National Income National Income Accounting:Important IdentitiesAccounting:Important Identities

Measuring the Production, Income, and Spending of Nations

National Income Accounts:

•Provide the formal structure for our macro-theory models

Aggregate Demand….aggregate income..consumed or investedAggregate Supply….Total output..paid as wages, interest and dividendsIn equilibrium….Aggregate Demand=Aggregate Supply (growth) Inputs=Outputs Real output price levelBroad magnitudes to characterize the economy

Basic Measures:

•Gross Domestic Product (GDP) is the value of final goods and services produced in the country within a given period

Notable termsfinal goodsIntermediate goods•Value Added•Past output vs. current outputs•Measure of welfare•Use of resources to avoid bads such as crime•Improvement in the qualityin the country

Factors of production….labor, capital, land

GDP= sum of payments to labor, capital, land and profits

˸Gross National Product (GNP)GDP+receipts from abroad made as factor payments to domestically owned factors of production.

•Net Domestic ProductGPP minus depreciation Depreciation is usually 11%NDP=89% of GDP

•National IncomeNDP-Indirect taxes that Business payIndirect taxes that Business pay nearly 10%NI is nearly 90% of NDP

PI is the total income received – whether it is earned or unearned – by the households of the economy before the payment of personal taxes.

It is found by adding transfer payments to and subtracting social security contributions ,corporate income taxes and undistributed corporate profits from the NI.

DI is the total income available to households after the payment of personal taxes. It is equal to PI less personal taxes and also equal to personal consumption expenditures plus personal saving.

GDP in 2003 $million

United States

Japan

Germany

United Kingdom

France

Itlay

China

Spain

Canada

Mexico

10,881,609

4,326,444

2,400,655

1,794,858

1,747,973

1,465,895

1,409,852

836,100

834,390

626,080

GDP:An important and versatile conceptWe will see that GDP measures

§ total income

§ total expenditure

§ total output

§ the sum of value-added at all stagesin the production of final goods

How to measure How to measure GDP?GDP?

There are three approaches to the measurement of GDP:

spending, income, and production.

Spending ApproachSpending ApproachThe spending approach divides GDP into

four areas: households (consumption) (C)businesses (investment) (I) government (G) and foreigners (net exports) (X-IM).

Investment (I)

def1: spending on [the factor of production] capital.

def2: spending on goods bought for future use. Includes:

§ business fixed investment spending on plant and equipment that firms will use to produce other goods & services§ residential fixed investment spending on housing units by consumers and landlords§ inventory investment the change in the value of all firms’ inventories

Investment vs. Capital§ Capital is one of the factors of production. At any given moment, the economy has a certain overall stock of capital.

§ Investment is spending on new capital.

Investment vs. CapitalExample (assumes no depreciation):§ 1/1/2002: economy has $500b worth of capital

§ during 2002: investment = $37b

§ 1/1/2003: economy will have $537b worth of capital

Stocks vs. FlowsFlow Stock

More examples:stock flowa person’s wealth a person’s saving# of people with # of new collegecollege degrees graduatesthe govt. debt the govt. budget deficit

A question for you:Suppose a firm

§ produces $10 million worth of final goods

§ but only sells $9 million worth.

Does this violate the expenditure = output identity?

Why output = expenditure§ Unsold output goes into inventory, and is counted as “inventory investment”… . ….whether the inventory buildup was intentional or not.

§ In effect, we are assuming that firms purchase their unsold output.

The income The income approachapproach

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.

The income approachThe income approach

The Income Components Include:

Wages and salaries Corporate profits Proprietors income (the profits of partnerships and soley owned

businesses, like a family restaurant) Farm income Rent Interest Sales taxes Depreciation (the amount of capital that has worn out during the

year)

Interest (only the interest payments made by business firms

are included and the interest payments made by government are excluded).

Corporate profits which are subdivided into

Corporate income taxes Dividends Undistributed corporate profits

Three additions are made to the income side to balance it with expenditures.

1.Indirect business taxes are added because they are initially income that later gets paid to government.

2.Depreciation or the consumption of fixed capital is added because it is initially income to businesses that later gets deducted in calculating profits.

3.Net foreign factor income is added because it reflects income from all domestic output regardless of the foreign or domestic ownership of domestic resources.

The production The production approachapproach

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

The three approaches--spending, income, and production– (should) result in equivalent values for GDP.

Personal consumption expenditures $245

Net foreign factor income earned in the U.S. 0004

Transfer payments 0012

Rents 0014

Consumption of fixed capital (depreciation) 0027

Social security contributions 0020

Interest 0013

Proprietors’ income 0033

Net exports 0011

Dividends 0016

Compensation of employees 0223

Indirect business taxes 0018

Undistributed corporate profits 0021

Personal taxes 0026

Corporate income taxes 0019

Corporate profits 0056

Government purchases 0072

Net private domestic investment 0033

Personal saving 0020

Below is a list of domestic output and national income figures for a given year. All figures are in billions. Determine the major national income measures by both the expenditures and income methods.

Simple Economy…..No govt…no foreign trade C=consumption I=investment S=saving Y= Income

Output produced=output sold

Y= C+I………….(1)

I=S

Y=C+S…………(2)

Introducing govt. in the above identity

G= govt. purchases of goods and servicesTA=all taxesTR=transfers to private sector (including interest)NX=net exports (exports-imports)YD=disposable income

Y=C+I+G+NX……….(3)

YD=Y+TR-TA………..(4)

YD= C+S………………(5)

C+S=Y+TR-TA

• LEAKAGES (Withdrawals (W) :  (T + S + IM) out of the system must equal

INJECTIONS (J):  (G + I + X) for the circular flow to balance (be in EQUILIBRIUM).

