National Income Accounting and GDP

• National Income Accounting measures the economy's overall performance
• Businesses track income and expenditures to assess economic health and strategize, acting as a parallel operation to National Income Accounting
• The Bureau of Economic Analysis (BEA) compiles the National Income and Product Accounts (NIPA)
• National Income Accounting helps in assessing economic health by comparing production levels, tracking economic performance by analyzing long-term trends, and formulating economic policies using data

Gross Domestic Product (GDP)

• GDP is the primary measure of economic performance with the total annual output of goods and services
• GDP is also called aggregate output
• GDP is defined as the total market value of all final goods and services produced within a country in a given year
• This includes all goods and services produced by citizen-supplied or foreign-supplied resources within the country
• U.S. GDP includes Fords made in an American-owned factory in Michigan and Hondas made in a Japanese-owned factory in Ohio

GDP as a Monetary Measure

• GDP is expressed in monetary terms for meaningful comparisons across years
• Producing 3 sofas and 2 computers in Year 1, and 2 sofas and 3 computers in Year 2, if sofas cost $500 and computers cost $2,000: Year 1 GDP = (3 × $500) + (2 × $2,000) = $5,500
• Producing 3 sofas and 2 computers in Year 1, and 2 sofas and 3 computers in Year 2, if sofas cost $500 and computers cost $2,000: Year 2 GDP = (2 × $500) + (3 × $2,000) = $7,000
• Year 2's GDP is higher because society values its total output more

Avoiding Multiple Counting

• To measure aggregate output accurately, all goods/services must be counted only once
• Intermediate goods (goods for resale or further production) are excluded
• Final goods (goods purchased for final use) are included
• Example: For a wool suit, GDP includes only the final sale price ($350) and ignores the intermediate values ($1,140 total if counted separately)

Value-Added Approach

• An alternative way to measure GDP is by adding up value added at each stage of production
• Value added = Firm's output market value minus cost of inputs from other firms
• Firm A (sheep ranch) sells wool for $120
• Firm B (wool processor) sells processed wool for $180, adding $60 in value
• Firm C (suit manufacturer) sells suits for $220, adding $40 in value
• Firm D (wholesaler) sells suits for $270, adding $50 in value
• Firm E (retailer) sells final suit for $350, adding $80 in value
• Total value added = $350 (same as final sale price)

What GDP Excludes

• Non-Production Transactions are excluded from GDP
• Types of non-production transactions include purely financial transactions
• Public transfer payments (Social Security, welfare, veterans' benefits) are purely financial transactions where no goods/services are exchanged
• Private transfer payments (gifts, allowances) are purely financial transaction that is just moving money around
• Stock market transactions are purely financial transactions, because buying/selling stocks does not count as production (but broker services do)
• Secondhand Sales selling used goods does not contribute to current production
• Selling a used car does not count towards GDP

Two Approaches to Measuring GDP

• The Expenditures Approach (Output Approach)
• The Income Approach (Earnings/Allocations Approach)
• GDP = Total spending on final goods/services in a given year
• GDP Formula: GDP = C + I + G + (X - M)
• C = Personal consumption expenditures (household spending)
• I = Gross private domestic investment (business investments)
• G = Government purchases of goods/services
• (X - M) = Net exports (exports minus imports)
• GDP = Total income earned from producing goods/services
• GDP includes wages, rent, interest, and profits
• Spending money = earning income
• Expenditures and Income Approach give the same GDP value because all spending on goods/services translates into income for someone else

Summary

• GDP is the total value of all final goods/services produced annually in an economy
• National income accounting helps assess, track, and improve economic health
• GDP is a monetary measure used to compare economic performance across years
• GDP avoids multiple counting by including only final goods or using the value-added approach
• GDP excludes non-production transactions (financial transactions, secondhand sales)
• GDP is measured in two ways: Expenditures approach (total spending) and Income approach (total income earned)

