NATIONAL INCOME ACCOUNTING CHAPTER 12 NATIONAL INCOME ACCOUNTING 2nd Semester, S.Y 2013 – 2014

National Income Accounting National income accounting is a framework that summarizes and categorizes productive activity in an economy over a period of time. GDP GNP GDP Per Capita National Income PCI PCI refers to income per head. PCI is obtained by dividing the national income by the number of population.

GDP: An Economic Barometer What exactly is GDP? How do we use it to tell us whether our economy is in a recession or how rapidly our economy is expanding? And how do we compare economic well-being across countries? How do we take the effects of inflation out of GDP to compare economic well-being over time?

What is gross domestic product (GDP)? Currency value (such as Philippine peso) of all final goods and services produced within a country in a given period Total income of a nation Measure of nation’s economic well-being Measure of a nation’s economic growth from one period to the next.

Gross Domestic Product GDP or gross domestic product is the market value of all final goods and services produced within a country in a given time period. This definition has four parts: Market value Final goods and services Produced within a country In a given time period

Gross Domestic Product Market value GDP is a market value—goods and services are valued at their market prices. To add apples and oranges, computers and popcorn, we add the market values so we have a total value of output in pesos.

Gross Domestic Product Final goods and services GDP is the value of the final goods and services produced. A final good (or service) is an item bought by its final user during a specified time period. A final good contrasts with an intermediate good, which is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service. Excluding intermediate goods and services avoids double counting.

Let’s Check Your Understanding Which of the following are final goods or services, and which are intermediate goods or services? A new automobile An oil filter purchased in a new automobile Banking services Gasoline A processor chip inside the tablet A bread flour

Gross Domestic Product Produced within a country GDP measures production within a country—domestic production.

GDP versus GNP Gross Domestic Product is the total market value of all final goods and services produced in a country in a given time period. Gross National Product is the total market value of all final goods and services produced by the citizens of a country in a given time period. GNP equals GDP plus net factor income received from or paid to other countries. A country’s gross national product, or GNP, is the market value of all the final goods and services produced anywhere in the world in a given time period by the factors of production supplied by the residents of that country. For example, Nike’s income from the capital that it supplies to its Vietnam shoe factory is part of U.S. GNP but not part of U.S. GDP. It is part of Vietnam’s GDP. Similarly, Toyota’s income on the capital it supplies to its Kentucky auto plant is part of U.S. GDP but not part of U.S. GNP. It is part of Japan’s GNP. GNP equals GDP plus net factor income received from or paid to other countries. The difference between U.S. GDP and GNP is small. But in an oil-rich Middle Eastern country such as Bahrain, where a large amount of capital is owned by foreigners, GNP is much smaller than GDP; and in a poor country such as Bangladesh, whose people work abroad and send income home, GNP is much larger than GDP

Gross Domestic Product In a given time period GDP measures production during a specific time period, normally a year or a quarter of a year.

𝐺𝐷𝑃=𝐶+𝐼+𝐺+(𝑋−𝑀) What’s included in GDP? Consumption expenditure Investment Government expenditure on goods and services Exports of goods and services Imports of goods and services Four groups buy the final goods and services produced: households, firms, governments, and the rest of the world. Four types of expenditure correspond to these groups:

What’s included in GDP? Consumption expenditure is the spending by households on consumption goods and services. Investment is the purchase of new capital goods (tools, instruments, machines, and buildings) and additions to inventories. Government expenditure on goods and services is expenditure by all levels government on goods and services. Net exports of goods and services is the value of exports of goods and services minus the value of imports of goods and services. Four groups buy the final goods and services produced: households, firms, governments, and the rest of the world. Four types of expenditure correspond to these groups:

Consumption Expenditure Consumption expenditure is the spending by households on consumption goods and services. Goods: groceries, clothes, gadgets Services: haircuts, oil changes Consumption (C) is the expenditure by households on consumption goods and services. It includes durables (goods lasting three or more years), nondurables, and services.

Investment by businesses and households What’s included in GDP? Investment by businesses and households Fixed assets for production New homes Inventories Investment (I) is the purchase of new capital goods (tools, instruments, machines, buildings, and other constructions) and additions to inventories. In other words, it is spending by firms, including final purchases on machinery, equipment and tools, all construction of new houses, buildings, and apartments, and additions to inventory.

Government expenditures by local and national government What’s included in GDP? Government expenditures by local and national government Roads and bridges School buildings Other public services Excluding transfer payments Government purchases of goods and services (G) are purchases of goods and services by all levels of government. It excludes transfer payments (welfare spending and unemployment compensation) because those payments do not represent new products or services; rather, they are transfers of income.

What’s included in GDP? Net exports the value of exports of goods and services minus the value of imports of goods and s Net exports of goods and services (X-IM or NX) is the value of exports of goods and services minus the value of imports of goods and services. In the United States, it is the value by which American spending on foreign goods and services exceeds foreign spending on American goods and services.

