Chapter 2 National Income Accounting Notes PDF

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CHAPTER 2 National Income Accounting 1. the national income accounts provide the formal structure for our macro theory models. 2. We divide output in two ways. (1) On the production side, output is paid out to labor in the form of wages and to capital in the form of interest and dividends (2) On the demand side, output is consumed or invested for the future 3. The division of output into factor payments (wages, etc.) on the production side provides a framework for our study of growth and aggregate supply. 4. The division of income into consumption, investment, and so on, on the demand side provides the framework for studying aggregate demand. 5. The input and output, or demand and production, accountings are necessarily equal in equilibrium 6. gross domestic product, or GDP is the value of all final goods and services produced in the country within a given period. 7. The output of each of these is valued at its market price, and the values are added together to get GDP.

THE PRODUCTION OF OUTPUT AND PAYMENTS TO FACTORS OF PRODUCTION 8. The production side of the economy transforms inputs, such as labor and capital, into output, GDP. 9. Inputs such as labor and capital are called factors of production , and the payments made to factors, such as wages and interest payments, are called factor payments . 10. labor payments equal the wage rate ( w ) times the amount of labor used 11. capital payments (the rent for the kitchen) equal the rental rate ( r ) times the amount of capital rented (1) Y = ( w * N ) + ( r * K ) + profit

GDP AND GNP 12. The first complication is that factor payments include receipts from abroad made as factor payments to domestically owned factors of production. Adding these payments to GDP gives gross national product , or GNP

GDP AND NDP 13. Capital wears out, or depreciates, while it is being used to produce output. Net domestic product (NDP) is equal to GDP minus depreciation 14. GDP thus comes closer to measuring the net amount of goods produced in the country in a given period 15. It is the total value of production minus the value of the amount of capital used up in producing that output 16. GNP is called gross national income (GNI) in some national income accounts datasets

NATIONAL INCOME 17. The third complication is that businesses pay indirect taxes (i.e., taxes on sales, property, and production) that must be subtracted from NDP before making factor payments 18. You should remember that about three-fourths of factor payments are payments to labor 19. Most of the remainder goes to pay capital. Only a small amount goes for other factors of production or true profits 20. GDP is the value of all final goods and services produced in the country within a given period. 21. GDP is the sum of all factor payments 22. Labor is the dominant factor of production

OUTLAYS AND COMPONENTS OF DEMAND 23. Total demand for domestic output is made up of four components: (1) consumption spending by households ( C ), (2) investment spending by businesses and households ( I ), (3) government (federal, state, and local) purchases of goods and services ( G ), (4) foreign demand for our net exports ( NX ). 24. The fundamental national income accounting identity is (1) Y = C + I + G + NX

CONSUMPTION 25. The table shows that the chief component of demand is consumption spending by the household sector

26. This includes spending on anything from food to golf lessons, but it also involves, as we shall see in discussing investment, consumer spending on durable goods such as automobiles—spending that might be regarded as investment rather than consumption 27. Given the share of government spending, higher consumption (or lower saving), as we will see in a moment, means either less investment or larger trade deficits

GOVERNMENT 28. Next in size we have government purchases of goods and services. This component of GDP includes such items as national defense expenditures, costs of road paving by state and local governments, and salaries of government employees 29. Transfer payments are not counted as part of GDP because transfers are not part of current production. 30. We speak of transfers plus purchases as government expenditure 31. Total government spending, both items that are counted in GDP and items that are not, plays a large role in determining how the economy is split between the public sector and the private sector

INVESTMENT 32. 33. 34. 35. 36.

37. 38.

39. 40. 41. 42.

