Lecture 2 National Income Accounting National Income Accounting

Lecture 2 National Income Accounting

National Income Accounting • The circular flow of income and expenditure • Measurement of National Income • The Components of GDP – C, I, G, NX 2

Economy’s Income & Expenditure • A nation’s total income gives an idea of performance of the economy • Gross Domestic Product (GDP) – Measures the total income of everyone in the economy – Measures the total expenditure on the economy’s output of goods and services • For an economy as a whole – Income must equal expenditure – Every transaction has a buyer and a seller • If someone pays someone else Ghc 100 to mow a lawn, the expenditure on the lawn service (Ghc 100) is exactly equal to the income earned from the production of the lawn service (Ghc 100). 3

Economy’s Income & Expenditure • Circular-flow diagram: – Another way to see equality of income and expenditure – Describes all transactions between all households and firms in a simple economy 4

Circular Flow diagram • Assumptions – Markets • Goods and services • Factors of production – Households • Own all factors of production • Spend all of their income – Firms • Pay rewards (wages, rent, profit) to resource owners 5

The Circular-Flow Diagram 6

The Circular Flow Diagram • In the circular flow diagram, money flows from households to firms, back to households and firms, etc… • We can therefore calculate GDP in this economy in two ways: – Adding up total purchases of households (expenditure) • Or, – Adding up total income (i. e. wages, interest, rent, profit) paid by firms and earned by households 7

The Circular Flow Diagram • Model unrealistic, however • Limitations? 8

The Circular Flow Diagram • Model unrealistic, however • Limitations – Households do not spend all of their income • Savings • Taxes – Households do not purchase all goods and services produced by firms • Government purchases • Other firms also make purchases for their own future production 9

The Measurement of GDP • Gross domestic product (GDP) – Market value of all final goods and services produced within a country in a given period of time 10

The Measurement of GDP • “GDP is the market value…” – “Cannot compare apples and oranges”. • But GDP does exactly that! How? – Use of market prices • reflect the value of the goods • What is a limitation of the use of market prices in calculating GDP? – Do increases in total market values always indicate increases in production of goods and services in an economy? 11

The Measurement of GDP • “… of all…” – All items produced in the economy • And sold legally in markets • Would goods like land, stocks or bonds be included in GDP? Why? • GDP includes value of owner-occupied homes – Rental values imputed 12

The Measurement of GDP – Excludes some items • Produced and sold illicitly – Examples? • Produced and consumed at home – Examples? – Interesting Thought: » Adwoa pays Kofi to weed her home for Ghc 100 a month. Contribution to GDP? » Adwoa marries Kofi still weeds the home each month. Contribution to GDP? 13

The Measurement of GDP • “… final…” – AC Bakeries use flour in the preparation of their loaves of bread • Are the flour and loaves both included in calculation of GDP? – Value of intermediate goods is already included in the prices of the final goods – Why is this important? – Exception: An intermediary good is produced and rather than being used, is added to firm’s inventory, to be used at a later date 14

The Measurement of GDP • “… goods and services…” – Tangible goods & intangible services • Books, shoes, etc • Haircut, music concert, etc 15

The Measurement of GDP • “… produced…” – Goods and services currently produced – Sale of new vs. used car 16

The Measurement of GDP • “… within a country…” – Goods and services produced domestically • Include output produced by foreigners • Exclude output produced by nationals in a foreign country 17

The Measurement of GDP • “… in a given period of time” – A year or a quarter 18

Discussion questions 1. What contributes more to GDP- production of an economy car or a luxury car? Why? 2. GDP does not include the value of used goods that are resold. Why would including such transactions make GDP a less informative measure of economic wellbeing? 3. A few years ago, Ama paid Ghc 500 to put together a record collection. Today, she sold her albums at a garage sale for Ghc 100. How does this sale affect GDP? 4. A farmer sells wheat to a baker for Ghc 2. The baker uses the wheat to make bread, which is sold for Ghc 3. What is the total contribution of these transactions to GDP? 19

THE COMPONENTS OF GDP 20

The Components of GDP • At any given time, various forms of spending on domestically produced goods may be happening: – Addo family may be having lunch at Papaye; Valco may be building a new factory; the Govt may be building new hospitals; Cadbury may be buying cocoa from domestic producers • We can study the composition of GDP among various types of spending 21

The Components of GDP • GDP is divided into four main components: – Consumption – Investment – Government Purchases – Net Imports • Exports • Imports 22

