Chapter 7 National Economic Accounting I. Expenditure Approach: measures the values of the goods and services that are bought Income Approach: measures incomes generated in producing the national output Another way of saying this is the expenditure approach adds up prices for all the output in the economy (over a one-year period) while the income approach adds up the costs for all the inputs needed to make the output. Table 7-2 (p.171) demonstrates the equality of the two approaches. All the value of the output is distributed to the various factors of production and nonincome costs. II. Gross Domestic Product (GDP) takes the expenditure approach, adding up values of good bought by C, I, and G, and subtracting the trade deficit (X-M=Xn). GDP is defined as the market value of all final goods and services produced in a year in a given economy. A given economy nearly always just means, “in one country.” A. Final goods and services means that only the price paid when the new production is bought gets counted. Most of the economy’s output goes through stages of production, and changes hands from producer to producer, each one adding some value in the good’s process of becoming final. To add in the values of the good at intermediate steps would be doublecounting, because all intermediate values are included in the final price. B. Work in progress and unsold inventory at the end of the year represents output for the year, so that must be added in GDP. Also, some of the output bought this year was from last year’s inventory or partially built last year. So last year’s inventory (that gets sold this year) must be subtracted from this year’s inventory (that gets sold next year) and the result is a net inventory figure (could be positive or negative) that you add to GDP. C. C= Personal Consumption Expenditures. Consumers buy three types of goods i. Durable goods: last a long time, like appliances, vehicles, computers, phones ii. Nondurable goods: used up quickly, like food, personal hygiene products, clothing iii. Services: someone does something for you, such as serving food, accounting or tax work, legal work, doctor D. I= Gross Private Domestic Investment i. Investment that only replaces worn-out capital is counted – that is why it is “gross” as opposed to “net” ii. Private means non-government (that would be public) spending iii. Domestic means within the nation’s borders, regardless of the nationality of the owner/ company doing the investment spending. iv. Investment consists of machinery/equipment, business and residential construction, and the net inventory E. G= Government Expenditures includes goods, services, and investment paid for by the government. i. The Government makes transfer payments (income security) in the form of welfare, unemployment benefits, and various subsidies to industry such as agriculture. Since these transfers of money are not in return for any good or services purchased, they do not get counted in GDP. F. Xn=Exports are output from the US economy and imports are bought here but not part of our country’s output, so the value of X (exports) must be added while M (imports) subtracted. X-M=Xn (net exports) and this value is added to GDP. III. Gross Domestic Income (GDI) relies on the income approach to total the income at market prices generated in the production of all final goods and services during a given period (one year, usually) in a given economy (usually one country). Since the value of the output is completely distributed among all forms of income, the GDP and GDI must be equal for the same time period. 1. GDI is calculated by totaling the payments to the four factors of production, plus depreciation (D: the capital consumption allowance), Indirect Business Taxes (T), and Net Factor Income from abroad. 2. Depreciation must be included in the GDI because some being capital used up is part of the cost of producing a good – but this can cot be included in payments to the factors of production. Similarly IBT, or simply T, is not payment to the factors for inputs, it is just another cost producers pass on to consumers, this one mandated by the government. 3. Finally, income to factors of production owned by foreigners is deducted from GDI while income to domestic owned factors of production located in foreign countries is added to the GDI. The net of these two is called Net Factor Income From Abroad (Yn) IV. While the US used to rely on the GNP for an indication of the country’s material well-being, it now relies primarily on GDP because it allows easy comparison to other countries’ income accounting methods. The difference is that GDP includes the value of goods and services produced within the nation’s borders, and GNP includes the value of goods and services produced by factors owned by US citizens. So a car factory in Michigan owned by Ford is part of GDP and GNP. But if it is in Michigan and owned by Toyota, then it is part of GDP but not GNP. Another way to look at it is if Ford owns the plant, but it builds in Canada, it’s part of GNP but not GDP. So a major advantage of GDP is it gives a better indication of economic activity actually taking place in a given country because the number includes all production that takes place domestically. Numerically, the difference between GNP and GDP is Yn. 1. In a country like Mexico where much of the factories (capital) and other types of production facilities are owned by foreigners, GDP can exceed GNP by around 5%. 2. GDP to GNP ratios for developed countries, and since almost all the numbers are very close to 100% this means that GDP and GNP are approximately equal, as in the US. The ratio for Canada is 103.7%, meaning GDP is 3.7 percent more than GNP there, reflecting the wide range of industrial interests, largely those of American businesses that choose to produce there due to the buying power of the dollar. V. Reminders on Deflating GDP 1. Nominal=Current=Money GDP is GDP based on the prices in which the output was produced. 