What are not included in GDP? Intermediate goods Used goods or Second-hand Sales Underground production (black market) Financial transactions Household production and consumption Transfer payments Intermediate goods. Only the final goods and services purchased for final use and not for resale or further processing and manufacturing are included in GDP. Intermediate goods are not counted in GDP. Intermediate goods are goods and services that are used for further processing and manufacturing or resale, for example, the lead that will eventually go in a pencil. This process avoids double-counting and therefore exaggerating GDP. Goods produced but not sold do go into GDP in the form of inventory investment. After that, they are not included in the GDP of the year in which they are sold. Second-hand sales/used goods. Expenditure on used goods is not part of GDP because these goods were part of GDP in the period in which they were produced and during which time they were new goods. Buying a house that is not new is not part of GDP. Also, bartered goods are not included in GDP. The black market/underground production. Illegal drugs, illegal goods, and illegal services in the underground economy are not part of GDP. The hidden part of the economy in which people trade in illegal goods and services and try to avoid taxes and regulations cannot be correctly ascertained. Financial transactions. When households buy financial assets such as bonds and stocks, they are making loans, not buying goods and services. Nothing new has been produced. Transfer payments. Transfer payments are payments from the government, including education grants, Social Security payments, welfare checks, and unemployment checks. They do alter household income, but they do not reflect the economy’s production.

What GDP does not tell us? Does not measure income distribution Does not measure non-monetary output or transactions (e.g., barter, household activities) Does not take into account desirable externalities, such as leisure or environment Does not measure social well-being Correlates to standard of living but is not a measure of standard of living

Real and nominal GDP When GDP is computed in the current year’s prices, rising prices (inflation) can make it difficult to determine if a change in GDP from one year to the next is due to the country’s production of more goods and services or to increases in the price level. Nominal GDP: GDP that is not adjusted for inflation. This reflects the current value of goods and services in current prices. Thus, it ignores the effect of inflation on the growth of GDP. Real GDP: measures the value of goods and services adjusted for change in the price level. It reflects the real change in output. This measure is called constant or adjusted GDP or constant money GDP. Nominal GDP is GDP at current price Real GDP is GDP adjusted for inflation.

Calculation of Nominal GDP Year Quantity Price Nominal GDP Good A 1,000 850 850,000 Good B 2,000 1,750 3,500,000 Good C 1,500 25,800 38,700,000 Good D 4,000 350 1,400,000 Good E 2,500 755 1,887,500 Good F 1,800 475 855,000 TOTAL 47,192,500 Price Index a normalized average (typically a weighted average) of prices for a given class of goods or services in a given region, during a given interval of time. It is a statistic designed to help to compare how these prices, taken as a whole, differ between time periods or geographical locations. 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃=𝑃𝑟𝑖𝑐𝑒 𝑥 𝑂𝑢𝑡𝑝𝑢𝑡

Calculation of Real GDP Year Quantity (Aggregate Output) Price Nominal GDP Price Index Real GDP 2009 1,000 50 50,000 33 1,500 2010 100 100,000 67 2011 150 150,000 2012 200 200,000 133 2013 250 250,000 167 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃= 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥 𝑃𝐼 = 𝑃𝑟𝑖𝑐𝑒 𝑖𝑛 𝑎 𝑔𝑖𝑣𝑒𝑛 𝑦𝑒𝑎𝑟 𝐵𝑎𝑠𝑒𝑑 𝑦𝑒𝑎𝑟 Price Index a normalized average (typically a weighted average) of prices for a given class of goods or services in a given region, during a given interval of time. It is a statistic designed to help to compare how these prices, taken as a whole, differ between time periods or geographical locations. *Base Year is 2011

GDP Deflator GDP deflator (implicit price deflator for GDP) is a measure of the level of prices of all new, domestically produced, final goods and services in an economy. It helps to adjust the Nominal GDP to a Real GDP figure 𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟= 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑥100 helps to adjust the Nominal GDP to a Real GDP figure. Measurement in national accounts In most systems of national accounts the GDP deflator measures the ratio of nominal (or current-price) GDP to the real (or chain volume) measure of GDP. The formula used to calculate the deflator is: Dividing the nominal GDP by the GDP deflator and multiplying it by 100 would then give the figure for real GDP, hence deflating the nominal GDP into a real measure.[1] It is often useful to consider implicit price deflators for certain subcategories of GDP, such as computer hardware. In this case, it is useful to think of the price deflator as the ratio of the current-year price of a good to its price in some base year. The price in the base year is normalized to 100. For example, for computer hardware, we could define a "unit" to be a computer with a specific level of processing power, memory, hard drive space and so on. A price deflator of 200 means that the current-year price of this computing power is twice its base-year price - price inflation. A price deflator of 50 means that the current-year price is half the base year price - price deflation. This can lead to a situation where official statistics reflect a drop in prices, even though they have stayed the same. Consider the example of the computer. From year to year, assume that the price of a new computer stays the same, but the computing power doubles. This would result in a price deflator of 50, though the consumer would have to spend the same amount of money on both systems. Unlike some price indexes (like the CPI), the GDP deflator is not based on a fixed basket of goods and services. The basket is allowed to change with people's consumption and investment patterns.[2] (Specifically, for GDP, the "basket" in each year is the set of all goods that were produced domestically, weighted by the market value of the total consumption of each good.) Therefore, new expenditure patterns are allowed to show up in the deflator as people respond to changing prices. The theory behind this approach is that the GDP deflator reflects up to date expenditure patterns. For instance, if the price of chicken increases relative to the price of beef, it is claimed that people will likely spend more money on beef as a substitute for chicken.

