National Income Accounting:Important Identities

USAID Reform Project Dr. Brijesh C. Purohit November 2005

Measuring the Production, Income, and Spending of Nations

National Income Accounts: Provide the formal structure for our macro-theory models Aggregate Demand.aggregate income..consumed or invested Aggregate Supply.Total output..paid as wages, interest and dividends In equilibrium.Aggregate Demand=Aggregate Supply (growth) Inputs=Outputs Real output price level Broad magnitudes to characterize the economy

Basic Measures: Gross Domestic Product (GDP) is the value of final goods and services produced in the country within a given period Notable terms final goods Intermediate goods Value Added Past output vs. current outputs Measure of welfare Use of resources to avoid bads such as crime Improvement in the quality in the country

Factors of production.labor, capital, land GDP= sum of payments to labor, capital, land and profits Gross National Product (GNP) GDP+receipts from abroad made as factor payments to domestically owned factors of production.

Net Domestic Product GPP minus depreciation Depreciation is usually 11% NDP=89% of GDP National Income NDP-Indirect taxes that Business pay Indirect taxes that Business pay nearly 10% NI is nearly 90% of NDP

PI is the total income received whether it is earned or unearned by the households of the economy before the payment of personal taxes. It is found by adding transfer payments to and subtracting social security contributions ,corporate income taxes and undistributed corporate profits from the NI. DI is the total income available to households after the payment of personal taxes. It is equal to PI less personal taxes and also equal to personal consumption expenditures plus personal saving.

GDP in 2003 United States Japan Germany United Kingdom France Itlay China Spain Canada Mexico

$million 10,881,609 4,326,444 2,400,655 1,794,858 1,747,973 1,465,895 1,409,852 836,100 834,390 626,080

GDP: An important and versatile concept We will see that GDP measures total income total expenditure total output

the sum of value-added at all stages in the production of final goods

How to measure GDP?

There are three approaches to the measurement of GDP: spending, income, and production.

Spending Approach

The spending approach divides GDP into four areas: households (consumption) (C) businesses (investment) (I) government (G) and foreigners (net exports) (X-IM).

Investment (I) def1: spending on [the factor of production] capital. def2: spending on goods bought for future use. Includes: business fixed investment spending on plant and equipment that firms will use to produce other goods & services residential fixed investment spending on housing units by consumers and landlords inventory investment the change in the value of all firms inventories

Investment vs. Capital Capital is one of the factors of production. At any given moment, the economy has a certain overall stock of capital. Investment is spending on new capital.

Investment vs. Capital Example (assumes no depreciation): 1/1/2002: economy has $500b worth of capital during 2002: investment = $37b 1/1/2003: economy will have $537b worth of capital

Stocks vs. Flows Flow Stock

More examples: stock a persons wealth # of people with college degrees the govt. debt

flow a persons saving # of new college graduates the govt. budget deficit

A question for you: Suppose a firm produces $10 million worth of final goods but only sells $9 million worth. Does this violate the expenditure = output identity?

Why output = expenditure Unsold output goes into inventory, and is counted as inventory investment . .whether the inventory buildup was intentional or not. In effect, we are assuming that firms purchase their unsold output.

The income approach

The income approach divides GDP according to who receives the income from the spending flow. In addition to aggregate income, national income and personal income are also used as measures of income.

The income approach

The Income Components Include: Wages and salaries Corporate profits Proprietors income (the profits of partnerships and soley owned businesses, like a family restaurant) Farm income Rent Interest Sales taxes Depreciation (the amount of capital that has worn out during the year)

Interest (only the interest payments made by business firms are included and the interest payments made by government are excluded).

Corporate profits which are subdivided into Corporate income taxes Dividends Undistributed corporate profits

Three additions are made to the income side to balance it with expenditures. 1.Indirect business taxes are added because they are initially income that later gets paid to government.

2.Depreciation or the consumption of fixed capital is added because it is initially income to businesses that later gets deducted in calculating profits.

3.Net foreign factor income is added because it reflects income from all domestic output regardless of the foreign or domestic ownership of domestic resources.

The production approach

The production approach looks at GDP from the standpoint of value added by each input in the production process. The three approaches--spending, income, and production (should) result in equivalent values for GDP.

Below is a list of domestic output and national income figures for a given year. All figures are in billions. Determine the major national income measures by both the expenditures and income methods.
Personal consumption expenditures Net foreign factor income earned in the U.S. Transfer payments Rents Consumption of fixed capital (depreciation) Social security contributions Interest Proprietors income Net exports Dividends Compensation of employees Indirect business taxes Undistributed corporate profits
$245 0004 0012 0014 0027 0020 0013 0033 0011 0016 0223 0018 0021

Personal taxes
Corporate income taxes Corporate profits Government purchases Net private domestic investment Personal saving

0026
0019 0056 0072 0033

0020

Simple Economy..No govtno foreign trade C=consumption I=investment S=saving Y= Income Output produced=output sold Y= C+I.(1) I=S Y=C+S(2)

Introducing govt. in the above identity G= govt. purchases of goods and services TA=all taxes TR=transfers to private sector (including interest) NX=net exports (exports-imports) YD=disposable income Y=C+I+G+NX.(3) YD=Y+TR-TA..(4) YD= C+S(5) C+S=Y+TR-TA

