National accounts: Part 2

1. National accounts:Part 2 Marc Prud’Homme University of Ottawa Last update: 14/09/12

2. National accounts at constant and current prices: a picture

3. Definition • National accounts are a measure of macroeconomic categories of production and purchase in a nation. • National income accounting: the study of the methods of measuring the aggregate output and aggregate income of an economy, taking the nation's economic pulse. It helps define the relationship between an economy's total output and total income. • The production categories are usually defined to be output in currency units by various industry categories, plus imports. • Output is usually approximately the same as industry revenue. • Input-output tables • The purchase categories are usually government, investment, consumption, and exports, or subsets of these (C + I + G + NX)

4. Definition • The amount produced is supposed to be approximately equal to the amount purchased. • The basic principle or fundamental national accounting identity): • the value of total output equals the value of total income. • This principle implies that the only way to increase real income is to increase real output. • This point is very important! • Real income cannot be increased without producing more! • Redistributing income does nothing to increase the amount of wealth available at any point in time.

5. Definition • National income accounting provides economists and statisticians with detailed information that can be used to track the health of an economy and to forecast future growth and development. • Although national income accounting is not an exact science, it provides useful insight into how well an economy is functioning, and where monies are being generated and spent. • Some of the metrics calculated by using national income accounting include gross domestic product (GDP), gross national product (GNP) and gross national income (GNI).

6. Definition • GDP: Is the market value of all officially recognized final goods and services produced within a country in a given period. • GDP per capita is often considered an indicator of a country's standard of living. • GDP per capita is not a measure of personal income. • Why per capita? • GDP gross: http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(nominal) • GDP (nominal) per capita: http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(nominal)_per_capita • Under economic theory, GDP per capita exactly equals the gross domestic income (GDI) per capita.

7. Definition • GDI: Is the total income received by all sectors of an economy within a nation. • It includes the sum of all wages, profits, and taxes, minus subsidies. • Since all income is derived from production (including the production of services), the gross domestic income of a country should exactly equal its gross domestic product (GDP). • The GDP is a very commonly cited statistic measuring the economic activity of countries, and the GDI is quite uncommon.

8. Definition • GDI (viewed another way): sum of the charges generated in the production of the final goods and services. • Because the market price of a final good or service reflects all the charges associated with producing that good or service, an “income-side” measure of output, gross domestic income (GDI), can be derived as the sum of the charges against production.

9. Definition • Specifically, GDI is measured as the sum of compensation of employees (the return to labour), taxes on production less subsidies (a non-income charge against production), net operating surplus (the net return to capital and entrepreneurship), and consumption of fixed capital (the using up of capital).

10. Definition • In theory, GDP and GDI are equal. • In practice, the differences in the data used to derive the two measures lead to a discrepancy. • This “statistical discrepancy” is defined in the NAs as the difference between GDP and GDI. It is then divided by two and the result is distributed between both GDP and GDI. • GDP and GDI are thus made to equal.

11. Definition • Another way to measure output is known as the “value added” (or production) approach. • In these accounts, value added is defined as the difference between an industry’s total output—that is, its sales plus the change in inventories arising from production—and its intermediate purchases from other industries. • When value added is aggregated across all industries in the economy, industry sales to and purchases from each other cancel out, and the remainder is industry sales to final users, or GDP.

12. Definition • GNP: Is the market value of all products and services produced in one year by labour and property supplied by the residents of a country. • Unlike Gross Domestic Product (GDP), which defines production based on the geographical location of production, GNP allocates production based on ownership. • GNP is the total value of all final goods and services produced within a nation in a particular year, plus income earned by its citizens (including income of those located abroad), minus income of non-residents located in that country. • GNP measures the value of goods and services that the country's citizens produced regardless of their location. • GNP is one measure of the economic condition of a country, under the assumption that a higher GNP leads to a higher quality of living, all other things being equal.

13. Definition • National accounts are a measure of macroeconomic categories of production and purchase in a nation. • The production categories are usually defined to be output in currency units by various industry categories, plus imports. (Output is usually approximately the same as industry revenue.) • Input-output tables • The purchase categories are usually government, investment, consumption, and exports, or subsets of these (C + I + G + NX) • The amount produced is supposed to be approximately equal to the amount purchased. • Measures are in practice made by national governments.

