National Income and Product Accounts

• National income and product accounts are data collected and published by the government describing
the various components of national income and output in the economy.

• The Department of Commerce is responsible for producing and maintaining the “National Income and
Product Accounts” that keep track of GDP.

Gross domestic product (GDP) is the total market value of all final goods and services produced within a given
period by factors of production located within a country.

Final Goods and Services

• The term final goods and services refers to goods and services produced for final use.

• Intermediate goods are goods produced by one firm for use in further processing by another firm.

Value added is the difference between the value of goods as they leave a stage of production and the cost of the
goods as they entered that stage.

• In calculating GDP, we can either sum up the value added at each stage of production, or we can
take the value of final sales. We do not use the value of total sales in an economy to measure
how much output has been produced.

Exclusions from GDP

• GDP ignores all transactions in which money or goods change hands but in which no new goods and
services are produced.

GDP Versus GNP

• GDP is the value of output produced by factors of production located within a country. Output produced
by a country’s citizens, regardless of where the output is produced, is measured by gross national product
(GNP).

Calculating GDP

GDP can be computed in two ways:

• The expenditure approach: A method of computing GDP that measures the amount spent on all final
goods during a given period.

• The income approach: A method of computing GDP that measures the income—wages, rents, interest,
and profits—received by all factors of production in producing final goods.

The Expenditure Approach

Expenditure categories:

• Personal consumption expenditures (C)—household spending on consumer goods.

• Gross private domestic investment (I)—spending by firms and households on new capital: plant,
equipment, inventory, and new residential structures

Expenditure categories:
 • Government consumption and gross investment (G)

• Net exports (EX – IM)—net spending by the rest of the world, or exports (EX) minus imports (IM)

The expenditure approach calculates GDP by adding together these four components of spending. In equation
form:
GDP  C  I  G  ( X  M )

Personal Consumption Expenditures

• Personal consumption expenditures (C) are expenditures by consumers on the following:

• Durable goods: Goods that last a relatively long time, such as cars and household appliances.

• Nondurable goods: Goods that are used up fairly quickly, such as food and clothing.

• Services: The things that we buy that do not involve the production of physical things, such as
legal and medical services and education.

Gross Private Domestic Investment

• Investment refers to the purchase of new capital.

• Total investment by the private sector is called gross private domestic investment. It includes the
purchase of new housing, plants, equipment, and inventory by the private (or non-government) sector.

• Nonresidential investment includes expenditures by firms for machines, tools, plants, and so on.

• Residential investment includes expenditures by households and firms on new houses and apartment
buildings.

• Change in inventories computes the amount by which firms’ inventories change during a given period.
Inventories are the goods that firms produce now but intend to sell later.

Gross Investment versus Net Investment

• Gross investment is the total value of all newly produced capital goods (plant, equipment, housing, and
inventory) produced in a given period.
• Depreciation is the amount by which an asset’s value falls in a given period.
• Net investment equals gross investment minus depreciation.

Government consumption and gross investment (G) counts expenditures by federal, state, and local governments
for final goods and services.
Net exports (EX – IM) is the difference between exports (sales to foreigners of U.S.-produced goods and services)
and imports (U.S. purchases of goods and services from abroad). The figure can be positive or negative.

The Income Approach

• National income is the total income earned by the factors of production owned by a country’s citizens.

• The income approach to GDP breaks down GDP into four components:

GDP = national income + depreciation + (indirect taxes – subsidies) + net factor payments to the rest of the
world + other

From GDP to Disposable Income

• Net national product equals gross national product minus depreciation; a nation’s total product minus
what is required to maintain the value of its capital stock.

• Personal income is the total income of households. Equals (national income) minus (corporate profits
minus dividends) minus (social insurance payments) plus (interest income received from the government
and households).

• Personal income is the income received by households after paying social insurance taxes but before
paying personal income taxes.

• The personal saving rate is the percentage of disposable personal income that is saved. If the personal
saving rate is low, households are spending a large amount relative to their incomes; if it is high,
households are spending cautiously.

Nominal versus Real GDP

• Nominal GDP is GDP measured in current dollars, or the current prices we pay for things. Nominal GDP
includes all the components of GDP valued at their current prices.

• When a variable is measured in current dollars, it is described in nominal terms.

Calculating Real GDP

• A weight is the importance attached to an item within a group of items.

 • A base year is the year chosen for the weights in a fixed-weight procedure.

• A fixed-weight procedure uses weights from a given base year.

Calculating the GDP Price Index

• The GDP price index is one measure of the overall price level.

• The old procedure used by the Bureau of Economic Analysis (BEA) to estimate changes in the overall price
level used the quantities produced in a chosen year (the base year) as weights. But overall price increases
are sensitive to the choice of the base year. The new procedure, known as the chained price index, avoids
the problems associated with the use of fixed weights.

The Problems of Fixed Weights

The use of fixed price weights to estimate real GDP leads to problems because it ignores:

1. Structural changes in the economy.

2. Supply shifts, which cause large decreases in price and large increases in quantity supplied.

3. The substitution effect of price increases.

Limitations of the GDP Concept

• Society is better off when crime decreases, but a decrease in crime is not reflected in GDP.

• An increase in leisure is an increase in social welfare, not counted in GDP.

• Nonmarket and domestic activities are not counted even though they amount to real production.

• GDP accounting rules do not adjust for production that pollutes the environment.

• GDP has nothing to say about the distribution of output. Redistributive income policies have no direct
impact on GDP.

• GDP is neutral to the kinds of goods an economy produces.

