National Income Accounting

How Do We Measure The Size and Health of an Economy?

Gross Domestic Product (GDP)

The dollar value

of all final goods and services

produced

within a country’s borders

in a given period of time (usually a year).

Gross National Product (GNP)

A subtle difference:

The dollar value

of all final goods and services

produced

by a nation’s citizens

in a given period of time (usually a year).

Let’s do some examples to see the difference

GDP Does NOT Include

• Intermediate goods/services (only final goods/services)

• 2nd hand sales AKA used goods• Not produced this year, so have already been counted in a previous year

• Stocks/bonds/securities

• Transfer payments• Public, like welfare/social security• Private, like gifts

• Transactions that cannot be counted or are not reported• Do-it-yourself or stay-at-home parent services• Black market transactions

Calculating GDP: 2 Methods/Approaches

1. Expenditures Method/Approach: Add up all the spending

2. Income Method/Approach: Add up all the incomes

In theory, these should produce the same total.

The Expenditures Method

GDP = C + Ig + G + Xn

(add up all the spending)

You must memorize this to be successful in this class!

Consumption (C)

Consumer Spending (Spending by households)• (on goods and services)

This is typically the largest component of GDP

Investment (Ig)

• “Gross Private Domestic Investment”

• Spending by businesses

• Includes• ***purchases of capital• ALL construction, even residential construction (houses)• ∆ Inventories

• Why should we add positive changes?• Why subtract negative changes?

Gross vs. Net

Gross _____________ - Depreciation = Net ______________

• Ig tells us how much new capital was produced (even if it just replaced depreciated capital).• In tells us how much extra capital there is (over and above the

production necessary to replace depreciated capital).• +In means increase in productive capacity (increased stock of

capital)• -In means decrease in productive capacity (decreased stock of

capital)

*Depreciation is also called “capital consumption allowance” or “consumption of fixed capital”.

• Not to be confused with Consumption (C)

Government Spending (G)

• Includes government purchases of:• Goods/services• “public capital” (parks, highways, other infrastructure)• Resources (like labor)

• Again, does NOT include transfer payments.

Net Exports (Xn) = Exports - Imports

Xn = X – M(Some books will abbreviate this with “NX”)

Why do we subtract imports?

Once Again, The Expenditures Method

•GDP = C + Ig + G + Xn

You must memorize this to be successful in this class!

The Income Method

Add up all the incomes:

Rent

+Wages (sometimes called “Wages and Salaries” or “Compensation of Employees”)

+Interest

+Profit

But profit won’t be given, so you must add up it’s parts

Rent

+Wages (sometimes called “Wages and Salaries” or “Compensation of Employees”)

+Interest

+Profit (2 kinds)

+Proprietors’ Income

Corporate Income/Profit (also not given, so must add 3 parts)

+Corporate Income Taxes

+Dividends

+Retained Earnings (AKA “Undistributed Corporate Profits”)

= National Income (NI) [fork in the road]

The Big 3 Adjustments

Rent

+Wages (sometimes called “Wages and Salaries” or “Compensation of Employees”)

+Interest

+Profit (2 kinds)

Proprietors’ Income

Corporate Income (also not given, so must add 3 parts)

Corporate Income Taxes

Dividends

Retained Earnings (AKA “Undistributed Corporate Profits”)

= National Income

+ Indirect Business Taxes (memorize!)

= NNP

+Depreciation (AKA capital consumption allowance AKA consumption of fixed capital)

=GNP

+Net Foreign Factor (=factor payments to rest of world

- factor payments from rest of world)

=GDP

The Side Calculations

National Income (NI) [earned, whether received by a human or not]

- Corporate Income Taxes

- Retained Earnings (AKA “Undistributed Corporate Profits”)

- Social Security Contributions

+ Transfer Payments

= Personal Income (PI) [received by a human, whether earned or not]

- Personal Taxes

= Disposable Income (DI)

- Consumption (C)

= Savings (S)

Shortcomings of GDP

GDP is not a perfect measure of economic well-being.

It fails to include:

• Non-market transactions (homemaking, do-it-yourself)

• Black market transactions and unreported income

• Satisfaction from work

• Satisfaction from leisure

• Improvements in product quality

• The negative effects of production on the environment

• Problems with inequality• What is “per-capita GDP?”

Nominal GDP vs. Real GDP

• Nominal (GDP, wages, etc.)• stated in “this year’s” dollars• NOT adjusted for changes in prices (inflation), so• CANNOT be used to make year-to-year comparisons

• Real (GDP, wages, etc.)• stated in “base year” dollars• Adjusted for changes in prices (inflation), so• CAN be used to make year-to-year comparisons

How to fix nominal figures to make them real

• Price Indexes • used to measure inflation• measure the price of a “market basket” of goods and services• then compare them to a “base year”

• PI for the base year: always = 100

• PI that adjusts GDP: GDP Price Index AKA “GDP deflator”

• PI that adjusts wages (later in the course): Consumer Price Index (CPI)

How to fix nominal figures to make them real

• The magic formula (works for everything but interest rates):

Practice problem:

Year Nominal GDP GDP Deflator Real GDP?

2005 $500 B 200

2006 $550 B 250