Measuring a Nation’s Income
To measure how much output, spending and income has been generated in a given time period, we use National Income Accounts. These accounts measure three things:
Before computing the National Income the meaning of term ‘National Income’ should be taken up
National Income is the money value of final flow of output of goods & services produced within an economy over a period of time, usually one year and net income earned from abroad
Gross Domestic Product
Gross Domestic Product (GDP) is the total value of the final goods & services produced within the domestic territorial limits of country over a period of time (1 year).
‘Market Value’ GDP uses market price as it reflects the value of goods. Higher the price higher is the contribution to GDP.
‘Of all’ GDP tries to be comprehensive. It includes all items produced in the economy and sold legally in the market.
‘Final’ GDP includes only the value of final goods and not intermediate goods as it is already included in the price of the final goods. Avoids double counting.
‘Goods and services’ GDP includes tangible goods (cars, clothing etc.) and intangible services (haircut, doctor’s visit etc)
‘Produced’ GDP includes goods and services currently produced and it does not include transaction involving items produced in the past.
‘Within a country’ GDP measures the value of production within the geographic territorial confines of a country, regardless of the nationality of the producer.
‘In a given period of time’ GDP measures the value of production that takes place within a specific interval of time, usually quarterly (3 months) and yearly.
T he Components of GDP
GDP can be decomposed into four components: consumption, investment, government purchases and net export.
Consumption is spending by households on:
Durable goods (cars, appliance)
Nondurables goods (food)
Investment is spending by firms on goods that will be used in the future to produce more goods and services:
Capital equipment (machines and tools)
Structure (factories, office building)
Inventories (goods produced but not yet sold)
By convention, the purchase of a newly built house is a form of spending by households that is also included in investment.
Note that inventory accumulation is counted as investment:
If Ford builds a $50,000 car in 2009, but the car sits in inventory through the end of the year, GDP and investment both rise by $50,000 in 2009.
Then, is car is sold in 2010, consumption rises by $50,000 but investment falls by $50,000, since Ford’s inventory is depleted. GDP remains unchanged.
The car adds to GDP during the year it is produced (2009), not during the year it is sold (2010).
Note that the term investment as it is used here has a different meaning from a household’s purchase of a financial asset like a stock or a bond.
Government spending includes:
Purchases of goods and services by federal, state and local governments.
Salaries of government workers.
Other forms of government disbursements, like social security payments, are called transfer payment and are not counted in GDP.
Net exports equal:
Exports: purchases of domestically (US) produced goods by foreigners.
Minus imports: purchases of foreign goods by US households and firms.
Why are net exports included in GDP?
Suppose that Boeing sells $100 millions in airplanes to British Airways
Conceptually, we want to include this $100 million in US GDP, since the income is earned by a US firm.
And, consistent with this idea, the $100 million in exports get added to US GDP.
But suppose that you spend $100,000 on a new Porsche.
Conceptually, we would not want to include this $100,000 in US GDP, since the income is earned by a German firm.
And, consistent with this idea:
US consumption rises by $100,000, adding $100,000 to GDP.
But US imports rise, subtracting $100,000 from net exports and also from US GDP.
In the end, US GDP is left unchanged.
One way of highlighting these ideas is to write out the national income accounting identity in slightly more detail, separating out contributions of exports and imports:
Approaches in calculating GDP
There are three ways of calculating GDP which is based on the different methods of calculating Nation Income i.e. Income method, Expenditure method & Value Added method; however the computed value of GDP remains the same under all methods
Expenditure Approach It measures GDP as the sum of expenditures of final goods & services.
Final Goods Those goods & services that are not purchased for the purpose of producing other goods & services or for resale.
Income Approach It measures GDP as the sum of incomes of factors of production (wages, salary, rent interest etc.)
Value Added Approach It measures GDP as the sum of value added at each stage of production (from initial to final stage). In Product method the aggregate value of goods & services produced in a year is calculated. The term that is used to denote the net contribution made by a firm is called its Value Added.
Income and Expenditure
GDP measures two things at once:
1. The total income of everyone in the economy.
2. The total expenditure on the economy’s output of goods and services.
Why? Because for the economy as a whole, income must equal expenditure. “For every buyer there must be a seller”.
CLOSED MODEL OF ECONOMY
The circular flow of income is one of the most useful economic models.
In fig.1, firms use factors of production provided by households. Land, labour, capital and entrepreneurship are used by firms to produce a good or service. The firms pay households a reward for using these factors. Rent for land, wages for labour, interest for capital and profit for entrepreneurship. Collectively these rewards are called income and we use the letter Y to represent them.
Circular flow of income is a simple way of showing how output, income and
expenditure circulate and change in an economy over a period of time.
– It shows the flow of money
– It shows the real flow of production and factor
A simple model
1. Households spend all their income on goods and services produced by a firm while firms spend all their revenues on factors of production owned by households
2. There is no government sector – no government spending and taxes
3. The economy is closed (no foreign sector)
In fig. 2 households save some of their income and deposit it in banks and other financial institutions. Savings in economic is defined as income not spent.
FROM CLOSED MODEL OF ECONOMY TO OPEN MODEL OF ECONOMY
The banks lend money to firms who in turn invest in new machinery, factories, research and development etc.
Note also that Expenditure is now made up of two items. Households spend money with firms for goods and services and this we now call consumption (C) and firms spend money with other firms (investment). Expenditure is therefore equal to consumption plus investment. E = C + I.
In fig. 3 we now add the government sector. Households in this model are required to pay taxes. When the government receives these taxes they then spend them (government spending) on building roads, paying soldiers, teachers and so on. In this model the total amount of expenditure is equal to consumption plus investment plus government spending. E = C + I + G.
In fig. 4 the overseas sector is added. This model is called an open model. The previous models all assumed that the economy was closed, i.e., no foreign trade occurred.
Notice that those items leaking out of the circular flow on the left of the model (S, T and M) have been labelled withdrawals and those items on the right (I, G and X) injections.
Finally for this simple open model we can see that expenditure is equal to consumption plus investment plus government spending plus exports. However, because the model is now open to the outside world domestic spending on goods and services which originate outside the economy must be subtracted. Therefore imports (M) have to be subtracted.
So, E = C + I + G + (X – M).
Real and Nominal GDP
If GDP rises from one year to the next, then either:
1. The economy is producing more goods and services, or
2. Goods and services are selling at higher prices.
Since what people really care about is the total volume of available goods and services, and not so much the prices at which these goods and services sell, we want to correct GDP for the effects of inflation, that is, for rising prices.
Real GDP makes this correction, by valuing the goods and services produced this year at constant prices that prevailed during a base year.
Nominal GDP does not make this correction. It values the goods and services produced this year at current prices that prevail this year.
GDP Deflator=Nominal GDP/Real GDP X 100
Now let’s ask what happens when…
The quantities of all goods and services produced rise, but prices stay the same.
- Real GDP rises.
- Nominal GDP rises by the same amount.
- The GDP deflator stays unchanged.
The prices of all goods and services rise, but quantities produced stay the same.
- Real GDP stays unchanged.
- Nominal GDP rises.
- The GDP Deflator rises.
The percentage increase in GDP Deflator from one period to the nest defines the rate of inflation.
GDP and Well Being
GDP measures the level of income and expenditure in the economy.
Since most people would prefer more income and expenditure to less, GDP per person can serve as a measure of economic well-being.
But let’s remember that GDP is a measure based on market value and therefore does not include:
- Childcare from a parent.
- Volunteer work.
- Environmental quality.
- Equity in the distribution on income and expenditure.