National Income Accounting Chapter #2

Introduction Why do we study the national income accounts? 1. Provides formal structure for macroecon theory models 2. Introduces statistics that characterize the economy Output defined in two ways 1. Production side: output = payments to factors workers (wages) & capital (interest, dividends) 2. Demand side: output = purchases by sectors of the economy Typically measured as GDP = value of all final goods and services produced in a country over a given period In 2012 US GDP = $15.7 trillion, population = 315 million, per capita GDP = $15.7 T / 315 M = $49,800

Production Side of the Economy Transforms inputs (labor, capital) into output (GDP) –Inputs = factors of production –Payments to these factors = factor payments The relationship between inputs and outputs defined by the production function  Y = f (N, K) where Y = output, N = labor, K = capital –For example: corn = f (land, labor, seed, machines)

From GDP to Factor Payments Output and income used interchangeably in macro econ  are they really equivalent? Three crucial distinctions between them: 1.Income from domestically owned factors used abroad  GNP = GDP + (dividends, interest & profit)  GNI = GNP – foreign taxes - Honda US profits part of GDP US but GNP JP if send to Japan 2.Capital wears down while being used to production output  NDP = GDP – depreciation (usually 87-89% of GDP) 3.Businesses pay indirect taxes (on sales, property & production) that must be subtracted from NDP before paying factors  Factor payments = NDP – indirect business taxes - Indirect business taxes account for more than 10% of NDP - Factor payments are roughly 80% of U.S. GDP - ¾ of factor payments go to labor

Demand Components: Y 2011 = C+I+G+NX Consumption (70.2%): Purchases of goods (durable & non-durable) & services by households (C/GDP varies by country) Investment (12.3%): Business sector’s ↑ in physical stock of capital (machinery & factories), including inventories (household’s inventories considered consumption, although new home constructions part of I) Government (20.3%): purchases of goods & services (e.g. defense & gov. employees’ salaries). Transfer payments (no current service in exchange) not part of GDP as not part of current production. Government expend = purchases + transfers. Net Exports (-3.8%): foreign purchases of domestic goods (exports) less domestic purchases of foreign goods (imports) (subtract imports from GDP = total demand for domestic production)

Some Identities Assume national income = GDP (income & output used interchangeably) & Output produced = output sold (accumulated inventories part of investment) Simple closed economy w/o public sector, output expressed as: Y ≡ C + I Income consumed or saved: Y ≡ C + S Combine components of demand & allocation of income: C + I ≡ Y ≡ C + S Rearrange: I ≡ Y – C ≡ S Open economy w/ public sector, output expressed as: Y ≡ C + I + G + NX Disposable income YD ≡ Y + TR – TA, consumed or saved Substitute: Y ≡ YD – TR + TA ≡ C + S – TR + TA ≡ C + I + G + NX Subtract C & rearrange: S – I ≡ (G + TR – TA) + NX

S, I, Government Budget, and Trade Excess of private savings over investment equals government budget deficit (gov. expenditures G + TR less gov. income) plus the trade surplus. Any sector that spends more than it receives in income has to borrow. Private sector can dispose of savings in three ways: 1.Make loans to the government 2.Lend to foreigners 3.Lend to firms who use the funds for I

Measuring Gross Domestic Product GDP = value of final goods & services currently produced within a country over a period of time Final (Exclude intermediate goods - tires bought by car manufacturer) Currently (Excludes used goods: Include new, but not sale of existing homes) Within a country (Regardless of producer’s nationality: Include US Hondas) Three major problems (due to omissions) with GDP measure: Non-market goods & services (baby sitting or baking at home) “Bads” (no subtraction from GDP to account for crime & pollution) Quality improvements (current electric light 25 time as efficient as 1 st in 1883)

Nominal vs. Real GDP Change in NGDP (value of output in a given period measured in current dollars) could be due to change in prices Change in RGDP (value of output in a given period measured in constant dollars using based year price) is due to change in production only Inflation is rate of change in prices & price is accumulation of past inflation π ≡ (P t – P t-1 ) / P t-1 = P t / P t-1 – 1&P t = P t-1 + πP t-1 = P t-1 (1 + π)

Price Indexes GDP deflator = ratio of NGDP to RGDP of that year –Widely based price index that is frequently used to measure inflation –Measures prices change between the base year and the current year CPI = cost of fixed basket of goods and services for representative urban consumers Differs from GDP deflator in three ways: 1.Limited basket of goods and services (only household goods and services) 2.Consumer basket in CPI is fixed, while that of the deflator varies 3.CPI includes imports, while deflator only considers goods produced in the US PPI = cost of fixed basket of goods and services for representative firm (raw materials & semi-finished) Uses prices at an earlier distribution stage than CPI & signals changes to come in CPI - closely watched by policymakers

Unemployment The unemployment rate = fraction of the workforce out of work looking for a job or expecting a recall from a layoff (4% low, anything above 9% high) –Important indicator of well-being of an economy/households –Optimal unemployment rates differ from country to country –Optimal unemployment rate linked to the potential level of output for a given economy –Alternative measures: official rate (10% in 09) + discouraged + marginally attached (w/o transportation) + part time for econ reasons (baby sitting vs day care) (17% in 09)

Nominal and Real Interest Rates Interest = payment over & above the principle repayment Nominal % = APR = return on an investment in current dollars Real % = adjusted for inflation Fisher’s Effect: (1 + R) = (1 + r)(1 + π) R = r + π + r π R ≈ r + π Since 1997: TIPS = Treasury inflation protected securities, every coupon PMT adjusted for inflation

Exchange Rate Each country has its currency in which prices are quoted Exchange rate = the price of a foreign currency –Direct Quote: One British pound is worth US $1.53 (Feb. 2013) –Indirect Quote: One US $ buys = 1/1.53 = pounds Appreciation = rate of change in the price of currency Floating exchange rate: determined by supply & demand Fixed exchange rate –Ex. A Bermuda dollar is always worth one U.S. dollar