GDP and the Circular Flow of Expenditure and Income GDP measures the value of production, which also equals total expenditure on final goods and total income. The equality of income and output shows the link between productivity and living standards. The circular flow diagram illustrates the equality of income, expenditure, and the value of production.

Approaches in GDP Calculation Expenditure Approach Production Approach Income Approach

Expenditure Approach The expenditure approach adds all the expenditures of the end-users of the output produced in a given year. It divides GDP into four areas: households (consumption), businesses (investment), government, and foreigners (net exports).

What are the components of GDP? Personal Consumption Expenditures (C) Investment (I) Government (G) Net Exports (X-M) Fixed Investment Inventories Exports Imports Expenditures on final goods and services are divided into four types: consumption, investment, government purchases, and net exports (exports – imports) of goods and services. Nonresidential Residential GDP = C + I + G + (X-M)

How much of GDP is each component? Component % of GDP Government 19% Investment 16% Consumption (PCE) 70 % The chart shows the average percent of GDP for each component of GDP. Consumption is the highest proportion of GDP, at 70%. Government spending accounts for 19% of GDP on average, and investment, 16%. Net exports have averaged -5%. Since imports have exceeded exports, net exports has been a drag on GDP. Changes to components of real GDP will change the overall level of real GDP. Net Exports -5% GDP 100%

Production Approach The production approach looks at GDP from the standpoint of value added by each input in the production process.

Income Approach The income approach divides GDP according to who receives the income from the spending flow. In addition to aggregate income, national income and personal income are also used as measures of income.

Expenditure and Income Approach GDP Amount (Billion Pesos) Corporate profits 305 Consumption of fixed capital or Depreciation 479 Gross private domestic investment 716 Personal taxes 565 Personal saving 120 Government expenditures 924 Imports 547 Net interest 337 Compensation of employees 2,628 Rental income 19 Exports 427 Personal consumption expenditure 2,966 Indirect business taxes 370 Contributions for social security 394 Transfer payments 543 Proprietor's income 328 Suppose the following are data for a given year from the annual report of NEDA. Calculate GDP using the expenditure approach and income approach

Expenditure and Income Approach   Expenditure Approach 𝐺𝐷𝑃=𝐶+𝐼+𝐺+(𝑋−𝑀) =2,966+716+924+ (427−547) =4,486 Income Approach GDP=𝑐𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠+𝑟𝑒𝑛𝑡𝑠+𝑝𝑟𝑜𝑓𝑖𝑡𝑠+ 𝑛𝑒𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡+𝑖𝑛𝑑𝑖𝑟𝑒𝑐𝑡 𝑡𝑎𝑥𝑒𝑠+𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =2,628+19+653+337+370+479 =4486

Amount (Billion Pesos) National Income GDP Amount (Billion Pesos) Corporate profits 305 Consumption of fixed capital or Depreciation 479 Gross private domestic investment 716 Personal taxes 565 Personal saving 120 Government expenditures 924 Imports 547 Net interest 337 Compensation of employees 2,029 Rental income 19 Exports 427 Personal consumption expenditure 2,966 Indirect business taxes 370 Contributions for social security 394 Transfer payments 543 Proprietor's income 328 Using the data in no. 8, compute the national income (NI) by making the required subtraction from GDP. Explain why NI might be a better measure of economic performance than GDP.

National Income 𝑵𝑰=𝑮𝑫𝑷−𝑫𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 𝑁𝐼=4,486−479 𝑁𝐼=4,007

Personal Income and Disposable Income GDP Amount (Billion Pesos) Corporate profits 305 Consumption of fixed capital or Depreciation 479 Gross private domestic investment 716 Personal taxes 565 Personal saving 120 Government expenditures 924 Imports 547 Net interest 337 Compensation of employees 2,029 Rental income 19 Exports 427 Personal consumption expenditure 2,966 Indirect business taxes 370 Contributions for social security 394 Transfer payments 543 Proprietor's income 328 Again using the data in no. 8, derive personal income (PI) from national income (NI). Then make the necessary adjustments to PI to obtain disposable income (DI).  

Personal Income and Disposable Income Personal income (PI) Personal Income (PI) =𝑁𝐼−𝑃𝑟𝑜𝑓𝑖𝑡𝑠− 𝐶𝑜𝑛𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛𝑠 𝑓𝑜𝑟 𝑆𝑜𝑐𝑖𝑎𝑙 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑦+𝑇𝑟𝑎𝑛𝑠𝑓𝑒𝑟 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑃𝐼=4,007−633−394+543 𝑃𝐼=3,523 Disposable income (DI)   𝐷𝐼=𝑃𝐼−𝑃𝑒𝑟𝑠𝑜𝑛𝑎𝑙 𝑡𝑎𝑥𝑒𝑠 𝐷𝐼=3,523−565 𝑃𝐼=2,958