John Petroff's "Macroeconomics, Chapter 5: National Income Accounting"

Read this information on gross national product (GNP) and gross domestic product (GDP). GDP refers to production counted within a country's borders, whereas GNP refers to production by domestic factors inside and outside of a country's borders. Global economists use the same method for calculating GDP so they can measure and compare each country's economic welfare or well-being. Note that some countries use GNP as a metric, but GDP is the standard accounting system.

Introduction

Economists use gross national product (GNP) to measure a country's economic activity. In this unit we analyze and reconcile components of GNP via the expenditure and the income approach, explore how economists make adjustments for inflation, and compare GNP to other measures of economic welfare.

National Income Accounting

Economists use national income accounting to determine how well a country is performing economically. We use two methods to calculate GNP: the expenditure approach adds up all of the purchases citizens have been made during the past year, the income approach adds up all of the earnings citizens have obtained during the past year.

 A country, just like a firm, needs to know how well it is doing economically. National income accounting provides the statistics that indicate whether the economy is doing well or encountering difficulties.

Gross National Product

Gross national product (GNP) is the sum total of all of the final goods and services a country has produced during the past year. Economists can calculate GNP with an expenditure or income approach. GNP excludes intermediate goods, second-hand sales, and financial transactions. Since GNP is an amount of money, economists have to adjust the final dollar figure, according to changes in the value of money.

 GNP measures a country's economic activity by adding up all of the different types of production: such as the cars, computers, and other commodities it produces. We use a currency or dollar amount to calculate and sum up all of the costs of these goods and services so we are able to easily compare and contrast our progress.

Gross Domestic Product

The gross domestic product (GDP) is the sum of all of the the final goods and services residents of a country produce domestically during a given year. According to many economists, limiting our definition to the production of domestic residents (excluding those who live abroad) offers a more useful picture of the level of economic activity within a country.

Note that gross national product (GNP) includes the income citizens receive from foreign investments (including any income they earn while living abroad).

• GNP does not include income earned by foreign nationals who live within the borders of the country. So, for example, GNP will include the income American citizens earn while they live in Germany, but it does not include the income German citizens earn while living in the United States.
• GDP only includes production within the domestic, geographical confines of a country, for all of its domestic residents, whether they are citizens or not.

 The GDP for a country that has many foreign firms operating within its borders is larger than its gross national product. On the other hand, the GDP for countries that have a lot of companies that operate in foreign countries, is smaller than the gross national product (the net income from foreigners is negative).

Intermediate Goods

Intermediate goods describe products that make up a final good. For example, we consider a tire to be an intermediate good when a car manufacturer makes or uses it to be part of the final car they plan to sell. However, the tire is considered a final good when a tire manufacturer makes it to sell directly to consumers as a replacement part. When we incorporate an intermediate good to be part of the final product, we add value to the final product.

 Most raw materials, such as metals and crude oil, are intermediate goods: we do not count them separately, but as part of the final good they incorporate. The tires we buy to replace used tires are final consumption (they are final goods), but the tires installed on new cars are intermediate goods.

Economists calculate GNP by adding all of the intermediate goods or value added to the final product: the final figure for value added should equal the cost of the final product. Many countries use a value added approach as the foundation for their tax systems.

 The work performed to assemble the many components of a car (engine, tires, windshield), describes the value added approach. We calculate this value by subtracting all of the costs of the materials and goods the manufacturer used to create the final product from the selling price.

Expenditure Approach

We calculate GDP as the sum of all expenditures: personal consumption expenditure (C), gross private domestic investment (Ig), government purchases (G), and net exports (Xn).

GDP = C + Ig + G + Xn

 The expenditure approach adds together everything that is purchased: it is equivalent to the income approach because purchases are only possible if income exists.

Personal Consumption Expenditure

Personal consumption expenditure is a compilation of the goods and services a household buys (except the house). It includes durables (cars, appliances), nondurables (clothing, food), and services (haircuts, doctor visits, airline tickets). Nondurables include items that will last less than a year (note that nondurables include clothing by convention, even though we hope the sweater we just bought will last more than a year). Nondurable expenditure is the most stable component of personal consumption expenditure.

 People buy all kinds of goods and services. Services include transportation, communication, banking, and insurance. Durable goods include furniture, appliances, equipment, and cars. Nondurable goods include items we would normally consume within a year, such as food, fuel, stationary, and clothing.

Gross Private Domestic Investment

Gross private domestic investment includes 1. new construction, 2. new capital (machines, trucks and equipment), and 3. changes in inventory. It excludes government and foreign investments. New construction includes all forms of new building, whether it is for rental or private residential purpose. Changes in inventory captures the goods produced in one year and sold in future years.

 When a company builds a plant or installs machinery and equipment: it makes an investment (it increases its capital). By convention, we consider the purchase of a private house to be an investment because the owner can sell it or rent it out at any point. We do not know if the buyer purchased it for this purpose.

