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National Income
Accounting
Chapter 8
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Laugher Curve
Three econometricians went out
hunting, and came across a large deer.
Irwin/McGraw-Hill
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Laugher Curve
Three econometricians went out
hunting, and came across a large deer.
The first econometrician fired, but
missed, by a yard to the left.
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Laugher Curve
The second econometrician fired, but
also missed, by a yard to the right.
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Laugher Curve
The second econometrician fired, but
also missed, by a yard to the right.
The third econometrician didn't fire, but
shouted in triumph, "We got it! We got
it!"
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Chapter Objectives
 State
why national income accounting is
important.
Irwin/McGraw-Hill
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Chapter Objectives
 State
why national income accounting is
important.
 Define GDP, GNP, and NI.
Irwin/McGraw-Hill
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Chapter Objectives
 State
why national income accounting is
important.
 Define GDP, GNP, and NI.
 Calculate GDP in a simple example,
avoiding double counting.
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Chapter Objectives
 Explain
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why GDP = C + 1 + G + (X - M).
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Chapter Objectives
 Explain
why GDP = C + 1 + G + (X - M).
 Distinguish between real and nominal
values.
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Chapter Objectives
 Explain
why GDP = C + 1 + G + (X - M).
 Distinguish between real and nominal
values.
 State some limitations of national
income accounting.
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National Income Accounting
 In
the 1930s it was impossible to talk
intelligently about macroeconomics
since the discussion lacked rigorous
terminology.
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National Income Accounting
 In
the mid-1930s, Keynesians Simon
Kuznets and Richard Stone began to
develop this terminology.
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National Income Accounting
 They
developed national income
accounting—a set of rules and
definitions for measuring economic
activity in the aggregate economy—that
is, in the economy as a whole.
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National Income Accounting
 Measuring
Total Economic Output of
Goods and Services
Irwin/McGraw-Hill
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National Income Accounting
 Measuring
Total Economic Output of
Goods and Services

Gross Domestic Product (GDP) is the total
value of all final goods and services
produced in an economy in a one-year
period.
Irwin/McGraw-Hill
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National Income Accounting
 Measuring
Total Economic Output of
Goods and Services

Gross Domestic Product (GDP) is the total
value of all final goods and services
produced in an economy in a one-year
period.
 It
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is the single most-used economic measure.
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National Income Accounting
 Measuring
Total Economic Output of
Goods and Services

Gross National Product (GNP) is the
aggregate final output of citizens and
businesses of an economy in one year.
Irwin/McGraw-Hill
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National Income Accounting
 Measuring
Total Economic Output of
Goods and Services

GDP measures the economic activity that
occurs within a country.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
National Income Accounting
 Measuring
Total Economic Output of
Goods and Services
GDP measures the economic activity that
occurs within a country.
 GNP measures the economic activity of the
citizens and businesses of a country.

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National Income Accounting
 Moving
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from GDP to GNP
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National Income Accounting
 Moving

from GDP to GNP
To move from GDP to GNP, net foreign
factor income is added to GDP.
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National Income Accounting
 Moving

from GDP to GNP
Net foreign factor income is the income
from foreign domestic factor sources minus
foreign factor incomes earned
domestically.
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National Income Accounting
 Moving

from GDP to GNP
One must add the foreign income of one's
citizens and subtract the income of
residents who are not citizens.
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Calculating GDP
 All
goods and services produced by an
economy must be weighted, that is,
each good and service must be
multiplied by its price.
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Calculating GDP
 Once
quantities of a particular good or
service are multiplied by its price, we
arrive at a value measure of the good or
service.
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Calculating GDP
 Finally,
all the value measures are
added to arrive at GDP.
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Calculating GDP
 GDP
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is a flow concept.
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Calculating GDP
 The
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store of wealth is a stock concept.
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Calculating GDP
 The
stock equivalent to National Income
Accounts is the Wealth Accounts—a
balance sheet of an economy’s stocks
of assets and liabilities.
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GDP Measures Final Output
 When
one firm sells products to another
firm for use in production of yet another
good, the first firm’s products are not
considered final output but intermediate
products.
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GDP Measures Final Output
 When
one firm sells products to another
firm for use in production of yet another
good, the first firm’s products are not
considered final output but intermediate
products.

Intermediate products are used as input in
the production of some other product.
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GDP Measures Final Output
 Not
accounting for intermediate
products would result in double and
triple counting.
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GDP Measures Final Output
 Not
accounting for intermediate
products would result in double and
triple counting.

If we did not eliminate intermediate goods,
a change in organization—say, a merger—
would look like a change in output
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Two Ways of Eliminating
Intermediate Goods
 The
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first is to calculate only final output.
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Two Ways of Eliminating
Intermediate Goods
 A second
way is to follow the value
added approach.

