National Income Accounting

Section 01: National Income Accounting

National Income Accounting is the methodology used in measuring the total output and income of the economy. To begin to measure the output of the U.S. economy we must understand the definition of what we call the Gross Domestic Product. The Gross Domestic Product (GDP) is the value of all the final goods and services produced in the domestic economy in a given year.

Certain words in this definition were italicized to give emphasis to key components of how the GDP is measured. Since the GDP measures the value of the goods and services produced it is important to note that the GDP is measured in dollars, NOT in units of output. Measuring the GDP in dollars allows us to aggregate or add up the output across very diverse types of goods and services. If the GDP were measured in units of output, for example, how do you add up 10 automobiles and two bushels of wheat? What does the sum of those two outputs equal? Can you imagine trying to do that with hundreds of thousands of goods and services and keeping it all in units of output? Fortunately, the GDP is measured in dollars, so if the 10 automobiles are valued at $25,000 each and the two bushels of wheat are valued at $10.00 dollars each, then the GDP is equal to $250,020. Measuring the GDP in dollars allows us to easily aggregate the value of a very disparate output.

The GDP includes the value of the final goods and services produced in a given year so as not to double or triple count the value of intermediate goods that are used in the production of a final product. If we produce an automobile in a given year, we only count the value of the automobile as a final product. We do not count the value of the glass in the windshield and the value of the rubber in the tires (both of which may have also been produced in that same year) and then count the value of the automobile also. If we did, the value of the windshield and the tires would be counted twice. Therefore, the GDP counts only the value of the final goods and services produced in a given year.

The fact that the GDP measures the value of the output in the domestic economy means that it includes the value of all of the final goods and services produced within the borders of the domestic economy, no matter who owns the factors of production. In other words, if a foreign company is producing a good within the borders of the United States, it is counted as part of the US GDP.

Notice in the definition of the GDP that the words in a given year were also italicized. This is to give emphasis to the notion that the GDP in any given year does NOT include the value of everything that is bought and sold in that year. It only includes the final goods and services that were produced in that year. Many items are bought and sold as used items each year, but they were included in the GDP of the year in which they were produced and NOT in subsequent years when they are bought and sold as used items. It will be useful here to mention what happens to the value of an item that is produced in a given year, but does not sell in the year in which it is produced. At the end of the year it is included in inventories for that year and is thereby included in that year’s GDP as will be seen when we discuss how to calculate GDP using the Expenditures Approach.

 

Return to the course in I-Learn and complete the activity that corresponds with this material.

Important Side Note: In 1991, the United States switched from using the GNP as the primary measure of output in our economy to using the GDP. As mentioned earlier, the GDP includes all of the final goods and services produced within the borders of the United States in a given year, no matter the national origin of the company producing those goods and services. A Toyota produced in the United States is, therefore, counted as part of the US GDP. The GNP, on the other hand, includes the value of the final goods and services produced by the national economy in a given year. A Toyota produced in the United States would be counted as part of the Japanese GNP because it was produced by the Japanese national economy. In a similar fashion, a Buick produced in China would be counted as part of the Chinese GDP, but would be counted as part of the US GNP.

There are two different ways to actually calculate the GDP. The GDP can be determined either by adding up all that is spent to buy this year’s output (the expenditures approach) or by summing up all the incomes derived from the production of this year’s output (the income approach).

Section 02: The Expenditures Approach

The expenditures approach to the GDP recognizes that there are four possible uses for the output of an economy in any given year. The output can be purchased by private households, by businesses, by the government, or by the foreign sector.

The total payment made by households on consumption goods and services is called consumption expenditures (C).

Firms, however, do not sell all of their output to households. Some of what they produce is purchased by other firms. The purchase of new plants, equipment, buildings, new homes, and additions to inventories is called investment expenditures (I). Note that is a significantly different definition of investment than the common use of the term. In the national income accounts, buying a stock, or an antique car, or precious gems, or a piece of art is NOT investment. 

