13e

Chapter 05:
National Income Accounting

McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

National Income Accounting

In order to formulate a policy to fix a
problem, decision makers need to
identify the extent of the problem.
To measure economic performance.

National income accounting was created

to provide answers to the following:
How much output is being produced? What
is it being used for?
How much income is being generated in the
marketplace?
Whats happening to prices and wages?
5-2

Learning Objectives
05-01. Know what GDP measures
and what it doesnt.
05-02. Know the difference between
real and nominal GDP.
05-03. Know why aggregate income
equals aggregate output.
05-04. Know the major submeasures
of output and income.
5-3

Measures of Output
Each good and service produced and
brought to market has a price, which
serves as a measure of its value.
Gross domestic product (GDP):
the total dollar value of all final
output produced within a nations
borders in a given time period,
usually one year.
5-4

Why Final Output?

GDP measurements exclude
intermediate goods.
Intermediate goods: goods or services
purchased for use as an input in the
production of final goods or in services.
Value added: the increase in the market
value of a product that takes place at each
stage of production.

The value added by each intermediate

good is captured in the market price of
the final good produced.
5-5

The Measurement of Output

Last Years Output

Amount

This Years Output

Amount

In
In Physical
physical Terms
terms

In
In Physical
physical Terms
terms

Oranges

2 billion

Oranges

3 billion

Bicycles

2 million

Bicycles

4 million

Rock concerts

700

Total:

Rock concerts

600

Total:

In Monetary
monetary Terms
terms

In Monetary
monetary Terms
terms

2 billion oranges @ $0.20 each

$400 million

3 billion oranges @ $0.20 each

$600 million

2 million bicycles @ $50 each

100 million

4 million bicycles @ $50 each

200 million

700 rock concerts @ $1 million each

700 million

600 rock concerts @ $1 million each

600 million

Total:

$1,200
$1200 million
million

Total:

$1,400
$1400 million
million

It is impossible to add up all output when output is counted in physical terms.

Accordingly, total output is measured in monetary terms, with each good or
service valued at its market price.
5-6

International Comparisons
GDP is geographically focused: output
produced within a nations borders.
This makes it easier to make international
comparisons of economic activity.

For more vivid comparisons, we

construct GDP per capita: average
GDP, or the total GDP divided by total
population.

5-7

GDP per Capita

GDP divided by population.
Average output per person.
Used as a measure of a countrys
standard of living.
Does not indicate the disparity of output
distributed to high-income earners and
low-income earners in that country.
Low GDP per capita reflects a lot of
deprivation in that country.
5-8

Measurement Problems
Nonmarket activities: GDP measures
exclude most goods and services produced
but not sold in the market.
Production not included:
Unpaid production done at home or by
volunteer workers.
Unreported production done off the books or
in the underground economy.

The official GDP measurement significantly

understates actual production in the
country.
5-9

Real GDP and Nominal GDP

A significant use of GDP is to measure how
production changes from year to year.
Price changes from year to year make it
difficult to compare one years GDP with
the next years GDP.
Both output levels and prices can change.
We want to see only the change in output
levels.
Because of this, we must remove the effects of
price changes from the GDP measurements.

5-10

Real GDP and Nominal GDP

Nominal GDP: the value of final output
produced in a given period, measured in
the prices of that period (current prices).
The effects of price changes are included.

Real GDP: the value of final output

produced in a given period, adjusted for
changing prices.
The effects of price changes are removed.

The current year market values are

recalculated in base year dollars.
5-11

Computing Real GDP

Base year: the year used for
comparative analysis; the basis for
indexing price changes.
We arbitrarily set a price index in the
base year to equal 100.

The GDP for any other year is

recalculated into base year dollars,
using the price index for that year.
5-12

Computing Real GDP

The general formula for computing real
GDP is
Real GDP in year t

Nominal GDP in year t

=
Price index

The price index represents a price level

percentage change
from the
base of
100 + Percentage
change
100. Price index =
100
5-13

Exercise 1
Convert nominal GDP to real GDP:
Nominal GDP in year t
Real GDP in year t =
Price index

Where (for 1991)

Nominal GDP = $5,677.5 billion
Price index = 117.8/100 or 1.178

Real GDP (1991) = $5,677.5/1.178

= $4,819.9 billion
5-14

Exercise 2
Convert nominal GDP to real GDP:
Nominal GDP in year t
Real GDP in year t =
Price index

Where (for year t)

Nominal GDP = $15 trillion
Price index = 150/100 or 1.5

Real GDP in year t =$15/1.5 =$10

trillion
5-15

Changes in GDP: Nominal and

Real

5-16

Net Domestic Product

Net domestic product (NDP): GDP less
depreciation.
NDP = GDP - Depreciation

When we produce, we wear out some of our

capital, which must be replaced.
Depreciation measures the value of capital we use
up.