Value added is the increase in value that a
firm contributes to a product or service.
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Two Ways of Eliminating
Intermediate Goods
 A second
way is to follow the value
added approach.
Value added is the increase in value that a
firm contributes to a product or service.
 It is calculated by subtracting intermediate
goods from the value of its sales.

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Value Added Approach
Eliminates Double Counting
Participants
Farmer
Cone factory
and ice
cream-maker
Middleperson
Vendor
Totals
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Cost of
Materials
$ 0
100
250
400
Value of
Sales
$ 100
250
400
500
Value Added
$ 100
150
150
100
© The McGraw-Hill Companies, Inc., 1998
Value Added Approach
Eliminates Double Counting
Participants
Farmer
Cone factory
and ice
cream-maker
Middleperson
Vendor
Totals
Irwin/McGraw-Hill
Cost of
Materials
$ 0
100
Value of
Sales
$ 100
250
Value Added
250
400
$ 750
400
500
$1,250
150
100
$500
$ 100
150
© The McGraw-Hill Companies, Inc., 1998
Value Added Approach
Eliminates Double Counting
Participants
Farmer
Cone factory
and ice
cream-maker
Middleperson
Vendor
Totals
Irwin/McGraw-Hill
Cost of
Materials
$ 0
100
Value of
Sales
$ 100
250
Value Added
250
400
$ 750
400
500
$1,250
150
100
$500
$ 100
150
© The McGraw-Hill Companies, Inc., 1998
Calculating GDP: Some
Examples
 Selling
your car to a neighbor does not
add to GDP.
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Calculating GDP: Some
Examples
 Selling
your car to a used car dealer
who sells your car to someone else for
a higher price, does add to GDP.
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Calculating GDP: Some
Examples
 Selling
your car to a used car dealer
who sells your car to someone else for
a higher price, does add to GDP.

The value added is the dealer's services.
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Calculating GDP: Some
Examples
 Selling
a stock or bond does not add to
GDP.
Irwin/McGraw-Hill
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Calculating GDP: Some
Examples
 Selling
a stock or bond does not add to
GDP.

The stock broker's commission for the sales
does add to GDP.
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Calculating GDP: Some
Examples
 Social
security payments, welfare
payments, veterans' benefits, and other
government transfer payments are not
included in GDP.
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Calculating GDP: Some
Examples
 The
work of unpaid housespouses does
not appear in GDP calculations.
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The Circular Flow
 The
national income accounting identity
is the accounting equality of output and
income.
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The Circular Flow
Household
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Firms
(production
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The Circular Flow
Goods
Household
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Firms
(production
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The Circular Flow
Factor services
Goods
Household
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Firms
(production
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The Circular Flow
nt
Factor services
Goods
Household
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Firms
(production
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The Circular Flow
nt
Factor services
Goods
Household
Firms
(production
al consumptio
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The Circular Flow
nt
Factor services
Goods
Household
Firms
(production
Financial markets
al consumptio
Irwin/McGraw-Hill
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The Circular Flow
nt
Factor services
Goods
Household
Firms
(production
Financial markets
al consumptio
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The Circular Flow
nt
Factor services
Goods
Household
Firms
(production
Government )G
Financial markets
al consumptio
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
The Circular Flow
nt
Factor services
Goods
Household
Firms
(production
Government )G
Financial markets
al consumptio
Other countr
ies
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Two Approaches to
Calculating GDP
 The
Irwin/McGraw-Hill
Income Approach
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Two Approaches to
Calculating GDP
 The

Income Approach
The income approach is shown on the top
half of the circular flow.
Irwin/McGraw-Hill
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Two Approaches to
Calculating GDP
 The

Income Approach
National income is the total income earned
by citizens and businesses in a country in
one year.
Irwin/McGraw-Hill
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Two Approaches to
Calculating GDP
 The

Income Approach
Firms make payments to households for
supplying their services as factors of
production.
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Two Approaches to
Calculating GDP
 The

Income Approach
These factors are broken up into employee
compensation, rent, interest, and profits.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Two Approaches to
Calculating GDP
 The

Income Approach
These factors are broken up into employee
compensation, rent, interest, and profits.
 Employee
compensation is payments for labor
such as salaries and wages.
Irwin/McGraw-Hill
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Two Approaches to
Calculating GDP
 The

Income Approach
These factors are broken up into employee
compensation, rent, interest, and profits.
 Rents
are payments for use of land and
buildings.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Two Approaches to
Calculating GDP
 The

