National-Income Accounting Chapter 5

Chapter Overview Part 2: Measuring Macro Outcomes: 5. National-Income Accounting: 6. Unemployment 7. Inflation

Chapter Overview 5. National-Income Accounting: 1. Measures of Output (Review of GDP, +…). 2. The Uses of Output (Review: GDP = C+I+G+(X-M)). 3. Measures of Income.

Measures of Output (Review of GDP).

Measures of Output National-income accounting: the measurement of aggregate economic activity, particularly national income and its components. These are Macroeconomic measures. Why are economists interested in these measures? …

Gross Domestic Product (GDP) is the total dollar value of final output produced within a nation’s borders in a given time period. LO1

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. LO1

GDP Versus GNP GDP: geographically focused, includes all output produced within a nation’s borders, … regardless of whose factors of production are used to produce it (foreign or domestic). LO1

GNP is dead I say! - It’s over! GDP Versus GNP GNP - Gross National Product : the old standard of measure, refers to output produced by American-owned factors, regardless of location GDP is the new standard of measure since 1992. GNP is dead I say! - It’s over! LO1

International Comparisons The geographic focus of GDP facilitates international comparisons of economic activity. LO1

GDP per Capita REVIEW: GDP per capita: total GDP divided by total population (average GDP). commonly used as a measure of a country’s standard of living.

World GDP per Capita

GDP per Capita However: Measures of per capita GDP tell us nothing about the way GDP is actually distributed or used, It is only a statistical average.

Measurement Problems The methods of calculating GDP create several problems: Non-market activities. Unreported income. Value added (double counting). Price fluctuations (real vs. nominal).

Non-Market Activities

Non-Market Activities GDP measures exclude most goods and services produced that are not sold in the market. This causes GDP to be understated. Exclusion of non-market activities causes problems when: comparing living standards over time, or between countries. LO1

Unreported Income

Unreported Income The GDP statistics fail to capture market activities that are not reported to tax or census authorities. The underground economy is motivated by tax avoidance or to conceal illegal activities. LO1

Value Added

Value Added The production of most goods and services involves a series of stages. To accurately measure GDP we must distinguish between two types of goods: intermediate goods, and… final goods. This avoids what in the accounting field is known as “double counting.” LO1

Value Added in Various Stages of Production (Pg. 91) LO1

Value Added Intermediate goods: Value added: goods or services purchased for use as inputs 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. LO1

Two Ways to Calculate GDP 1. Compute the value of the final output. 2. Count only the value added at each stage of production. LO2

Value added Stages of Production Transaction Value Value Added 1. Logger produces logs for the sawmill: $500 $500 2. Sawmill produces lumber for the furniture factory: $1,200 $700 3. Furniture factory produces furniture for the Store: $5,000 $3,800 4. Store sells furniture to the Public: $7,500 $2,500 Total Value of Transactions: $14,200 $7,500

Real Versus Nominal GDP

Computing Real GDP Inflation: the increase in the average level of prices of goods and services. Inflation distorts comparisons of GDP over time. Nominal vs. Real GDP - accounting for inflation.

Real Versus Nominal GDP the value of final output produced in a given period, measured in the prices of that period (current prices). Real GDP: the value of final output produced in a given period, adjusted for changing prices. ***Why Hidden = Redundant with previous slide as adjusted.

Computing Real GDP A base period is picked to be the time period used for comparative analysis. It is the basis for the indexing of price changes.

Computing Real GDP

Computing Real GDP The general formula for computing real GDP is: (2005 prices)

Computing Real GDP

Computing Real GDP (Pg. 92) Base year Index value = 103.3

Changes in GDP: Nominal Versus Real

Nominal to Real GDP Year GDP Deflator 1997 1998 1999 2000 2001 2002 2003 2004 2005 89 92 96 100 101 104 111 118 126 Nominal GDP (Billions $) 312 397 452 521 537 596 676 719 814 Nom. Change (Billions $) 85 55 69 16 59 80 43 95 Real GDP (Billions $) 351 432 470 521 531 573 609 609 646 Real Change (Billions $) 81 38 51 10 42 36 0 37

Chain-Weighted Price Adjustments Chain-weighted indices use a moving average of price levels in consecutive years as an inflation adjustment. You won’t be tested on chain-weighted indices. LO3

Net Domestic Product (NDP) Now let’s make an ADJUSTMENT to GDP: LO3

Net Domestic Product (NDP) Example situation: You produce You’ve got – $1,000 ↑ Wore out Produced→ $10,000 (GDP) LO3

Net Domestic Product (NDP) We can’t produce as much output next year unless… … we replace the capital we use-up this year. Depreciation: - the consumption of capital in the production process. (the wearing out of plant and equipment). LO3

Net Domestic Product (NDP) GDP: Total output. NDP: Total output after subtracting the value of capital stock used up. LO3

Net Domestic Product (NDP) Depreciation Depreciation GDP GDP NDP Depreciation Depreciation New Capital Stock Old Capital Stock

Net Domestic Product (NDP) Net Domestic Product is what we’ve produced (GDP), minus the capital we’ve worn out (depreciation). The amount of output we (C+G) could consume without reducing our stock of capital. NDP = GDP – depreciation LO3

Net Domestic Product GDP NDP GDP Capital Stock Old Capital Stock Depreciation Depreciation GDP NDP GDP Depreciation Depreciation Capital Stock Old Capital Stock

Gross vs. Net Investment production of new plant, equipment, and structures (capital),… …plus changes in business inventories, …and new residential construction. LO3

