Macroeconomics

1. Macroeconomics Unit 5 National Income Accounting The Top Five Concepts

2. Introduction In this unit we explore the components of GDP and the output or income that is contained within each component. We also learn the importance of calculating real economic growth by eliminating the effects of inflation. Finally we examine the topics of investment and personal income.

3. Concept 1: GDP GDP is the total market value of all final goods and services produced within a nation’s borders in a given time period. It is measured in monetary terms – meaning the total dollar value of each good or service valued at its market price. GDP measures only output produced within a specific nation’s borders. For example, the GDP for the United States includes all final goods and services produced within the U.S., including output by foreign owned companies who have factories here.

4. Concept 1: GDP GDP does not include everything that is actually produced within a country. Only final goods and services are reported, not unfinished goods. In addition the following items are not included: • Unreported income is not included. • Some babysitting, lawn care, cleaning, painting, etc. • Illegal activities are also not included.

5. Concept 1: GDP Intermediate goods which are purchased for use as an input in the production of final goods or services are not included in the GDP number. This eliminates counting output twice. Examples of intermediate goods includes processor chips of personal computers, seats for new cars, hamburger buns being used for hamburgers at a fast food restaurant.

6. Types of GDP Nominal GDP is the value of final output produced in a given time period, measured in the prices of that period (current prices). Nominal GDP numbers are the most often reported in the media. For example, the nominal GDP in the year 2000 was $9.963 trillion. The nominal GDP in the year 1995 was $7.4 trillion. Can we easily compare these two numbers as stated? NO! Why? Because there was also inflation during the five year period which is reflected in the 2000 GDP figure. To eliminate the effects of inflation we must calculate the real GDP.

7. GNP GNP refers to Gross National Product. GNP was frequently used in the past to show economic growth. GNP is the value of all final goods and services produced by companies whose headquarters are located in a specific country. For example, if Kellogg’s, the cereal company, had a plant operating in Japan, that plant’s output would be reported under U.S. GNP. Similarly if Toyota had an assembly plant in the U.S., the total output from that plant would be reported in Toyota’s home country Japan. The switch from GNP to GDP occurred to more accurately reflect output within a nation’s borders regardless of a company’s country of origin.

8. Concept 2: Calculating Real GDP Real GDP is calculated by taking the nominal GDP for a specific year, and dividing it by the price index. Real GDP provides an accurate number that can be used to measure true economic growth. A price index provides you with information about how much prices have changed from year to year. Formula: Real GDP in year t = nominal GDP in year t / price index

9. Concept 2: Calculating Real GDP Going back to our previous example, in 1995 nominal GDP was $7.4 trillion and in 2000 nominal GDP was $9.963 trillion. How much did GDP really change during the five year period? If the change in the price index from 1995 to 2000 was 9%, we are ready to calculate the real GDP: Real GDP in 2000 = $9.963 trillion / 1.09 = $9.14 trillion (1995 Prices) Notice that the 9% increase in prices was converted to a price index by adding 1 to the 9% (.09) change. Now we can compare the two years.

10. Concept 2: Calculating Real GDP Our nominal GDP in 1995 was $7.4 trillion and the real GDP in 2000 was $9.14 trillion in 1995 prices. Therefore we can say that real GDP grew by $1.74 trillion during the five year period. Students normally have a difficult time with these conversions to real GDP. Before attempting to solve any problems, read the question carefully. What are you being asked to compare or convert? Lets do another problem.

11. Concept 2: Calculating Real GDP In 2000 the nominal GDP was $9.963 trillion. What is the real GDP in 2000 using1990 prices? Average prices for the time period increased by 26.6%. Real GDP in year 2000 = nominal GDP in 2000 / price index (1990 Prices) To solve this problem you simply plug in the numbers. Real GDP in 2000 = $9.963 trillion / 1.266 = $7.869 trillion (1990 prices)

12. Concept 2: Calculating Real GDP If the nominal GDP for 1990 was $5.803 trillion, our economy actual grew by $2.066 trillion ($7.869 trillion - $5.803 trillion). If we did not calculate real GDP, we would wrongly assume that our economy grew by $4.160 trillion ($9.963 trillion - $5.803 trillion). That’s the importance of calculating the real GDP – it tells us if true economic growth is occurring and the actual amount of growth. Nominal GDP can increase simply because of price increases over time. Real GDP shows real growth!