Income Approach
These factors are broken up into employee
compensation, rent, interest, and profits.
 Interest
includes payments for loans by
households to firms.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Two Approaches to
Calculating GDP
 The

Income Approach
These factors are broken up into employee
compensation, rent, interest, and profits.
 Profits
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are payments to the owners of firms.
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Two Approaches to
Calculating GDP
 The
Irwin/McGraw-Hill
Expenditure Approach
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Two Approaches to
Calculating GDP
 The

Expenditure Approach
The expenditure approach is shown on the
bottom half of the circular flow.
Irwin/McGraw-Hill
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Two Approaches to
Calculating GDP
 The

Expenditure Approach
Specifically, GDP is equal to the sum of the
four categories of expenditures.
Irwin/McGraw-Hill
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Two Approaches to
Calculating GDP
 The

Expenditure Approach
Specifically, GDP is equal to the sum of the
four categories of expenditures.
GDP = C + I + G + (X - M)
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Two Approaches to
Calculating GDP
 The

Expenditure Approach
Consumption
Irwin/McGraw-Hill
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Two Approaches to
Calculating GDP
 The

Expenditure Approach
Consumption
 When
individuals receive income, they can
spend it on domestic goods, save it it, pay
taxes, or buy foreign goods.
Irwin/McGraw-Hill
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Two Approaches to
Calculating GDP
 The

Expenditure Approach
Consumption
 This
is the largest and most important of the
flows.
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Two Approaches to
Calculating GDP
 The

Expenditure Approach
Investment
Irwin/McGraw-Hill
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Two Approaches to
Calculating GDP
 The

Expenditure Approach
Investment
 The
portion of their income that individuals
save leaves the income stream and goes into
financial markets.
Irwin/McGraw-Hill
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Two Approaches to
Calculating GDP
 The

Expenditure Approach
Investment
 Business
spending on equipment, structures,
and inventories is counted as investment.
Irwin/McGraw-Hill
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Two Approaches to
Calculating GDP
 The

Expenditure Approach
Government consumption and investment
Irwin/McGraw-Hill
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Two Approaches to
Calculating GDP
 The

Expenditure Approach
Government consumption and investment
 When
individuals pay taxes, those taxes are
either spent by government on goods and
services or are returned to individuals in the
form of transfer payments.
Irwin/McGraw-Hill
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Two Approaches to
Calculating GDP
 The

Expenditure Approach
Government consumption and investment
 The
connection drawn between the
government and the financial markets is there
because if the government runs a deficit, it
must borrow from financial markets to make
up the difference.
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Two Approaches to
Calculating GDP
 The

Expenditure Approach
Net exports
Irwin/McGraw-Hill
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Two Approaches to
Calculating GDP
 The

Expenditure Approach
Net exports
 Spending
on foreign goods escapes the system
and does not add to domestic production, thus
spending on imports are subtracted from total
expenditures.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Two Approaches to
Calculating GDP
 The

Expenditure Approach
Net exports
 Exports
to foreign nations are added to total
expenditures.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Two Approaches to
Calculating GDP
 The

Expenditure Approach
Net exports
 Exports
to foreign nations are added to total
expenditures.
 These flows are usually combined into net
exports.
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Two Approaches to
Calculating GDP
 Equality
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of Income and Expenditure
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Two Approaches to
Calculating GDP
 Equality

of Income and Expenditure
Income and expenditures must be equal
because of the rules of double-entry
bookkeeping.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Two Approaches to
Calculating GDP
 Equality
of Income and Expenditure
Income and expenditures must be equal
because of the rules of double-entry
bookkeeping.
 Profit is the balancing item.

Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Two Approaches to
Calculating GDP
 Equality

of Income and Expenditure
The national income accounting identity
allows GDP to be calculated either by
adding up all values of final output or by
adding up the values of all earnings or
income.
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Using GDP Figures
 Comparing
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GDP Among Countries
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Using GDP Figures
 Comparing

GDP Among Countries
GDP is important since we can compare
one country with another and one year's
production with another year's.
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Using GDP Figures
 Comparing

GDP Among Countries
Per capita GDP is another measure often
used to compare nations' GDP.
Irwin/McGraw-Hill
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Using GDP Figures
 Comparing

GDP Among Countries
Per capita GDP is another measure often
used to compare nations' GDP.
 Per
capita can be a poor measure of the various
living standards in various nations.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Using GDP Figures
 Comparing

GDP Among Countries
Per capita GDP is another measure often
used to compare nations' GDP.
 To
get around the problems of per capita GDP,
economists use purchasing power parity,
which adjusts for different relative prices
among nations before making comparisons.
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Using GDP Figures
 Economic
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Welfare Over Time
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Using GDP Figures
 Economic

