Chapter 2. The Measurement and Structure of the Canadian Economy. Copyright 2009 Pearson Education Canada

National Income Accounting The national income accounts is an accounting framework used in measuring current economic activity. There are three approaches: The product approach measures the amount of output produced, excluding output used up in intermediate stages of production. Copyright 2009 Pearson Education Canada 2-2

National Income Accounting (continued) The income approach measures the incomes received by the producers of output. The expenditure e approach measures the amount of spending by the ultimate purchasers of output. Copyright 2009 Pearson Education Canada 2-3

Why the Three Approaches Are Equivalent The market value of a good (product) and the spending on a good (expenditure) are always the same. The seller s receipts (expenditure) are equal to the total income generated by the economic activity y( (income). Copyright 2009 Pearson Education Canada 2-8

Why the Three Approaches Are Equivalent (continued) The key to understanding how national accounts are put together is to focus on the ultimate or final users of the goods and services. Fundamental identity of national income accounting: total production = total income = total expenditure Copyright 2009 Pearson Education Canada 2-9

The Product Approach to Measuring GDP A nation s gross domestic product (GDP) is the market value of final goods and services newly produced within a nation during a fixed period of time (location, location, location). This is the broadest and most well known measure of economic activity and what is typically reported in the press. Using market values (i.e. prices) allows adding the production of different goods and services according to their importance. Copyright 2009 Pearson Education Canada 2-10

The Product Approach to Measuring GDP (continued) Problems with the market values: Some goods are not sold in markets, e.g., household h and volunteer services. The underground economy illegal activities and legal activities hidden from the government. Lack of market values to use when calculating the government s contribution to the GDP. Copyright 2009 Pearson Education Canada 2-11

The Product Approach to Measuring GDP (continued) GDP includes only goods and services newly produced within the current period. It is a sum of value added value of an output less value of what is used up in production. Intermediate goods are those used up in the production of other goods in the same time period. Copyright 2009 Pearson Education Canada 2-12

The Product Approach to Measuring GDP (continued) GDP includes only final goods not intermediate goods, the end products. New capital goods and inventory investment are final goods in this framework. They are produced during the period and not used up. What happens to inventories in the next period when the goods are sold? Do we double count? Copyright 2009 Pearson Education Canada 2-13

GDP versus GNP Gross national product (GNP) is the market value of final goods newly produced d by domestic or owned factors of production (capital, labour) during the current period, regardless of their location ownership, ownership, ownership. Some of these factors will be located abroad. Copyright 2009 Pearson Education Canada 2-14

GDP versus GNP (continued) Canadian owned capital and labour used abroad produce output and income. They are included into Canadian GNP, not GDP Foreign owned capital and labour used in Canada ada produce output and income. They are included into Canadian GDP, not GNP Copyright 2009 Pearson Education Canada 2-15

GDP versus GNP (continued) Net factor payments from abroad (NFP) is: income paid to domestic factors of production by the rest of the world; minus income paid to foreign factors of production by the domestic economy. GDP + NFP = GNP Copyright 2009 Pearson Education Canada 2-16

GDP versus GNP (continued) In 2006 Canadian GDP was $1446.4 billion and Canadian GNP was $1435.7 billion. The somewhat less than 1% difference arises because of the scale of foreign investments in Canada. When foreign firms invest in Canada, the interest and profits they earn enter GDP, not GNP Notice that there is a relationship between GDP and GNP it is NFP. Copyright 2009 Pearson Education Canada 2-17

The Expenditure Approach to Measuring GDP Y = C + I + G + NX Y = GDP C = consumption I = investment G = government purchases of goods and services NX = net exports of goods and services (exports minus imports) Income-Expenditure Identity Copyright 2009 Pearson Education Canada 2-18

The Expenditure Approach (continued) GDP: total production or total income or total expenditure. Consumption ( 60% of GDP): consumer durable goods (7.3%); semi-durable goods(4.6%); nondurable goods (13.5%); Services (30.1%). Copyright 2009 Pearson Education Canada 2-19

