National Income accounting

• Why accounting?
• Provides a formal structure for macro-theory models. In addition to looking at real output, the national income accounts include measures of overall price level.
• Provides a few numbers with which one can characterize the economy.
• GDP (Gross domestic product) is the value of all final goods and services produced in the country within a given period.

• Inputs such as labor and capital are called factors of production and the payments made to factors, such as wages and interest payments, are called factor payments.

• GDP and GNP: GNP is GDP along with the receipts from abroad, for example, the profits of Honda in U.S. will be added in the GNP of Japan.
• GDP and NDP: The capital wears out, or depreciates, while it is being used to produce output. Net domestic product (NDP) is equal to GDP minus the depreciation.
• National income: Businesses pay indirect taxes (taxes on sales, property, and production) that must be subtracted from the NDP before making factor payments. What is left for making factor payments is national income.

• About 3/4th of factor payments are payments to labor and the remainder goes to pay capital. (Labor is the dominant factor payment and GDP is the sum of all factor payments).

Components of Demand

• Total demand for domestic output is made up of four components:

1. consumption spending by households (C)
2. investment spending by businesses and households (I)
3. government purchases of goods and services (G)
4. foreign demand for out net exports (NX)

• The fundamental national income identity is

\[ Y \equiv C + I + G + NX \]

• Examples of consumption spending by household sector are foods, golf lessons,
• Examples of government purchases of goods and services are spending on national defenses, cost of road paving, salaries of government employees.
• We refer to government spending on goods and services are purchases of goods and services. In addition, government makes transfer payments (payments that are made to people without the people providing a current service in exchange). Typical transfer payments are social security benefits and unemployment benefits. Transfer payment are not counted as part of GDP and they are not part of current production.
• Investments: Investment means additions to the physical stock of capital. Examples are housing construction, building or machinery, construction of factories and offices, addition to a firm’s inventories of goods.
• Human capital: is the knowledge and ability to produce that is embodied in labor force. Though investment in education can be regarded as investment in human capital, the official accounts treat personal educational investments as consumption and public educational expenditures as government spending.
• Convention: Investment is associated with the business sector’s adding to the physical stock of capital, including inventories. All household expenditures (except housing construction) are considered as consumption spending. The total investment is regarded as gross investment and net investment is gross investment minus depreciation.
• Net exports: Accounts for domestic spending on foreign goods and foreign spending on domestic goods. The difference between the exports and imports is called net exports.

Identities

Simple Economy

• A simple economy is one in which there are no government and foreign sector.
• The value of output is denoted by \(Y\), consumption by \(C\) and investment spending by \(I\).
• Output produced equals output sold, i.e., \(Y = C + I\).
• The income, \(Y\), will be allocated as savings and the remaining will be consumption. Here \(S\) denote private saving. Then \(Y = S + C\).
• Combining two equations, we see that \(S = I\). In a simple economy, investment is equal to saving.
• In a simple economy, the only way an individual can save is by undertaking an act of physical investment.

Economy with Government and Foreign trade

• We denote government purchase of goods and services by \(G\), and all taxes by \(TA\). Transfers to private sector (including interest to public debt) is denoted by \(TR\). Net exports (exports minus imports) is \(NX\).
• Fundamental identity: \(Y = C + I + G + NX\).
• The disposable income (YD) is equal to income plus transfers less taxes, hence \(YD = Y + TR - TA\). The disposable income is equal to savings plus consumption. \(YD = C + S\).
• We see that

\[ S - I = (G + TR - TA) + NX.\]

• The term \(G + TR - TA\) is called government budget deficit (BD). \(G + TR\) is the total government expenditure. Budget deficit is the excess of government’s spending over it’s receipts and it is negative of Budget surplus (\(BS = TA - (G + TR)\)). NX is called trade surplus and when it is negative, it is called trade deficit.
• The identity says that the excess of savings over investment in the private sector is equal to the government budget deficit plus the trade surplus.

Measuring GDP

• Final goods and value added: We insist on final goods so that we can avoid double counting, i.e., the intermediate goods are not considered into. This can also be achieve by finding sum total of value added at each step.
• Current output: GDP consists of value of output currently produced. It thus excludes transactions in existing commodities, such as old masters of existing houses (we add construction of houses in GDP, but we do not add change of houses).

Problems of measurement of GDP

• GDP data are often far from perfect measures of either economic output or welfare.
• Valued added at households are not counted in GDP, things like taking care of own children, etc, have a value of zero.
• The accounts does not subtract anything for environmental pollution and degradation.
• It is difficult to account correctly for improvements in the quality of goods. National income accountants try to adjust for improvements in quality, but the task is not easy.
• There are attempts made to construct an adjusted GNP that takes into account some of the difficulties.

Inflation and Price indices

• Real GDP measures changes in physical output in the economy between different time periods by valuing all goods produced at the same prices.

• Nominal GDP measures the value of output in a given period in the prices of that period, or at current value of money.

• Inflation is the rate of change in prices, and the price level is the cumulation of past inflations. If \(P_{t-1}\) represents the price level last year and \(P_t\) represent today’s price level, then the inflation rate over the past year can be written as \(\pi = \frac{P_{t} - P_{t-1}}{P_{t-1}}\). If the inflation rate is negative, one terms it as deflation.

Price indices

• The main price indices are
• GDP deflator,
• Consumer price index (CPI),
• Personal consumption expenditure deflator,

• Producer price index.

• GDP deflator: GDP deflator is the ratio of nominal GDP in a given year to the real GDP of that year.
• Consumer price index: Measures the cost of buying a fixed basket of goods and services representative of the purchases of urban customers.
• CPI differs from GDP deflator is three ways:
• Deflator measures the prices of a much wider group of goods and services than CPI does.
• CPI measures the cost of a given basket of goods which is the same from year to year, however the basket of goods included in deflator differs from year to year.
• CPI includes prices of imports, whereas the deflator includes only the prices of goods produces within the country.
• Personal consumption expenditure deflator (PCE) measures inflation in consumer purchases bases on the consumption sector of the national income accounts.

• Producer price index (PPI), like CPI is a measure of the cost of a given basket of goods. It differs fro CPI by it’s coverage; the PPI includes, for example, raw materials and semi-finished goods. PPI is constructed from prices at the level of the first significant commercial transaction.

• Core inflation: Prices of certain goods are volatile, suggesting that price changes are often temporary. For this reason, policymakers often concentrate on core inflation, which excludes changes to food and energy sector, these measures are often reported for both CPI and PCE deflator.

• Unemployment: rate measures the fraction of workforce that is out of work and is looking for job or expecting a recall from layoff.

• Interest rates: Nominal interest rates lists returns in terms of current value of currency, while real interest rates subtract inflation to give return in terms of currency of constant value.

• Exchange rate: is the price of foreign currency. Some countries allow exchange rate to float, meaning that price is determined by supply and demand. Other countries fix the value of exchange rate by offering to exchange their currency for dollars at a fixed rate. The exchange rate need not reflect on whether goods are expensive or cheap in the other country.