Gross vs. Net Investment The difference between GDP and NDP is mirrored by the difference between gross investment and net investment: Gross investment: - total investment expenditure in a given time period. Net investment: = gross investment – depreciation LO3

Net Investment Total capital stock has increased Dep. I G Gross Investment I G The change in our capital stock GDP (positive) NDP Net Investment Gross Investment C Gross Investment Depreciation Depreciation New Capital Stock Old Capital Stock

Total capital stock has decreased Net Investment C G I Gross Investment Depreciation Gross Inv. Total capital stock has decreased G GDP NDP Net Investment C Depreciation Depreciation Depreciation Gross Inv. (negative) Capital Stock

Negative Net Investment The stock of capital — the total collection of plant and equipment — will not grow unless gross investment exceeds depreciation. (***Positive net investment***) LO3

2. The Uses of Output ( Re: C+I+G+(X-M) )

The Uses of Output The 4 major uses of total output parallel the four sets of market participants: Households – consumption (C) = 70% Business Firms – investment (I) = 17% Government – gov’t spending (G) = 20% Foreigners - net exports (X-M) = –7%

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

-New Residential Construction. Investment Investment goods: plant, machinery, equipment. Also includes: net inventory changes, and … -New Residential Construction.

Government Spending Resources purchased by the government sector are unavailable for consumption or investment purposes. Government spending on goods and services (excludes income transfers) claims about one-fifth of our annual output.

Net Exports Net exports are the value of exports minus the value of imports. Exports are goods and services sold to foreign buyers. Imports are goods and services purchased from foreign sources.

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

3. Measures of Income.

Measures of Income GDP accounts have two sides. Expenditures – the demand side. Income – the supply side. LO2

Measures of Income Income = Output …so… Income = GDP By charting the flow of income through the economy, we see FOR WHOM our output is produced. LO2

The Circular Flow (pg. 44) Product Goods and services markets demanded Consumers Business Firms Product markets Factor Goods and services demanded Goods and services supplied Factors of production supplied Factors of production demanded

Income = Output Factor market Product market VALUE OF OUTPUT (Pg. 97) VALUE OF OUTPUT VALUE OF INCOME Factor market Product market Consumer spending Wages Investment spending Profits Taxes Government spending Interest Net exports Rent Depreciation Allowances LO2

The Equivalence of Expenditure and Income (2006 data in billions of dollars) (Pg. 98) LO2

Measures of Income Economists break down the nation’s production into various measures of income: GDP gross domestic product NDP net domestic product NI national income PI personal income DI disposable income C consumption S savings And don’t forget: Net investment = gross investment - depreciation LO2

Depreciation & Net Domestic Product 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 LO3

Depreciation & Net Domestic Product NDP = GDP – depreciation LO3

National Income (NI) National income (NI): total income earned by current, domestically- owned factors of production. Wages, interest, and profits paid to foreigners are not part of U.S. income. They need to be subtracted from the income flow. Incomes earned by U.S. citizens in other nations represents an inflow of income to U.S. households and are added. This + & - is known as net foreign factor income. LO3

National Income (NI) Net foreign factor income = + Foreign wages earned by Americans – American wages paid to foreigners NI = NDP + net foreign factor income LO3

Personal Income (PI) Personal income (PI): the income received by HOUSEHOLDS before payment of personal taxes. Personal income (PI) = National income (NI), – indirect bus. taxes, – corporate taxes, – retained earnings, – Social Security taxes, + transfer payments, + net interest. LO3

Personal Income (PI) Indirect Business Taxes: When goods are sold in the marketplace, their purchase price is typically encumbered with some sort of sales tax. LO3

Personal Income (PI) Corporate taxes and retained earnings: These are taken out of corporate profits, Therefore, they are not received by households. They must be subtracted from national income. Social security taxes are also subtracted. Transfer payments and net interest are added. LO3

Disposable Income Disposable income (DI): the after-tax income of households. It is PI minus personal (income) taxes. It’s what’s left at the end for you and I to spend. Disposable income = personal income – personal taxes LO3

Measures of Income Economists break down the nation’s production into various measures of income: GDP gross domestic product NDP net domestic product NI national income PI personal income DI disposable income LO2

Disposable income = Consumption + Saving All disposable income is either: consumed, or … saved. Saving: disposable income less consumption; (that part of disposable income not spent on current consumption). Disposable income = Consumption + Saving LO3

The Flow of Income, 2006 (Pg. 99) LO3

The Flow of Income

Problem 1 GDP GDP GDP PI DEP? NDP PI GDP GDP PI DI PI PI NI PI

Problem 2 GDP GDP GDP PI DEP? NDP PI GDP GDP PI DI PI PI PI NI

The Flow of Income LO2

The Flow of Income The dollar value of output will always equal the dollar value of income. LO2

The Flow of Income Total income (GDP) ends up distributed in 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. LO2

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). LO2

Circular Flow of Spending and Income (Pg. 101) LO2

Chapter Questions 1. The manuscript for this book was typed by a friend. Had I hired a secretary to do the same job, GDP would have been higher, even though the amount of output would have been identical. Why is this? Does this make sense?

Chapter Questions 2. GDP I 1981 was $2.96 trillion. It grew to $3.07 trillion in 1982, yet the quantity of output actually decreased. How is this possible?

Chapter Questions 3. If gross investment is not large enough to replace the capital that depreciates in a particular year, is net investment greater or less than zero? What happens to our production possibilities?

Chapter Questions 6. What jobs are likely part of the underground economy? 7. How might the quality of life be adversely affected by an increase in GDP?

National-Income Accounting End of Chapter 5