National Income Accounting (NIA)

1. National Income Accounting (NIA) • Outline: • Functions of NIA • Gross Domestic Product (GDP) • The Value Added approach to GDP • The Expenditure Approach to GDP • The Factor Payments Approach to GDP • Real versus Nominal GDP • Problems with GDP

2. National income accounting (NIA)is the measurement of aggregate or total economic activity. NIA is useful for assessing the performance of the macroeconomy. NIA is also helpful in evaluating the effectiveness of policy initiatives such as the Bush tax cuts.

3. Flow variables A Flow Variable is measure of a process that takes place over a period of time. Examples: Income, spending, output.

4. Stock variables Stock variables are measured at a specific point in time. Examples: Checking account balance, credit card debt, inventories.

5. Production is a flow variable

6. Gross Domestic Product (GDP) GDPis the market value of new goods and services produced in the economy in one year within the nation’s borders. GDP is our basicmeasure of economicactivity

7. Three approaches to measuring GDP • The value-addedapproach • The expenditure approach • The income approach

8. Value-added is the increase in the market value of a good that takes place at each stage of the production -distribution process. Value-Added The revenue a firm receives minus the cost of the intermediate goods it buys.

9. Stages of Production $5.00NotebookPaper $3.50NotebookPaper $2.25NotebookPaper $1.50Raw Paper $1.00Wood Chips Office SuppliesManufacturer Lumber Mill Paper Mill Wholesaler Retailer

10. Summing the value-added at each stage

11. Don't double count! To count the notebook in GDP, we count the final transaction only. Otherwise, we would be counting value added twice.

12. We can measure output (GDP) by summing value added by all firms in one year. This would also be equal to total factor payments distributed.

13. Here we simplyadd up allexpenditures fornew goods and services in oneyear The expenditureapproach GDP = C + I + G + NX Where, Cis personal consumption expenditure;Iis gross private domestic investment;Gis government expenditure (local, state, and federal); andNXis net exports, or Exports minus Imports

14. Consumption • Household spending for newly-produced goods and services is defined as consumption. We distinguish between 3 categories or types: • Spending for consumer durables • Spending for consumer nondurables • Spending for consumer services.

15. Consumer Spending by Type, 2007 (in billions) Total spending byU.S. householdsin 2007 was a $9.9trillion Source: Bureau of Economic Analysis

17. What is investment? • All spending by business firms for newly built equipment ,business structures, and software. • All changes in business inventories of raw materials, semi-finished articles, and finished goods. • All spending by households for newly-built homes.

18. Investment does NOT include • The purchase of stocks, bonds, or other financial assets. • Secondhand sales Remember that investment only happens when there is production of new tangible capital goods

21. The residential construction industry is in a major slump.

22. Government Expenditures All expenditures for newly produced, final goods and services by all levels of government. For purposes of computing GDP, G DOES NOT include transfer payments such as social security or food stamps.

23. Net Exports (NX) of the U.S. (Monthly)

25. MEASURING U.S. GDP The Expenditure Approach

26. Value of production = Income = Expenditure The market value of goods and services produced MUST be equivalent to factor payments of firms for the use of resources AND expenditure for goods and services.

27. The Income Approach • The NIA divides earned income into 2 categories: • Wages or compensation of employees: Includes wages and salaries plus fringe benefits—such as health insurance, pension, and social security contributions. • Interest, Rent, and Profit or the net operating surplus: the sum of the incomes earned by capital, land, and entrepreneurship.

28. Interest, Rent, and Profit • Interest is the income households receive on loans they make minus the interest they pay on their borrowing. • Rent includes payments for the use of land and other rented inputs. • Profit includes the profits of corporations and small businesses.

29. Net Domestic Product at Factor Cost: The sum of factor payments—wages, interest, rent and profits. We must make two adjustments to get from net domestic product at factor cost to GDP • From factor cost to market price; • From gross to net.

30. From Factor Cost to Market Price • The expenditure approach values goods at market prices; the income approach values them at factor cost. • Indirect taxes (such as sales taxes) make market prices exceed factor cost. • Subsidies (payments by government to firms) make factor cost exceed market prices. • To convert the value at factor cost to the value at market prices, we must: • Add indirect taxes and subtract subsidies

31. From Gross to Net • The expenditure approach measures gross product; the income approach measures net product. • Gross profit is a firm’s profit before subtracting the depreciation of capital. • Net profit is a firm’s profit after subtracting the depreciation of capital. • Depreciationis the decrease in the value of capital that results from its use and from obsolescence.

32. MEASURING U.S. GDP: The Income Approach

34. Real versus Nominal GDP • We use money to measure the market value of new goods and services produced produced in the economy. • The value (or purchasing power) of money is subject to change over time. • Hence we need to adjust nominal GDP (that is, GDP measured at current prices) for changes in the value of money. • GDP adjusted for changes in the value of money is called real GDP.

35. Nominal GDP Calculation To calculate nominal GDP in 2002, sum the expenditures on apples and oranges in 2002 as follows: Expenditure on apples = 100 × $1 = $100Expenditure on oranges = 200 × $0.50 = $100Nominal GDP = $100 + $100 = $200

36. Now we will calculate nominal GDP for 2003 and compare Expenditure on apples = 160 × $0.50 = $80Expenditure on oranges = 220 × $2.25 = $495Nominal GDP = $80 + $495 = $575 Our problem is that the nominal GDP figures do not give us an accurate read of period-to-period changes in actual production. Notice that a part of the change in nominal GDP from 2002 to 2003 resulted from a change in prices.

37. “Traditional” Real GDP calculation The traditional method converts nominal GDP to real GDP by measuring GDP in all periods at “base period prices” To correct for changes in the value of money , we will establish 2002 as our base year. That is, we will measure 2003 output at 2002 prices.

38. Traditional method: measuring 2003 GDP at 2002 prices Expenditure on apples = 160 × $1.00 = $160Expenditure on oranges = 220 × $0.50 = $110Nominal GDP = $80 + $495 = $270 Thus, real GDP increased from 2002 to 2003—but not by as much as nominal GDP

39. New Method of Calculating Real GDP To use this method, we must value 2002 output at 2003 prices and 2003 output at 2002 prices. 2002Quantities and 2003 Prices 2003 Quantities and 2002 Prices • Measured at 2002 prices, Real GDP increased by 35% from 2002 to 2003 [($70/$200) × 100] • Measured at 2003 prices, real GDP increased by 15% from 2002 to 2003 [($75/$500) × 100]

40. The next step is to average together the percentage increases for 2002 and 2003. Thus we have: Therefore, since real GDP in 2002 is $200, this chain-weighted method of converting nominal to real GDP gives us real GDP in 2003 of $250.

42. GDP per Person in the United States www.economagic.com

43. Limitations of (real) GDP as a measure of the standard of living • Household (non-market) production • The underground economy • Leisure time • Environment quality

44. Economist Quality of Life Index The Economist Index weighs the following factors • Income • Health • Freedom • Unemployment • Family life • Climate, • Political stability and security • Gender equality • Family and community life

45. Index ranges from 1 to 10. Source: The Economist 1 Out of 111 countries rated