Welfare Over Time
Comparing output over time is best done
with real output which is nominal output
adjusted for inflation.
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Using GDP Figures
 Real
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and Nominal GDP
© The McGraw-Hill Companies, Inc., 1998
Using GDP Figures
 Real

and Nominal GDP
Nominal GDP is GDP calculated at existing
prices.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Using GDP Figures
 Real

and Nominal GDP
Real GDP is nominal GDP adjusted for
inflation.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Using GDP Figures
 Real

and Nominal GDP
Real GDP is nominal GDP adjusted for
inflation.
 Real
GDP is important to society because it
measures what is really produced.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Using GDP Figures
 Real

and Nominal GDP
Real GDP is nominal GDP adjusted for
inflation.
 By
dividing nominal GDP by the GDP deflator,
we arrive at real GDP.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Using GDP Figures
 Real

and Nominal GDP
Real GDP is nominal GDP adjusted for
inflation.
 By
dividing nominal GDP by the GDP deflator,
we arrive at real GDP.
Nominal GDP
Real GDP =
GDP deflator
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Some Limitations of National
Income Accounting
 GDP
measures market activity, not
welfare.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Some Limitations of National
Income Accounting
 GDP
measures market activity, not
welfare.

GDP does not measure happiness, nor does
it measure economic welfare.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Some Limitations of National
Income Accounting
 GDP
measures market activity, not
welfare.

Welfare is a complicated idea, very difficult
to measure.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Some Limitations of National
Income Accounting
 Measurement
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Errors
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Some Limitations of National
Income Accounting
 Measurement

Errors
GDP figures do not measure all market
economic activity.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Some Limitations of National
Income Accounting
 Measurement

Errors
GDP figures do not measure the following
market activities:
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Some Limitations of National
Income Accounting
 Measurement

Errors
GDP figures do not measure the following
market activities:
 Illegal
drug sales.
 Under-the-counter sales of goods to avoid
income and sales taxes.
 Work performed and paid for in cash.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Some Limitations of National
Income Accounting
 Measurement

Errors
GDP figures do not measure the following
market activities:
 Unreported
sales.
 Prostitution, loan sharking, extortion, and other
illegal activities.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Some Limitations of National
Income Accounting
 Measurement

Errors
Estimates of the size of the underground
economy range from1.5 to 20 percent of
GDP.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Some Limitations of National
Income Accounting
 Measurement

Errors
A second type of measurement error
occurs in adjusting GDP for inflation.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Some Limitations of National
Income Accounting
 Measurement

Errors
A second type of measurement error
occurs in adjusting GDP for inflation.
 If
the price and the quality of a product go up
together, has the price really gone up?
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Some Limitations of National
Income Accounting
 Measurement

Errors
A second type of measurement error
occurs in adjusting GDP for inflation.
 Is
it possible to measure the value of quality
increases?
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Some Limitations of National
Income Accounting
 Misinterpretation
Irwin/McGraw-Hill
of Subcategories
© The McGraw-Hill Companies, Inc., 1998
Some Limitations of National
Income Accounting
 Misinterpretation

of Subcategories
For example, the line between investment
and consumption is often fuzzy.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Some Limitations of National
Income Accounting
 Misinterpretation

of Subcategories
For example, the line between investment
and consumption is often fuzzy.
 Buying
a steam iron would be consumption,
and if it is used to iron team T-shirts sold by a
home business, it would still be counted as
consumption.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Some Limitations of National
Income Accounting
 Misinterpretation

of Subcategories
For example, the line between investment
and consumption is often fuzzy.
 Investment
includes private housing units, but
they do not usually add to our stock of
productive tools.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Some Limitations of National
Income Accounting
 Misinterpretation

of Subcategories
For example, the line between investment
and consumption is often fuzzy.
 Investment
includes private housing units, but
they do not usually add to our stock of
productive tools.
 The garages and spare bedrooms might if they
are used in an income-producing capacity.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Some Limitations of National
Income Accounting
 Misinterpretation

of Subcategories
Some social scientists have developed
alternatives to GDP such as the Gross
Process Indicator (GPI).
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
Some Limitations of National
Income Accounting
 Misinterpretation

of Subcategories
Some social scientists have developed
alternatives to GDP such as the Gross
Process Indicator (GPI).
 The
GPI tries to measure pollution, education,
health concerns, as well as GDP.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
GDP Is Worth Using Despite
Its Limitations
 National
income accounting should be
used with sophistication.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
GDP Is Worth Using Despite
Its Limitations
 It
is a powerful economic tool that
informs average citizens about the
direction the economy is moving.
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998
National Income
Accounting
End of Chapter 8
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 1998