National Income Accounting

1. National Income Accounting Principles of Macroeconomics Professor Dalton ECON 201 Boise State University

2. National Income Accounting • 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. • National income accounting is a way of measuring total, or aggregate production.

3. The National Income Accounting Identity • The equality of output and income is an accounting identity in the national income accounts. • The identity can be seen in the circular flow of income in an economy: for an economy as a whole, income must equal expenditure. • Supply and demand determine the market equilibrium price and quantity that is produced and exchanged in each market.

4. The Circular-Flow Diagram Product Markets $ $ Businesses Households $ $ Factor Markets

5. The Circular-Flow Diagram Product Markets $ $ Businesses Households $ $ Factor Markets

6. The Economy’s Income and Expenditure • A measure of the income and expenditures of an economy is Gross Domestic Product (GDP). • Gross Domestic Product measures: • an economy’s total expenditure on newly produced goods and services or the total income earned from the production of these goods and services.

7. Gross Domestic Product • The total market value of all final goods and services produced during a given period of time within a country.

8. Gross National Product • The total market value of all final goods and services produced during a given period of time by a nation’s residents, regardless of the place produced.

9. Measuring Output • GDP is output produced within a country’s borders, while GNP is output produced by a country’s citizens. • The difference between GDP and GNP is net foreign factor income (GNP = GDP + NFFI). • Net foreign factor income = income from foreign sources of domestic factors minus income from domestic sources of foreign factors (foreign income of our citizens minus income earned in U.S. by non-citizens).

10. GDP v. Wealth • GDP is a flow – a quantity during a certain time period; reported quarterly on an annualized basis. • Wealth is a stock – a quantity measured at a point in time. • Wealth accounts – balance sheet of an economy’s stocks of assets and liabilities.

11. Important Features of GDP • Output is valued at market determined prices; Output is measured in dollar terms. • GDP records only the output of finalgoods. We want to count “production” only once.

12. What Is and What Is Not Counted in GDP? • GDP includes all items produced in the economy and sold legally in markets. • GDP does not include items produced and consumed at home and never enter the marketplace. • GDP does not include items produced and sold illicitly, such as illegal drugs.

13. GDP Measures Final Output • GDP does not measure total transactions in the economy. • It counts final output but not intermediate goods. • Counting the sale of final goods and intermediate products would result in double and triple counting.

14. Calculating GDP • Calculating GDP: • All goods and services produced by an economy must be weighted; each good and service is multiplied by its price. Once quantities of a particular good or service are multiplied by its price, we arrive at a value measure of the good or service. All the units of value are added to arrive at GDP.

15. Calculating GDP: Examples • Selling a stock or bond does not add to GDP; The stock broker's commission from the sales does add to GDP. • Social security payments, welfare payments, and veterans' benefits are not included in GDP; Only the cost of transferring is included in GDP. • The work of unpaid house-spouses does not appear in GDP calculations; GDP only measures market activities so unpaid value added is not included in GDP.

16. Two Methods of Computing An Economy’s Income • Expenditure Approach: • Sum the total expenditures by households (from the top portion of the circular flow). • Income Approach: • Sum the total wages and profit paid by firms for resources (from the bottom portion of the circular flow).

17. The Circular-Flow Diagram Product Markets $ $ Businesses Households $ $ Factor Markets

18. The Expenditure Approach • The expenditure approach measures the expenditures in product markets. • GDP is equal to the sum of the four categories of expenditures. GDP = C + I + G + (X - M)

19. Components of GDP • Consumption (C) : • Is the spending by on goods and services • e.g. buying clothing, food, movie tickets • Investment (I) : • Is the purchases of capital equipment and structures • e.g. factories, houses, etc.

20. Consumption • When individuals receive income, they can spend it on domestic goods, save it, pay taxes, or buy foreign goods. • Personal consumption expenditures – payments by households for goods and services. • Consumption is the largest and most important of the flows. • It is also the most obvious way in which income received is returned to firms.

21. Investment • The portion of income that individuals save leaves the income stream and goes into financial markets; in financial markets, businesses acquire resources for investment. • Gross private investment – business spending on equipment, structures, and inventories. • Depreciation– the decrease in an asset's value due to it wearing out. • Net private investment– gross private investment minus depreciation.

22. Components of GDP • Government Purchases (G) : • Includes spending on goods and services by local, state and federal governments (e.g. roads, police, etc.). • Does not include transfer payments. • Net Exports (NX) or (X – M ): • Exports minus imports.

23. Government • Taxes are either spent by government on goods and services or are returned to individuals in the form of transfer payments. • Government consumption expenditures and gross investment – government payments for goods and services or investment in equipment and structures. • If the government runs a deficit, it must borrow from financial markets to make up the difference, competing with businesses for saving of households.

24. Net Exports • Spending on imports are subtracted from total expenditures because spending on imports “leaks from the system” and does not add to domestic production. • Exports to foreign nations are added to total expenditures because spending on exports is “injected into the system” and adds to domestic production. • These two flows are usually combined into net exports.

25. GDP by Expenditures Consumption $8,282.5 Investment $1,947.0 Government Purchases $2,197.2 Plus Exports $1,189.5 Minus Imports $1,801.2 GDP $11,814.9 2004:3 Current Dollar GDP (Billions) For updated information, contact FRED or the Bureau of Economic Analysis.

