions as:

 How much output is being produced? What is it being

used for?
 How much income is being generated?
 What’s happening to prices and wages?
 National Income Accounting

 In the 1930s it was impossible for macroeconomics to

exist in the form we know it today because many
aggregate concepts had not yet been formulated, or
were lacking rigor.
 National Income Accounting

 In the mid-1930s, two Keynesians, Simon

Kuznets and Richard Stone, began to develop
this terminology.
 National Income Accounting

 They developed national income accounting –

a set of rules and definitions for measuring
economic activity in the aggregate economy –
that is, in the economy as a whole.
 For an economy as a whole, income must equal
expenditure because:

 Every transaction has a buyer and a seller.

 Every dollar of spending by some buyer is a

dollar of income for some seller.
The Circular Flow Model of Income and Output
Spending ($) (=GDP) Revenues ($) (=GDP)
Product Markets
Goods and Goods and
Services Services Sold
Purchased

Flows of Goods and Services

Households Firms
Flows of Dollars

Labor, Land, Capital Inputs for

and Entrepreneurship Production

Factor Markets
Income ($) (=GDP) Wages, Rent, Interest
and Profits ($) (=GDP)
Gross Domestic Product (GDP)

 Each good and service produced and brought

to market has a price which serves as a
measure of value for calculating total output
 The Measurement of Output
Last Year’s Output Amount This Year’s Output Amount

In physical terms In physical terms

Oranges 2 billion Oranges 3 billion
Bicycles 2 million Bicycles 4 million

Rock concerts 700 Rock concerts 600

Total: ? Total: ?

In monetary terms In monetary terms

2 billion oranges @ $0.20 each $400 million 3 billion oranges @ $0.20 each $600 million

2 million bicycles @ $50 each 100 million 4 million bicycles @ $50 each 200 million
700 rock concerts @ $1 million each 700 million 600 rock concerts @ $1 million each 600 million

Total: $1200 million Total: $1400 million

It is impossible to add up all output when output is counted in physical terms.

Accordingly, total output is measured in monetary terms, with each good or
service valued at its market price.
 National Income Accounting:
Measuring Economic
Performance
Gross Domestic Product (GDP)

 the value of all final goods and services produced in

a country in a period of time, almost always one
year.

 Only goods and services produced in the current

period are included in this year’s GDP.
 GDP Versus GNP

 Gross National Product (GNP): Output

produced by a nation’s factors of production
no matter where it takes place

 GDP is geographically focused, including only

output produced within a nation’s borders
regardless of whose factors are used
Measuring Total Economic Output of
Goods and Services

 GDP measures the economic activity that

occurs within a country.

 GNP measures the economic activity of the

citizens and businesses of a country.

 Gross National Income (GNI)

Measuring Total Economic Output of
Goods and Services

 Net foreign factor income is added to GDP to create

the GNP.
 Net foreign factor income is the income from
foreign domestic factor sources minus foreign
factor incomes earned domestically.
 In other words, we must add the foreign income of
our citizens and subtract the income of residents
who are not citizens.
 THE MEASUREMENT OF GDP

 “GDP is the Market Value . . .”

 Output is valued at market prices.
 “. . . Of All Final . . .”
 It records only the value of final goods, not
intermediate goods (the value is counted only
once).
 “. . . Goods and Services . . .”
 It includes both tangible goods (food, clothing, cars)
and intangible services (haircuts, housecleaning,
doctor visits).
 THE MEASUREMENT OF GDP

 “. . . Produced . . .”
 It includes goods and services currently produced, not
transactions involving goods produced in the past.

 “ . . . Within a Country . . .”
 It measures the value of production within the geographic
confines of a country.

 “. . . In a Given Period of Time.”

 It measures the value of production that takes place within a
specific interval of time, usually a year or a quarter (three
months).
 Value Added

 The production of most goods and services

involves a series of stages

 To accurately measure GDP we must

distinguish between intermediate goods and
final goods
 Value Added

 Intermediate goods: Goods or services

purchased for use as input in the production
of final goods or services

 Value added: The increase in the market value

of a product that takes place at each stage of
the production process
Value Added Approach Eliminates Double
Counting

Participants Cost of Value of Value Added

Materials Sales
Farmer $ 0 $ 100 $ 100
Cone factory 100 250 150
and ice
cream-maker
Middleperson 250 400 150
Vendor 400 500 100
Totals $ 750 $1,250 $500
 Value Added in Various Stages of
Production
Value of Value
Stages of Production
Transactions Added
1. Farmer grows wheat, sells it to miller $0.12 $0.12

2. Miller converts wheat to flour, sells it to baker 0.28 0.16

3. Baker bakes bagel, sells it to bagel store 0.60 0.32

4. Bagel store sells bagel to consumer 0.75 0.15

Total $1.75 $0.75

The value added at each stage represents a contribution to

total output.
Two Methods of Calculating GDP

 There are two methods of calculating GDP:

the expenditure approach and the income
approach.

