Tracking the U.S. Economy

1. National Income Accounting2. Expenditure approach to GDP3. Income approach to GDP4. Circular flow of income and

expenditure5. Leakages and injections6. Limitations of GDP

National income accounting (NIA) is the measurement of aggregate or total economic activity.

NIA is useful for assessing the performance of the

macroeconomy. NIA is also helpful in evaluating the effectiveness of policy

initiatives such as the Bush tax cuts.

“One person’s spending is another person’s income”

Every dime I spend for new goods and services must be received as income (wages,

salaries, rent, interest, or profit) by resource owners.

Aggregate spending for new, final goods and services = GDP = Aggregate income received by resource owners (national Income)

•Expenditure approach to GDP: Add together all spending on new, final goods and services produced within the nation’s borders in a year.•Income approach: Add all earnings from all resources used to produce output within the nation’s borders in a year.

GDP = C + I + G + (X – M)

Where,

C is personal consumption expenditure;I is gross private domestic investment;G is government expenditure (local, state, and federal)X is exports, and;M is imports

Expenditure approach

The market value of all final goods and services and services produced during a year by resources located within the country, regardless of who owns the resources.

Gross Domesti c Product (GDP)

Final goods and services are sold to final, or end, users.

For example, tires purchased by a consumer are final goods. Tires purchased by Ford Motor are intermediate goods.

Production in a Toyota Plant in Kentucky is counted in U.S. GDP. Production in a Ford Plant in Mexico is counted in Mexican GDP.

Household spending for newly-produced goods and services is defined as consumption. We distinguish between 3 categories or types:

Spending for consumer durables

Spending for consumer nondurables

Spending for consumer services.

Consumpti on

Category

Spending in 2007

(billions)

Percent of Total

Durables $1,082.5 11

Nondurables 2,804.5 29

Services 5,949.7 60

Source: Bureau of Economic Analysis

Consumer Spending by Type, 2007 (in billions)

Total spending byU.S. households

in 2007 was a $9.9

trillion

Gross private domesti c investment ( I )

•Business spending for newly built equipment, software , and structures.•Net additions to business inventories of raw materials , semifinished goods, and finished goods.•New residential housing construction.

Investment does NOT include

•The purchase of stocks, bonds, or other financial assets.

•Secondhand salesRemember that investment only

happens when there is production of new

tangible capital goods

$505

$1,024

$540

Components of Investment, 2007 (in billions)

Bus. StructuresEquip. & SoftwareResidential

Inventory invest-ment (-30.4 billion) not included

Government Expenditures

For purposes of computing GDP, G DOES NOT include

transfer payments such as social security or

food stamps.

All expenditures for newly produced, final goods and services by all levels of government.

Net Exports (X – M)

We subtract imports from GDP since we

do not want to count foreign output in

domestic GDP

Net Exports (NX) of the U.S. (Monthly)

MEASURING U.S. GDPThe Expenditure Approach

Value-addedAt each stage of production, the selling price of a product minus the cost of intermediate goods purchased from other firms.

Value-added is equivalent to the factor income earned by resource owners at a particular stage of production (like oil drilling).

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Computation of value added for a new desk

Stage ofProduction

(1)Sale

Value

(2)Cost of

IntermediateGoods

(3)Value

Added

LoggerMillerManufacturerRetailer

$20 50120200

-$20 50 120

$20 30 70 80

Market value of final good $200

The value added at each stage of production is the sale price at that stage minus the cost of intermediate goods, or column (1) minus column (2). The value added at each stage sum to the market value of the final good.

The Income Approach The NIA divides earned income into 2

categories:

1. Wages or compensation of employees: Includes wages and salaries plus fringe benefits—such as health insurance, pension, and social security contributions.

2. Interest, Rent, and Profit or the net operating surplus: the sum of the incomes earned by capital, land, and entrepreneurship.

Interest, Rent, and Profit

–Interest is the income households receive on loans they make minus the interest they pay on their borrowing. –Rent includes payments for the use of land and other rented inputs.–Profit includes the profits of corporations and small businesses.

