IE University

National Income Accounting

Problem Set 2

Part 1 - National Income Accounting

1. i) Explain each one of the components from our definition of GDP (i.e. GDP is the VALUE of
all FINAL goods, etc, etc). ii) Why is the difference between rich and poor countries not as big
as GPD data might suggest? iii) Which is the difference between GDP and GNP? iv) What is
the difference between real GDP and nominal GDP and why is this difference important?
i) GDP is the value of all FINAL goods and services remunerated, declared and
produced within a territory during a specific period of time. Do you know why we
only consider final goods which are remunerated, declared and produced? I am sure
you know why).
ii) GDP takes only remunerated and declared goods into account. Because poor
countries tend to have more not remunerated and not declared economic activities,
their GDP tends to be undervalued. The not remunerated activities arise of many
task that households in poorer countries do on their own, whereas households in
richer countries source them out to service provider and it becomes remunerated.
Also poor countries usually have a bigger sector of activities in the underground
economy which are not declared, that since the value is not know then they cannot
be part of the GDP.
iii) The GDP (Gross Domestic Product) measures the value within a territory
whereas GNP (Gross National Product) measures the value performed by all citi-
zens of the country regardless where they produce it. In former times the numerical
difference between those two wasn’t too big. But since the globalisation took place,
significant path of GDP are produced by citizens who don’t belong to the coun-
try they work in. Hence nowadays there is a difference and because GDP better
describes the economic condition of a country, GNP is no longer a very useful mea-
surement of economic activity.
iv) GDP can increase for two reasons: an increase in economic activity or/and an
increase in prices. In real GDP only production is allowed to change, while keeping
prices constant, and in nominal GDP both are allowed to change. An increase in
prices will generate an increase in nominal GDP, but this does not means that eco-
nomic activity has increased thus, in order to GDP to be a an accurate measurement
of economic activity, REAL GDP mus be used instead.
2. i) How is GDP calculated so that intermediate goods are not considered twice in the computa-
tion? ii) Why is the Valued Added Method used as an alternative to the final good method of
calculation? iii) What is the difference in computing the value of a public service and a private
good? iv) Las Meninas, the painting by Velzaquez, is now hanging from one of the walls at Museo
del Prado where is visited daily by thousands of people. Should this event be considered a part
of the GDP of Spain? If you answer is yes, where should be registered in the National Income
Accounting from Spain?
i) Due to the fact that certain goods are sold as final products and others are sold
and used as intermediate goods, this could create a problem of double counting when
trying to calculate the GDP. In order to avoid double counting of intermediate goods,
these are not directly included into the calculation of GDP. That is, GDP includes
only the value of final goods, however intermediate goods are indirectly included,

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 because their value is already incorporated in the prices of final goods. There is
one exception to this principle that arises when an intermediate good is produced
but is not immediately sold or applied to the production of a final good. In these
cases, the intermediate good is added to a firm’s inventory investment, thereby being
temporarily included as part of GDP (until it is used or sold).
ii) The distinction between final and intermediate goods can be problematic. A firm
may use the same good for its own consumption or it can apply it to the production
of another good. As for GDP calculation, in the first case the good would be a
final good, whereas in the latter case it would be an intermediate good. However, it
would be cumbersome to ask firms how much they spent in what is considered final
goods for GDP purposes, and how much in intermediate goods. To circumvent this
problem, the Valued Added Method is used as an alternative method to calculate
GDP. Instead of trying to isolate only final goods and services, one can look at the
value added for each good and service (intermediate or not) produced in an economy.
Firms are simply asked about the value added they generated, which is simply the
difference between the value of the production output (at any particular stage in the
overall production process) and the value of all intermediate inputs employed. This
approach estimates GDP, that is, the value of all final goods and services produced,
through the valuation of every stage of production involved in producing them.
iii) The difference in computing the value of a public service and a private good
is that, while private goods are sold in the market and have a known price, public
services don’t go through the market, so at first glance, we don’t have any price to
value them. As a result, instead of being valued at market prices, public services
enter the GDP formula at their cost, that is, as public expenses (the money paid by
the State to supply those public services to the society. A new question: if the state
cleans the street, should all the money spend in street cleaning be included in the
GDP or only the salaries paid? The answer is only the salaries. Why?
iv) The answer to this question is easier than it seems: since Museo del Prado is a
public museum (belongs to the state), then the salaries payed to its employees is the
only part that is registered in Spain´s GDP. What happens if instead the Meninas
hangs form the wall of a private museum? Well, this is a more challenging questions.
Any ideas?
3. i) We know that GDP=INCOME=EXPENDITURE. Explain intuitively where the above identity
comes from. ii) Spanish firms saw their sales decrease during the last month, because of this the
identity GDP=EXPENDITURE no longer holds. Is the statement true or false (explain)? iii)
Why imports appear subtracting in the identity Y = C + I + G + X − M ? iv) Why investment
is the only expenditure done by firms that is considered in the identity Y = C + I + G + X − M ?
i) When looking at GDP = INCOME this equation equates GDP to the income that
households receive from the firm in terms of wages, interest for capital, rent for land
and profits for entrepreneurship. This is the case since GDP is equal to the value
added created by an economy and because the value added of each firm is distributed
among the factors of production (which created the value added). When using the
identity GDP = EXPENDITURES, it must be the case that total spending equals
total production (or GDP).

ii) I (Investment) includes all the unsold products of a firm. Therefore, if a good is
produced then GDP increases, if it is sold it goes to C or G or I (in case that it was
a machine), but it is not sold, it goes to inventories (I). In any case, Expenditures
= C+I+G will increase. Thus the identity GDP = EXPENDITURES always holds
(the statement is false).