Capital Consumption Allowance

Capital consumption allowance describes the new capital a business produces to replace the capital they expended during the past year. We also call it depreciation. Capital consumption allowance (CCA) equals the difference between gross investment (Ig) and net investment (In):

CCA = Ig – In

 All machines and equipment used to produce other goods, are subject to "wear and tear." or depreciation. Accountants devote part of capital goods production to replace this wear and tear. Otherwise, the productive capacity of a country would be depleted. The replacement of the capital used is capital consumption allowance.

Net Investment

Net private domestic investment equals gross private domestic investment minus capital consumption allowance. It is the most sensitive component of GDP. Negative net investment implies the country is depleting its capital stock and production is decreasing. A positive net private domestic investment implies economic growth.

 The productive capacity of a nation will increase only if net investment is positive. This can easily be verified at the level of a single plant: the number of new machines installed in any given year must be greater than the machines that have been used up during that year.

Government Purchases

Government purchases combine the goods and services government agencies buy: from paper clips, to bridges, to public hospitals. Note that government purchases do not include transfer payments (benefits passed on to citizens, such as pensions, student grants, or unemployment compensation).

 In many countries the government is the largest single purchaser of goods and services. Local, state and national government buys all kinds of products: from hospitals, to bridges, to computers. Governments spend a great deal of money to provide services to their citizens, such as payments to build libraries, roads, and provide police services.

Net Exports

The amount of net exports equals the difference between total exports minus total imports. A country's net exports is the same as the trade or merchandise balance of payments. When imports exceed exports (and the balance of payments is in deficit), the amount of net exports is negative.

 Americans produce and sell exports to foreign countries, including computers, airplanes and various crops. Imports, on the other hand, are the items Americans buy from foreigners (perhaps with the income they earned from their export sales).

Income Approach

The income approach sums all income derived from productive activities.

 If we compare a nation to a business, the income approach would be an allocation of the funds generated from the sales of one year (net of costs of intermediate goods), to the various expenses and retained profit.

Net National Product

Net national product (NNP) equals gross national product minus capital consumption allowance. NNP = GNP – CCA.

We calculate net domestic product as NDP = GDP – CCA

Remember that the difference between NNP and NDP includes the net income of citizens who live abroad earn and transfers made to foreigners who live within the country's borders.

 We must deduct the production we devote to maintaining a constant level or stock of means of production (the capital consumption allowance), to see whether we have created any new consumption and income occurred during the year.

National Income

National income (NI) equals the net national product or the sum of salaries, rent, interest, profit and proprietors' income minus indirect business taxes:

NI = NNP – (indirect business taxes).

 National income is the sum of all forms of gross income. You can think about NI in the same way as the gross salary you receive in your employee paycheck, before taxes and other deductions are taken out.

Indirect business taxes include all forms of sales and excise taxes.

 Sales taxes are the largest part of indirect business taxes. Consumers pay sales taxes whenever they make a purchase, as an addition to the price for the item. Businesses collect these sales taxes on behalf of the government. Consequently, companies should not consider this money they collect to be income.

Personal Income

Personal income (PI) equals national income, including any transfer payments, such as social security and pension benefits, welfare and unemployment benefits. Transfer payments deducted from national income include: social security contributions, undistributed corporate profits, and corporate income taxes.

Transfer Payments

Transfer payments are additions and subtractions to national income to obtain personal income. Additions include social security retirement payments, unemployment benefits and welfare payments. Subtractions include social security contributions, corporate income taxes and undistributed corporate profits.

 Transfer payments are benefits that are not connected to productive activity. Social security is an example of a transfer payment: the government collects social security contributions from current workers to give to retired workers.

Disposable Income

Disposable income (DI) equals a person's gross personal income minus personal income taxes. People distribute disposable income among their personal consumption expenditure and savings.

 You can readily see the disposable income you receive from your employer. Your employer takes various amounts (taxes and transfer payments) out of your gross salary. In macroeconomics, we simply look at these figures from a national perspective.

Real GDP

Real GDP is GDP adjusted for inflation (or the change in value of money). Unadjusted GDP is nominal or current GDP. The adjustment consists in dividing nominal or current GDP by the price index (the price index is a deflator).

 We call GNP, adjusted for inflation, "real" in the same way we think about the amount of goods or services we can buy with a certain amount of money or a single paycheck, during at a given time. We call this real purchasing power.

Price Index

Economists construct a price index by calculating the weighted average of the price of a basket of goods in a given year, divided by the weighted average of the price of the same basket in another year. Government officials and the media often report on the consumer price index or CPI.

 The consumer price index is the average price consumers report they must pay for a set basket of goods in different markets (such as in different cities across the nation). Economists use this average to determine whether the country is experiencing any inflation or deflation (prices are increasing or decreasing).