National Income Accounting (NIA) Outline: 1.Functions of NIA 2.Gross Domestic Product (GDP) 3.The Value Added approach to GDP 4.The Expenditure Approach to GDP 5.The Factor Payments Approach to GDP 6.Real versus Nominal GDP 7.Problems with GDP

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 Obama stimulus plan

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

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

Production is a flow variable

GDP is the market value of new, final goods and services produced year within the nation’s borders in a given time period. Gross Domestic Product (GDP) GDP is our basic measure of economic activity

Final versus Intermediate Goods A final good or service is produced for a final user and not as a component of a final good. Examples: Cars, pizzas, luggage An intermediate good or service is used as a component of a final good or service Examples: Radiator hoses, flour, plastics.

Three approaches to measuring GDP The value-added approach The expenditure approach The income approach

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

$1.00 Wood Chips $1.50 Raw Paper $2.25 Notebook Paper $3.50 Notebook Paper $5.00 Notebook Paper Lumber Mill Paper Mill Office Supplies Manufacturer Wholesaler Retailer

Summing the value-added at each stage StageValue Added Lumber milling$1.00 Paper processing.50 Office Supply Manufacturing.75 Wholesaling1.25 Retailing1.50 Total$5.00

To count the notebook in GDP, we count the final transaction only. Otherwise, we would be counting value added twice.

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.

Here we simply add up all expenditures for new goods and services in one year GDP = C + I + G + NX Where, C is personal consumption expenditure; I is gross private domestic investment; G is government expenditure (local, state, and federal); and NX is net exports, or Exports minus Imports The expenditure approach

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

Source: Bureau of Economic AnalysisBureau of Economic Analysis Consumer Spending by Type, 2009 (in billions) Total spending by U.S. households in 2009 was a $10.1 trillion

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

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

The residential construction industry is in a major slump = 100

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

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

MEASURING U.S. GDP The Expenditure Approach ItemSymbol$% of GDP ConsumptionC9, InvestmentI1, Government ExpenditureG2, Net ExportsNX Gross Domestic ProductGDP14, , 1 st Quarter, in billions of dollars Source:

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.

The Income Approach The NIA divides earned income into 2 categories: 1.Wages or compensation of employees: Includes wages and salaries plus fringe benefits—such as health insurance, pension, and social security contributions. 2.Interest, Rent, and Profit or the net operating surplus: the sum of the incomes earned by capital, land, and entrepreneurship.

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.

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 1.From factor cost to market price; 2.From gross to net.

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

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. – Depreciation is the decrease in the value of capital that results from its use and from obsolescence.

MEASURING U.S. GDP: The Income Approach Item$% of GDP Compensation of Employees7, Interest, Profit, Rent (Net Operating Surplus)3, Net Domestic Product at Factor Cost11, Indirect Business Taxes less Subsidies Depreciation (Capiial Consumption)1, GDP (Income Approach)13, Statistical Discprepency GDP (Expenditure Approach)14, , 1 st Quarter, in billions of dollars Source:

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.

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 = $100 Expenditure on oranges = 200 × $0.50 = $100 Nominal GDP = $100 + $100 = $200

Now we will calculate nominal GDP for 2003 and compare Expenditure on apples = 160 × $0.50 = $80 Expenditure on oranges = 220 × $2.25 = $495 Nominal 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.

“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.

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

New Method of Calculating Real GDP ItemQuantityPrice Apples160$1.00 Oranges220$0.50 ItemQuantityPrice Apples100$0.50 Oranges200$2.25 To use this method, we must value 2002 output at 2003 prices and 2003 output at 2002 prices Quantities and 2002 Prices 2002Quantities and 2003 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]

The next step is to average together the percentage increases for 2002 and 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.

GDP per Person in the United States

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

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

Country/Rank 1 Index Ireland/18.33 Norway/38.05 Australia/67.93 Italy/87.81 Spain/ USA/ Japan/ France/ Mexico/ China/ Indonesia/ Russia/ Out of 111 countries rated Source: The EconomistThe Economist Index ranges from 1 to 10.