National Income Accounting and Key Macroeconomic Variables

Why do we need to study national income accounting?

1. National Income Accounting – provides the formal structure to macroeconomic theory.

a. Production side – output is paid to the factors of production; provides a framework for
studying growth and aggregate supply.

b. Demand side – output is consumed or invested; framework for studying aggregate demand.

c. Equilibrium AS=AD; makes possible the study of real output.

d. NIA includes measures of overall price levels which provides a basis for studying inflation.

2. NIA provides ballpark figures that are useful in characterizing the economy.

Definitions:

● Gross Domestic Product (GDP) - value of all final goods and services produced in a country
within a given period.

● Factors of production - inputs such as land, labor, and capital.

● Production Function - the relationship between inputs and outputs expressed in a

mathematical formula: 𝑌 = 𝑓(𝑁, 𝐾) [Y - output; N - labor; K - capital]

● Total Output = labor payments + capital payments + profit :

𝑌 = (𝑤 * 𝑁) + (𝑟 * 𝐾) + 𝑝𝑟𝑜𝑓𝑖𝑡 [w - wage rate; r - rent]

Components of demand for domestically produced goods and services:

1. Consumption spending by households ( C ) - food, housing, clothing expenditures

2. Investment spending businesses and households (I) - gross private domestic investment,
depreciation not included.
3. Government purchases of goods and services (G)
4. Foreign demand for net exports (NX) - difference between exports and imports

𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
Simple Economy - no government and foreign trade

● Output produced = Output sold

● Unsold output is treated as accumulation of inventories and considered as part of
investment
● All output is either consumed or invested
● 𝑌 = 𝐶 + 𝐼 [Y - value of output; C - consumption; I - investment spending]
● How is income allocated? 𝑌 = 𝐶 + 𝑆 [S - private sector saving]
● 𝐶+𝐼 =𝑌 = 𝐶 +𝑆
● Left: components of demand; Right: allocation of income; output produced is equal to
income received; income received is spent on goods and services.
● Also: 𝐼 = 𝑌 − 𝐶 = 𝑆 [investment=savings]
● Individuals can save only through physical investment such as storing grain or borrowing
from individuals who save.
● The government spends, gives transfer payments, and collects taxes.
● Transfers (TR) include interest on public debt.
● Part of income is spent on taxes (TA) and the private sector receives transfers (TR), hence:
𝑆 − 𝐼 = (𝐺 + 𝑇𝑅 − 𝑇𝐴) + 𝑁𝑋
● Disposable Income: 𝑌𝐷 = 𝐶 + 𝑆
● (𝐺 + 𝑇𝑅 − 𝑇𝐴) - government budget deficit (GBD) or the excess of government spending
over its receipts
● The budget deficit is the negative budget surplus: 𝐵𝑆 = 𝑇𝐴 − (𝐺 + 𝑇𝑅)
● NX - trade surplus; when negative, trade deficit
● 𝑆 − 𝐼 equals GBD plus trade surplus
● When S=I, the budget deficit is reflected in an equal external deficit.
● Any sector that spends more than it receives must borrow.

3 ways of disposing savings (private sector):

1. Make loans to the government; this can pay for BD;

2. Lend to foreigners; this means foreigners are earning and has to borrow to pay for the goods
they buy;
3. Lend to business firms which use the funds for investment.

Measuring GDP:

● Final goods and value added: double counting must be avoided.

● Current output: GDP is the value of current output; transactions in existing commodities
are not included.

Problems in GDP Measurement

● GDP is also a measure of the people’s welfare

 ● Does an increase in GDP imply that people are better off?
● Some outputs are poorly measured because they are not traded in the market
● Some resources are used to contain/limit “bads” such national security and crime;
environmental degradation
● Difficult to account improvements in the quality of goods (ex: computers)

Inflation and Price Indexes

● GDP is measured using prices.

● Real GDP measures changes in physical output of the economy between two periods; value
of all goods in the 2 periods at the same prices or in constant dollars.
● Nominal GDP measures the value of output in the given period in the prices of that period,
or in current prices.
● Nominal GDP changes from year to year for 2 reasons: change in the physical output of the
economy and change in the market prices.
● Real GDP is the one being used to determine changes in physical output.

Inflation and Prices

● Inflation - the rate of change in prices

● The price level is the accumulation of past inflations
𝑃𝑡−𝑃𝑡−1
● Inflation rate: Π = 𝑃𝑡−1
[Π - inflation rate; 𝑃𝑡 - today’s price; 𝑃𝑡−1 - price last year.
● Hence, today’s price is: 𝑃𝑡 = 𝑃𝑡−1 + (Π * 𝑃𝑡−1)

Price Indexes

1. GDP Deflator
● Real GDP provides us with a measure of inflation, the GDP deflator
● GDP deflator - the ratio of nominal GDP in a given year to real GDP of that year.
● Measures the change in prices that occurred between the base year and the current year.
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
● 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃
2. CPI - Consumer Price Index
● CPI measures the cost of buying a fixed basket of goods and services representative of the
purchases of urban consumers.
● Difference from the GDP deflator: (1) the deflator measures the prices of a wider range of
goods than CPI; (2) CPI measures a given basket of goods that is the same every year; (3)
CPI directly includes prices of imports.
3. Producer Price Index
● A measure of the cost of a given basket of goods but includes raw materials and
semi-finished goods.
● Designed to measure prices at an early stage of the distribution system.
Philippines

