National Income Accounting (NIA)

Outline:

1. Functions of NIA

2. Gross Domestic Product (GDP)

3. The Value Added approach to GDP

4. The Expenditure Approach to GDP

5. The Factor Payments Approach to GDP

6. Real versus Nominal GDP

7. Problems with GDP

National income accounting (NIA) is the measurement of aggregate or total economic activity.

NIA is useful for assessing the performance of the

macroeconomy. NIA is also helpful in evaluating the

effectiveness of policy initiatives such as the Bush tax cuts.

Flow variables

A Flow Variableis measure of a process that takes place over a period of time.

Examples: Income, spending, output.

Stock variables

Stock variables are measured at a specific point in time.

Examples: Checking account balance, credit card debt, inventories.

Production is a flow variable

GDP is the market value of new goods and services produced in the economy in one year within the nation’s borders.

Gross Domestic Product (GDP)

GDP is our basicmeasure of economic

activity

Three approaches to measuring GDP

• The value-added approach

• The expenditure approach

• The income approach

Value-Added Value-added is the increasein the market value of a good

that takes place at each stage of the production

-distribution process.

The revenue a firm receives minus the cost of the intermediate goods it buys.

$1.00Wood Chips

$1.50Raw Paper

$2.25Notebook

Paper

$3.50Notebook

Paper

$5.00Notebook

Paper

Lumber Mill

Paper Mill

Office SuppliesManufacturer

Wholesaler Retailer

Summing the value-added at each stage

Stage Value Added

Lumber milling $1.00Paper processing

.50

Office Supply Manufacturing

.75

Wholesaling 1.25Retailing 1.50Total $5.00

To count the notebook in GDP, we count the final transaction only. Otherwise, we would be counting value added twice.

We can measure output (GDP) by summing value added by all firms in one year. This would also be

equal to total factor payments distributed.

Here we simplyadd up all

expenditures fornew goods

and services in oneyear

GDP = C + I + G + NX

Where,

C is personal consumption expenditure;I is gross private domestic investment;G is government expenditure (local, state, and federal); andNX is net exports, or Exports minus Imports

The expenditure approach

ConsumptionHousehold spending for newly-produced goods and services is defined as consumption. We distinguish between 3 categories or types:Spending for consumer durablesSpending for consumer nondurablesSpending for consumer services.

Category

Spending in 2007

(billions)

Percent of Total

Durables $1,082.5 11

Nondurables 2,804.5 29 Services 5,949.7 60

Source: Bureau of Economic Analysis

Consumer Spending by Type, 2007 (in billions)

Total spending byU.S. households

in 2007 was a $9.9

trillion

All spending by business firms for newly built equipment ,business structures, and software.

All changes in business inventories of raw materials, semi-finished articles, and finished goods.

All spending by households for newly-built homes.

What is investment?

Investment does NOT include

• The purchase of stocks, bonds, or other financial assets.

• Secondhand salesRemember that

investment only happens when there is production of new tangible capital

goods

$505

$1,024

$540

Components of Investment, 2007 (in billions)

Bus. StructuresEquip. & SoftwareResidential

Inventory invest-ment (-30.4 billion) not included

The residential construction industry is in a major slump.

Government Expenditures

For purposes of computing GDP, G

DOES NOT include transfer payments such

as social security or food stamps.

All expenditures for newly produced, final goods and services by all levels of government.

Net Exports (NX) of the U.S. (Monthly)

MEASURING U.S. GDPThe Expenditure Approach

Value of production = Income = Expenditure

The market value of goods and services produced MUST

be equivalent to factor payments of firms for the use of resources AND expenditure

for goods and services.

The Income Approach The NIA divides earned income into 2

categories:

1. Wages or compensation of employees: Includes wages and salaries plus fringe benefits—such as health insurance, pension, and social security contributions.

2. Interest, Rent, and Profit or the net operating surplus: the sum of the incomes earned by capital, land, and entrepreneurship.

Interest, Rent, and Profit

–Interest is the income households receive on loans they make minus the interest they pay on their borrowing. –Rent includes payments for the use of land and other rented inputs.–Profit includes the profits of corporations and small businesses.

Net Domestic Product at Factor Cost: The sum of factor payments—wages, interest, rent and profits.