26. The Relative Sizeof GDP Components Net Exports -5.2% Government Purchases 18.6% Investment 16.5% Consumption 70.1% 2004:3 GDP

27. The Income Approach • The income approach measures the factor payments by businesses in factor markets. • National income (NI) is the total income earned by households; employee compensation, rent, interest, and profits. GDP = w + r + i + π

28. The Circular-Flow Diagram Product Markets $ $ Businesses Households $ $ Factor Markets

29. Components of National Income • Employee compensation (w) consists of payments for labor such as salaries and wages. • Rent (r) consists of payments for use of land and buildings. • Interest (i) includes payments for loans by households to firms. • Profits (π) are payments to the owners of firms.

30. Components of National Income Actual national income accounts are: Compensation of Employees Proprietor’s Income Rental Income Corporate Profits Net Interest and miscellaneous

31. Expenditure = Income • Income and expenditures must be equal because of the rules of double-entry bookkeeping. Profit is the balancing item. • To go from GDP to national income: • GDP + net foreign factor income = GNP • GNP – minus depreciation – indirect business taxes = National Income

32. Net foreign factor income Depreciation Net exports Indirect business taxes Government expenditures Rents Interest Investment Profits GNP GDP National Income Consumption Employee compensation Expenditure = Income (1) Expenditures (2) Output (3) Income = =

33. GDP by Incomes(and adjustments) Wages & Salaries $ 6,657.4 Rent $ 153.8 Interest $ 546.7 Profits & Proprietor’s Income $ 2,020.9 = National Income $ 9,378.8 Plus Depreciation $ 1,497.9 Plus Indirect Business Taxes $ 885.9 Minus Net Foreign Factor Income $ 38.2 (Plus Statistical Discrepancy) $ 90.4 = GDP $ 11,814.9 2004:3 Current Dollar GDP (Billions) For updated information, contact FRED or the Bureau of Economic Analysis.

34. Relative Size of National Income Components Corporate Profits = 11.9% Net Interest = 5.8% Rental Income = 1.6% Proprietors’ Income = 9.6% Wages and Salaries = 71.0% 2004:3 GDP

35. Real versus Nominal GDP • GDP is the market value of the economy’s current production, referred to as Nominal GDP. • Real GDP measures any given year’s total output in “constant” prices. • An accurate view of the economy requires adjusting nominal to real GDP, using the GDP Price Deflator.

36. GDP Price Deflator • The GDP Price Deflator is a price index that uses a bundle of all final goods and services. • The GDP Price Deflator tells us the rise in nominal GDP that is attributable to a rise in prices.

37. Real and Nominal GDP • Real GDP is arrived at by dividing nominal GDP by the GDP deflator. Real GDP = Nominal GDP x 100 GDP Deflator

38. Real and Nominal GDP 1998 2004 Price Quantity $ Value Price Quantity $ Value CD’s $15 1,000 $15,000 $30 1,300 $39,000 Tapes $5 2,000 $10,000 $10 2,600 $26,000 Nominal GDP $25,000 $65,000

39. Real and Nominal GDP 1998 2004 Price Quantity $ Value Price Quantity $ Value CD’s $15 1,000 $15,000 $30$15 1,300 $39,000$19,500 Tapes $5 2,000 $10,000 $10$5 2,600 $26,000$13,000 Nominal GDP $25,000 $65,000$32,500

40. Limitations of National Income Accounting • Limitations of national income accounting include the following: • Measurement problems exist. • GDP measures economic activity, not welfare. • Subcategories are often interdependent.

41. GDP and Well-Being • GDP per person(GDP per capita) tells us the income of the average person in the economy. • It is a good measure of the material well-being of the economy as a whole. • More real GDP means being able to consume more goods and services. • It is not intended to be a measure of happiness or quality of life.

42. GDP and Well-Being • Some factors and issues not in GDP that lead to the “well-being” of the economy: • Factors that contribute to a good life such as leisure. • Factors that lead to a quality environment. • The value of almost all activity that takes place outside of organized markets, e.g. volunteer work and child-rearing.

43. GDP Measures Market Activity • GDP does not measure happiness, nor does it measure economic welfare. • Welfare is a complicated idea, very difficult to measure.

44. Measurement Errors • GDP figures leave out the following: • Illegal drug sales. • Under-the-counter sales of goods to avoid income and sales taxes. • Work performed and paid for in cash. • Unreported sales. • Prostitution, loan sharking, extortion, and other illegal activities.

45. Measurement Errors • A second type of measurement error occurs in adjusting GDP for inflation. • If the price and the quality of a product go up together, has the price really gone up? • Is it possible to measure the value of quality increases?

46. Other Measures of Income • Net domestic product (NDP ) • GDP minus depreciation (capital consumption adjustment). • Net National Product (NNP) • GNP minus depreciation.

47. Other Measures of Income • Personal income (PI) • national income plus net transfer payments from government minus amounts attributed but not received. PI = NI + Transfer payments from government + Net non-business interest income – Corporate retained earnings – Social security taxes

48. Other Measures of Income • Disposable personal income (DPI) • personal income minus personal income taxes and payroll taxes. • Disposable personal income is what people have readily available to spend. DPI = PI - Personal taxes