● CPI, an indicator of the change in the average retail prices of a fixed basket of goods and
services commonly purchased by households relative to a base year.
● The CPI is used in calculating the inflation rate and purchasing power of the peso.
● CPI is generated by the Philippine Statistics Authority (PSA) from survey data collected
weekly and twice a month through the Survey of Retail Prices of Commodities and
Services.
● Prices are collected through personal interviews from selected stalls in public markets,
sari-sari stores, supermarkets and service shops all over the country.
● The CPI is computed as the weighted arithmetic mean of price relatives (basket of
goods/services).
𝑠𝑢𝑚 [(𝑃𝑛/𝑃0)𝑊)]
𝐶𝑃𝐼 = 𝑠𝑢𝑚 (𝑊)
* 100 [𝑃𝑛 - current price; 𝑃0 - base period price; W = 𝑃0𝑄0 =weights

𝐶𝑃𝐼2−𝐶𝑃𝐼1
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 = 𝐶𝑃𝐼1
* 100 [𝐶𝑃2-CPI in the second period; 𝐶𝑃1-CPI in the previous
period

Core Inflation

● Measures the underlying trend or movement in average consumer prices

● Compliments CPI or headline inflation
● Does not include prices that are volatile
● Shows the broad underlying trend in consumer prices
● Used as an indicator of long term and future inflation
● It is usually affected by the amount of money in the economy or monetary policy.

Unemployment Rate

● Measures the fraction of the workforce that is out of work and looking for a job or
expecting a recall from a lay-off.
 Income and Spending

The Goods Market

● Yearly movements in economic activity

● Interactions between production, income, and demand

Why does output fluctuate around its potential level?

● In business cycles booms and recessions - output rises and falls along the trend of potential
output.
● What explains business cycles?

Income Determination Model

● Two sector, consumption and savings

● Three sector, government spending
● Fiscal policy, multiplier
● Four sector model - 4th sector (international sector)

Business Cycles and Aggregate Demand

● Keynesian Economics - changes in AD impacts on output, employment and prices in the

short run.
● Economic History - no economy grows in a smooth and even pattern.
● Upward and downward movements in output, inflation, interest rates and employment
from the business cycle characterizes all market economies.
● Business cycles are economy-wide fluctuations in national output, income and
unemployment usually lasting from 2-10 years, marked by widespread expansion or
contraction in most sectors of the economy.

Typical Business Cycle

● Business cycles are divided in 2 phases - recession (the downturn of a business cycle) and
expansion.
 ● Recession is a recurring period of decline in total output, income and employment and are
contractions in many sectors of the economy.
● Depression - a recession that is both large in both scale and duration.
● The actual patterns of business cycles are irregular.
● No two business cycles are quite the same but they share some similarities.

Customary Characteristics of a Recession

● Investment usually falls sharply in recessions - Housing is first to decline (US Economy),
consumer purchases decline sharply most of the time too. As businesses slow production
down, real GDP falls.
● Employment usually falls sharply in the early stages of a recession.
● As output slows, inflation slows and the demand for raw materials declines as materials’
prices. Wages and prices of services will rise less rapidly.
● Business profits fall sharply. In anticipation of this, common stock prices fall as investors
sniff the scent of a business downturn.
● As business conditions deteriorate and employment falls, central banks start to lower short
term interest rates to stimulate investment and other interest rates as well.

Business Cycle Theories

● Exogenous vs. Internal Cycles - economists have been debating about reasons for business
fluctuations; some think they are caused by monetary fluctuations, others by productivity
shock and still others by changes in exogenous spending.
● Exogenous Business Cycle Theory - these theories find the sources of the business cycle in
the fluctuations of factors outside the economic system; wars, revolutions, elections, oil
prices, gold discoveries, population migration, discoveries of new lands and resources, in
scientific breakthroughs and technological innovations, climate change and the weather.
● Internal Business Cycle Theory - mechanisms within the economic system; every expansion
breeds recession and contraction and vice versa; originates from the financial sector.
 ● The Model of Aggregate Demand - theory of fluctuations; interaction between output and
spending; spending determines output and income; output and income also determine
spending.

Assumptions

● Fixed prices
● Firms are willing to sell any amount of output at the given level of prices
● The aggregate supply curve is flat
● AD is the total amount of goods demanded in the economy: 𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
● Equilibrium Output: 𝑌 = 𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
● When AD ≠ output, there is unplanned inventory (IU) investment or disinvestment:
𝑈𝐼 = 𝑌 − 𝐴𝐷 [IU - unplanned additions to inventory.
● If Y>AD, there is unplanned investment, IU>0.