13. Concept 2: Calculating Real GDP Let’s do one more problem – just in case! Suppose the price level is 100 for 1996 and the price level is 103.3 in 1998. If the nominal GDP in 1998 was $8,800 billion, what is the real GDP in 1998 using 1996 prices? In this problem we are already using a price index. To solve this problem, simply divide the nominal GDP of $8,800 billion by the price index (103.3), and multiply the result by 100. Or if you prefer, divide the nominal GDP of $8,800 billion by 1.033. In either case the answer is $8,518.9 billion. The real GDP in 1998 (using 1996 prices) was $8,518.9 billion.

14. Inflation & GDP The changes in the value of GDP between each year is affected by growth (or decline) and inflation or deflation. Inflation is an increase in the average prices of goods and services. Deflation is a decrease in the average prices of goods and services. When the government reports real GDP values, they use a chain-weighted index to compute them. Instead of a single base year, a moving average of several years is used. This increases the accuracy of price changes.

15. GDP Changes Increases in nominal GDP reflect higher prices as well as more output (growth). Increases in real GDP reflect changes in growth only. The effects of inflation are removed. Therefore if an individual wishes to examine changes in economic growth, it is better to use real GDP which eliminates the effects of inflation.

16. Net Domestic Product Net Domestic Product is equal to GDP minus depreciation. Depreciation is defined as the consumption of capital in the production process; the wearing out of plant and equipment. Different capital items may have different depreciation rates depending upon the estimated life of the item. Each year a dollar amount is subtracted from the initial value of an item to reflect depreciation. In terms of economic growth business must invest not only enough to cover depreciation, but exceed it in order to have true economic growth.

17. Concept 3: Investment Investment is the expenditures on new plant, equipment, and structures (all are capital items) in a given time period, plus changes in business inventory. New residential construction is also included in this category. Gross investment is the total expenditure on investment during a given time period. Net investment is equal to gross investment less depreciation. To have economic growth net investment must be positive.

18. Concept 3: Investment Investment rates are watched by economists. If gross investment exceeds the amount of depreciation, then business is expanding production, and our capital stock is increasing. If gross investment is less than depreciation, then our equipment is wearing out faster than it is being replaced – we have a decline in capital stock. Net investment is positive when gross investment exceeds depreciation, and negative when it is less.

19. Uses of Output In unit 2 we learned that most of all output produced in the United States is produced for consumer consumption. Output is also produced for investment. Investment output consists of plants, equipment, etc. Investment output is used by companies to produce final goods and services. Investment goods also consist of changes in business inventories and new residential construction. Output is also consumed by federal, state, and local governments. Some output is produced for export while we also import output from other countries.

20. Uses of Output The final category of output is called Net Exports. Net Exports contains the total dollar value of all goods and services exported, minus the total dollar value of all goods and services imported. If Net Exports are positive, we are exporting more than we are importing. If it is negative, we are importing more than we are exporting.

21. Concept 4: Uses of Output We have examined four different categories of output: Consumption (Consumer use of output) Investment (Business use of output) Government (Government use of output) Net Exports (Exports - Imports) Added together we get the value of GDP using this formula: GDP = C + I + G + (X – IM)

22. Output=Income A basic economic principle is that all output produced is equal to the total value of income. The total market value of incomes will usually equal the market value of output.

23. National Income National Income (NI) is the total income earned by current factors of production: To determine NI you take the total amount of GDP less depreciation, less indirect business taxes, and plus net foreign factor income. Indirect business taxes remove income from the flow between product and factor markets. Sales taxes are an example. Net foreign factor income is the difference between the income generated by foreign entities here, and the income generated by domestic entities overseas.

24. Concept 5: Personal and Disposable Income Personal income is the income received by households before payment of personal taxes. From National Income, you subtract corporate taxes, retained earnings, Social Security payments, and add transfer payments and net interest. Then you have the value of personal income. Once personal taxes are paid, we are left with disposable income. Disposable income is either spent or saved by consumers.

25. Summary • GDP – what’s included/excluded. • Intermediate goods. • Real and nominal GDP. • Gross & Net Investment. • GDP=C + I + G + (X-IM) • Personal Income, Disposable Income.