2. Real=Constant GDP is GDP based on the prices of goods in a base year (this eliminates the effect of prices on GDP since the base year, deleting inflation) 3. Mathematically, how do economists change the NGDP (commonly reported GDP numbers) to RGDP (an indication of actual output, not simply the effects of inflation)? The Bureau of Labor Statistics (BLS) has to track prices, specifically, the prices of goods and services in a “market basket” for a family of four in the urban area. The first total expenditures for this typical family is set to equal 100 (mathematically the dollar value of the market basket is multiplied by 100/ dollar value of the market basket, so the base year value always equals 100). The BLS continues tracking prices in years after the base year. So if 1979 is the base year, the CPI or consumer price index for 1979 = 100. In 1980 the BLS sees in their survey that the price of the market basket has increased overall 5%. So 1980 CPI = 105. NGDP = 8.4 trillion dollars. RGDP = NGDP/CPI * 100= 8.4/105 * 100 = 8 trillion. Trick question: how much did RGDP increase from 1979? Not enough information to answer; all we know is inflation was 5%. If we know that RGDP in 1979 was 7.3 trillion, then we could say RGDP grew almost 10% in 1980. What this does is reports GDP (1980) in 1979 dollars, making the prices constant for “constant” or “real” GDP. In this example there was inflation so the CPI adjustment “deflates” NGDP. 4. Besides the CPI, the BLS tracks the WPI to watch what happens to wholesale prices and the Commerce Dept. has the general price index which is the best indication of all prices in the economy. It works the same way to deflate NGDP as the CPI. VI.Excluded from GDP 1. GDP only includes output that has a recorded payment. This excludes any unpaid labor, whether it is by an in-home parent or (cleaning, cooking, laundry, driving, gardening) chores by children, volunteering in the community, do-it-yourself projects for home improvement or building furniture. Only if any of these services is bought from someone is it part of GDP. 2. Illegal transactions are not recorded so do not get included in GDP. 3. Economic transactions involving no new production. This includes: i. Sale of used goods – initial value already recorded in the year the good was produced ii. Intermediate goods - all intermediate values are included in the final price iii.Sale of financial instruments – bonds, stocks, options and any other financial securities are just a change in ownership, not any new production. The only aspect of the transaction that would count in GDP is the brokerage fee to conduct the transaction. VII. GDP is “Gross” because it includes all I, not adjusting for the fact that a substantial portion of I only replaces D (depreciated, worn-out capital). In (Net Private I) is I-D. New capital investment, minus the used up capital, of a given year, is In. So GDP- D is NNP and GDI-D is NNI. NI (National Income) is the net income at factor prices generated in the production of all final goods and services. At factor prices means at the prices in the factor markets not the product markets, so IBT (like excise & sales taxes) are not included. It is “net” so depreciation is not included. So NI is total payments to the factors of production, or NNP-IBT. Personal Income (PI) is similar to NI except it only includes income earned by individuals. Therefore, income such as corporate profits and retained earnings are subtracted, while income such as dividends and government transfer payments to individuals are added to NI. DI (disposable income) can be found simply by subtracting PT (personal taxes like income and property taxes) from PI, leaving only the money people have available to spend. DI is after-tax income. DI also equals the sum of the three (accounting) categories that PI can be spent on: C, PS (personal savings), and ICL (interest on consumer loans). Table 7-5 (p.172) is a step-by-step guide showing how only slight alterations mark the difference between each successive National Income Accounting measure. VIII. Final Value and Value-Added methods Final Value only adds the prices of the goods sold to the final user, that is, the price paid by whoever buys the new good. Value-Added combines the value of each good at each stage of its production. This is especially clear when you have several companies who each do some part of the production before the product reaches the market. The example given in the table (p.164) is of 200 ice cream cones (final goods), which begins as farm output. The farm output required for the final goods has a value at which it is sold by the farmer. The next company to add value is the “Cone factory and Ice cream maker,” which processes the raw ingredients into a bulk manufactured product. The factory adds value, as does the middleperson whose business it is to route goods to retailers. Then the Ice Cream Vendor adds value by storing it in an appealing location that will get noticed by consumers, having staff on hand to explain the qualities of the product and conduct the final transaction, and using part of their “overhead” (expenses) to get the product sold. Their value-added is combined with the values-added at previous stages to get the final value. Final Value is the US method of calculation; however several European countries use a Value-Added Tax. IX. Does GDP necessarily improve well-being? The assumption that GDP (and particularly GDP per capita) tracks the well-being of individuals in a country remains the dominant belief. There are challenges to this linkage, including: 1. All the forms of excluded output do in fact improve well-being, despite the fact they are uncounted in GDP. This includes volunteer work, household labor, chores for kids, all uncounted production that improves well-being (the exception is illegal economic activity) 2. Much of the counted output ignores byproducts that decrease well-being. The clearest example of this is air or water pollution caused by industrial output. While a ten-year period in which output doubles may make the GDP growth rate soar, the pollution resulting may decrease well-being for individuals. A more indirect example is that large corporations expanding market share often increases GDP, but can put other forms of more localized businesses into bankruptcy, causing net job loss, fewer choices, and farther traveling distances for consumers (think of Wal-Mart). 3. Output that does count may not add to well-being. Advertising that gives bad information or does not assist in economic decision making is an example. An argument can be made that defense spending, past a certain point, adds nothing to well-being. Also, the question of whether GDP growth is desirable has been raised because a characteristic of growth is pollution. On the other hand, eliminating pollution completely is not realistic because the opportunity cost to do so becomes too much for industry to cover and continue operating, and GDP growth generates money for research and implementation of cleaner production methods.