LEAKAGES (Withdrawals (W) : (T + S + IM) out of the system must equal INJECTIONS (J): (G + I + X) for the circular flow to balance (be in EQUILIBRIUM). Withdrawals [ T + S + IM] = Injections [G + I + X] can be broken down to three important balances in the economy: 1. T - G: the Government's Budgetary Balance; 2. S - I: the Private Sector's Saving/Investment Balance; 1. IM - X: the Country's Trade Balance (current account of Balance of Payments)

C=YD-S=Y+TR-TA-S..(6) Consumption is disposable income less saving Or consumption is equal to income plus transfers less taxes and saving Using RHS of (6) in (3):

Y=C+I+G+NX.(3)
Y= (Y+TR-TA-S)+ I+G+NX S-I=(TR-TA+G)+NX(7) Govt. budget deficit,I.e., total govt. expenditure consisting of govt. Purchases of goods and services(G) plus govt. transfer payments (TR) Minus amount of taxes (TA) received by govt. equals excess of private saving over investment and net exports

The budget deficit, trade, saving and investment(in Rs. Billion) Saving (S)1000 Investment(I)1000 Budget Deficit(BD)..0 Net Exports (NX)0 1000 1000 1000 850 900 950 150 0 150 0 100 -100

Exercises
Q.1 What would happen to GDP if the govt. hired unemployed Workers, who had been receiving amount $TR in unemployment Benefits, as govt. employees and now paid them $TR to do nothing? Explain. Q.2In the national income accounts, what is the difference between: a)A firms buying an auto for an executive and the firms paying the Executive additional income to buy the automobile herself? b)Your hiring your spouse (who takes care of the house) rather than having him or her do the work without pay? c)Your deciding to buy an Indian car rather than a German car?

3. The following is information from the national income accounts for a hypothetical country: GDP Gross investment Net investment Consumption Government purchases of goods and services Government budget surplus $6, 000 800 200 4, 000 1, 100 30

What is: a. NDP? d. Disposable personal income? b. Next exports? e. Personal saving? c. Government taxes minus transfers?

GDP and GDP deflator

We would like to convert different goods

quantities and prices into one single quantity of composite good and one general price level. How? We use the concepts of nominal GDP, real GDP and

GDP deflator to achieve such aggregation.

Real vs. Nominal GDP

GDP is the value of all final goods and services

produced domestically. Nominal GDP measures these values using current prices
Real GDP measure these values using the prices of a base year.

Real and Nominal GDP

2001 Nominal GDP Bread (ton) Milk (thousand Litres)
Total GDP

2006 Nominal GDP

2006 Real GDP

1 at Rs.1 2 at Rs.2 2 at Rs. 1 thousand thousand thousand Rs. 1thousand .. Rs. 4 thousand Rs.2 thousand 1 at Rs 0.5 thousand. ...Rs. 0.5 thousand Rs. 1.5 thousand 3 at Rs.0.75 thousand ..Rs. 2.25 thousand Rs. 6.25 thousand 3 at Rs.0.50 thousand ..Rs.1.50 thousand Rs. 3.50 thousand

Real GDP and living standard Changes in nominal GDP can be due to: changes in prices changes in quantities of output produced Changes in real GDP can only be due to changes in quantities, because real GDP is constructed using constant base-year prices. Therefore, changes in real GDP measure changes in living standard.

GDP Deflator While real GDP captures living standard, cost of living is measured by general price level. One measure of the general price level is the GDP Deflator, defined as GDP deflator = 100 * Nominal GDP /Real GDP

Measuring the Cost of Living Inflation refers to a situation in which the economys overall price level is rising. The inflation rate is the percentage change in the price level from the previous period.

Exercise: The following table shows nominal GDP and an appropriate price index for a group of selected years. Compute real GDP. Indicate in each calculation whether you are inflating or deflating the nominal GDP data
Nominal GDP billions Price index (1992=100) Real GDP billions

1959 1964

$ 507.2 663.0

23.0 24.6

$______ $______

1967
1973 1988

833.6
1382.6 5049.6

26.6
35.4 86.1

$______
$______ $______

1995

7265.4

107.8

$______

CPI vs. GDP deflator prices of capital goods included in GDP deflator (if produced domestically) excluded from CPI prices of imported consumer goods included in CPI excluded from GDP deflator the basket of goods CPI: fixed GDP deflator: changes every year

International Comparisons of GDP

In any attempt to compare GDP between countries, some account must be taken of differences in prices. Adjustment for GDP based on exchange rates makes some improvement in the comparison of GDP figures.
However, if we wish to determine the value of GDP in another country, some information on the price differences of goods is needed.

Purchasing power parity exchange rates attempt to adjust exchange rates for differences in the prices of goods across borders through the use of a ratio of price indexes. The exchange rate is adjusted to reflect this ratio

Once this adjustment is made, international rankings of countries based on GDP or per capita GDP tend to fluctuate as exchange rates vary, while the corresponding prices do not.

Despite their variability due to exchange rate fluctuations,

purchasing power parity exchange rates provide a better basis for international comparisons than an adjustment based solely on exchange rates.