The Expenditure Approach (continued) Investment (22.5% of GDP): fixed investment (19.2%): residential construction (6.8%), nonresidential investment (5.9%), machinery and equipment (6.5%); inventory investment (0.5%); government investment (2.8%). So, I measures public and private investment Copyright 2009 Pearson Education Canada 2-20

The Expenditure Approach (continued) Government purchases of goods and services ( 20% of GDP): Government purchases (all levels), other than capital goods; Excludes transfers (between different levels of government and individuals) Excludes interest payments on national debt Copyright 2009 Pearson Education Canada 2-21

The Expenditure Approach (continued) Net exports of goods and services (2.6% of GDP): NX = Exports Imports Exports produced locally, purchased abroad. Imports produced abroad, purchased locally. Copyright 2009 Pearson Education Canada 2-22

The Income Approach to Measuring GDP Net national income is the sum of: Labour income (51.0%); Corporate profits (14.7%); Interest and investment income (4.4%); Unincorporated business income (6.0%). Indirect taxes less subsidies Depreciation Copyright 2009 Pearson Education Canada 2-23

The Income Approach to Measuring GDP (continued) Labour income (51.0%): wages, salaries, employee benefits; employer contributions to the EI and the CPP. Corporate profits (14.7%) which are used to pay taxes levied on corporations; dividends to shareholders; retained earnings (corporate saving). Copyright 2009 Pearson Education Canada 2-24

The Income Approach to Measuring GDP (continued) Interest and investment income (4.4%): interest earned by individuals from business and foreign sources; minus interest paid by individuals. By convention, interest on government debt is excluded because it is not used to produce new goods and services. Unincorporated business income (6.0%): income of self-employed, which includes both labour and capital income. Copyright 2009 Pearson Education Canada 2-25

The Income Approach to Measuring GDP (continued) Two other items need to be accounted for: Indirect taxes less subsidies (11.2%): provincial sales taxed (PST); goods and services tax (GST); minus subsidies. Capital consumption allowances or depreciation the value of capital that wears out during the measured period (12.8%) In calculating the components of national income, depreciation is subtracted from total/gross income So, to compute the total/gross amount of income, we must add depreciation back in Copyright 2009 Pearson Education Canada 2-26

Private Sector Income Private disposable income (PDI) is the amount of income the private sector (households and businesses) has available to spend after paying taxes and receiving ggovernment transfers: PDI = Y + NFP + TR + INT T TR: transfers received from the government INT: interest payments on government s debt T: taxes Copyright 2009 Pearson Education Canada 2-27

Government Sector Income Similarly, the net income of the government sector (NGI) is given by: NGI = T TR INT Note: if we add the two sources of income we get Y + NFP or GNP. Copyright 2009 Pearson Education Canada 2-28

Saving and Wealth Often we want to study wealth, not just current income. Wealth comes from saving part of past income. Wealth is the difference between assets and liabilities. National wealth is the sum of all households, firms, and government s wealth within the nation. Saving is current income minus current spending Copyright 2009 Pearson Education Canada 2-29

Measures of Saving: Private Saving S pvt = (Y + NFP T + TR + INT) C Private saving = private disposable income consumption The ratio of S pvt to private disposable income is called the private saving rate. Copyright 2009 Pearson Education Canada 2-30

Measures of Saving: Government Saving S govt = NGI G = (T TR INT) G = T (TR + INT + G) Gov t saving = net gov t income gov t purchases of goods and services If there is a budget surplus: T (TR+INT+G) >0 and S govt >0 If there is a budget deficit: T (TR+INT+G) <0 and S govt <0 Copyright 2009 Pearson Education Canada 2-31

Measures of Saving: National Saving National saving (S) is the saving of the economy as a whole: S = S pvt + S govt = (Y + NFP T + TR + INT - C) + (T TR INT G) = Y + NFP C G. Copyright 2009 Pearson Education Canada 2-32