Gross private domestic investment requires some definitions the term investment means additions to the physical stock of capital investment does not include buying a bond or purchasing stock in Apple Computer. Investment includes housing construction, building of machinery, construction of factories and offices, and additions to a firm’s inventories of goods. If we think of investment more generally as any current activity that increases the economy’s ability to produce output in the future, we would include not only physical investment but also what is known as investment in human capital Investment in education can be regarded as investment in human capital, but the official accounts treat personal educational expenditures as consumption and public educational expenditures as government spending. From the economic point of view, there is little difference between a household’s building up an inventory of peanut butter and a grocery store’s doing the same. Nevertheless, in the national income accounts, the individual’s purchase is treated as a personal consumption expenditure, whereas the store’s purchase is treated as inventory investment. Investment is associated with the business sector’s adding to the physical stock of capital, including inventories all household expenditures (except new housing construction) are counted as consumption spending. It is gross investment in the sense that depreciation is not deducted. Net investment is gross investment minus depreciation.

NET EXPORTS 43. When foreigners purchase goods we produce, their spending adds to the demand for domestically produced goods. Correspondingly, that part of our spending that purchases foreign goods must be subtracted from the demand for domestically produced goods. Accordingly, the difference between exports and imports, called net exports , is a component of the total demand for our goods 44. Demand for GDP is split into four components: consumption, investment, government spending, and net exports, according to the identity of the purchaser (1) Y = C + I + G + NX .

45. we simplify our analysis by making assumptions that ensure that national income is equal to GDP. 46. For the most part, we disregard depreciation and thus the difference between GDP and NDP as well as the difference be- tween gross investment and net investment 47. We also disregard indirect taxes and business transfer payments. With these conventions in mind, we refer to national income and GDP interchangeably as income or output. 48. These simplifications have no serious consequences and are made only for convenience

A SIMPLE ECONOMY 49. 50. 51. 52. 53.

54. 55. 56. 57. 58. 59. 60.

The value of output in our simple economy, which has neither a government nor foreign trade, by Y Consumption is denoted by C and investment spending by I . first key identity is that output produced equals output sold. We count the accumulation of inventories as part of investment (1) Y = C + I How will income be allocated? Part will be spent on consumption, and part will be saved. (1) Y = S + C (2) where S denotes private sector saving. (3) whole of income is allocated to either consumption or saving Combining 52 and 53 (1) C + I = Y = C + S The left-hand side of identity shows the components of demand, and the right-hand side shows the allocation of income. The value of output produced is equal to income received, and income received, in turn, is spent on goods or saved Subtracting consumption from each part of identity 54 (1) I = Y - C = S Identity shows that in this simple economy investment is identically equal to saving . In a very simple economy, the only way the individual can save is by undertaking an act of physical investment— for example, by storing grain or building an irrigation channel In a slightly more sophisticated economy, one could think of investors financing their investing by borrowing from individuals who save

REINTRODUCING THE GOVERNMENT AND FOREIGN TRADE 61. We denote government purchases of goods and services by G and all taxes by TA . Transfers to the private sector (including interest on the public debt) are denoted by TR . Net exports (exports minus imports) are denoted by NX . 62. Accordingly (1) Y = C + I + G + NX ------------------- 8 63. we turn to the derivation of the very important relation between output and disposable income 64. we have to recognize that part of income is spent on taxes and that the private sector receives net transfers ( TR ) in addition to national income 65. Disposable income ( YD ) is thus equal to income plus transfers less taxes (1) YD = Y + TR - TA ------------------------(9) 66. Disposable income, in turn, is allocated to consumption and saving: (1) YD = C + S -------------------------------10 67. Rearranging identity (9) and inserting for Y in identity (8), we have (1) YD - TR + TA = C + I + G + NX --------------------------11 68. Putting identity (10) into identity (11) yields (1) C + S - TR + TA = C + I + G + NX ------------------------------- 12 69. With some rearrangement, we obtain (1) S - I = (G + TR - TA) + NX ------------------------------13

SAVING, INVESTMENT, THE GOVERNMENT BUDGET, AND TRADE 70. The first set of terms on the right-hand side ( G + TR - TA ) is the government budget deficit (BD) 71. G + TR is equal to total govern- ment expenditure, consisting of government purchases of goods and services ( G ) plus government transfer payments ( TR )