The Consumption Function and AD

● Starting with a simple economy

● Government and foreign trade are omitted. 𝐺 = 𝑁𝑋 = 0
● Assumption: Consumption increases with the level of income.
● Consumption Function: 𝐶 = 𝐶 + 𝑐𝑌, 𝐶 > 0, 0 < 𝑐 < 1

Consumption and Saving

● What happens to the rest of income, the fraction (1-c), that is not spent on consumption?
● Income is either spent or saved in a simple economy; income not spent is saved: 𝑆 = 𝑌 − 𝐶
● Savings function relates the level of saving to the level of income:
𝑆 = 𝑌 − 𝐶 = 𝑌 − 𝐶 − 𝑐𝑌 =− 𝐶 + (1 − 𝑐) 𝑌
 ● Saving is an increasing function of the level of income because the marginal propensity to
save (MPS), is positive.

Consumption, Aggregate Demand, and Autonomous Spending

● Four Sector Economy

● Add Investment (I), government spending (G), and taxes (TA), and foreign trade (NX) are
added to the model.
● Assume that each is autonomous, determined outside the model and assumed to be
independent of income: 𝐼 = 𝐼; 𝐺 = 𝐺; 𝑇𝐴 = 𝑇𝐴; 𝑇𝑅 = 𝑇𝑅; 𝑁𝑋 = 𝑁𝑋
● Consumption now is determined by disposable income.
● 𝑌𝐷 = 𝑌 − 𝑇𝐴 + 𝑇𝑅
● 𝐶 = 𝐶 + 𝑐𝑌𝐷 = 𝐶 + 𝑐(𝑌 + 𝑇𝑅 − 𝑇𝐴)
● Equilibrium Output starting with AD:
● 𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋

● Part of AD function is autonomous: 𝐴 = 𝐶 − 𝑐(𝑇𝐴 − 𝑇𝑅) + 𝐼 + 𝐺 + 𝑁𝑋

● AD increases with the level of income because consumption demand increases with income.
Equilibrium Income and Output

● The equilibrium level of income is when AD=Output.

● The 45◦line, AD=Y
● Equilibrium means that at that level of output and income, planned spending equals
production.

● The position of the AD schedule is determined by its slope, c (MPC); and intercept, 𝐴
(autonomous spending).
● For a given 𝐴, a steeper aggregate demand function implies a higher level of equilibrium
income.
● For a given MPC, a higher level of autonomous spending, implies a higher equilibrium
level of income.
● Hence, the equilibrium level of output is higher: (1) the larger the marginal propensity to
consume, c, and (2) the higher the level of autonomous spending, 𝐴.

The Government Sector

● Government purchases of goods and services, G.

● Taxes and transfers affect the relation between output and income, Y, and the disposable
income.
● Disposable Income (YD) is the net income available for spending by households.
● It is income plus transfers minus taxes: 𝑌 = 𝑇𝑅 − 𝑇𝐴
● Consumption Function: 𝐶 = 𝐶 + 𝑐𝑌𝐷 = 𝐶 + 𝑐(𝑌 + 𝑇𝑅 − 𝑇𝐴)
● Fiscal Policy - government purchases, transfers, and the tax structure.
● Assumption: constant government purchases, G; TR; and a proportional income tax,
collecting a fraction, t, of income in the form of taxes: 𝐺 = 𝐺; 𝑇𝑅 = 𝑇𝑅; 𝑇𝐴 = 𝑡𝑌
● Since tax collections, and therefore YD, C, and AD, depend on the tax rate t, the multiplier
depends also on the tax rate.
● Consumption Function becomes: 𝐶 = 𝐶 + 𝑐(𝑌 + 𝑇𝑅 − 𝑡𝑌)
 ● = 𝐶 + 𝑐𝑇𝑅 + 𝑐(1 − 𝑡)𝑌

Income Taxes and the Multiplier

● Income taxes lower the multiplier.

● If the MPC is 0.8 and taxes=0, the multiplier is 5.
● With the same MPC and a tax rate of 0.25, what happens to the multiplier? What is the
effect of income taxes on the multiplier? Why?

Income Taxes as Automatic Stabilizers

● The proportional income tax is an example of automatic stabilizers.

● An automatic stabilizer automatically reduces the amount by which output changes in
response to a change in autonomous demand.

Effects of a Change in Fiscal Policy

● An increase in G is a change in autonomous spending.

 ● Suppose the government raises transfer payments, 𝑇𝑅
● Autonomous expenditure increases only by 𝑐∆𝑇𝑅, so output will rise by 𝑎𝐺 *𝑐∆𝑇𝑅
● The multiplier for transfer payments is smaller than that for government spending by a
factor c.
● This is because part of any increase in 𝑇𝑅 is saved.

Implications

● The AD theory implies that changes in government spending and taxes affect the level of
income. Thus, fiscal policy can be used to stabilize the economy.

Application

Budget Deficit

● Effects of government’s borrowing - crowding out

● The budget surplus (BS): 𝐵𝑆 = 𝑇𝐴 − 𝐺 − 𝑇𝑅
Effects of Government Purchases and Tax Changes on the Budget Surplus

● Will an increase in government purchases reduce the budget surplus? Yes. Increased G is
reflected in a reduced surplus or increased deficit. However the increased G will also cause
an increase in Y and increase tY (Income Tax) collection.
● Possibility: Tax collection might increase by more than government purchases.