National Income Accounting

Principles of MacroeconomicsProfessor Dalton

ECON 201Boise State University

National Income Accounting

National income accounting – a set of rules and definitions for measuring economic activity in the aggregate economy – that is, in the economy as a whole.

National income accounting is a way of measuring total, or aggregate production.

The National Income Accounting Identity

The equality of output and income is an accounting identity in the national income accounts.

The identity can be seen in the circular flow of income in an economy: for an economy as a whole, income must equal expenditure.

Supply and demand determine the market equilibrium price and quantity that is produced and exchanged in each market.

Households

Businesses

Factor Markets

Product Markets$ $

$$

The Circular-Flow Diagram

Households

Businesses

Factor Markets

Product Markets$ $

$$

The Circular-Flow Diagram

The Economy’s Income and Expenditure

A measure of the income and expenditures of an economy is Gross Domestic Product (GDP).

Gross Domestic Product measures:• an economy’s total expenditure on

newly produced goods and services or the total income earned from the production of these goods and services.

Gross Domestic Product

The total market value of all final goods and services produced during a given period of time within a country.

Gross National Product

The total market value of all final goods and services produced during a given period of time by a nation’s residents, regardless of the place produced.

Measuring Output

GDP is output produced within a country’s borders, while GNP is output produced by a country’s citizens.

The difference between GDP and GNP is net foreign factor income (GNP = GDP + NFFI).• Net foreign factor income = income from

foreign sources of domestic factors minus income from domestic sources of foreign factors (foreign income of our citizens minus income earned in U.S. by non-citizens).

GDP v. Wealth

GDP is a flow – a quantity during a certain time period; reported quarterly on an annualized basis.

Wealth is a stock – a quantity measured at a point in time.• Wealth accounts – balance sheet of an

economy’s stocks of assets and liabilities.

Important Features of GDP

Output is valued at market determined prices; Output is measured in dollar terms.

GDP records only the output of final goods. We want to count “production” only once.

What Is and What Is Not Counted in GDP?

GDP includes all items produced in the economy and sold legally in markets.

GDP does not include items produced and consumed at home and never enter the marketplace.

GDP does not include items produced and sold illicitly, such as illegal drugs.

GDP Measures Final Output

GDP does not measure total transactions in the economy.• It counts final output but not

intermediate goods.• Counting the sale of final goods and

intermediate products would result in double and triple counting.

Calculating GDP

Calculating GDP:• All goods and services produced by an

economy must be weighted; each good and service is multiplied by its price. Once quantities of a particular good or service are multiplied by its price, we arrive at a value measure of the good or service. All the units of value are added to arrive at GDP.

Calculating GDP: Examples

Selling a stock or bond does not add to GDP; The stock broker's commission from the sales does add to GDP.

Social security payments, welfare payments, and veterans' benefits are not included in GDP; Only the cost of transferring is included in GDP.

The work of unpaid house-spouses does not appear in GDP calculations; GDP only measures market activities so unpaid value added is not included in GDP.

Two Methods of Computing An Economy’s

Income

Expenditure Approach :• Sum the total expenditures by

households (from the top portion of the circular flow).

Income Approach :• Sum the total wages and profit paid by

firms for resources (from the bottom portion of the circular flow).

Households

Businesses

Factor Markets

Product Markets$ $

$$

The Circular-Flow Diagram

The Expenditure Approach

The expenditure approach measures the expenditures in product markets.

GDP is equal to the sum of the four categories of expenditures.

GDP = C + I + G + (X - M)

Components of GDP

Consumption (C) :• Is the spending by on goods and

services e.g. buying clothing, food, movie tickets

Investment (I) :• Is the purchases of capital equipment

and structures e.g. factories, houses, etc.

Consumption

When individuals receive income, they can spend it on domestic goods, save it, pay taxes, or buy foreign goods.

Personal consumption expenditures – payments by households for goods and services.

Consumption is the largest and most important of the flows.

It is also the most obvious way in which income received is returned to firms.

Investment

The portion of income that individuals save leaves the income stream and goes into financial markets; in financial markets, businesses acquire resources for investment.

Gross private investment – business spending on equipment, structures, and inventories.• Depreciation – the decrease in an asset's

value due to it wearing out.• Net private investment – gross private

investment minus depreciation.

Components of GDP

Government Purchases (G) :• Includes spending on goods and

services by local, state and federal governments (e.g. roads, police, etc.).

• Does not include transfer payments. Net Exports (NX) or (X – M ) :

• Exports minus imports.

Government

Taxes are either spent by government on goods and services or are returned to individuals in the form of transfer payments.

Government consumption expenditures and gross investment – government payments for goods and services or investment in equipment and structures.

If the government runs a deficit, it must borrow from financial markets to make up the difference, competing with businesses for saving of households.

Net Exports

Spending on imports are subtracted from total expenditures because spending on imports “leaks from the system” and does not add to domestic production.

Exports to foreign nations are added to total expenditures because spending on exports is “injected into the system” and adds to domestic production.

These two flows are usually combined into net exports.

GDP by Expenditures

Consumption $8,282.5Investment $1,947.0Government Purchases $2,197.2Plus Exports $1,189.5Minus Imports $1,801.2GDP $11,814.9

2004:3 Current Dollar GDP (Billions) For updated information, contact FRED or the Bureau of Economic Analysis.