72. TA is the amount of taxes received by the government. The difference ( G + TR - TA ) is the excess of the government’s spending over its receipts, or its budget deficit. 73. The budget deficit is a negative budget surplus (1) BS = TA - ( G + TR ) 74. The second term on the right-hand side is the excess of exports over imports, or the net exports of goods and services, or net exports for short. NX is also called the trade surplus . When net exports are negative, we have a trade deficit . 75. identity (13) states that the excess of saving over investment ( S - I ) in the private sector is equal to the government budget deficit plus the trade surplus. 76. for the private sector, saving is equal to investment, then the government’s budget deficit (surplus) is reflected in an equal external deficit (surplus) 77. Any sector that spends more than it receives in income has to borrow to pay for the excess spending 78. The private sector has three ways of disposing of its saving (1) It can make loans to the government, which thereby pays for the excess of its spending over the income it receives from taxes (2) Or the private sector can lend to foreigners, who are buying more from us than we are buying from them. They therefore are earning less from us than they need in order to pay for the goods they buy from us, and we have to lend to cover the difference (3) Or the private sector can lend to business firms, which use the funds for investment. In all three cases, households will be paid back later, receiving interest or dividends in addition to the amount they lent

MEASURING GROSS DOMESTIC PRODUCT FINAL GOODS AND VALUE ADDED 79. GDP is the value of final goods and services produced. The insistence on final goods and services is simply to make sure that we do not double-count. 80. The components of the car that are bought by the manufacturers are called intermediate goods , and their value is not included in GDP. 81. Similarly, the wheat that goes into a pie is an intermediate good. We count only the value of the pie as part of GDP; we do not count the value of the wheat sold to the miller and the value of the flour sold to the baker 82. In practice, double counting is avoided by working with value added . At each stage of the manufacture of a good, only the value added to the good at that stage is counted as part of GDP. The value of the wheat produced by the farmer is counted as part of GDP. Then the value of the flour sold by the miller minus the cost of the wheat is the miller’s value added. If we follow this process along, we will see that the sum of the value added at each stage of processing is equal to the final value of the bread sold.

CURRENT OUTPUT 83. GDP consists of the value of output currently produced . It thus excludes transactions in existing commodities, such as old masters or existing houses. We count the construction of new houses as part of GDP, but we do not add trade in existing houses. 84. We do, however, count the value of realtors’ fees in the sale of existing houses as part of GDP.

PROBLEMS OF GDP MEASUREMENT 85. GDP data are, in practice, used not only as a measure of how much is being produced but also as a measure of the welfare of the residents of a country 86. data are far from perfect measures of either economic output or welfare. There are, specifically, three major problems (1) Some outputs are poorly measured because they are not traded in the market. Note, too, that government services aren’t directly priced by the market. (2) Some activities measured as adding to GDP in fact represent the use of resources to avoid or contain “bads” such as crime or risks to national security. Similarly, the ac- counts do not subtract anything for environmental pollution and degradation. This issue is particularly important in developing countries. For instance, one study of Indonesia claims that properly accounting for environmental degradation would reduce the measured growth rate of the economy by 3 percent.

(3) It is difficult to account correctly for improvements in the quality of goods. This has been the case particularly with computers, whose quality has improved dramatically while their price has fallen sharply. But it applies to almost all goods, such as cars, whose quality changes over time 87. Attempts have been made to construct an adjusted GNP series that takes account of some of these difficulties, moving closer to a measure of welfare

INFLATION AND PRICE INDEXES 88. Real GDP measures changes in physical output in the economy between different time periods by valuing all goods produced in the two periods at the same prices, or in constant dollars . 89. Measuring inflation would be straightforward if prices of all goods grew proportionately. However, when the price of one good grows faster than the price of another, consumers shift purchases away from the now relatively more expensive good toward the less expensive one. The use of chain-weighted indexes helps correct for changes in the market basket. 90. Nominal GDP measures the value of output in a given period in the prices of that period, or, as it is sometimes put, in current dollars. 91. Nominal GDP changes from year to year for two reasons. (1) First, the physical output of goods changes, and, second, market prices change (2) Changes in nominal GDP that result from price changes do not tell us anything about the performance of the economy in producing goods and services. That is why we use real rather than nominal GDP as the basic measure for comparing output in different years.

