2-1

Chapter 2

National Income Accounting

• Item
• Item
• Item
• Etc.

McGraw-Hill/Irwin
Macroeconomics, 10e 2-2
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
 Introduction
• Why do we study the national income accounts?
1. National income accounting provides structure for our
macroeconomic theory models
2. Introduces statistics that characterize the economy
• Output defined in two ways
1. Production side: output = payments to workers in wages, capital
in interest and dividends
2. Demand side: output = purchases by different sectors of the
economy
 as per accounting, output measured via demand and
production equal in equilibrium
• Output typically measured as GDP = value of all final
goods and services produced within a country over a
particular period of time.
2-3
 Production Side of the Economy
• The production side of the economy transforms
inputs (labor, capital) into output (GDP)
• Inputs referred to as factors of production
• Payments to these factors are referred to as factor
payments
• The relationship between inputs and outputs is
defined by the production function  Y  f ( N , K ) (1)
where Y = output, N = labor, K = capital
• “Output is a function of labor and capital,” where the
functional form can be defined in various ways
• The production function is crucial to the discussion of
growth theory in chapters 3 and 4

2-4
 From GDP to National Income
• Use the terms output and income interchangeably in
macroeconomics, but are they really equivalent?
There are a few crucial distinctions between them:
1. Capital wears down over time while it is being used in
the production process  Net domestic product = GDP –
depreciation
• NDP is the total value of production minus the value of the
amount of capital used up in producing that output
• NDP is usually 89% of GDP
2. Businesses pay indirect taxes (i.e. taxes on sales,
property, and production) that must be subtracted from
NDP before making factor payments  National Income
= NDP – indirect business taxes
• Indirect business taxes account for nearly 10% of NDP
• National income is roughly 80% of GDP

2-5
 Components of Demand
• Total demand for domestic output is made up of
four components:
1. Consumption spending by households (C)
2. Investment spending by firms (I)
3. Government spending (G)
4. Foreign demand for our net exports (NX)

 The fundamental national income accounting identity is

Y  C  I  G  NX (3)

2-6
 Consumption
• Consumption = purchases [Insert Figure 2-2 here]
of goods and services by
the household sector
• Includes spending on durable
(ex. Cars), non-durable (ex.
Food), and services (ex.
Medical services)
• Consumption is the primary
component of demand
• Consumption as a share of
GDP varies by country
• Figure 2-2 compares
consumption as a share of
GDP for the U.S. to Japan

2-7
 Government
• Government purchases of goods and services
include items such as national defense expenditures,
costs of road paving by state and local
governments, and salaries of government
employees
• Government also makes transfer payments =
payments made to people without their providing a
current service in exchange
• Ex. Social security, unemployment benefits
• Transfer payments are NOT included in GDP since not a
part of current production
• Government expenditure = transfers + purchases

2-8
 Investment
• Investment = additions to the physical stock of
capital (i.e. building machinery, construction of
factories, additions to firms inventories)
• In the national income accounts, investment
associated with business sector’s adding to the
physical stock of capital, including inventories
• Household’s building up of inventories is considered
consumption, although new home constructions
considered part of I, not C
• Gross investment included in GDP measure, which is
net investment plus depreciation
2-9
 Net Exports
• Accounts for domestic [Insert Fig. 2-4 here]
purchases of foreign goods
(imports) and foreign
purchases of domestic
goods (exports)  NX =
Exports – Imports
• Subtract imports from GDP
since accounting for total
demand for domestic
production
• NX can be >, <, or = 0
• U.S. NX has been negative
since the 1980’s  trade
deficit
2-10
 Some Identities: A Simple Economy
• Assume national income equals GDP, and thus use terms
income and output interchangeably (convenience)
• Begin with a simple economy: closed economy with no public
sector  output expressed as Y  C  I (4)
• Only two things can do with income: consume and save 
national income expressed as Y  C  S (5), where S is
private savings
• Combine (4) and (5): C  I  Y  C  S (6)
 
demand income
• Rearrange (6) s.t. I Y C  S (7), or investment =
savings

2-11
 Some Identities: Adding G and NX
• When add the government and the foreign sector, the
fundamental identity becomes Y  C  I  G  NX (8)
• Disposable (after-tax) income, YD, is what consumers split
between C and S when have a public sector, or
YD  Y  TR  TA (9), where TR = transfer payments
and TA = taxes  YD  C  S (10)
• If rearrange (9) and substitute (8) for Y, then
YD  TR  TA  C  I  G  NX (11)
• Substituting (10) into (11): C  S  TR  TA  C  I  G  NX
(12)
S  I  (G  TR  TA )  NX
• Rearranging: (13)

2-12
 S, I, Government Budget, and Trade
• S  I  (G  TR  TA )   NX , where G + TR is total
      TradeSurplus
BudgetDeficit

government expenditures and TA is government income 

difference between expenditures and income is the
government budget deficit
• Excess of savings over investment (S > I) in the private sector is
equal to the government budget deficit plus the trade surplus
• Any sector that spends more than it receives in income has to
borrow to pay for the excess spending
• Private sector can dispose of savings in three ways:
1. Make loans to the government
2. Private sector can lend to foreigners
3. Private sector can lend to firms who use the funds for I

2-13
 Measuring Gross Domestic Product
• GDP = the value of final goods and services currently
produced within a country over a period of time
• Only count final goods and services  NO DOUBLE COUNTING
• Ex. Would not include the full price of a car AND the tires bought
by the manufacturer for the car  tires = intermediate goods
• Only count goods and services currently (in the time period being
considered) produced & excludes transactions involving used goods
• Ex. Include the construction of new homes in current GDP, but not
the sale of existing homes
• Only count goods and services produced within a country, regardless
of the ownership/nationality of the producing firm
• Ex. Include the sale of a car produced by a Japanese car
manufacturer located in the U.S. in U.S. GDP

