National-Income Accounting Chapter 5 McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Chapter Overview Part 2: Measuring Macro Outcomes: 5. National-Income Accounting: 6. Unemployment 7. Inflation 2 Chapter Overview 5. National-Income Accounting: 1. Measures of Output (Review of GDP, +…). 2. The Uses of Output (Review: GDP = C+I+G+(X-M)). 3. Measures of Income. 3 1. Measures of Output (Review of GDP). 4 Measures of Output National-income accounting: the measurement of aggregate economic activity, particularly national income and its components. These are Macroeconomic measures. Why are economists interested in these measures? … 5 Gross Domestic Product (GDP) Gross domestic product (GDP): is the total dollar value of final output produced within a nation’s borders in a given time period. LO1 6 Gross Domestic Product (GDP) Each good and service produced and brought to market has a price. That price serves as a measure of value for calculating total output. LO1 7 GDP Versus GNP GDP: geographically focused, includes all output produced within a nation’s borders, … regardless of whose factors of production are used to produce it (foreign or domestic). LO1 8 GDP Versus GNP GNP - Gross National Product : the old standard of measure, refers to output produced by Americanowned factors, regardless of location GDP is the new standard of measure since 1992. GNP is dead I say! - It’s over! LO1 9 International Comparisons The geographic focus of GDP facilitates international comparisons of economic activity. LO1 10 GDP per Capita REVIEW: GDP per capita: total GDP divided by total population (average GDP). commonly used as a measure of a country’s standard of living. 11 World GDP per Capita 12 GDP per Capita However: Measures of per capita GDP tell us nothing about the way GDP is actually distributed or used, It is only a statistical average. 13 Measurement Problems The methods of calculating GDP create several problems: Non-market activities. Unreported income. Value added (double counting). Price fluctuations (real vs. nominal). 14 Non-Market Activities 15 Non-Market Activities GDP measures exclude most goods and services produced that are not sold in the market. This causes GDP to be understated. Exclusion of non-market activities causes problems when: comparing living standards over time, or between countries. LO1 16 Unreported Income 17 Unreported Income The GDP statistics fail to capture market activities that are not reported to tax or census authorities. The underground economy is motivated by tax avoidance or to conceal illegal activities. LO1 18 Value Added 19 Value Added The production of most goods and services involves a series of stages. To accurately measure GDP we must distinguish between two types of goods: intermediate goods, and… final goods. This avoids what in the accounting field is known as “double counting.” LO1 20 Value Added in Various Stages of Production (Pg. 91) Stages of Production 1. Farmer grows wheat, sells it to miller Value of Transactions Value Added $0.12 $0.12 2. Miller mills wheat to flour, sells it to baker 0.28 0.16 3. Baker bakes bagel, sells it to bagel store 0.60 0.32 4. Bagel store retails bagel to consumer 0.75 0.15 $1.75 $0.75 Total LO1 21 Value Added Intermediate goods: goods or services purchased for use as inputs in the production of final goods or services. Value added: the increase in the market value of a product that takes place at each stage of the production process. LO1 22 Two Ways to Calculate GDP 1. Compute the value of the final output. 2. Count only the value added at each stage of production. LO2 23 Value added Stages of Production Transaction Value Value Added 1. Logger produces logs for the sawmill: $500 $500 2. Sawmill produces lumber for the furniture factory: $1,200 $700 3. Furniture factory produces furniture for the Store: $5,000 $3,800 4. Store sells furniture to the Public: $7,500 $2,500 Total Value of Transactions: $14,200 $7,500 24 Real Versus Nominal GDP 25 Computing Real GDP Inflation: the increase in the average level of prices of goods and services. Inflation distorts comparisons of GDP over time. Nominal vs. Real GDP accounting for inflation. 26 Computing Real GDP A base period is picked to be the time period used for comparative analysis. It is the basis for the indexing of price changes. 