We must make two adjustments to get from net

domestic product at factor cost to GDP

1. From factor cost to market price;

2. From gross to net.

From Factor Cost to Market Price

– The expenditure approach values goods at market prices; the income approach values them at factor cost.

– Indirect taxes (such as sales taxes) make market prices exceed factor cost.

– Subsidies (payments by government to firms) make factor cost exceed market prices.

– To convert the value at factor cost to the value at market prices, we must:

• Add indirect taxes and subtract subsidies

From Gross to Net

–The expenditure approach measures gross product; the income approach measures net product.–Gross profit is a firm’s profit before subtracting the depreciation of capital.–Net profit is a firm’s profit after subtracting the depreciation of capital.–Depreciation is the decrease in the value of capital that results from its use and from obsolescence.

MEASURING U.S. GDP: The Income Approach

Real versus Nominal GDP

• We use money to measure the market value of new goods and services produced produced in the economy.

• The value (or purchasing power) of money is subject to change over time.

• Hence we need to adjust nominal GDP (that is, GDP measured at current prices) for changes in the value of money.

• GDP adjusted for changes in the value of money is called real GDP.

Nominal GDP Calculation

To calculate nominal GDP in 2002, sum the expenditures on apples and oranges in 2002 as follows:

Expenditure on apples = 100 × $1 = $100Expenditure on oranges = 200 × $0.50 = $100

Nominal GDP = $100 + $100 = $200

Now we will calculate nominal GDP for 2003 and compare

Expenditure on apples = 160 × $0.50 = $80Expenditure on oranges = 220 × $2.25 = $495

Nominal GDP = $80 + $495 = $575

Our problem is that the nominal GDP figures do not give us an

accurate read of period-to-period changes in actual production.

Notice that a part of the change in nominal GDP from 2002 to 2003 resulted from a change in prices.

“Traditional” Real GDP calculation

The traditional method converts nominal GDP to real GDP by measuring GDP in all periods at “base period prices”

To correct for changes in the value of money , we will

establish 2002 as our base year. That is, we will

measure 2003 output at 2002 prices.

Traditional method: measuring 2003 GDP at 2002 prices

Expenditure on apples = 160 × $1.00 = $160

Expenditure on oranges = 220 × $0.50 = $110Nominal GDP = $80 + $495 = $270

Thus, real GDP increased from 2002 to 2003—but not by as much as nominal GDP

New Method of Calculating Real GDP

ItemQuantit

y PriceApples 160 $1.00 Orange

s 220 $0.50

Item Quantity Price

Apples 100 $0.50

Oranges 200 $2.25

To use this method, we must value 2002 output at 2003 prices and 2003 output at 2002 prices.

2003 Quantities and 2002 Prices2002Quantities and 2003 Prices

• Measured at 2002 prices, Real GDP increased by 35% from 2002 to 2003 [($70/$200) × 100]

• Measured at 2003 prices, real GDP increased by 15% from 2002 to 2003 [($75/$500) × 100]

The next step is to average together the percentage increases for 2002 and 2003. Thus we have:

%252

%15%35Re

alGDP

Therefore, since real GDP in 2002 is $200, this chain-weighted method of converting nominal to real GDP gives us real GDP in 2003 of $250.

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Chained 2000 Dollars Current Dollars

Gross Domestic Product (GDP) of the USA (in billions)

Year

Source: www.bea.gov

0

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Nominal Chained 1996 dollars

GDP per Person in the United States

www.economagic.com

• Household (non-market) production• The underground economy• Leisure time• Environment quality

Limitations of (real) GDP as a measure of the standard of living

Economist Quality of Life Index

• Income• Health• Freedom• Unemployment• Family life• Climate,• Political stability and security• Gender equality• Family and community life

The Economist Index weighs the following

factors

Country/Rank1

Index

Ireland/1 8.33Norway/3 8.05Australia/6 7.93Italy/8 7.81Spain/10 7.73USA/13 7.62Japan/17 7.39France/25 7.08Mexico/32 6.77China/60 6.08Indonesia/71 5.81Russia/105 4.80

1 Out of 111 countries rated

Source: The Economist Index ranges from 1 to 10.