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

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.

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.

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

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

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.

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

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.

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).

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.

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

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.

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.

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.

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.

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).

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

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)

Components of GDP Consumption (C) : Investment (I) : 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.

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.

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.

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.

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.

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.

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. Imports must be subtracted because they were counted among the goods and services purchased here, but they weren’t produced here.

The Relative Size of GDP Components Net Exports -5.2% Government Purchases 18.6% Investment 16.5% Consumption 70.1% 2004:3 GDP

The Income Approach GDP = w + r + i + π 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

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

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.

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

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

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

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. Imports must be subtracted because they were counted among the goods and services purchased here, but they weren’t produced here.

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

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.

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.

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

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

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

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.

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.

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.

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

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.

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?

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

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

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