Chapter 2 The Measurement and Structure of the National Economy

I. National Income Accounting:

National income accounts are an accounting framework is useful in measuring economic activity.

A. Three approaches—all produce the same measurement of the production of the economy.

1. product approach: how much output is produced
2. income approach: how much income is created by production
3. Expenditure approach: how much purchasers spend

B. Why all three approaches are the same: Assumes no unsold goods (at this point) then the market values of goods and services produced must equal the amount buyers spend to purchase them (product approach=expenditure approach). What the seller receives (income) must equal what is spent (expenditure).

II. Gross Domestic Product (GDP)

A. GDP vs. GNP

GNP= output produced by domestically owned factors or production. (By our people)

GDP= includes production produced by foreign owed factors of production within the countries border and excludes domestically owned production in foreign countries. (On our soil)

1. GDP = GNP – net factor payment from abroad (NFP)

2. How big is the difference?

B. Product approach: The market value of all final goods and services produced within a nation during a fixed period of time.

1. Market value: allows comparison between different goods. Has some problems – ignores some goods. underground economy, and government services.

2. Final goods and service: Treatment of inventories; Capital goods; Avoids double counting; Value added.

3. New production: Ignores goods produced in previous periods

C. Expenditure approach: Total spending on final goods and services produced within a nation during a specified period of time.

1. Income expenditure identity and four categories of spending: Consumption (C), Investment (I), government purchases of goods and services (G) and net exports (NX)

Y = C + I + C + NX

2. Consumption(C): Spending by domestic households on final goods and services

a. Consumer durable goods: Long lasting goods
b. Nondurable goods used up quickly
c. Services

3. Investment (I): Spending on new capital goods by business

a. Business fixed investment
b. Residential fixed investment
c. Inventory investment: Changes in the amount of unsold goods, goods in progress and new materials

4. Government purchases of goods and services (G):

a. State and local vs. Federal spending
b. Transfers and interest payments on debt are not counted. They are counted in total government expenditure which is not the same as government purchases of goods and services.

5. Net exports (NX): exports minus imports

a. Need to subtract imports since they are counted in C. I and G can add goods produced within the country purchased by foreign interests (exports).

D. Income approach adds up income received by producers, including profits and taxes paid to the government

1. Income generated by production

a. National income =
compensation of employees
+ proprietors income
+ rental income of persons
+ corporate profits
+ net interest
+ taxes on production
+ business transfers
+ surplus of gov enterprises

b. National income + statistical discrepancy = Net National Product (NNP)

Note: This changed a couple years ago. If you have an old addition, you may see the indirect business tax. It is no long used in this equation!

c. NNP + depreciation = GNP

d. GNP – NFP = GDP

2. Income of private sector and government

a. Private disposable income = income of private sector = private sector income earned at home (Y or GDP) and abroad (NFP) + payments from the government sector (transfers TR and interest on debt INT) – taxes paid to government (T) = Y + NFP + TR + INT – T

b. Government net income = T- TR – INT

III. Saving and Wealth

A. Wealth Difference between assets and liabilities

B. Measures of aggregate savings

1. Saving = current income – current spending; saving rate = saving/current income

2. Private saving (Spvt) Spvt = Y + NFP – T + TR + INT – C

3. Government Saving (Sgovt) Sgovt = T – TR- INT – G

a. Government saving = Government budget surplus (deficit = -Sgovt)

4. National Saving= private saving + government saving

S = Spvt + Sgovt = Y + NFP - C – G = GNP - C – G

C. The uses of private saving

1. S = I + (NX + NFP) = I + CA

CA = NX + NFP = current account balance

2. The use of savings identity

Spvt = I – Sgovt + CA

If the budget deficit increases one or a combination of the following happen

1) private saving must rise
2) investment must fall
3) the current account balance must fall

IV. Prices Indexes, Inflation and Interest Rates

A. Nominal vs. Real variables

Nominal Variables – Measures the economic variable in terms of the current market value.

Real Variable—Measure the variable valued at the prices in a base year.

B. Real vs. Nominal: Calculation the differences

Examples Small country only produces base balls and baseball bats


# of Balls

# of Bats

# of Caps

# of Gloves

Price Balls


































Year Nominal GDP Real GDP

1 (3000*2)+(5000*50)+(8000*5)+(2000*60)=416000 (300*2)+(5000*50)+(800*5)+(2000*60)=416000

2 (3100*3)+(5020*55)+(7970*9)+(2050*55)=469880 (3100*2)+(5025*50)+(7970*5)+(2025*60)=420050

3 (3150*2)+(5025*56)+(7960*15)+(2025*53)=514425 (3150*2)+(5025*50)+(7960*5)+( 2025*60)=418850

C. Price indexes and inflation

1. Calculation of price indexes

Uses a basket of goods and their prices to measure the overall change in the price level.

2. Variable weight index

Varies the weight of the goods in the basket

Variable Weight = value of current basket at current prices

Price Index value of current basket at base year price

Example: GDP deflator measures the change in the price level using the GDP of a country. GDP deflator = Nominal GDP/ Real GDP

3. Fixed weight price index:

Measures the change in price of a fixed basket of goods.

Fixed Weight = value of fixed basket at current prices

Price Index value of fixed basket at base year prices

Example the Consumer Price index (CPI)

For above example keep the quantity of goods produced the same in each year and let the prices change.

4. Calculation of inflation rate

The inflation rate will be the growth rate of the price index

Inflation = Price index Year 2 – Price Index Year 1
                        Rate Price Index Year 1

5. Which is better?

D. Interest rates

1. Real vs. Nominal interest rates

a. real interest rate = real return on an asset

b. Real interest rate = nominal interest rate – inflation

2. Expected real interest rate