Capital Stock, Investment, and Depreciation

• Stock of Capital: Total capital available at a given time
• Gross Investment: Total addition of capital goods over a period
• Depreciation: The loss of value of capital due to use and aging
• Net Investment: Gross investment minus depreciation
• If gross investment > depreciation, capital stock increases
• If gross investment < depreciation, capital stock decreases
• If gross investment = depreciation, capital stock remains constant
• Reservoir = Stock of capital
• Water inflow = Gross investment
• Water outflow = Depreciation
• If inflow > outflow, the reservoir (capital stock) rises
• If inflow < outflow, the reservoir (capital stock) declines
• If inflow = outflow, the reservoir (capital stock) remains constant

Components of GDP (Expenditures Approach)

• GDP is calculated using: GDP = C + I + G + Xn
• Personal Consumption Expenditures (C): Spending by households on goods and services
• Gross Private Domestic Investment (I): Spending on business investments in equipment and structures, residential construction, and changes in inventories
• Government Purchases (G): Spending by all levels of government on final goods and services (excludes transfer payments)
• Net Exports (Xn) = Exports (X) - Imports (M): The difference between what a country sells abroad and what it buys from other countries
• If X > M, net exports are positive, contributing to GDP
• If X < M, net exports are negative, reducing GDP

Example (U.S. 2005 GDP Calculation)

• Consumption (C) = $8,746 billion
• Investment (I) = $2,105 billion
• Government Purchases (G) = $2,363 billion
• Net Exports (Xn) = -$727 billion (Imports exceeded exports)
• Total GDP = $8,746 + $2,105 + $2,363 - $727 = $12,487 billion

Income Approach to GDP Calculation - Components of National Income

• Compensation of Employees: Wages, salaries, and benefits paid to workers
• Rents: Income earned from property rental (Net Rent = Gross Rent - Depreciation)
• Interest: Payments for the use of money (e.g., savings deposits, CDs, bonds)
• Proprietors' Income: Earnings of sole proprietors and unincorporated businesses
• Corporate Profits: Profits of incorporated businesses, divided into
• Corporate Income Taxes: Paid to the government
• Dividends: Paid to shareholders
• Retained Earnings: Saved by corporations for reinvestment
• Taxes on Production and Imports: Includes sales tax, excise tax, business property tax, and license fees

Adjustments to National Income to Derive GDP

• Net Foreign Factor Income: Adjusts for income earned abroad by U.S. citizens and income earned in the U.S. by foreigners
• U.S. 2005 Example: Net foreign income = -$34 billion (foreigners earned more in the U.S. than Americans earned abroad)
• Foreign income is subtracted from national income
• Statistical Discrepancy: A balancing item to align the income and expenditure approaches
• U.S. 2005 Example: +$43 billion
• Consumption of Fixed Capital (Depreciation): Accounts for the loss of capital over time
• U.S. 2005 Example: $1,574 billion

U.S. 2005 Income Approach Example

• Compensation of Employees: $7,125 billion
• Rents: $498 billion
• Interest: $939 billion
• Proprietors' Income: $1,352 billion
• Corporate Profits: $917 billion
• Taxes on Production and Imports: $1,074 billion
• Total National Income = $10,904 billion
• Adjustments: Net Foreign Factor Income: -$34 billion
• Adjustments: Statistical Discrepancy: +$43 billion
• Adjustments: Consumption of Fixed Capital: +$1,574 billion
• Total GDP (Income Approach) = $12,487 billion (matches Expenditures Approach)

Comparative GDPs of Nations (2005, Trillions of Dollars)

• United States: $12.5
• Japan: $4.5
• Germany: $2.8
• China: $2.2
• United Kingdom: $2.2
• France: $2.1
• Italy: $1.8
• Canada: $1.1
• India: $0.8
• Mexico: $0.7
• These values were converted using international exchange rates

Key Takeaways

• GDP can be calculated using the Expenditures Approach (C + I + G + Xn) or Income Approach
• Investment plays a crucial role in capital stock growth, but depreciation reduces it
• Net exports (Xn) impact GDP, with trade deficits reducing it
• The U.S. GDP in 2005 was $12.5 trillion making it the largest in the world
• Adjustments like net foreign factor income, statistical discrepancy, and consumption of fixed capital align the income and expenditure approaches
• National income includes wages, rent, interest, proprietors' income, corporate profits, and production taxes