NDP is the amount of output we could

consume without reducing our stock of capital.
5-17

Net Domestic Product

The distinction between GDP and NDP
is mirrored in the difference between
gross investment and net investment:
Gross investment: total investment
expenditure in a given time period.
Net investment: gross investment less
depreciation.
When net investment is positive, the economy
grows.
When net investment is negative, the economy
declines.
5-18

Thecircularflowofnationseconomy

5-19

MeasuresofIncome
TherearetwowaystomeasureGDP:
Measureexpenditures(demandside).
Measureincome(supplyside).
Types of Income

Types of Expenditure

Land: Rent

Households:
Consumption

Labor: Wages

Firms: Investment

Capital: Interest

Government:
Governments Spending

Entrepreneurship: Profit

Foreigners: ExportImport

Total Income=GDP

C+I+G+(X-M)=GDP
5-20

The Uses of Output

The users of output indicate what mix of
output has been selected (answering WHAT
to produce):
Consumption (C): goods and services used
by households (about two-thirds of GDP).
Investment (I): plant, machinery, and
equipment produced (about 15% of GDP).
Government spending (G): resources
purchased by the public sector (about one-fifth
of GDP).
Net exports (X - M): the value of exports (X)
minus the value of imports (M).
5-21

Net Exports
Imports (M): goods and services made
in foreign lands but purchased in the
United States.
Exports (X): goods and services
produced in the United States but
purchased in foreign lands.
We add exports to our GDP, but
subtract imports from our GDP.
The difference between exports and
imports is called net exports (X M).
5-22

GDP Components
The value of GDP can be computed
by adding up these expenditures:
GDP = C + I + G + ( X M )

where:
C = consumption expenditure
I = investment expenditure
G = government expenditure
X = exports
M = imports
5-23

Measures of Income
There are two ways to measure GDP:
Measure expenditures (demand side).
Measure income (supply side).

The total value of market incomes must

equal the total value of final output, or
GDP.
By tracking income in the economy, we
see FOR WHOM the output is produced.
5-24

The Equivalence of Expenditure and

Income

5-25

Measures of Income
Output = Income.
The spending that establishes the
value of output also determines the
value of incomes.
We can track the distribution of funds
from GDP to disposable income.

5-26

From GDP to Disposable

Income
GDP Depreciation = Net domestic
product (NDP)
NDP + Net foreign factor income =
National income (NI)
National income (NI) is the total
income earned by U.S. factors of
production.
5-27

From GDP to Disposable

Income
There are several adjustments that have to be
made to national income in order to get to personal
income.
Subtract

Indirect business taxes.

Corporate profits.
Interest and miscellaneous payments.
Social Security taxes.

Add
Transfer payments.
Capital income.

This yields personal income (PI).

5-28

From GDP to Disposable

Income
Personal income (PI) is pretax income
received by households.
Disposable income (DI) is what
remains of personal income after taxes
are paid.
PI Personal taxes (T) = DI.

We can do two things with our DI: spend it

or save it.
DI = Consumption (C) + Saving (S).

Saving: that part of DI not spent on C.

5-29

Income Summary
Households receive personal income
(PI) as payment for the resources they
own and provide.
How do households dispose of their
Income?
They spend: consumption (C).
They save: saving (S).
They pay taxes: taxes (T).
Personal income (PI) = C + S + T

5-30

The Flow of Income

GDP, on the income side, ends up
distributed in this way:
To households, in the form of disposable income.
Returned to GDP as consumer spending.

To businesses, in the form of retained earnings

and depreciation allowances.
Returned to GDP as business investment spending.

To government, in the form of taxes.

Returned to GDP as government spending.

5-31

The Economy Tomorrow

Quality of life.
Do the GDP accounts tell us anything about the
quality of life?
GDP per capita is one measure of the standard of
living.
It, however, ignores intangible pleasures that
improve the quality of life.
Social well-being and economic well-being arent
always synonymous.
The quality of life depends on what specific mix of
good and services that GDP includes.
5-32

Revisiting the Learning

Objectives
05-01. Know what GDP measures and
what it doesnt.
It measures annual output and income flows.
There are several forms of production that
are not included.
It is measured in dollar terms, so there must
be a correction made for price changes. The
corrected value is called real GDP.

5-33

Revisiting the Learning

Objectives
05-02. Know the difference between
real and nominal GDP.
Nominal GDP: as measured with the
effects of price changes included.
Real GDP: the effects of price changes
have been removed.

5-34

Revisiting the Learning

Objectives
05-03. Know why aggregate income
equals aggregate output.
All income generated by market sales
that is, GDP is received by someone.
Thus the value of aggregate output
must equal the value of aggregate
income.

5-35

Revisiting the Learning

Objectives
05-04. Know the major submeasures of
output and income.
Net domestic product: NDP is GDP less
depreciation.
National income: NI is NPD plus net foreign
factor income.
Personal income: PI is NI less several taxes
and corporate profit plus transfer payments
and capital income.
Disposable income: DI is PI less personal
income taxes.
5-36