Government purchases of finished products of businesses and all direct purchases of resources are called government expenditures (G).

The expenditure by the rest of the world on goods and services produced by domestic firms (exports) minus the US expenditures on goods and services produced by the rest of the world (imports) is called net exports (NX).

Where Y is the GDP (the total output or income of the economy).

Example

Personal Consumption	3,657
Depreciation	400
Wages	3,254
Indirect Business Taxes	500
Interest	530
Domestic Investment	741
Government Expenditures	1,098
Rental Income	17
Corporate Profits	341
Exports	673
Net Foreign Factor Income	20
Proprietor’s Income	403
Imports	704

Let me demonstrate calculating the GDP using the Expenditures Approach with the above hypothetical data:

Section 03: The Income Approach

The Income Approach to calculating the GDP recognizes that the total expenditures on the economy’s output in any given year must equal the total income generated by the production of that same output. Adding up what is spent on purchasing the output of the economy in a given year (the expenditures approach) has to equal the sum of all of the incomes that are generated in producing that output in a given year (the income approach). If you think about the total income earned in a given year by the factors of production, you must go back to the payments made to those factors we discussed previously. Remember that labor is paid a wage, land is paid rent, capital is paid interest, and the entrepreneur is paid a profit. In the case of the entrepreneur, the National Income Accounts recognize that there are two types of entrepreneurs in our economy, and they each earn a different type of profit. One type of entrepreneur starts up his own business and he will earn what is called proprietor’s income. Another type of entrepreneur (remember: an entrepreneur is a risk taker) invests in someone else’s business, and he earns a profit that is called corporate profit. So, we will now define “National Income” as the sum of these five payments made to the four factors of production:

To go from National Income to GDP you must add in the value of production that is never received as income by a factor of production. This is done by adding Indirect Business Taxes (sometimes called sales taxes), Depreciation (the value of the capital that is used up by producing the output of the economy), and Net Foreign Factor Income (NFFI) to National Income. The NFFI is the difference between factor payments received from the foreign sector by US citizens and factor payments made to foreign citizens for US production. Each of these payments hovers around 3% of GDP, but since NFFI is the difference between the two they tend to cancel each other out and NFFI is usually a very small number, less than 1% of GDP.

The final Income Approach to the GDP is therefore given by:

Where, again, Y equals GDP.

Another important measure which is sometime calculated in the National Income Accounts is the called the Net Domestic Product and it is equal to: NDP = GDP – Depreciation

Example

I will demonstrate calculating the GDP using the Income Approach with the hypothetical date given earlier:

This is the same value for the GDP received when calculating it using the Expenditures Approach.

Important Side Note: When using the actual data for a large economy like the United States, the Expenditures Approach and the Income Approach do not yield exactly the same value. However, it turns out to be close and within what the government refers to as a “statistical discrepancy.”

Section 04: Measuring Changes in GDP over Time

The GDP is often used to measure the growth in an economy over time. If the GDP is rising, we assume the economy is growing; if the GDP is falling, the economy is shrinking and presumably is in the midst of an economic downturn. Since the GDP measures the value of the final goods and services produced in the domestic economy in a given year, however, the GDP can rise from one year to the next for one of three reasons: either because the economy has produced more from one year to the next, because the value of the product has gone up from year to year, or both. Since the value is measured in dollar prices, the GDP would go up from one year to the next, even if you produced exactly the same amount of output in both years but the prices of the products were to rise. It is therefore important to distinguish between what is called the Nominal GDP and what is called the Real GDP.

The Nominal GDP measures the value of the output of final goods and services using current dollar prices. It is the value of a given year’s output using the dollar prices that prevailed in that given year (referred to as current dollar prices).

The Real GDP measures the value of the output of final goods and services using constant dollar prices. It is the value of a given year’s output using the dollar prices that prevailed in a previous year, called the base year (referred to as constant dollar prices).