The Uses of Private Saving Private saving is used to fund new capital investment, borrow/lend with foreign countries, and to help with government deficits: S = = (C I + + I (NX = I + CA + G + + NFP) NX) + NFP C G CA is the current account balance payments received from abroad for exports minus payments made to foreigners for imports, NFP included (CA = NX + NFP) Copyright 2009 Pearson Education Canada 2-33

The Uses of Saving Identity S S govt = I + CA S govt S pvt = I + ( S govt ) + CA Private saving is used in three ways: to fund investment (I); to fund the government budget deficit (-S govt ); or to purchase assets from foreigners or lend abroad the current account balance (CA). This is the uses-of-saving identity. Copyright 2009 Pearson Education Canada 2-34

Relating Saving and Wealth Saving is a flow variable a variable that is measured per unit of time. Wealth is a stock variable a variable that is measured at a point in time. In many cases, a flow variable is the rate of change in a stock variable Copyright 2009 Pearson Education Canada 2-35

Relating Saving and Wealth (continued) National wealth consists of: country s domestic physical assets (e.g. capital goods, land); country s net foreign assets country s foreign assets minus its foreign liabilities. National wealth can change through changes in the value of national saving (I+CA) or changes in the value of the stock of wealth. Copyright 2009 Pearson Education Canada 2-36

Nominal Variables vs. Real Variables So far we have worked with just nominal variables (in current dollar terms) This is useful because we can add up market value of various goods But, compare GDP in 1900 vs. 2000: Change in quantities or in prices? Real variables: economic variable measured in terms of a base year Measure physical quantity of economic activity Copyright 2009 Pearson Education Canada 2-37

Real GDP Nominal GDP (or current-dollar GDP) is the dollar value of an economy s final output at current market prices. Real GDP (or constant-dollar GDP) is the physical volume of an economy s final output using the prices of a base year. Real GDP is a measure that allows us to make better comparisons over time what has changed, prices or quantities? Copyright 2009 Pearson Education Canada 2-38

A Simple Example 1-39

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Price Indices A pie price index is a measure e of the average level of prices for some specified set of goods and services, relative to the prices in a specified base year. The GDP deflator is a price index that measures the overall level of prices of goods and services included in GDP: GDP Deflator = Nominal GDP Real GDP Copyright 2009 Pearson Education Canada 2-41

Price Indices (continued) In our example, the GDP deflator in year 2 is $66000/$62000 =1.065, so the overall level of prices is 6.5% higher in year 2 than in year 1 The Consumer Price Index (CPI) measures the price of consumer goods. The CPI is calculated for a fixed consumer basket. CPI is calculated as the ratio of the value of the basket at different points in time Copyright 2009 Pearson Education Canada 2-42

Inflation The rate of inflation is the percentage rate of increase in a price index (e.g. CPI) per period: (P P ΔP π = t+ 1 t = t+ 1 t+ 1 P P t t Pt is the price level in period t Pt+1 is the price level in period t+1 Pt+1 is change in the price level between t and t+1 ) Copyright 2009 Pearson Education Canada 2-43

Interest Rates An interest rate is a rate of return promised by a borrower to a lender. We talk about the interest est rate. Although they are numerous, they move up and down together. Copyright 2009 Pearson Education Canada 2-45

Real versus Nominal Interest Rates The real interest rate is the rate at which the real value (or purchasing power) of an asset increases over time. The nominal interest rate (i) is the rate at which the nominal value of an asset increases over time. This is what is generally reported in the newspaper Copyright 2009 Pearson Education Canada 2-46

Expected Real Interest Rate But investment decisions cannot be based on i π, because the eventual inflation rate is not known at the time investments are made. The expected real interest rate (r) is the rate at which the real value of an asset is expected to increase over time. r = i π e π e = an expected inflation rate If π=π e, then the real interest t rate = expected one Copyright 2009 Pearson Education Canada 2-49