The Relative Sizeof GDP Components

Consumption 70.1%

Investment 16.5%

Government Purchases

18.6%

Net Exports -5.2%

2004:3 GDP

The Income Approach

The income approach measures the factor payments by businesses in factor markets.

National income (NI) is the total income earned by households; employee compensation, rent, interest, and profits.

GDP = w + r + i + π

Households

Businesses

Factor Markets

Product Markets$ $

$$

The Circular-Flow Diagram

Components of National Income

Employee compensation (w) consists of payments for labor such as salaries and wages.

Rent (r) consists of payments for use of land and buildings.

Interest (i) includes payments for loans by households to firms.

Profits (π) are payments to the owners of firms.

Components of National Income

Actual national income accounts are:Compensation of EmployeesProprietor’s IncomeRental IncomeCorporate ProfitsNet Interest and miscellaneous

Expenditure = Income

Income and expenditures must be equal because of the rules of double-entry bookkeeping. Profit is the balancing item.

To go from GDP to national income:• GDP + net foreign factor income = GNP• GNP – minus depreciation – indirect

business taxes = National Income

Expenditure = Income

=

GDP

Net foreign factor income

GNP

DepreciationIndirect business taxes

Rents

Interest

Profits

Employee compensation

National Income

(3)Income

(2)Output

Net exportsGovernment expenditures

Investment

Consumption

(1)Expenditures =

GDP by Incomes(and adjustments)

Wages & Salaries $ 6,657.4Rent $ 153.8Interest $ 546.7Profits & Proprietor’s Income $ 2,020.9= National Income $ 9,378.8Plus Depreciation $ 1,497.9Plus Indirect Business Taxes $ 885.9Minus Net Foreign Factor Income $ 38.2(Plus Statistical Discrepancy) $ 90.4= GDP $

11,814.9

2004:3 Current Dollar GDP (Billions) For updated information, contact FRED or the Bureau of Economic Analysis.

Relative Size of National Income Components

2004:3 GDP

Wages and Salaries = 71.0%

Corporate Profits = 11.9%

Proprietors’ Income = 9.6%

Net Interest = 5.8%

Rental Income = 1.6%

Real versus Nominal GDP

GDP is the market value of the economy’s current production, referred to as Nominal GDP.

Real GDP measures any given year’s total output in “constant” prices.

An accurate view of the economy requires adjusting nominal to real GDP, using the GDP Price Deflator.

GDP Price Deflator

The GDP Price Deflator is a price index that uses a bundle of all final goods and services. • The GDP Price Deflator tells us the rise

in nominal GDP that is attributable to a rise in prices.

Real and Nominal GDP

Real GDP is arrived at by dividing nominal GDP by the GDP deflator.

Real GDP = Nominal GDP x 100

GDP Deflator

Real and Nominal GDP

1998 2004

PriceQuantity$ Value Price Quantity $ Value

CD’s $15 1,000 $15,000 $30 1,300 $39,000

Tapes $5 2,000 $10,000 $10 2,600 $26,000

Nominal GDP $25,000 $65,000

Real and Nominal GDP

1998 2004

PriceQuantity$ Value Price Quantity $ Value

CD’s $15 1,000 $15,000 $30$15 1,300$39,000$19,500

Tapes $5 2,000 $10,000 $10$5 2,600$26,000$13,000

Nominal GDP $25,000 $65,000$32,500

Limitations of National Income Accounting

Limitations of national income accounting include the following:• Measurement problems exist.• GDP measures economic activity, not

welfare.• Subcategories are often interdependent.

GDP and Well-Being

GDP per person (GDP per capita) tells us the income of the average person in the economy.• It is a good measure of the material well-being

of the economy as a whole.• More real GDP means being able to consume

more goods and services.• It is not intended to be a measure of happiness

or quality of life.

GDP and Well-Being

Some factors and issues not in GDP that lead to the “well-being” of the economy:• Factors that contribute to a good life such

as leisure.• Factors that lead to a quality environment.• The value of almost all activity that takes

place outside of organized markets, e.g. volunteer work and child-rearing.

GDP Measures Market Activity

GDP does not measure happiness, nor does it measure economic welfare.

Welfare is a complicated idea, very difficult to measure.

Measurement Errors

GDP figures leave out the following:• Illegal drug sales.• Under-the-counter sales of goods to

avoid income and sales taxes.• Work performed and paid for in cash.• Unreported sales.• Prostitution, loan sharking, extortion,

and other illegal activities.

Measurement Errors

A second type of measurement error occurs in adjusting GDP for inflation.• If the price and the quality of a product go

up together, has the price really gone up?• Is it possible to measure the value of

quality increases?

Other Measures of Income

Net domestic product (NDP )• GDP minus depreciation (capital

consumption adjustment).

Net National Product (NNP)• GNP minus depreciation.

Other Measures of Income

Personal income (PI)• national income plus net transfer

payments from government minus amounts attributed but not received.

PI = NI + Transfer payments from government + Net non-business interest income

– Corporate retained earnings– Social security taxes

Other Measures of Income

Disposable personal income (DPI)• personal income minus personal income

taxes and payroll taxes. Disposable personal income is what

people have readily available to spend.

DPI = PI - Personal taxes