As an example to illustrate the dramatic difference between the nominal and real GDP’s in two different years, consider the fact that the Nominal GDP in the United States in 1960 was 513 billion dollars. In 1990, the US Nominal GDP was 5.757 trillion dollars. Do you think that the US economy really expanded by over 10 times in 30 years? Surely there was growth in the United States between 1960 and 1990, but we did not produce over 10 times as much output in 1990 as in 1960. Part of that seeming growth can be accounted for because prices went up during that 30 year period, so it would be interesting to know what the GDP in 1990 would be calculated to be if the prices in 1990 had been the same as they were in 1960. This would give us a measure called the Real GDP. The Real GDP in 1990 (using 1960 prices as the base year) was approximately 804 Billion Dollars. So we can see, in real terms, the economy did not even double between these two years, whereas in nominal terms it appeared to go up by over ten times! This should illustrate the importance of looking at the real GDP when calculating growth in an economy, so as not to be misled into thinking an economy is growing when it is actually just experiencing large increases in prices.

Price Indices and GDP Growth

Inflation is an upward movement in the average level of prices and deflation is a downward movement in the average level of prices. The price level is measured by a price index—the average level of prices in one period relative to their average level in an earlier period. The two most common price indices are called the Consumer Price Index (CPI) and the GDP Deflator. We will discuss the CPI in a future lesson.

GDP Price Index

The GDP Deflator includes all of the items (C,I,G, and NX) included in the GDP. When comparing the value of the GDP from year to year, we use the GDP Deflator to make a valid comparison, i.e. one that takes into account the changes in prices that have occurred in the economy between the two years.

In order to calculate Real GDP, we use the GDP Deflator. For example, let’s assume we have a very simple economy that only produces three products: pineapples, snorkels, and beach umbrellas. The prices and outputs of these items in the current and base years are as follows:

		Current Period		Base Period
ITEM	Output	Price	Expenditures	Price	Expenditures
Pineapples	4,240	$1.30	$5,512	$1.00	$4,240
Snorkels	5,000	$10.00	$50,000	$8.00	$40,000
Umbrellas	1,060	$100.00	$106,000	$100.00	$106,000

The Nominal GDP will be the value of the current year’s output using the current year’s prices:

The Real GDP will be the value of the current year’s output using the base year’s prices:

Notice that the GDP Deflator is equal to the Nominal GDP divided by the Real GDP and multiplied times 100.

This deflator tells us that there has been 4.175% inflation over the period from the base year to the current year. Note that if the prices had been the same in the base year and in the current year, the Nominal and the Real GDP would have been the same in the current year and the deflator would have equaled 100. A deflator of 100 indicates NO inflation between the two periods. A deflator greater than 100 indicates inflation and a deflator less than 100 indicates deflation (a decline in the average price level from one year to the next).

Is the GDP a Good Measure of Economic Output and Welfare?

Several examples of items not included in the official GDP statistics have caused some to suggest that the GDP is a poor measure of the economy’s total output. In other words, some final goods and services produced in the economy are not counted as part of the GDP. The suggestion, therefore, is that the official GDP reported in any given year seriously under-represents the total value of all final goods and services produced in the economy in that year. Consider the following examples:

Underground Economy—most goods and services that are illegal or produced “under the table” are not counted in the GDP. This could be anything from illegal drugs to you building a deck on your neighbor’s house and him rebuilding your engine in exchange.

Household Services—if you hire a maid to come in and clean your house, it is counted as part of the GDP, but if you clean your house yourself, it is not counted as part of the GDP. Most household production is not counted as part of the GDP, even though a final good or service is produced.

Additionally, some suggest the GDP is a poor measure of social welfare. For example, you could have two countries with exactly the same GDP and population, which might lead you to believe that both countries are equally well off. In Country A, however, the workers may labor for 70 hours per week, while in Country B they may labor for only 40 hours per week. Or Country A may be a dirty and polluted place to live, while Country B may be a pristine, pleasant place to live. As long as we value things like leisure time and clean living conditions, the GDP alone will not tell us how well off a population is.

Return to the course in I-Learn and complete the activity that corresponds with this material.