Net Domestic Product at Factor Cost: The sum of factor payments—wages, interest, rent and profits.

We must make two adjustments to get from net

domestic product at factor cost to GDP

1. From factor cost to market price;

2. From gross to net.

From Factor Cost to Market Price

– The expenditure approach values goods at market prices; the income approach values them at factor cost.

– Indirect taxes (such as sales taxes) make market prices exceed factor cost.

– Subsidies (payments by government to firms) make factor cost exceed market prices.

– To convert the value at factor cost to the value at market prices, we must:

• Add indirect taxes and subtract subsidies

From Gross to Net

–The expenditure approach measures gross product; the income approach measures net product.–Gross profit is a firm’s profit before subtracting the depreciation of capital.–Net profit is a firm’s profit after subtracting the depreciation of capital.–Depreciation is the decrease in the value of capital that results from its use and from obsolescence.

MEASURING U.S. GDP: The Income Approach

Disposable Income (DI )and Net Taxes (NT )

Disposable income (DI) is the income households have available to spend or save after paying taxes and receiving transfer payments.

Net taxes (NT) are tax payments minus transfer payments received

Note that: GDP = DI + NT

and: DI = C + S

Leakages and Injecti ons

Leakages are any diversion from the domestic spending stream; includes saving, taxes, and imports.

Injections are expenditure in domestic goods markets by spending agents other than domestic households; includes investment, government expenditure, and exports.

Leakages Equal Injecti ons

National Income accounting identities:

C + I + G + (X – M) = DI + NT (1)

DI = C + S (2)

Substitute (2) into (1) to obtain:

C + I + G + (X – M) = C + S + NT (3)

Canceling out C’s and adding M to both sides:

I + G + X = C + S + M (4)

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Circular flow of income and expenditure

1: GDP=aggregate income2: Taxes leak3: Transfer payments enterNet taxes: NT = taxes – transfers4: Disposable income flows to householdsDI = aggregate income – NT5: Households spend or save DIConsumption entersSavings leak6: Investment enter7: Government purchases enter8: Imports leak9: Exports enter10: Consumption + Investment + Government purchases + Net export = Aggregate expenditure

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Expenditure and income statement for the US economy in 2006 (in trillions of dollars)

Aggregate Expenditure

Consumption (C) Gross investment (I)Government purchases (G)Net exports (X-M) GDP

$9.22 2.21 2.52 -0.76$13.19

cc

Aggregate Income

DepreciationNet taxes on productionCompensation of employeesProprietors’ incomeCorporate profitsNet interestRental income of persons GDP

$1.61 0.92 7.45 1.01 1.55 0.60 0.05$13.19

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Deriving net domestic product and national income in 2006 (in trillions of dollars)

Gross domestic product (GDP)Minus depreciationNet domestic product

Plus net earnings of American resources abroad

National income

$13.19 -1.61 11.58

+ 0.08$11.66

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• Deriving personal income and disposable income in 2006 (in trillions of dollars)

National incomeIncome received but not earned minus income earned but not received

Personal incomeMinus personal taxes and nontax charges

Disposable income

$11.66

-0.68 10.98

-1.35 $9.63

•Household (non-market) production

•The underground economy

•Leisure time

•Environment quality

Limitations of (real) GDP as a measure of the standard of living

Economist Quality of Life Index

•Income•Health•Freedom•Unemployment•Family life•Climate,•Political stability and security•Gender equality•Family and community life

The Economist Index weighs the following

factors

Country/Rank1

Index

Ireland/1 8.33

Norway/3 8.05

Australia/6 7.93

Italy/8 7.81

Spain/10 7.73

USA/13 7.62

Japan/17 7.39

France/25 7.08

Mexico/32 6.77

China/60 6.08

Indonesia/71 5.81

Russia/105 4.801 Out of 111 countries rated

Source: The Economist Index ranges from 1 to 10.