 This is because of the national income

accounting identity.
The National Income Accounting
Identity

 Although these methods differ, the resulting

GDP is the same, apart from minor “statistical
discrepancies.”
 The Expenditure Approach to
Measuring GDP

 Economists usually categorize expenditures into four

categories:
 consumption, C
 investment, I
 government purchases, G
 net exports (NX) = exports (X) minus imports (M)
or (X – M).

 Following the expenditure method,

GDP = C + I + G + (X – M)
 Consumption

 When individuals receive income, they

can spend it on domestic goods, save it ,
pay taxes, or buy foreign goods.
 Consumption

 Consumption is the largest and most

important of the flows (expenditures).

 It is also the most obvious way in which

income received is returned to firms.
 The Expenditure Approach to
Measuring GDP
3 categories of consumption spending:

 nondurable goods
-tangible consumer items typically consumed
or used up in a relatively short period of time
 durable consumer goods
-longer-lived consumer goods; the most
important category is consumer vehicles
 services
 The Expenditure Approach to
Measuring GDP

 In boom periods, when GDP is rising rapidly,

expenditures on durables often increase
dramatically.
 In years of stagnant or falling GDP, sales of
durable goods often plummet.
 By contrast, sales of nondurables tend to be
more stable over time because purchases of
such goods are more difficult to shift from
one time period to another.
 The Expenditure Approach to
Measuring GDP

 Services are intangible items of value, as

opposed to physical goods.

 As incomes have risen, service

expenditures have been growing faster
than spending on goods
 Investment

 The portion of income that individuals save

leaves the spending stream and goes into
financial markets.

 Business spending on equipment, structures,

and inventories is counted as part of gross
private investment, together with household
spending on new owner-occupied housing.
 The Expenditure Approach to
Measuring GDP
 Investment, as used by economists, refers to
the creation of capital goods whose purpose is
to produce other goods.

 This definition of investment deviates from the

popular use of that term.

 For instance, purchases of stock are not an

investment as defined by economists (i.e., an
increase in capital goods).
 Investment

 Sooner or later, plant and equipment

wears out.

 This wearing-out process is called

depreciation – the decrease in an asset's
value.
 Investment

 Economists differentiate between total

or gross private domestic investment
and the new investment that is above
and beyond replacement investment.

 Net private investment – gross

private investment less depreciation.
 The Expenditure Approach to
Measuring GDP

three categories of investment purchases :

 business fixed investment,

 inventory investment (changes in
inventories).
 residential investment
 The Expenditure Approach to
Measuring GDP

 Business fixed investments

 sometimes called producer goods,
 include all spending on capital goods that increase
our future production capabilities
 machinery, tools, and factory buildings,

 Inventory investment
 all businesses purchases that add to inventories to
meet customer demands.

 residential construction
 The Expenditure Approach to
Measuring GDP

 In recent years, investment expenditures have

generally been around 15 percent of gross
domestic product.

 Investment spending is the most volatile

category of GDP, however, and tends to
fluctuate considerably with changing business
conditions.
 The Expenditure Approach to
Measuring GDP

 When the economy is booming, investment

purchases tend to increase dramatically.

 In downturns, the reverse happens.

 Government Expenditures

 Government payments for goods and services

or investment in equipment and structures
are referred to as government expenditures.
 Government Expenditures

 There is a connection between the

government and the financial markets.

 If the government runs a deficit, it must

borrow from financial markets to make up the
difference.
 Government Expenditures

 When individuals pay taxes, those taxes are

either spent by government on goods and
services or are returned to individuals in the
form of transfer payments.
 Transfer Payments

 Transfer payments are not included in

government purchases because that
spending does not go to purchase newly
produced goods or services.
 Net Exports

 Spending on foreign goods escapes the

system and does not add to domestic
production, thus spending on imports
are subtracted from total expenditures.
 Net Exports

 Exports to foreign nations are added to total

expenditures.

 These flows are usually combined into net

exports (exports minus imports).
 GDP and NDP

 Net domestic product (NDP) is the sum

of consumption expenditures,
government expenditures, net foreign
expenditures, and investment less
depreciation.

NDP  GDP – depreciation

 GDP and NDP

 NDP is actually preferable to GDP as an

expression of a nation's domestic output.

 Since it is so hard to measure depreciation in

the real world, economists use capital
consumption allowance rather than
depreciation.
 GDP and NDP

The distinction between GDP and NDP

is mirrored in the difference between
gross investment and net investment
 The Income Approach to
Measuring GDP

 The income approach to measuring GDP

involves summing the incomes received by
producers of goods and services.
 The Income Approach to
Measuring GDP

 When someone makes an expenditure for a good or

service, that spending creates income for someone
else.

 Someone receives the money spent, and that receipt

of funds is called income.