14. Flow diagram

15. Production boundary • One of the fundamental questions that must be addressed in preparing national economic accounts is how to define the production boundary. • Production boundary: What parts of the myriad human activities are to be included in or excluded from the measure of the economy’s production.

16. Production boundary • GDP is defined as the sum of all economic activity taking place on the Canadian territory. • Having defined the economic territory it is important to be clear about what is defined as economic activity. • According to the SNA“Economic production may be defined as an activity carried out under the control and responsibility of an institutional unit that uses inputs of labour, capital, and goods and services to produce outputs of goods or services. • There must be an institutional unit that assumes responsibility for the process and owns any goods produced as outputs or is entitled to be paid, or otherwise compensated, for the services provided.”

17. Production boundary • Under this definition, certain natural processes may be included in or excluded from production, depending upon whether they are under the ownership or control of an entity in the economy. • For example, the growth of trees in an uncultivated forest is not included in production, but the harvesting of the trees from that forest is included.

18. Production boundary • The decision whether to include a particular activity within the production boundary takes the following into account: • Does the activity produce a useful output? • Are the products or activity marketable and does it have a market value? • If the product does not have a meaningful market value can a market value be assigned (for instance, can a value be imputed)? • Would exclusion (or inclusion) of the product of the activity make comparisons between countries or over time more meaningful?

19. Production boundary • In practice, the ESA 95 production boundary can be summarised as follows: • “The production of all goods, whether supplied to other units or retained by the producer for own final consumption expenditure or gross capital formation, and services only in so far as they are exchanged in the market and/or generate income for other economic units.” • For households, this has the result of including the production of goods on own-account, for example the produce of farms consumed by the farmer’s own household. (However, in practice, produce from gardens has proved impossible to estimate so far.)

20. Production boundary • Domestic and personal services produced and consumed within the same household, for example: cleaning, decoration and maintenance of the dwelling; cleaning, servicing and repair of household durables; preparation and serving of meals; care, training and instruction of children; care of sick or elderly people; and transportation of household members or goods. • Volunteer services that do not lead to the production of goods, for example: caretaking and cleaning without payment. • Natural breeding of fish in open seas. • Although the production of some of these services does take considerable time and effort, the activities are self-contained with limited repercussions for the rest of the economy and, as the vast majority of household domestic and personal services are not produced for the market, it is very difficult to value the services in a meaningful way.

21. Production boundary • The general definition of the production boundary may then be restricted by functional considerations. • Certain household activities—such as housework, do-it-yourself projects, and care of family members—are excluded, partly be­ cause by nature these activities tend to be self-contained, have limited impact on the rest of the economy and because their inclusion could diminish the usefulness of the accounts for long-standing analytical purposes, such as business cycle analysis.

22. Production boundary • The production boundary is further restricted by practical considerations about whether the productive activity can be accurately valued or measured. • Illegal activities, such as gambling and prostitution in some states, should in principle be included in measures of production. They are often excluded from the U.S. accounts because they are by their very nature conducted out of sight of public scrutiny and so data are not available to measure them.

23. Production boundary • Finally, the production boundary is sometimes altered in order to accommodate innovations and structural changes in the economy. • Previous revisions of the National accounts resulted in an increase in production because of a change in definition that recognized business and government expenditures for software as fixed investment rather than as intermediate purchases for business and as consumption expenditures for government.

24. Market value • Goods and services in the NAs are measured at market prices, i.e., the value of output is equal to the market price of the good or service times the quantity of the good or service produced during the year. • In cases where market prices do not fully reflect the value of a good or service or where services are provided without an actual exchange, the value of the good or service produced may be “imputed” from similar market transactions. • In cases where there are no similar market transactions available to impute a value, such as for goods or services that are provided for free (or at insignificant prices) by government and non-profit institutions, the market price is estimated based on the costs of production.

25. Imputations • Imputations are made to include in the accounts the value of certain goods and services that have no observable price and are often not associated with any observable transaction. • Examples: • In their role as an intermediary between borrowers and lenders, banks provide services for which they do not charge an explicit price. The value of the service reflected by such exchanges is imputed. • Imputations are also made to keep GDP invariant to institutional arrangements. For example, unlike the provision for payment of housing services to a renter by a landlord, the provision of housing services to an occupant that owns the housing does not involve an exchange between two or more transactors. However, excluding the value of such services would cause variations in GDP that would depend only on variations in institutional arrangements. Therefore, the NIPAs include an imputation of the value of the services provided by owner-occupied housing.

