National-Income Accounting Chapter 5

Introduction Measures of output: Help us understand how the economy works or how well (or poorly) it is performing. Provide a useful perspective on the way the economy works.

Measures of Output National-income accounting refers to the measurement of aggregate economic activity, particularly national income and its components.

Gross Domestic Product (GDP) Gross domestic product (GDP) is the total dollar value of final output produced within a nation’s borders in a given time period.

Gross Domestic Product (GDP) Each good and service produced and brought to market has a price. That price serves as a measure of value for calculating total output.

The Measurement of Output

The Measurement of Output

GDP Versus GNP Gross National Product (GNP) refers to output produced by American-owned factors regardless of location. GDP refers to output produced within America’s borders.

GDP Versus GNP GDP is geographically focused, including all output produced within a nation’s borders regardless of whose factors of production are used to produce it.

International Comparisons The geographic focus of GDP facilitates international comparisons of economic activity.

GDP per Capita GDP per capita is total GDP divided by total population–average GDP. GDP per capita is commonly used as a measure of a country’s standard of living.

GDP per Capita People in low per capita GDP countries have little access to telephones, televisions, paved roads, or schools.

GDP per Capita Measures of per capita GDP tell us nothing about the way GDP is actually distributed or used – they are only a statistical average.

Measurement Problems The methods of calculating GDP create a few problems.

Non-Market Activities GDP measures exclude most goods and services produced that are not sold in the market. A homemaker who cleans, washes, gardens, shops and cooks produces goods of value. Because they are not exchanged in the market they are not included in GDP.

Non-Market Activities Exclusion of non-market activities causes problems when comparing living standards over time or between countries.

Unreported Income The GDP statistics fail to capture market activities that are not reported to tax or census authorities.

Unreported Income The underground economy is motivated by tax avoidance or to conceal illegal activities.

Value Added Not all reported market transactions get included at full value in GDP statistics. If it did, the same output would be counted repeatedly.

Value Added The production of most goods and services involves a series of stages. To accurately measure GDP we must distinguish intermediate goods from final goods.

Value Added Intermediate goods are goods or services purchased for use as input in the production of final goods or services.

Value Added Value added is the increase in the market value of a product that takes place at each stage of the production process.

Value Added in Various Stages of Production

Two Ways to Calculate GDP Compute the value of the final output. Count only the value added at each stage of production.

Real Versus Nominal GDP Changes in GDP brought about by changes in the price level can give a distorted view of economic activity.

Real Versus Nominal GDP Distinguishing increases in quantity from increases in prices is done by distinguishing between real GDP and nominal GDP.

Real Versus Nominal GDP Nominal GDP is the value of final output produced in a given period, measured in the prices of that period. Real GDP is the value of final output produced in a given period, adjusted for changing prices.

Real Versus Nominal GDP The distinction between nominal and real GDP is important whenever the price level changes.

Computing Real GDP The base period is the time period used for comparative analysis. It is the basis for the indexing of price changes.

Computing Real GDP The general formula for computing real GDP is:

Computing Real GDP

Computing Real GDP Inflation tends to obscure actual declines in real output. Inflation is the increase in the average level of prices of goods and services.

Changes in GDP: Nominal Versus Real 6000 7000 5000 4000 3000 8000 9000 $10000 1980 1985 1990 1996 1995 2000 GDP (billions of dollars per year) Nominal GDP

Chain-Weighted Price Adjustments Chain-weighted indices use a moving average of price levels in consecutive years as an inflation adjustment.

Net Domestic Product Changes in real GDP tell us how much the economy’s output is growing. Growth is at the expense of future output unless factors of production are replaced.

Net Domestic Product Next year we won’t be able to produce as much output unless we replace factors of production we use this year. The value of capital used up in producing goods and services is called depreciation.

Net Domestic Product Depreciation is the consumption of capital in the production process — the wearing out of plant and equipment.

NDP = GDP – depreciation Net Domestic Product Net domestic product is the amount of output we could consume without reducing our stock of capital. NDP = GDP – depreciation

Net Domestic Product Some of each year’s output must consist of investment goods to maintain our production possibilities.

Net Domestic Product Investment is spending on (production of) new plant, equipment, and structures (capital) in a given time period, plus changes in business inventories.

Net Domestic Product The distinction between GDP and NDP is mirrored in the difference between gross investment and net investment.

Net Domestic Product Gross investment is total investment expenditure in a given time period. Net investment is gross investment less depreciation.