Income Measurements and National Accounts - Understanding Personal Income (PI)

• Pl includes all income received by households, whether earned or not
• Transfer payments (e.g., Social Security, welfare, disability, education payments to veterans, private pensions) must be added to PI since they are received but not earned
• In adjusting from National Income (NI) to PI subtract earned but not received income: Taxes on production and imports, Social Security contributions, Corporate income taxes, and Undistributed corporate profits
• In adjusting from National Income (NI) to PI add income that is received but not earned (transfer payments)

Income Measurements and National Accounts - Example (U.S. 2005)

• National Income (NI): $10,904 billion
• Personal Income (PI): $10,248 billion
• Disposable Income (DI)

Disposable Income (DI)

• Formula: DI = Personal Income - Personal Taxes
• Personal taxes include: Income taxes, Property taxes, and Inheritance taxes
• Formula for allocation: DI = C + S
• Consumption (C): Spending on goods and services
• Savings (S): Remaining income after consumption
• Example (U.S. 2005), PI: $10,248 billion
• Example (U.S. 2005), Personal Taxes: $1,210 billion
• Example (U.S. 2005), DI: $9,038 billion

Understanding the Circular Flow Model - Sectors in the Economy

• Households receive DI which they divide between consumption and savings
• Businesses receive funds from sales and reinvest in capital
• Government collects taxes and spends on goods, services, and transfers
• Foreign Sector: Imports and exports contribute to GDP adjustments

Understanding the Circular Flow Model - Flows in the Economy

• Orange Arrows: Spending flows (Consumption + Investment + Government + Net Exports → GDP)
• Green Arrows: GDP allocations and adjustments leading to NDP, NI, PI, DI
• Net Exports (NX): Exports - Imports; affects GDP positively or negatively

Key Economic Indicators - Gross Domestic Product (GDP) & Adjustments

• GDP Formula: GDP = C + I + G + (X - M)
• Consumption (C): Household spending
• Investment (I): Business expenditures
• Government Spending (G): Public expenditures
• Net Exports (X - M): Exports minus imports
• Net Domestic Product (NDP): Adjusts for capital depreciation
• Formula: NDP = GDP - Consumption of Fixed Capital (Depreciation)

Key Economic Indicators - National Income (NI)

• Measures all income earned through U.S.-owned resources (domestic & abroad)
• Formula: NI = NDP - Statistical Discrepancy + Net Foreign Factor Income
• Since 2003, NI includes taxes on production and imports
• Personal Income (PI): Includes all household income, earned or not
• Disposable Income (DI): Pl after taxes

Nominal vs. Real GDP

• Nominal GDP: Based on current-year prices and affected by inflation
• Real GDP: Adjusted for price changes using a price index
• Real GDP Formula: Real GDP = (Nominal GDP / Price Index) × 100
• Price Index measures changes in a market basket of goods over time
• Example Calculation: If Nominal GDP = $140 billion, Price Index = 200
• Example Calculation: Real GDP = (140 / 200) × 100 = $70 billion

Price Index & Inflation Adjustment

• Price Index Formula: Price Index = (Price of Market Basket in Given Year / Price of Market Basket in Base Year) × 100
• Example: Price in Year 1 = $10 (Base Year), Price in Year 2 = $20
• Example: Price Index Year 2 = (20/10) × 100 = 200
• Interpreting Price Index: A price index of 200 means prices have doubled since the base year
• Interpreting Price Index: A price index of 50 means prices have halved

Economic Implications

• Adjust for Inflation, because Nominal GDP can rise due to price increases, not actual economic growth
• Real GDP reflects actual increases in production and living standards
• Understanding Growth: A 5% increase in GDP due to inflation does not reflect actual economic growth
• Understanding Growth: A 5% increase in Real GDP indicates more goods/services produced, improving living standards