26. Final versus intermediate products • In the NAs, production represents unduplicated output. • I.E., GDP is designed to avoid double counting the value of goods and services that are inputs into the production of other goods and services and that are not used in future production. • These intermediate inputs are already reflected in the market value of the final product and are therefore excluded so that the measure of output is an unduplicated total. • This is done using either the final expenditures (C + I + G + NX) approach or the value added (VA) approach, as described below.

27. A word about value added • Value added: the difference between the sale price and the production cost of a product is the value added per unit. • Summing value added per unit over all units sold is total value added. • Total value added is equivalent to Revenue less Outside Purchases (of materials and services). • Value Added is a higher portion of Revenue for integrated companies, e.g., manufacturing companies, and a lower portion of Revenue for less integrated companies, e.g., retail companies.

28. A word about value added • Total value added is very closely approximated by Total Labour Expense (including wages, salaries, and benefits) plus "Cash" Operating Profit (defined as Operating Profit plus Depreciation Expense, i.e., Operating Profit before Depreciation). • In national accounts VA refers to the contribution of the factors of production, i.e., land, labour, and capital goods, to raising the value of a product and corresponds to the incomes received by the owners of these factors.

29. A word about value added • The national value added is shared between capital and labour (as the factors of production), and this sharing gives rise to issues of distribution. • The factors of production provide "services" which raise the unit price of a product (X) relative to the cost per unit of intermediate goods used up in the production of X. • In the national accounts gross value added is obtained by deducting intermediate consumption from gross output. • Thus gross value added is equal to net output. • Net value added is obtained by deducting consumption of fixed capital (or depreciation charges) from gross value added. • Net value added therefore equals gross wages, pre-tax profits net of depreciation, and indirect taxes less subsidies.

30. A word about value added • Final Good or Service: Is a good or services that is produced for its final user and not as a component of another good or service. • Intermediate Good or Service: Is a good or service produced that is produced by one firm, bought by another firm, and used as a component of a final good or service.

31. Farmer’s value added Value of wheat Miller’s value added Value of flour Baker’s value added Wholesale value of bread Grocer’s value added Retail value of bread; Final expenditure on bread Value added: an illustration Value added Farmer Intermediate expenditure Miller Final expenditure Baker Grocer Consumer

32. Another example with value added • Measuring a country’s total output is not a simple matter. • The output of a single firm can be measured fairly easily. In the case of a firm making pasta, for example, it can be measured as tonnes of pasta made during the year, or, if we multiply the number of tonnes by the price of the pasta, by the amount of output valued in dollars. • But we shall see that it makes little sense to add together the output measured in dollars from all firms to arrive at a macroeconomic figure.

33. Another example with value added

34. Another example with value added • The above discrepancy generated the national accountants’ innovative idea of calculating the contribution of each firm not as its output, but as its value added. • This expression is profound since it consists of measuring the value that the firm adds to that of the firms that supply its inputs.

35. Another example with value added • Consider the pasta example… • Compared with the situation in the first year, when there was only firm A, the value added by firm A2 is not equal to 100 000 dollars. • That is because firm A2 buys 30 000 dollars’ worth of flour, whereas previously it had made this flour itself and did not count this as output. • Therefore, the national accounts system proposes calculating the value added of firm A2 as 100 000 – 30 000 dollars. • In other words, the value of the firm’s output minus the value of the products used to carry out its production during the period.

36. Another example with value added

37. Another example with value added • GDP is defined as being equal to the sum of the value added of each firm, government institution and producing household in a given country: • GDP = Σ value added. • Because each value added is itself equal to output minus intermediate consumption, the end result is: • GDP = Σ outputs – Σ intermediate consumptions.

38. Another example with value added • The products consumed in the production process during the period are known as intermediate consumption. • By deducting their value from that of output, one eliminates the double counting that occurred earlier when summing of the output of firms A1 and A2. • In the second year, the output of flour was in fact counted twice: once in the value of the output of firm A1 (30 000 dollars) and a second time in the value of the output of firm A2 (whose 100 000 dollars in output in fact includes the value of the flour bought and used in the production process).