Consumption • Consumption, C • The part of GDP purchased by households as final users • Spending by households on goods and services • Largest component of GDP • Includes estimations for – Food, fuel, clothes, haircuts, concerts, etc • Includes household spending on education – Consumption vs investment good? ? ? 23

Consumption • Households buy but not part of Consumption (and therefore may not be part of GDP): – purchases of new housing – Used goods • why exempted? – Stocks, bonds and land • Why exempted? • Part of Consumption but households do not buy: – Total value of food stuffs produced on farms and consumed by farmers and families – Total value of housing services produced by owner-occupied homes 24

Private Investment • Investment is the purchase of goods that will be used in the future to produce more goods and services – Capital formation • Three components: – Business purchases of plant, equipment, and software – New-home construction – Changes in inventory stocks • Goods that have been produced but not yet sold 25

Private Investment • Business purchases of plant, equipment, and software • Why not considered as intermediate goods? 26

Private Investment • Business purchases of plant, equipment, and software • Why not considered as Intermediate goods? – Intermediate goods used up in production of this year’s goods and services – Firm’s plants, equipment and software lasts for many years » Only a small part used to make up current production • Therefore, new plant, equipment and software regarded as final goods 27

Private Investment • New Home Construction – Most new homes purchased by households • Why not included in Consumption? 28

Private Investment • New Home Construction – Most new homes purchased by households • Why not included in Consumption? – Residential housing an important part of country’s capital stock – Increases in capital stock regarded as investment » Measure of Private Investment should correspond with increase in nation’s capital stock 29

Private Investment • Changes in Inventory – Inventory: Goods that are produced but not yet sold • Goods on store shelves • Goods making their way through the production process in factories • Raw materials waiting to be used – Count changes in firms’ inventories as part of investment in measuring GDP 30

Private Investment • If do not include, could underestimate total production of goods and services in a year • Scenario – In a year, automobile industry produced $100 bn worth of automobiles • $80 bn sold to customers • Remaining unsold $20 bn added to inventories – If count consumption alone, we underestimate total production • Contribution to GDP is $80 bn(consumption) + $20 bn(private investment)= $100 bn 31

Private Investment • What if Inventory stocks decline during the year? • Scenario – Automobile industry produced $100 bn this year, but sold $120 bn • Extra $20 bn must have come from inventory stocks – Excluded. Why? • Total contribution to GDP $120 bn(Consumption) + [-20 bn(Private Investment)]= $100 bn 32

Private Investment • Inventory added to nation’s investment because unsold goods part of a nation’s capital stock – Provide services in the future when finally sold and used • An increase in inventories – Increase in nation’s capital stock • A decrease in inventories – Decrease in nation’s capital stock 33

Private Investment • Excludes – Government investment • Police cars, courthouses, fire stations, schools, etc – Consumer durables • Fridges, computers, washing machines, etc – Human capital • Additional skills and training acquired by workforce during the year • E. g. surgeon, electrician, police detective, etc • Ignores depreciation – Capital used up during the year • Other measures of total income 34

Government Purchases • Spending by state and local governments on goods and services • Government Investment – Capital goods purchased by government agencies • Roads, hospitals, schools, etc • Government Consumption – Spending on goods and services that are used up during the period • Salaries of gov’t workers, computer paper for gov’t offices, fuel for gov’t vehicles, electricity used in gov’t building, etc 35

Government Purchases • Includes goods and services – Goods • Fighter jets, police cars, school buildings – Services • Performed by police, legislators, military, etc 36

Government Purchases • Government purchases do not include transfer payments – Any payment that is not compensation for supplying goods, services or resources – Money redistributed from one group of citizens (taxpayers) to another (the poor, the unemployed, the elderly) • Example: unemployment insurance benefit, welfare payments, money disbursed to homeless shelters, etc • Why not included? 37

Net Exports • Net exports, NX = Exports - Imports – Exports • Spending on domestically produced goods by foreigners – Imports • Spending on foreign goods by domestic residents 38

Measurement of national income • Expenditure Approach • Value-Added Approach • Factor Payments (or Income) Approach 39

The Expenditure Approach • Add up value of the goods and services purchased by each category of final user GDP= C + I + G + NX 40

GDP and Its Components: Expenditure Approach This table shows total GDP for the U. S. economy in 2009 and the breakdown of GDP among its four components. When reading this table, recall the identity Y = C + I + G + NX. 41

Next Class- Postponed • Measurement of national income – Value-Added Approach – Factor Payments (or Income) Approach • Other measures of Income – GNP, National Income, Personal Income, Disposable income • Nominal and real measures • Limitations of the national income concept 42