Summary of Relationships

• GDP Formula: C + I + G + (X - M); Purpose: Total market value of goods/services produced in a country
• NDP Formula: GDP - Depreciation; Purpose: Accounts for capital wear and tear
• NI Formula: NDP - Statistical Discrepancy + Net Foreign Factor Income; Purpose: Total earned income by U.S. factors of production
• PI Formula: NI - Income Earned but Not Received + Income Received but Not Earned; Purpose: Measures total income received by households
• DI Formula: PI - Personal Taxes; Purpose: Income available for spending/saving
• Real GDP Formula: Nominal GDP / (Price Index ÷ 100); Purpose: Adjusts GDP for inflation

Key Takeaways

• PI includes all income received by households, including transfer payments
• DI is the amount households can use for consumption or savings
• The Circular Flow Model shows how money moves between households, businesses, government, and foreign markets
• GDP must be adjusted for inflation to compare economic performance over time
• Real GDP provides a more accurate picture of economic growth than Nominal GDP

Limitations of GDP

• Psychic Income & Job Satisfaction: GDP does not account for non-monetary satisfaction (psychic income) from work
• Improved Product Quality: GDP measures quantity, not quality, BEA adjusts for some quality improvements, but not comprehensively
• The Underground Economy: Includes illegal activities (e.g., gambling, smuggling, prostitution, drug trade) and unreported legal activities, Estimated at 8% of recorded GDP in the U.S., leading to underreporting of GDP by $1 trillion in 2005
• International Underground Economy Variation: Influenced by regulation, taxation, and law enforcement. Greece, Italy, Spain: Large underground economies (~25-30% of GDP)
• United States, Switzerland: Small underground economies (~5-10% of GDP)
• GDP and the Environment: GDP does not subtract environmental costs (pollution, congestion, noise, toxic waste), Ironically, spending on pollution clean-up adds to GDP
• Composition and Distribution of Output: GDP does not differentiate between socially beneficial vs. harmful goods (e.g., encyclopedias vs. assault rifles counted equally if priced the same), GDP doesn't show income distribution
• Noneconomic Sources of Well-Being: GDP does not measure quality of life improvements: Lower crime rates, Peaceful international relations, Improved social interactions, Better family dynamics, Reduced substance abuse

How GDP Data is Collected - Bureau of Economic Analysis (BEA) Sources - Consumption Data Sources

• Retail Trade Survey (Census Bureau) - 22,000 firms surveyed
• Survey of Manufacturers - 50,000 establishments
• Service Survey - 30,000 service businesses
• Industry Trade Sources - Auto and aircraft manufacturers provide direct data

How GDP Data is Collected - Investment Data Sources

• Uses the same sources as consumption but separates consumer goods from capital goods
• Census Construction Surveys: Housing Starts Survey & Housing Sales Survey measure residential construction
• Census Construction Surveys: Construction Progress Reporting Survey measures nonresidential construction
• Inventory Data: BEA gathers inventory changes from Retail Trade Survey, Wholesale Trade Survey (7,100 firms), and Survey of Manufacturing
• Government Purchases Data Sources
• U.S. Office of Personnel Management: Wages & benefits for public vs. private sectors
• Census Construction Surveys: Distinguish private vs. public sector construction
• Survey of Government Finance: Provides government expenditure data
• Net Exports Data Sources
• U.S. Customs Service: Tracks exports and imports of goods
• BEA Surveys: Collects data on exports and imports of services

Summary of GDP Concepts

• GDP = Market value of all final goods & services produced within a nation's borders in a year
• Exclusions: Intermediate goods (to avoid double counting)
• Exclusions: Non-production transactions (e.g., stock & bond sales)
• Exclusions: Secondhand sales (used goods)
• Expenditure Aprouch: GDP = C + I + G + (X - M)
• Income Approach: GDP = Sum of all incomes from production
• Gross Investment: Total spending on new capital (replacement + net investment)
• Net Investment: Gross investment minus depreciation
• Positive Net Investment = Economy's capital stock grows

Summary of GDP Concepts - Other National Accounts

• Othe accounts include Net Domestic Product (NDP) = GDP - Depreciation
• Other accounts include National Income (NI) = NDP + Net Foreign Factor Income
• Other accounts include Personal Income (PI) = Total income before taxes
• Other accounts include Disposable Income (DI) = PI - Personal Taxes

Summary of GDP Concepts - Adjusting for Inflation

• Price Index = (Current Year Market Basket Price / Base Year Market Basket Price) × 100
• Nominal GDP: Measures output in current prices (not inflation-adjusted)
• Real GDP: Adjusts nominal GDP for price changes (reflects actual production changes)
• GDP Deflator: Adjusts nominal GDP to real GDP

Key Questions to Consider

• How are national income statistics useful?
• Why does GDP equal total income in the economy?
• Why does GDP include only final goods and exclude stocks, bonds, and secondhand sales?
• What is the difference between gross and net private domestic investment?
• Why are changes in inventories counted as investment spending?
• What happens if inventories decrease during the year?