39. Another example with value added • The composite formula for GDP (known as an “aggregate”) constitutes a macroeconomic indicator of output that is independent of the pattern of organisation and avoids double counting. • It provides a good illustration of the three essential rules followed by national accountants when they move from the microeconomy to the macroeconomy: • avoid double counting; • devise aggregates that are economically significant; and • create indicators that are measurable in practice.

40. Capital, investment, and depreciation • Economic production as defined above covers all final goods and services produced during a given period. • Nondurable goods and services are generally consumed fully within a year. • In contrast, durable goods—such as equipment and software—and structures provide services over longer periods of time.

41. Capital, investment, and depreciation • In the NAs, purchases of new durable goods and structures by businesses or government for use in production are treated as gross fixed investment (or capital formation), as are purchases of new residential housing. • Purchases of durable goods by individuals, on the other hand, are treated as consumption in the NAs, rather than as investment, in accordance with the NA convention that nonmarket household production is outside the scope of GDP.

42. Capital, investment, and depreciation • Both consumption and investment contribute to GDP in the NAs, but the distinction is important because investment implies a stock of fixed assets, or capital, which in turn implies depreciation, or a decline in the value of the stock of capital over time. • More specifically, depreciation, or the consumption of fixed capital, is defined as the deductions from the capital stock over the period due to age, wear and tear, accidental damage, and obsolescence.

43. Capital, investment, and depreciation • Thus, depreciation is a charge against production—that is, it reflects an amount that would need to be set aside to eventually replace fixed assets as they are used up in the production process—and is therefore a component of the NAs income-side measure of output. • Its inclusion in GDI ensures that the measure fully reflects the income-side value of final goods and services, but it also suggests that the measure overstates the capabilities of the economy to produce goods and services for consumption or to add to the capital stock.

44. Capital, investment, and depreciation • Thus, “net” measures that are provided in the NAs—that is, measures that exclude depreciation, such as net domestic product (NDP) and net domestic investment—are preferred for many analyses. • Nevertheless, GDP remains the most commonly cited statistic of the overall level of economic activity.

45. Inventories • A key component of investment, and thus GDP, is the change in private inventories, which reflects the value of goods that have been produced but not yet sold. • For a given period, additions to inventories reflect production in that period and so are included in GDP, while withdrawals from inventories reflect production in past periods and so are excluded from GDP. • In the NAs, additions to, less withdrawals from, inventories is measured as ending period less beginning period inventories and recorded as a single item, “change in inventories.”

46. How to measure GDP? • Because producers have to pay to get the materials and workers they need (so they receive an income); then what is produced is bought by someone (consumers or wholesalers = expenditure; to make it easier to understand we assume that all is sold, although this is not actually necessary); and what was produced of course is output. So… • Income = Expenditure = Output. • Circular flow diagram

47. How to measure GDP? • Incomes consist of wages, interest, rent, and profit. • Note that profit always adjusts to make incomes equal expenditure. Why? • If we pay out $90 to make an item (it goes as income to someone) and then we sell it for $100 (which is expenditure), it means that profit is $10. • But we know that incomes + profit ($90 + $10) = $100 • And we know that expenditure = $100 • So incomes must equal expenditure, as profit is always the difference between the two.

48. Some technical problems when adding up the GDP • For incomes, we must exclude transfer payments (they are not a reward for producing anything) like old age pensions or child support. • For output, we must avoid double counting, e.g., we take just the price of a loaf of bread, not the value of the wheat, flour, transport and storage costs in addition; they are already included in the final price, as the retailer sells at a price that covers all his or her earlier costs! • “Value added” is used at each stage to avoid double counting.

49. Some technical problems when adding up the GDP • Because there are so many items to find and add up, the three methods are never quite identical in practise – in the real world there is a statistical discrepancy (people make mistakes in recording, there are time lags in pieces of paper moving about, some get lost and so forth) and we use a “balancing item” to make the figures exactly the same. It is usually quite small.

50. Uses of GDP (and its variants such as NNI) • Measuring the performance of the economy • Measuring long term growth • Monitoring the success (or failure) of economic policies • Business cycles • Forecasting • International comparisons • Economic well-being or standards of living • In Europe they are used to determine the contribution of a country to the EU budget. • Debt and deficit as a % of GDP for determining eligibility to EMU