INFLATION AND PRICES 92. Inflation is the rate of change in prices, and the price level is the cumulation of past inflations 93. If Pt −1 represents the price level last year and P t represents today’s price level, then the inflation rate over the past year can be written as

(1)

94. Once raised, the price level doesn’t fall unless the inflation rate is negative—in other words, unless there is a deflation

PRICE INDEXES 95. No single price index is perfect. The main price indexes are the GDP deflator, the consumer price index, the personal consumption expenditure deflator, and the producer price index.

The GDP Deflator 96. The calculation of real GDP gives us a useful measure of inflation known as the GDP deflator . The GDP deflator is the ratio of nominal GDP in a given year to real GDP of that year. 97. Since the GDP deflator is based on a calculation involving all the goods produced in the economy, it is a widely based price index that is frequently used to mea- sure inflation 98. The deflator measures the change in prices that has occurred between the base year and the current year.

The Consumer and Producer Price Indexes 99. The consumer price index (CPI) measures the cost of buying a fixed basket of goods and services representative of the purchases of urban consumers. 100. The CPI differs in three main ways from the GDP deflator i. First, the deflator measures the prices of a much wider group of goods than the CPI does ii. Second, the CPI measures the cost of a given basket of goods, which is the same from year to year.The basket of goods included in the GDP deflator, however, differs from year to year,

depending on what is produced in the economy in each year . By contrast, the CPI mea- sures the cost of a fixed basket of goods that does not vary over time iii. Third, the CPI directly includes prices of imports, whereas the deflator includes only prices of goods produced in the United States. 101. The GDP deflator and the CPI differ in behavior from time to time. For example, at times when the price of imported oil rises rapidly, the CPI is likely to rise faster than the deflator. However, over long periods the two produce quite similar measures of inflation 102. The producer price index (PPI) is the fourth price index that is widely used. Like the CPI, the PPI is a measure of the cost of a given basket of goods. However, it differs from the CPI in its coverage; the PPI includes, for example, raw materials and semifinished goods. It differs, too, in that it is designed to measure prices at an early stage of the distribution system. Whereas the CPI measures prices where urban households actu- ally do their spending—that is, at the retail level—the PPI is constructed from prices at the level of the first significant commercial transaction. 103. The personal consumption expenditure (PCE) deflator measures inflation in con- sumer purchases based on the consumption sector of the national income account

Core Inflation 104. Policymakers are interested in measuring ongoing inflationary trends. The prices of some goods are very volatile, suggesting that price changes are often temporary. For this reason policymakers focus on core inflation , which excludes changes to food and energy prices. 14 Core inflation measures are reported for both the CPI and the PCE deflator.

UNEMPLOYMENT 105. The unemployment rate measures the fraction of the workforce that is out of work and looking for a job or expecting a recall from a layoff 106. The official number counts as unemployed only people who are actively trying to find work (or who are on temporary layoff and expect to be called back to work). 107. If someone has become too discouraged about finding a job to actively look for work, he no longer counts as officially unemployed.

INTEREST RATES AND REAL INTEREST RATES 108. The interest rate states the rate of payment on a loan or other investment, over and above principal repayment, in terms of an annual percentage. 109. The nominal interest rates that we see in the newspaper state returns in dollars. 110. Real interest rates subtract inflation to give a return in terms of dollars of constant value

EXCHANGE RATES 111. The exchange rate is the price of foreign currency. 112. Whether a particular currency is worth more or less than a dollar has nothing to do with whether goods are more expensive in that country,

SUMMARY 113. GDP is the value of all final goods and services produced in the country within a given period 114. On the production side, output is paid out...