Key Terms and Concepts

• National Income Accounting
• Gross Domestic Product (GDP)
• Intermediate Goods vs. Final Goods
• Expenditures Approach vs. Income Approach
• Personal Consumption Expenditures (C)
• Gross Private Domestic Investment (I)
• Net Private Domestic Investment
• Government Purchases (G)
• Net Exports (X - M)
• Taxes on Production and Imports
• Consumption of Fixed Capital (Depreciation)
• Net Domestic Product (NDP)
• National Income (NI)
• Personal Income (PI)
• Disposable Income (DI)
• Nominal GDP vs. Real GDP
• Price Index & GDP Deflator

Real GDP Calculation

• If the price index is above 100, deflate nominal GDP (adjust downward for inflation)
• If the price index is below 100, inflate nominal GDP (adjust upward for deflation)

What Is Included in GDP?

• GDP includes final goods and services produced within a country's borders in a given year
• Interest on an AT&T corporate bond = No (This is a financial transaction, not a production of goods/services)
• Social Security payments received by a retired factory worker = No (Transfer payments are not included since no new production occurs)
• Unpaid services of a family member painting the home = No (Non-market transactions are not included in GDP)
• Income of a dentist = Yes (Payment for services rendered is included in GDP)
• Money received from selling a used textbook = No (This was counted in GDP when it was first sold. This is a second-hand sale)
• Monthly allowance received by a college student = No (This is a private transfer payment. No production occurs)
• Rent received on a two-bedroom apartment = Yes (Rent is payment for a service, so it is included in GDP)
• Resale of a current-year Honda to Kim = No (The car was already counted when it was first sold)
• Publication of a college textbook = Yes (New goods produced in a given year are included in GDP)
• A 2-hour decrease in the workweek = No (This does not directly relate to production, just labor hours)
• Purchase of an AT&T corporate bond = No (Financial transactions do not count towards GDP)
• A $2 billion increase in business inventories = Yes (An increase in inventories is considered investment spending)
• Purchase of 100 shares of GM stock = No (Stock purchases are financial transactions, not production)
• Purchase of an insurance policy = Yes (Insurance is considered a service and is included in GDP)

Key National Income and Product Account (NIPA) Numbers

• Bureau of Economic Analysis (BEA) compiles NIPA tables.
• BEA is located in the U.S. Department of Commerce.
• Four Components of GDP: Consumption, Investment, Government Purchases and Net Exports
• Consumption: Data from retail sales, consumer spending reports
• Investment: Business expenditures, housing starts, and inventory levels
• Government Purchases: Federal, state, and local government spending reports
• Net Exports: Trade balance data from the Census Bureau

Nominal vs. Real GDP Trends

• Nominal GDP: Measures output using current prices.
• Real GDP: Adjusts for inflation, showing true economic growth.
• Nominal GDP is usually greater than real GDP: Inflation causes the price level to rise, making nominal GDP higher
• Nominal GDP is usually greater than real GDP: Real GDP accounts for changes in purchasing power by adjusting for inflation
• Nominal GDP is usually greater than real GDP: The GDP deflator helps measure the difference between nominal and real GDP

GDP Comparisons Among Nations

• GDP can be examined on the World Bank Website
• GDP can be assessed to rank North and South American countries
• GDP can be expressed as ratios of U.S. GDP to compare economic size
• The U.S. typically has the highest GDP in the Americas
• Other countries' GDPs are significantly smaller in comparison
• Economic disparities exist between North and South American nations due to differences in industrialization, productivity, and infrastructure