 Therefore, by adding up all of the incomes received

by producers of goods and services, we can calculate
the gross domestic product because output creates
income of equal value.
 The Income Approach to
Measuring GDP

 Factor payments include

 Wages, salaries, and certain supplements paid to labor
for the use of labor services,
 Rent and royalties received by property owners who
permit others to use their assets
 Interest as payments for the use of capital goods
 Profits for entrepreneurs who put labor, land, and
capital together.
 Proprietors’ income vs. corporate profits
Indirect Business Taxes
• Taxes levied as a percentage of the prices of goods
sold and therefore become a part of the revenue
received by firms
• These taxes on production and imports do not
represent payment to factors of production

Depreciation
• annual allowances set aside for the replacement of
worn-out plant and equipment
 INCOME APPROACH

Compensation of Employees
+ Proprietors’ Income
+ Rental Income of Persons
+ Corporate Profits
+ Net Interest (interest received – interest paid)
____________________________
NATIONAL INCOME
 INCOME APPROACH

National Income
+ Indirect Business Taxes ( less subsidies)
___________________________________
NET NATIONAL PRODUCT
 Income approach

Net National Product

+ Depreciation
_________________________________
GROSS NATIONAL PRODUCT (GNP)
 INCOME APPROACH

Gross National Product

- Foreign Factor Income Received from the ROW
+ Payments of Factor Income to the ROW
_______________________________________
GROSS DOMESTIC PRODUCT (GDP)
 The Flow of Income

 The dollar value of output will always equal

the dollar value of income
• Total income (GDP) ends up distributed
 To households in the form of disposable
income
 To businesses in the form of retained
earnings and depreciation allowances
 To government in the form of taxes
 Income and Expenditure

 The flow of income that starts with GDP

ultimately returns to the market in the
form of new consumption (C),
investment (I), and government
purchases (G)
Calculating Personal Disposable
Income

 Personal Income measures the total amount of

income received by households and non-
corporate businesses.

 Personal Disposable Income (PDI) is the

personal income available to individuals after
taxes.
Personal Disposable Income

Gross Domestic Product

+ Receipts from ROW
- Payments to ROW
_______________________________
GROSS NATIONAL PRODUCT
Personal Disposable Income

Gross National Product

- Depreciation
______________________________
NET NATIONAL PRODUCT
Personal Disposable Income

Net National Product

- Indirect Taxes (minus Subsidies)
______________________________
NATIONAL INCOME
PERSONAL DISPOSABLE INCOME

National Income
- Corporate Profits (minus Dividends)
- Social Security Payments
+ Personal Interest Income
+ Transfer Payments
_________________________________
PERSONAL INCOME
PERSONAL DISPOSABLE INCOME

Personal Income
- Personal Taxes
- Other Non-Tax Payments
______________________________________
PERSONAL DISPOSABLE INCOME
REAL VERSUS NOMINAL GDP

Nominal GDP values the production of

goods and services at current prices.

Real GDP values the production of goods

and services at constant prices.
REAL vs. NOMINAL GDP
REAL vs. NOMINAL GDP
 REAL vs. NOMINAL GDP

Base year:
The year used for comparative analysis; the basis for indexing
price changes
 GDP DEFLATOR

- a measure of the price level calculated as the

ratio of nominal GDP to real GDP times 100.

 It tells us the rise in nominal GDP that is

attributable to a rise in prices rather than a rise
in the quantities produced.
 GDP DEFLATOR

Nominal GDP
GDP deflator =  100
Real GDP
GDP DEFLATOR
 GDP DEFLATOR

Converting Nominal GDP to Real GDP

Nominal GDP20XX
Real GDP20XX   100
GDP deflator20XX
 Measurement Problems

Methods of calculating GDP entail

measurement problems in accounting for
all economic activity
 Non-Market Activities - Goods and services
produced that are not sold in a market
 Unreported Income - Market activities not
reported to tax or census authorities
Calculating GDP: Some Examples

 Selling your car to a neighbor does not

add to GDP.
 Selling your car to a used car dealer who
sells your car to someone else for a
higher price, does add to GDP.
 The value added is the dealer's services.
Calculating GDP: Some Examples

Selling a stock or bond does not

add to GDP.

The stock broker's commission for

the sales does add to GDP.
Calculating GDP: Some Examples

 Pension payments, welfare payments,

employment insurance benefits, and other
government transfer payments are not
included in GDP.

 The work of unpaid house spouses does not

appear in GDP calculations.
GDP AS A MEASURE OF ECONOMIC WELL-BEING

 GDP is the best single measure of the

economic well-being of a society.

 GDP per capita (GDP per person) tells us the

income and expenditure of the average
person in the economy.
 GDP per Capita

= Total GDP divided by total population;

average GDP

 commonly used as a measure of a country’s

standard of living
 measures of per capita GDP tell us nothing
about how GDP is actually distributed or used
GDP AS A MEASURE OF ECONOMIC WELL-BEING

 Higher GDP per person indicates a

higher standard of living.

 GDP is not a perfect measure of the

happiness or quality of life, however.
 LIMITATIONS OF GDP as a measure

 GDP excludes
 most items that are produced and consumed at
home and that never enter the marketplace.
(underground economy)

 items produced and sold illicitly, such as illegal

drugs.

 the value of a clean environment.

 LIMITATIONS OF GDP as a measure

GDP excludes

 the value of leisure.

 the value of almost all activity that takes place

outside of markets, such as the value of the time
parents spend with their children.

 the value of volunteer work.