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 iii) Imports of foreign goods and services (M) appear subtracting in the identity Y
= C + I +G+ X - M because by doing so we can isolate the value of final goods and
services produced domestically, excluding all imported goods and services that have
been produced abroad but consumed by nationals. When a domestic household, firm,
or the government buys a good or service from abroad, this increases consumption,
investment, or government purchases, but GDP only measures the value of goods
and services produced within the country’s territory. Since it would be very costly
to obtain information on which type of goods (whether produced domestically or
abroad) are being consumed by each economic sector, we let them be included in
the first part of the identity (C + I + G), and later on we subtract all the imported
goods and services (M), regardless of the economic sector that has purchased them.
iv). In order to avoid double counting, only final goods are considered in te calcula-
tion of GDP, therefore only the spending of firms in final goods should considered.
Do firms by final goods or only intermediate goods? Think of an intermediate good
as something that disappears during the production process (a tire for a new car
disappears since once the car is sold, the tire is nop longer in the factory, is gone).
Is there something that does not disappears during the production process? Yes,
machinery and equipment. Therefore, the only purchase from firms that is consid-
ered a final good is machinery, equipment, factories, etc. In this class (an in Macro
in general) this type of purchases are called INVESTMENT. What happens with
the depreciation of this equipment? Think. Think. A hint: Why GDP is GROSS
and not NET? Voila!
4. On Guapolandia only seeds and necklaces are produced. Necklaces are made with seeds, while
the seeds which are not used for producing necklaces are consumed as final goods. In 2012, 200
kg. of seeds and 300 necklaces were produced. It takes two hundred grams of seeds to make one
necklace. If the price of seeds is 5 euros per kg. and the price of a necklace is 10 euros then

(a) Find the GDP of Guapolandia using the value of final goods method. (HINT: The answer
is 3700 )
(b) Find the added value of the sector producing seeds and the sector producing necklaces. Is
your answer consisted with the result obtained in a)?
(c) The necklace industry pays wages to workers for 200 euros and the seeds industry for 100
euros. The necklace industry pays 100 euros for rent (the seed industry pays no rent). Find
the total income for Guapolandia. Is your answer consisted with the result obtained in a)
and b)?
(d) Of the 300 necklaces, 50 are exported and sold outside Guapolandia. Also, 50 necklaces
were left unsold (they should consider hiring a marketing expert). All seeds are sold to the
domestic market. Find total expenditures. Does your result is consistent with a), b) and
c)? (in other words, does GDP = C + I + G + X − M holds?)

a) In Guapolandia, all necklaces are consumed as final goods, whereas some seeds
are consumed as final goods, and others are used to produce necklaces (intermediate
good). Given that 300 necklaces were produced and that each one needs 0,2 kg of
seeds to be produced, a total of 60 kg of seeds were used as intermediate goods
(i.e. 60kg seeds= 300 necklaces 0,2kg seeds). This in turn implies that 140kg of
seeds (i.e., 140 = 200 - 60) were consumed as final goods. As a result, the GDP of
Guapolandia, measured as the value of all final goods produced in the economy, is
equal to: GDP = 140 x 5 + 300 x 10 = 3700 euros.

b) The value added produced by each sector equals the value of the final output,
minus the cost of the inputs needed to obtain the production. Value added of the

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seeds sector = 200 kg x 5 - 0 = 1000 euros. Value added of the necklaces sector
=300 necklaces x 10 - 60kg x 5 =2700 euros. With the value added approach, the
GDP of Guapolandia is also 3700 euros.

c) Total Wages = Ws + Wn = 100+200. Total Rent = Rs + Rn = 100 + 0 =

100. Profit necklaces= (300 x 10) - (60 kgs x 5) - (200+100) = 2400. Profit Seeds
= (200kgs x 5) - (100) = 900. Using the income method, the GDP of Guapolandia
would be the sum of all the profits made by both industries, along with the factor
payments, that is Total Income = 100+200+100+ 2400+900 = 3700.
d) Recall that the 50 unsold necklaces will be included under investment as an
inventory. The identity GDP = C + I + G + X -M still holds since:

(a) C = 200 necklaces x 10 + 140 kg seeds x 5 = 2700 euros.

(b) I = 50 necklaces x 10 = 500 euros (inventory investment).
(c) G = 0 (no information is given regarding government purchases.
(d) X = 50 necklaces x 10 = 500 euros.
(e) M = 0 (no information is given regarding imported goods and services).

Therefore, total expenditure = C + I +G+ X - M = 2700 + 500 + 500 = 3700 =

GDP. Looking at the results, we can confirm that the equation holds.