2-14
 Problems of GDP Measurement
• There are three major criticisms of the GDP
measure:
1. Omits non-market goods and services
• Ex. Work of stay-at-home mothers and fathers not included in GDP
2. No accounting for “bads” such as crime and pollution
• Ex. Crime is a detriment to society, but there is no subtraction from
GDP to account for it
3. No correction for quality improvements
• Ex. Technological improvements are beneficial to the economy, but
nothing is added to GDP to account for them

 Despite these drawbacks, GDP is still considered

one of the best economic indicators for estimating
growth in an economy
2-15
 Nominal vs. Real GDP
• NGDP is the value of output in a given period measured in
current dollars
• NGDP in 2007 is the sum of the value of all outputs measured in 2007
dollars: N
NGDP2007   Pi 2007 2007
* Qi
i 1
• Changes in NGDP could be purely due to changes in prices  if GDP
is to be used as a measure of output, need to control for prices
• RGDP is the value of output in constant dollars  scaled by
a based year price, so that any change in GDP is due to
change in production, not prices
• If PB is the price in the base year for good i, RGDP in 2007 is:
N
RGDP2007   Pi B * Qi2007
i 1

2-16
 Inflation and Prices
• Inflation, , is the rate of change of prices:   Pt  Pt 1
t
Pt 1
where Pt is today’s price and Pt-1 is last period’s price
• Additionally, Pt  Pt 1  ( Pt 1 *  ) , or today’s price equals
last year’s price, adjusted for inflation
• If  > 0, prices are increasing over time  inflation
• If  < 0, prices are decreasing over time  deflation
• How do we measure prices?
• For the macroeconomy, need a measure of overall prices = price
index
• There are several price indexes, but most common are CPI, PPI, and
the GDP deflator

2-17
 Price Indexes: GDP Deflator
• GDP deflator is the ratio of NGDP in a given year to
RGDP of that year
• Since GDP deflator is based on a calculation involving all
goods produced in the economy, it is a widely based price
index that is frequently used to measure inflation
• Measures the change in prices between the base year and
the current year
• Ex. If NGDP in 2006 is $6.25 and RGDP in 2006 is
$3.50, then the GDP deflator for 2006 is
$6.25/$3.50 = 1.79  prices have increased by
79% since the base year

2-18
 Price Indexes: CPI
• CPI measures the cost of buying a fixed basket of
goods and services representative of the
purchases
of urban consumers
• Measure of the cost of living for the average household
• Differs from GDP deflator in three ways:
1. CPI measures prices of a more limited basket of goods and
services (only household goods and services)
2. The bundle of goods in the consumer basket is fixed, while
that of the deflation is allowed to vary
3. CPI includes prices of imports, while GDP deflator only
considers those goods produced within the U.S.
2-19
 Price Indexes: PPI
• PPI measures the cost of buying a fixed basket of
goods and services representative of a firm
• Captures the cost of production for a typical firm
• Market basket includes raw materials and semi-finished
goods
• PPI is constructed from prices at an earlier stage of
the distribution process than the CPI
• PPI signals changes to come in the CPI and is thus
closely watched by policymakers
 Over long periods of time, the two measures
yield similar values and trends for inflation
2-20
 Unemployment
• The unemployment rate measures [Insert figure 2-8 here]
the fraction of the workforce that
is out of work and looking for a
job or expecting a recall from a
layoff
• Important indicator of well-being
of an economy as being without a
job suggests a reduction in
income and purchases
• Optimal unemployment rates
differ from country to country 
optimal unemployment rate linked
to the potential level of output for
a given economy (see figure 2-8)

2-21
 Interest Rates and Real Interest Rates
• Interest rate = rate of payment on a loan or other
investment over and above the principle repayment
in terms of an annual percentage
• Cost of borrowing money OR benefit of lending money
• Nominal interest rate = return on an investment in
current dollars
• Real interest rate = return on an investment,
adjusted for inflation
• If R is the nominal rate, and r is the real rate, then
we can define the nominalR rate
r  as:

2-22
 Exchange Rate
• Each country has its own currency in which prices
are quoted
• In the U.S. prices are quoted in U.S. dollars, while in
Canada prices are quoted in Canadian dollars and most of
Europe uses the euro
• Exchange rate = the price of a foreign currency
• Ex. The British pound is worth U.S. $1.84
• Floating exchange rate  price of a currency is
determined by supply and demand
• Fixed exchange rate  price of a currency is fixed
• Ex. A Bermuda dollar is always worth one U.S. dollar
2-23
 Section Summaries
• GDP is the value of all final goods and services produced in
the country within a given period.
• On the production side, output is paid out as factor
payments to labor and capital. On the demand side, output
is consumed or invested by the private sector, used by the
government, or exported.
• Y ≡ C + I + G + NX.
• C + G + I + NX ≡ Y ≡ YD + (TA – TR) ≡ C + S + (TA – TR).
• The excess of the private sector's saving over investment is
equal to the sum of the budget deficit and net exports.
• Nominal GDP measures the value of output in a given period
in the prices of that period, that is, in current dollars.

2-24
 Section Summaries
• Inflation is the rate of change in prices, and the price level is
the cumulation of past inflations.
• Nominal interest rates give the return on loans in current
dollars. Real interest rates give the return in dollars of
constant value.
• The unemployment rate measures the fraction of the labor
force that is out of work and looking for a job.
• The exchange rate is the price of one country's currency in
terms of another's.

2-25