• Withdrawals [ T + S + IM] = Injections [G + I + X] can be broken down to three important balances in the economy:

1. T - G:  the Government's Budgetary Balance;

2. S - I:  the Private Sector's Saving/Investment Balance;

1. IM - X:  the Country's Trade Balance (current account of Balance of Payments)

C=YD-S=Y+TR-TA-S……………………..(6)

Consumption is disposable income less savingOr consumption is equal to income plus transfers less taxes and saving

Using RHS of (6) in (3):

Y=C+I+G+NX……….(3)

Y= (Y+TR-TA-S)+ I+G+NXS-I=(TR-TA+G)+NX…………………………(7)Govt. budget deficit,I.e., total govt. expenditure consisting of govt. Purchases of goods and services(G) plus govt. transfer payments (TR) Minus amount of taxes (TA) received by govt. equals excess of private saving over investment and net exports

The budget deficit, trade, saving and investment(in Rs. Billion)

Saving (S)……………1000 1000 1000 1000Investment(I)…………1000 850 900 950Budget Deficit(BD)…..0 150 0 150Net Exports (NX)……0 0 100 -100

Exercises

Q.1 What would happen to GDP if the govt. hired unemployed Workers, who had been receiving amount $TR in unemployment Benefits, as govt. employees and now paid them $TR to do nothing?Explain.

Q.2In the national income accounts, what is the difference between:a)A firm’s buying an auto for an executive and the firm’s paying theExecutive additional income to buy the automobile herself?

b)Your hiring your spouse (who takes care of the house) rather than having him or her do the work without pay?

c)Your deciding to buy an Indian car rather than a German car?

3. The following is information from the national income accounts for a hypothetical country:

GDP $6, 000Gross investment 800Net investment 200Consumption 4, 000Government purchases of goods and services 1, 100Government budget surplus 30

What is:a. NDP? d. Disposable personal income?b. Next exports? e. Personal saving? c. Government taxes minus transfers?

GDP and GDP deflator

§ We would like to convert different goods

quantities and prices into one single quantity of composite good and

one general price level. How?

§ We use the concepts of nominal GDP, real GDP and

GDP deflator to achieve such aggregation.

Real vs. Nominal GDP

§ GDP is the value of all final goods and services

produced domestically.§ Nominal GDP measures these values using current prices.§ Real GDP measure these values using the prices of a base year.

Real and Nominal GDPReal and Nominal GDP

2001 Nominal GDP

2006 Nominal GDP

2006 Real GDP

Bread (ton) 1 at Rs.1 thousand

… Rs. 1thousand

2 at Rs.2 thousand

.. Rs. 4 thousand

2 at Rs. 1 thousand…………Rs.2 thousand

Milk (thousand Litres)

1 at Rs 0.5 thousand………....Rs. 0.5 thousand

3 at Rs.0.75 thousand…………..Rs. 2.25 thousand

3 at Rs.0.50 thousand…………..Rs.1.50 thousand

Total GDP Rs. 1.5

thousand

Rs. 6.25 thousand

Rs. 3.50 thousand

Real GDP and living standard

Changes in nominal GDP can be due to:§ changes in prices§ changes in quantities of outputproduced

Changes in real GDP can only be due tochanges in quantities, because real GDP isconstructed using constant base-yearprices. Therefore, changes in real GDPmeasure changes in living standard.

GDP DeflatorWhile real GDP captures living standard,

cost of living is measured by general price level.

One measure of the general price level is the GDP Deflator, defined asGDP deflator = 100 * Nominal GDP /Real GDP

Measuring the Cost of Living§ Inflation refers to a situation in which the economy’s overall price level is rising.§ The inflation rate is the percentage change in the price level from the previous period.

Nominal GDP billions Price index (1992=100) Real GDP billions

1959 $ 507.2 23.0 $______

1964 663.0 24.6 $______

1967 833.6 26.6 $______

1973 1382.6 35.4 $______

1988 5049.6 86.1 $______

1995 7265.4 107.8 $______

Exercise: The following table shows nominal GDP and an appropriate price index for a group of selected years. Compute real GDP. Indicate in each calculation whether you are inflating or deflating the nominal GDP data

CPI vs. GDP deflatorprices of capital goods• included in GDP deflator (if produced domestically) • excluded from CPIprices of imported consumer goods • included in CPI• excluded from GDP deflator

the basket of goods• CPI: fixed• GDP deflator: changes every year

International International Comparisons of GDP Comparisons of GDP

In any attempt to compare GDP between countries, some account must be taken of differences in prices.

Adjustment for GDP based on exchange rates makes some improvement in the comparison of GDP figures.

However, if we wish to determine the value of GDP in another country, some information on the price differences of goods is needed.

Purchasing power parity exchange rates

attempt to adjust exchange rates for

differences in the prices of goods across

borders through the use of a ratio of price indexes.

The exchange rate is adjusted to reflect this ratio

•Once this adjustment is made, international rankings of countries

• based on GDP or per capita GDP tend to fluctuate

•as exchange rates vary, while the corresponding prices do not.

•Despite their variability due to exchange rate fluctuations,

• purchasing power parity exchange rates provide a better basis

for international comparisons than an adjustment based

solely on exchange rates.