28 Computing Real GDP 29 Computing Real GDP The general formula for computing real GDP is: nominal GDP in year t Real GDP in year t = price index $13,245 billion Real GDP in 2006 = $12,822 billion 103.3 (2005 prices) 100 30 Computing Real GDP 31 Computing Real GDP (Pg. 92) Base year 2005 1. Nominal GDP (in billions) $12,456 2. Change in nominal GDP 3. Change in the price level, 2005 to 2006 4. Real GDP in 2005 dollars 5. Change in real GDP 2006 $13,245 + $789 Index value = 103.3 $12,456 3.3% $12,822 + $366 32 Changes in GDP: Nominal Versus Real 33 Nominal to Real GDP Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 GDP Deflator 89 92 96 100 101 104 111 118 126 Nominal GDP 312 397 452 521 537 596 676 719 814 (Billions $) Nom. Change 85 55 69 16 59 80 43 95 (Billions $) Real GDP (Billions $) Real Change 351 432 81 470 38 521 51 531 10 573 42 609 36 609 0 646 37 (Billions $) nominal GDP in year t Real GDP in year t = price index 34 Chain-Weighted Price Adjustments Chain-weighted indices use a moving average of price levels in consecutive years as an inflation adjustment. You won’t be tested on chainweighted indices. LO3 35 Net Domestic Product (NDP) Now let’s make an ADJUSTMENT to GDP: LO3 36 Net Domestic Product (NDP) Example situation: You produce You’ve got – $1,000 ↑ Wore out LO3 Produced→ $10,000 (GDP) 37 Net Domestic Product (NDP) We can’t produce as much output next year unless… … we replace the capital we use-up this year. Depreciation: - the consumption of capital in the production process. (the wearing out of plant and equipment). LO3 38 Net Domestic Product (NDP) Depreciation Depreciation GDP GDP NDP New Capital Stock Depreciation Old Capital Stock 40 Net Domestic Product (NDP) Net Domestic Product is what we’ve produced (GDP), minus the capital we’ve worn out (depreciation). NDP = GDP – depreciation The amount of output we (C+G) could consume without reducing our stock of capital. LO3 41 Net Domestic Product Depreciation Depreciation GDP GDP NDP Depreciation Capital Stock Old Capital Stock 42 Gross vs. Net Investment Investment: production of new plant, equipment, and structures (capital),… …plus changes in business inventories, …and new residential construction. LO3 43 Gross vs. Net Investment The difference between GDP and NDP is mirrored by the difference between gross investment and net investment: Gross investment: - total investment expenditure in a given time period. Net investment: = gross investment – depreciation LO3 44 Net Investment Total capital stock has increased Dep. Gross I Investment G The change in our capital stock GDP NDP (positive) C Gross Investment New Old Capital Capital Stock Stock Net Investment Gross Depreciation Investment Depreciation 45 Net Investment Gross Inv. Depreciation Gross I Investment Total capital stock has decreased G GDP NDP C Depreciation Capital Stock Depreciation Depreciation Gross Inv. Net Investment (negative) 46 2. The Uses of Output ( Re: C+I+G+(X-M) ) 48 The Uses of Output The 4 major uses of total output parallel the four sets of market participants: Households – consumption (C) = 70% Business Firms – investment (I) = 17% Government – gov’t spending (G) = 20% Foreigners - net exports (X-M) = –7% 49 3. Measures of Income. 55 Measures of Income GDP accounts have two sides. Expenditures – the demand side. Income – the supply side. LO2 56 Measures of Income Income = Output …so… Income = GDP By charting the flow of income through the economy, we see FOR WHOM our output is produced. LO2 57 The Circular Flow (pg. 44) Goods and services demanded Product markets Goods and services supplied Business Firms Consumers Factors of production supplied Factor markets Factors of production demanded 58 Income = Output (Pg. 97) VALUE OF OUTPUT VALUE OF INCOME Consumer spending Wages Investment spending Government spending Product market Profits Interest Rent Net exports Taxes LO2 Factor market Depreciation Allowances 59 The Equivalence of Expenditure and Income (2006 data in billions of dollars) (Pg. 98) Expenditure Consumer goods and services Investment in plant, equipment, and inventory Government goods and services Exports Imports Total value of output LO2 Income $9,269 2,212 2,527 1,466 (2,229) $13,245 Wages and salaries Corporate profits Proprietors’ income Farm income Rents Interest Sales taxes Depreciation Statistical discrepancy Total value of income $7,489 1,070 1,015 20 164 583 740 1,576 70 $13,240 60 Measures of Income Economists break down the nation’s production into various measures of income: GDP NDP NI PI DI C S gross domestic product net domestic product national income personal income disposable income consumption savings And don’t forget: Net investment = gross investment - depreciation LO2 61 Depreciation & Net Domestic Product NDP = GDP – depreciation LO3 63 National Income (NI) National income (NI): total income earned by current, domesticallyowned factors of production. Wages, interest, and profits paid to foreigners are not part of U.S. income. They need to be subtracted from the income flow. Incomes earned by U.S. citizens in other nations represents an inflow of income to U.S. households and are added. This + & - is known as net foreign factor income. LO3 64 National Income (NI) Net foreign factor income = + Foreign wages earned by Americans – American wages paid to foreigners NI = NDP + net foreign factor income LO3 65 Personal Income (PI) Personal income (PI): the income received by HOUSEHOLDS before payment of personal taxes. Personal income (PI) = National income (NI), – indirect bus. taxes, – corporate taxes, – retained earnings, – Social Security taxes, + transfer payments, + net interest. LO3 66 Disposable Income Disposable income (DI): the after-tax income of households. It is PI minus personal (income) taxes. It’s what’s left at the end for you and I to spend. Disposable income = personal income – personal taxes LO3 69 Measures of Income Economists break down the nation’s production into various measures of income: GDP NDP NI PI DI LO2 gross domestic product net domestic product national income personal income disposable income 70 Disposable Income All disposable income is either: consumed, or … saved. Saving: disposable income less consumption; (that part of disposable income not spent on current consumption). Disposable income = Consumption + Saving LO3 71 The Flow of Income, 2006 (Pg. 99) Income flow Gross domestic product (GDP) Less depreciation Net domestic product (NDP) Plus net foreign factor income National Income (NI) Amount (in billions) Income flow Amount (in billions) $13,245 Less retained earnings (391) (1,576) Less Social Security taxes (945) 11,669 Plus transfer payments 1,602 54 Plus net interest 511 11,723 Personal income (PI) 11,514 Less personal (inc.) taxes Less indirect business taxes (751) Disposable income Consumption Less corporate taxes LO3 (235) Saving (1,361) 10,153 9,299 854 72 The Flow of Income ***What we produce (GDP) = Income National Income Accounting ***GDP = C+I+G+(X-M) Net Investment = Gross Investment Depreciation GDP What we’ve produced (income) in our borders, in total. NDP What we’ve produced (income) after accounting for the capital we’ve used up. NI What we’ve produced (income) after depreciation, regardless of national boundary. PI The gross income of households before their income is taxed. DI Household income after taxes – what we have leftover to spend. - depreciation + net foreign factor income - Indirect business tax - Corporate tax - Social Security tax - Retained earnings + Transfer payments + Net interest - minus personal taxes Consumption Savings 73 Problem 1 GDP GDP GDP PI DEP? NDP PI GDP GDP PI DI PI PI NI PI 74 Problem 2 GDP GDP GDP PI DEP? NDP PI GDP GDP PI DI PI PI PI NI 75 The Flow of Income The dollar value of output will always equal the dollar value of income. LO2 77 The Flow of Income Total income (GDP) ends up distributed in the following way: To households: in the form of disposable income. To businesses: in the form of retained earnings and depreciation allowances. To government: in the form of taxes. LO2 78 Income and Expenditure The flow of income that starts with GDP ultimately returns to the market in the form of: new consumption (C), investment (I), and … government purchases (G). LO2 79 Circular Flow of Spending and Income (Pg. 101) LO2 80 Chapter Questions 1. The manuscript for this book was typed by a friend. Had I hired a secretary to do the same job, GDP would have been higher, even though the amount of output would have been identical. Why is this? Does this make sense? 81 Chapter Questions 2. GDP I 1981 was $2.96 trillion. It grew to $3.07 trillion in 1982, yet the quantity of output actually decreased. How is this possible? 82 Chapter Questions 3. If gross investment is not large enough to replace the capital that depreciates in a particular year, is net investment greater or less than zero? What happens to our production possibilities? 83 Chapter Questions 6. What jobs are likely part of the underground economy? 7. How might the quality of life be adversely affected by an increase in GDP? 84 National-Income Accounting End of Chapter 5 McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved