© the mcgraw-hill companies, inc., 1998 irwin/mcgraw-hill national income accounting chapter 8

© The McGraw-Hill Companies, Inc., 1998Irwin/McGraw-Hill

National Income National Income AccountingAccounting

Chapter 8


Laugher CurveLaugher Curve

Three econometricians went out hunting, and came across a large deer.



Three econometricians went out hunting, and came across a large deer.

The first econometrician fired, but missed, by a yard to the left.



The second econometrician fired, but also missed, by a yard to the right.



The second econometrician fired, but also missed, by a yard to the right.

The third econometrician didn't fire, but shouted in triumph, "We got it! We got it!"


Chapter ObjectivesChapter Objectives

State why national income accounting is important.




Define GDP, GNP, and NI.




Define GDP, GNP, and NI. Calculate GDP in a simple example,

avoiding double counting.



Explain why GDP = C + 1 + G + (X - M).



Explain why GDP = C + 1 + G + (X - M). Distinguish between real and nominal

values.



Explain why GDP = C + 1 + G + (X - M). Distinguish between real and nominal

values. State some limitations of national

income accounting.


National Income National Income AccountingAccounting In the 1930s it was impossible to talk

intelligently about macroeconomics since the discussion lacked rigorous terminology.


National Income National Income AccountingAccounting In the mid-1930s, Keynesians Simon

Kuznets and Richard Stone began to develop this terminology.


National Income National Income AccountingAccounting They developed 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 National Income AccountingAccounting Measuring Total Economic Output of

Goods and Services



Goods and Services Gross Domestic Product (GDP) is the

total value of all final goods and services produced in an economy in a one-year period.



Goods and Services Gross Domestic Product (GDP) is the

total value of all final goods and services produced in an economy in a one-year period.

It is the single most-used economic measure.



Goods and Services Gross National Product (GNP) is the

aggregate final output of citizens and businesses of an economy in one year.



Goods and Services GDP measures the economic activity

that occurs within a country.



Goods and Services GDP measures the economic activity

that occurs within a country. GNP measures the economic activity

of the citizens and businesses of a country.


National Income National Income AccountingAccounting Moving from GDP to GNP



To move from GDP to GNP, net foreign factor income is added to GDP.



Net foreign factor income is the income from foreign domestic factor sources minus foreign factor incomes earned domestically.



One must add the foreign income of one's citizens and subtract the income of residents who are not citizens.


Calculating GDPCalculating GDP

All goods and services produced by an economy must be weighted, that is, each good and service must be 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.



Finally, all the value measures are added to arrive at GDP.



GDP is a flow concept.



The store of wealth is a stock concept.



The stock equivalent to National Income Accounts is the Wealth Accounts—a balance sheet of an economy’s stocks of assets and liabilities.


GDP Measures Final GDP Measures Final OutputOutput When one firm sells products to another

firm for use in production of yet another good, the first firm’s products are not considered final output but intermediate products.


GDP Measures Final GDP Measures Final OutputOutput When one firm sells products to another

firm for use in production of yet another good, the first firm’s products are not considered final output but intermediate products. Intermediate products are used as

input in the production of some other product.


GDP Measures Final GDP Measures Final OutputOutput Not accounting for intermediate

products would result in double and triple counting.


GDP Measures Final GDP Measures Final OutputOutput Not accounting for intermediate

products would result in double and triple counting. If we did not eliminate intermediate

goods, a change in organization—say, a merger—would look like a change in output


Two Ways of Two Ways of Eliminating Eliminating Intermediate GoodsIntermediate Goods The first is to calculate only final output.


Two Ways of Two Ways of Eliminating Eliminating Intermediate GoodsIntermediate Goods A second way is to follow the value

added approach. Value added is the increase in value

that a firm contributes to a product or service.


Two Ways of Two Ways of Eliminating Eliminating Intermediate GoodsIntermediate Goods A second way is to follow the value

added approach. Value added is the increase in value

that a firm contributes to a product or service.

It is calculated by subtracting intermediate goods from the value of its sales.


Value Added Approach Value Added Approach Eliminates Double Eliminates Double

CountingCountingParticipants Cost of

MaterialsValue of

SalesValue Added

Farmer $ 0 $ 100 $ 100Cone factoryand icecream-maker

100 250 150

Middleperson 250 400 150Vendor 400 500 100Totals


Value Added Approach Value Added Approach Eliminates Double Eliminates Double

CountingCountingParticipants Cost of

MaterialsValue of

SalesValue Added

Farmer $ 0 $ 100 $ 100Cone factoryand icecream-maker

100 250 150

Middleperson 250 400 150Vendor 400 500 100Totals $ 750 $1,250 $500


Calculating GDP: Some Calculating GDP: Some ExamplesExamples Selling your car to a neighbor does not

add to GDP.


Calculating GDP: Some Calculating GDP: Some ExamplesExamples Selling your car to a used car dealer

who sells your car to someone else for a higher price, does add to GDP.


Calculating GDP: Some Calculating GDP: Some ExamplesExamples Selling your car to a used car dealer

who sells your car to someone else for a higher price, does add to GDP. The value added is the dealer's

services.


Calculating GDP: Some Calculating GDP: Some ExamplesExamples Selling a stock or bond does not add to

GDP.


Calculating GDP: Some Calculating GDP: Some ExamplesExamples Selling a stock or bond does not add to

GDP. The stock broker's commission for the

sales does add to GDP.


Calculating GDP: Some Calculating GDP: Some ExamplesExamples Social security payments, welfare

payments, veterans' benefits, and other government transfer payments are not included in GDP.


Calculating GDP: Some Calculating GDP: Some ExamplesExamples The work of unpaid housespouses does

not appear in GDP calculations.


The Circular FlowThe Circular Flow

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


Household Firms (production




Goods




Factor services

Goods




Factor services

Goods

Wages, rents, interest, profits(1)




Factor services

Goods

Personal consumption(4)





Factor services

Goods


Savings(3) Financial markets





Factor services

Goods

Investment(3)


Savings(3) Financial markets





Factor services

Goods

Investment(3)


Savings(3)

(2)GovernmentSpendingTaxes(2)

Government

Financial markets





Factor services

Goods

Investment(3)


Savings(3)

Imports(5)Exports(5)

(2)GovernmentSpendingTaxes(2)

Government

Financial markets

Other countries




Two Approaches to Two Approaches to Calculating GDPCalculating GDP The Income Approach



The income approach is shown on the top half of the circular flow.



National income is the total income earned by citizens and businesses in a country in one year.



Firms make payments to households for supplying their services as factors of production.



These factors are broken up into employee compensation, rent, interest, and profits.




Employee compensation is payments for labor such as salaries and wages.




Rents are payments for use of land and buildings.




Interest includes payments for loans by households to firms.




Profits are payments to the owners of firms.


Two Approaches to Two Approaches to Calculating GDPCalculating GDP The Expenditure Approach



The expenditure approach is shown on the bottom half of the circular flow.



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



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

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



Consumption



Consumption When individuals receive income, they

can spend it on domestic goods, save it it, pay taxes, or buy foreign goods.



Consumption This is the largest and most important of

the flows.



Investment



Investment The portion of their income that

individuals save leaves the income stream and goes into financial markets.



Investment Business spending on equipment,

structures, and inventories is counted as investment.



Government consumption and investment




When individuals pay taxes, those taxes are either spent by government on goods and services or are returned to individuals in the form of transfer payments.




The connection drawn between the government and the financial markets is there because if the government runs a deficit, it must borrow from financial markets to make up the difference.



Net exports



Net exports Spending on foreign goods escapes the

system and does not add to domestic production, thus spending on imports are subtracted from total expenditures.



Net exports Exports to foreign nations are added to

total expenditures.



Net exports Exports to foreign nations are added to

total expenditures. These flows are usually combined into

net exports.


Two Approaches to Two Approaches to Calculating GDPCalculating GDP Equality of Income and Expenditure



Income and expenditures must be equal because of the rules of double-entry bookkeeping.



Income and expenditures must be equal because of the rules of double-entry bookkeeping.

Profit is the balancing item.



The national income accounting identity allows GDP to be calculated either by adding up all values of final output or by adding up the values of all earnings or income.


Using GDP FiguresUsing GDP Figures

Comparing GDP Among Countries



Comparing GDP Among Countries GDP is important since we can

compare one country with another and one year's production with another year's.



Comparing GDP Among Countries Per capita GDP is another measure

often used to compare nations' GDP.




often used to compare nations' GDP. Per capita can be a poor measure of the

various living standards in various nations.




often used to compare nations' GDP. To get around the problems of per capita

GDP, economists use purchasing power parity, which adjusts for different relative prices among nations before making comparisons.



Economic Welfare Over Time



Economic Welfare Over Time Comparing output over time is best

done with real output which is nominal output adjusted for inflation.



Real and Nominal GDP



Real and Nominal GDP Nominal GDP is GDP calculated at

existing prices.



Real and Nominal GDP Real GDP is nominal GDP adjusted for

inflation.




inflation. Real GDP is important to society because

it measures what is really produced.




inflation. By dividing nominal GDP by the GDP

deflator, we arrive at real GDP.


Some Limitations of Some Limitations of National Income National Income AccountingAccounting GDP measures market activity, not

welfare.



welfare. GDP does not measure happiness, nor

does it measure economic welfare.



welfare. Welfare is a complicated idea, very

difficult to measure.


Some Limitations of Some Limitations of National Income National Income AccountingAccounting Measurement Errors



GDP figures do not measure all market economic activity.



GDP figures do not measure the following market activities:




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.



Estimates of the size of the underground economy range from1.5 to 20 percent of GDP.



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?


Some Limitations of Some Limitations of National Income National Income AccountingAccounting Misinterpretation of Subcategories



For example, the line between investment and consumption is often fuzzy.




Buying a steam iron would be consumption, and if it is used to iron team T-shirts sold by a home business, it would still be counted as consumption.




Investment includes private housing units, but they do not usually add to our stock of productive tools.




Investment includes private housing units, but they do not usually add to our stock of productive tools.

The garages and spare bedrooms might if they are used in an income-producing capacity.



Some social scientists have developed alternatives to GDP such as the Gross Process Indicator (GPI).



Some social scientists have developed alternatives to GDP such as the Gross Process Indicator (GPI).

The GPI tries to measure pollution, education, health concerns, as well as GDP.


GDP Is Worth Using GDP Is Worth Using Despite Its LimitationsDespite Its Limitations National income accounting should be

used with sophistication.


GDP Is Worth Using GDP Is Worth Using Despite Its LimitationsDespite Its Limitations It is a powerful economic tool that

informs average citizens about the direction the economy is moving.


National Income National Income AccountingAccounting

End of Chapter 8

© the mcgraw-hill companies, inc., 1998 irwin/mcgraw-hill national income accounting chapter 8

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