The Underground Economy

• The underground economy is the part of an economy in which transactions take place and in which
income is generated that is unreported and therefore not counted in GDP.

Per Capita GDP/GNP

• Per capita GDP or GNP measures a country’s GDP or GNP divided by its population.

• Per capita GDP is a better measure of well-being for the average person that its total GDP or GNP.
 Measuring the Cost of Living

Measuring the Cost of Living

• Inflation refers to a situation in which the economy’s overall price level is rising.

• The inflation rate is the percentage change in the price level from the previous period.

THE CONSUMER PRICE INDEX

• The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a
typical consumer.

• The Bureau of Labor Statistics reports the CPI each month.

• It is used to monitor changes in the cost of living over time.

• When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living.

How the Consumer Price Index Is Calculated

• Fix the Basket: Determine what prices are most important to the typical consumer.

• The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical
consumer buys.

• The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and
services.

• Find the Prices: Find the prices of each of the goods and services in the basket for each point in time.

• Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and
services at different times.

• Choose a Base Year and Compute the Index:

• Designate one year as the base year, making it the benchmark against which other years are
compared.

• Compute the index by dividing the price of the basket in one year by the price in the base year
and multiplying by 100.

Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding
period.

• The Inflation Rate

• The inflation rate is calculated as follows:

CPI in Year 2 - CPI in Year 1

Inflation Rate in Year 2 =  100
CPI in Year 1
Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example

• Calculating the Consumer Price Index and the Inflation Rate: Another Example

• Base Year is 2002.

• Basket of goods in 2002 costs $1,200.

• The same basket in 2004 costs $1,236.

• CPI = ($1,236/$1,200)  100 = 103.

• Prices increased 3 percent between 2002 and 2004.

Problems in Measuring the Cost of Living

• The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is
not a perfect measure of the cost of living.
• Substitution bias
• Introduction of new goods
 • Unmeasured quality changes

Substitution Bias

o The basket does not change to reflect consumer reaction to changes in relative prices.

 Consumers substitute toward goods that have become relatively less expensive.

 The index overstates the increase in cost of living by not considering consumer
substitution.

Introduction of New Goods

o The basket does not reflect the change in purchasing power brought on by the introduction of
new products.

 New products result in greater variety, which in turn makes each dollar more valuable.

 Consumers need fewer dollars to maintain any given standard of living

Unmeasured Quality Changes

o If the quality of a good rises from one year to the next, the value of a dollar rises, even if the
price of the good stays the same.

o If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price
of the good stays the same.

o The BLS tries to adjust the price for constant quality, but such differences are hard to measure.

• The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI
to overstate the true cost of living.

o The issue is important because many government programs use the CPI to adjust for changes in
the overall level of prices.

o The CPI overstates inflation by about 1 percentage point per year.

The GDP Deflator versus the Consumer Price Index

• The GDP deflator is calculated as follows:

Nominal GDP
GDP deflator =  100
Real GDP

• The BLS calculates other prices indexes:

• The index for different regions within the country.

• The producer price index, which measures the cost of a basket of goods and services bought by
firms rather than consumers.

• Economists and policymakers monitor both the GDP deflator and the consumer price index to
gauge how quickly prices are rising.

• There are two important differences between the indexes that can cause them to diverge

• The GDP deflator reflects the prices of all goods and services produced domestically, whereas...

• …the consumer price index reflects the prices of all goods and services bought by consumers.
 • The consumer price index compares the price of a fixed basket of goods and services to the price
of the basket in the base year (only occasionally does the BLS change the basket)...

• …whereas the GDP deflator compares the price of currently produced goods and services to the
price of the same goods and services in the base year.

CORRECTING ECONOMIC VARIABLES FOR THE EFFECTS OF INFLATION

• Price indexes are used to correct for the effects of inflation when comparing dollar figures from
different times.

Dollar Figures from Different Times

• Do the following to convert (inflate) Babe Ruth’s wages in 1931 to dollars in 2001:
Price level in 2001
Salary 2001  Salary1931 
Price level in 1931

177
 $80,000 
15.2

 $931,579

Table 2 The Most Popular Movies of All Times, Inflation Adjusted

Indexation

• When some dollar amount is automatically corrected for inflation by law or contract, the amount is said
to be indexed for inflation.

Real and Nominal Interest Rates

• Interest represents a payment in the future for a transfer of money in the past.

• The nominal interest rate is the interest rate usually reported and not corrected for inflation.

• It is the interest rate that a bank pays.

• The real interest rate is the nominal interest rate that is corrected for the effects of inflation.

• You borrowed $1,000 for one year.

 • Nominal interest rate was 15%.

• During the year inflation was 10%.

Real interest rate = Nominal interest rate – Inflation

= 15% - 10% = 5%

Summary

• The consumer price index shows the cost of a basket of goods and services relative to the cost of the
same basket in the base year.

• The index is used to measure the overall level of prices in the economy.

• The percentage change in the CPI measures the inflation rate.

• The consumer price index is an imperfect measure of the cost of living for the following three reasons:
substitution bias, the introduction of new goods, and unmeasured changes in quality.

• Because of measurement problems, the CPI overstates annual inflation by about 1 percentage point.
• The GDP deflator differs from the CPI because it includes goods and services produced rather than goods
and services consumed.
• In addition, the CPI uses a fixed basket of goods, while the GDP deflator automatically changes the group
of goods and services over time as the composition of GDP changes.
• Dollar figures from different points in time do not represent a valid comparison of purchasing power.
• Various laws and private contracts use price indexes to correct for the effects of inflation.
• The real interest rate equals the nominal interest rate minus the rate of inflation.