Net Domestic Product The stock of capital — the total collection of plant and equipment — will not grow unless gross investment exceeds depreciation.

The Uses of Output The GDP accounts also tell us what mix of output has been selected, that is, society’s answer to the core issue of WHAT to produce.

The Uses of Output The major uses of total output conform to the four sets of market participants: consumers, business firms, government, and foreigners.

Consumption Goods and services used by households are called consumption goods. Consumer spending claims nearly two-thirds of our annual output.

Investment Investment goods are the plant, machinery, and equipment that we produce. Also includes net inventory changes and new residential construction.

Government Spending Resources purchased by the government sector are unavailable for consumption or investment purposes.

Net Exports Exports are goods and services sold to foreign buyers. Imports are goods and services purchased from foreign sources.

Net Exports We export some goods. This makes GDP larger than the sum of our own consumption, investment, and government purchases.

Net Exports We import some goods and services. These are not calculated as part of America’s GDP because they were not produced within our borders.

Net Exports Exports are added to GDP and imports are subtracted. Net Exports are the value of exports minus the value of imports.

Computing GDP The value of GDP can be computed by adding up expenditures of market participants: GDP = C + I + G + (X – IM) Where: C = Consumption expenditure X = exports I = investment expenditure IM = imports G = government expenditure

Measures of Income GDP accounts have two sides. One side focuses on expenditure – the demand side. The other side focuses on income – the supply side.

Measures of Income The total value of market incomes must equal the total value of final output, or GDP.

Output = Income Factor market Product market VALUE OF INCOME VALUE OF OUTPUT Net exports Consumer spending Investment spending Wages Profits Interest Rent Government spending Sales taxes Depreciation Factor market Product market

The Equivalence of Expenditure and Income

National Income By charting the flow of income through the economy, we see FOR WHOM the output is produced.

NDP = GDP – depreciation Depreciation charges reduce GDP to the level of NDP (Net Domestic Product) before any income is available to current factors of production. NDP = GDP – depreciation

Indirect Business Taxes When goods are sold in the marketplace, their purchase price is typically encumbered with some sort of sales tax.

Net Foreign Factor Income Wages, interest, and profits paid to foreigners are not part of U.S. income. They need to be subtracted from the income flow.

Net Foreign Factor Income Incomes earned by U.S. citizens in other nations represents an inflow of income to U.S. households and are added.

National Income Once depreciation charges and indirect business taxes are subtracted from GDP and net foreign income is added, we have national income.

NI = NDP – indirect business taxes + net foreign factor income National Income National income (NI) is total income earned by current factors of production. NI = NDP – indirect business taxes + net foreign factor income

Personal Income Corporate taxes and retained earnings represent the part of corporate profits not received by households and are subtracted from national income. Social security taxes are also subtracted. Transfer payments and net interest are added.

+ (transfer payments + net interest) Personal Income Personal income (PI) is the income received by households before payment of personal taxes. Personal income = National income – (corporate taxes + retained earnings + Social Security taxes) + (transfer payments + net interest)

Disposable income = personal income – personal taxes Disposable income (DI) is the after-tax income of households. It is personal income less personal taxes. Disposable income = personal income – personal taxes

Disposable income Saving is that part of disposable income not spent on current consumption –disposable income less consumption.

Disposable income = Consumption + Saving All disposable income is either consumed or saved. Disposable income = Consumption + Saving

The Flow of Income

The Flow of Income The dollar value of output will always equal the dollar value of income.

Total income (GDP) ends up distributed the following way: 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.

Circular Flow of Spending and Income 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).

Circular Flow of Spending and Income Factor market PI NDP Net exports Government spending Saving Depreciation Retained earnings Personal taxes Transfer payments Net interest Corporate taxes Social Security taxes Indirect business taxes GDP NI Business Government Households DI Consumption Product market Investment Sales revenue

The Quality of Life Do the GDP accounts – either the expenditure side or the income side – tell us anything we really want to know about the quality of life?

Intangibles Economic measures do not capture the completeness of the way in which we view the world or the totality of what makes our lives satisfying.

Intangibles For example, a clear day, a sense of accomplishment or even a smile can do more for a person’s well-being than movement in the GDP account, but cannot be measured.

Index of Well-Being Researchers at Fordham University have devised an alternative index of well-being called the Index of Social Health.

National-Income Accounting End of Chapter 5