components

SHORT ANSWER (200 words or less): List the components of aggregate expenditure. Choose two of these components, and explain the composition of each.

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How do we keep track of the most complex economy
in world history? what’s gross

about the gross domestic product? What’s domestii
about it7 If you make you-rse{

a tuna Sandwich, how much does your effort add to the
gross domestic product?

Becausepriceschangeovertime,howcanweComparetheeconomy,sproduction
inoneyearwiththatinotheryears?Answers,totheseandotherquestionsare
addressed in this chapter, whichintroduces an economic

scorecard for a $r4 trillion

*r.& * e !#*

U.S. economy. That scorecard is the

national income accounting sYs-
tem, which reduces a huge network

of economic activity to a few aggre-

gate measures.
As you will see, aggregate output . I should spend as much as I can, because Gonsumer spending

is measured either by the spend- keeps the economy healthy.
ing on that output or by the income st,;,utv Disaqrte :lt/on9lY litr’:t-
de”rived from producing it. we i”-“””

“‘-? -‘ g 4 5 s 7
examine each aPProach and learn

why they are equivalent. The major

tbmponents and imPortant equaii-
ties built into the national income accounts are offered

here as another way of under-

standinghowtheeconomywolks-notasaforeignlanguagetobemasteredbefore
the next exam. The emphasis is more on economic intuition

than on accounting pre-

cision. The body of tire chapter provides the background
you need for later chapters’

I.ffi1 The Froduat -rn*ir< rriqrr:cse* "fopics ciscusseC iir ef a Natiore . :, .chapter /

inciucet, ,,. , .
How do we ll’Ieasure the econ- e National incsfire,acesuntt I ‘6l Leakges’and injecliqns’
omy’s performance7 During imitations of national
*r.h of-th” rzth ani r8;;;;: o ExpendiiureapproachtoGDP

e
lrrorru..ornting

turies, when the dominant eco- Q lneomeappruachto6DP :. _ –
nomic policy was mercantiiism, e C*culart*wof,inismeanO:

C eofsumer’prneindex

il::il”iff”*: t::i ;’:ffi?I;
– ;;;;;;”;; o GDPpriceindex

ty the stock of Precious metals a
natlon accumulated in the Public
treasury. Mercantilism led to restrictions on international trade,

but this had the unin-

tended consequence of reducing the gains from comparative advantage’
In the latter

half of the lgth century, rranEois queJ.ay became the first
to measure economic activ-

ity as aflou. In r75g he published his Tatleau tconomique, which
described the circular

flow ofoutput and income through
different sectors of the economy’ His insight was

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,*s a;’

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CHI\PTER 7 liacilltitl 11li: ii S LlcLir:o’rlr 99

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exDenditure
ao’uroach to GDP
*itiulat’utg GDP bY add-
ing rtP sPer:ding on all

fina{ qoods atlri servtces
prndlrcer! in the natiOr!
dr”rri*g th+ Year

income aPproaeh
ts GDF
$alculaling GSF bY

adding uP ail *arnings
fr*n1 Ytsgurees u*ed ta
produee output ln the
r’laiio* dirr;slS the Yea’

final.goads and
servlces
socds ancl servi**s ssld
ta iirial, or *fid, users

intermediate
goods and sen/ices
aoods and servlces

[.rrchased bY iirms f or

aeiditisnal Prscesstn g

oncl re*al*

double counting
the misiake el inck’:ri-
ing ircth the valde of
i:rt*rr*eeliaie Pred*cts
anql the value oJ !i*al
nrotJttcts in calculatins
cicss domestic Product;
i**r:*ting tlr+ sanr{: Pra-
.leJct!$* lilore ttratr s*c*

E

likely insPired bY his k-nor1l- i
edge of blood’s circular Jtow in i
the bodY-Quesnay was court

ff,ysician to King
Louis XV of

France.
Rough measures of

national income were devel-

oped inEngland two centuries

ago, Uut detailed calcuiations

Uuitt uP from microeco-
nomic data were refined in

the United States during the

Great DePression’ The result-

ing national income accounling

svstem organizes huge quan-

tities of data coiiected from
a variety of sources across
America’ These data were
summarized, assembled into

u .oh”rurrt framework’ and
reported bY the federal gov-

.rrr*”trr. The conception
and imPlementation of these

t..orrni, has been hailed as
one of the greatest achieve-
ments of the zoth century’
The U’S’ national income
accounts are the most widely

copied and most highlY

regatded jn the rr”orid a::g ta::ei rlreir riere -cper’
Simon Kuznets, the Nobei ?dze in r97r for

“giving

q”””iio,*” precision lo economic entities ”

National lncome Aecounts

How do the national income accounts
keep track

oftheeconomy’sincrediblevarietyofgoodsand
services, from hiking boots to Pilates

classes? The

gt”tt-J”.tt, ic produci, or GfP’ m1as1t::^tl”
market

value of all final goods and services
produced dur-

ing a year by resources located in
the United States’

,*E”rii”r, ot,^,t’o owns the resources’ For
example’

GDP includes production in the United
States by for-

“ign
nr*r, .,,th “‘

a Toyota nlant-i1 Kentucky’
but

excludes forelgn produciion by
U’S’ firms’ such as a

Ford Plant in Mexico’
The national income accounts

are based on the

simple fact that one person’s spendingis
another person’s

income. GDP canbe *”*”””d eitherby total
spending

on U.S. production or by total income
received from

;;;;;;”.tion’ rhe expenditure approach
adds up

;;”;il;g on all n’.'”i gooat and services
produced

;;;;; tfre year’ the iniorne approach adds
up earn-

ings during the y91r by those whl nrod-1ce
all that

output’ ln the douote’ eitry bookkeeping
system r1.11t.:

ir”.’r. rr-t” economy, spending on
aggregate output ls

recordedononesideoftheledgerandincomefrom
producing that aggregate output

is recorded on the

other side.
Gross domestic product includes “:ty li:]

noo,i, nttd seruices, which are
goods and servlces

:;ffi”;; in”t, ot end, user’ A toothbrush’ a pair
of

contact ienses, and a bus ride
are examples of

final

*””at “”a
services’ Whether a sale is to the

final

ir”, a”p”rlas on who buys the pTg-Y:’
When vou

i”u .iiit””, that’s reflectld in GDP’ when
KFC buys

;iJ;;;”,r”,, th”t” not counted in
GDP because

KFC is not the final consumer’
Only “ft”t-:|”

chicken

is cooked and sold by KFC is
the transaction counted

in GDP.
Intermediate goods and serviees

are those pur-

chasedforadditionalprocessing.a’.dresale,iike
*iZ;. .r.i.ten. This cr’ange may b3 imperceptible’
as when a grocer buys cained

goods to.restock the

shelves. or the inter’mediat”
goodr can be dramati-

.
“uv “t,”‘”

a Tl;J,iJ :?:1 :i::Jfin :,,: 1::
canvas and $3o In olIS lnfo a wur

L!’ -‘ ‘. .*

;;:;”;. sales of intermediate goods
and servrces are

excluded from GDP io avoid ihe
problem of double

-^,rnting which is counting an item’s
value more

Lv s.. !^- -a t

thanonce.Forexampl””Jppot”the,grocerbuys
il;;;;;”a for $o’ot ana ieits it for$:’oo’

If GDP

counted both the intermediate
transaction of $o’6o

and the final transaltion of $r ‘oo’
the recorded value

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1OO PART z Frlndanentals of Macroec0tt0tlltcs

– -:$reciiale goods

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– : : :: 5o would exceed its final value by $o.6o. Hence,
: .ll counts only the final value. As another exam-
. – .= ::r zoo8 Wal-Mart paid $z8Z billion for products
; . -:.C for $:ZS billion. If GDP counted intermedi-
] =-= ::ansactions and final transactions, it would be-“-:-: cil]ion too high. GDP also ignores most of the
‘r r”:,:’idhand value of used goods, such as existing

=
.,.,,.at, used cars, and used textbooks. These goods

:
.,
‘=:. counted in GDP when they were produced. But
*. – as the services provided by the grocer and by

”-a–l,,lart are captured in GDR so are the services
:::-.–ied by real estate agents, used-car dealers, and
-==i-book sellers.

&*P Based &ffi the
*xpenditure Approaelt
..-: :,::ed already, one way to measure GDP is to add
r:=:-,iing on all final goods and services produced
.:- ::re economy during the year. The easiest way
:: *::Cerstand the spending approach is to divide
:r-=gate expenditure into its components: con-

sumption, investment, government purchases, and
net exports. Consurnption, or more specifically, per-
sonal consumption expenditures, consists of purchases
of final goods and services by households during
the year. Consumption is the iargest spending cat-
egory averaging about two-thirds of U.S. GDP during
the last decade. Along with seruices like dry cleaning,
haircuts, and air travel, consumption includes nondu-
rable goods,like soap and soup, and durable goods, like
furniture and kitchen appliances. Durabie goods are
expected to last at least three years.

Investmer:t, or more specifically, gross private
domestic investment, consists of spending on new cap-
ital goods and on net additions to inventories. The
most important investment is p’hysicai eapitai, such
as new buildings and new machinery. investment
also includes new residentiai construction. Although
it fluctuates from year to year, investment averaged
about one-sixth of U.S. GDP during the last decade.
More generally, investment consists of spending on
current production that is not used for current con-
sumption. A net increase to inventories also counts as
investment because it represents current production
not used for current consumption. Inventsries are
stocks of goods in process, such as computer parts,
and stocks offinished goods, such as new computers
awaiting sale. Inventories
help manufacturers cope
with unexpected changes in
the supply of their resources
or in the demand for their
products.

Although investment
inciudes purchasing a new
residence, it excludes pur-
chases of exisling buildings
and machines and pur-
chases of financial assets,
such as stocks and bonds.
Existing buildings and
machines were counted in
GDP when they were pro-
duced. Stocks and bonds are
not investments themselves
but simply indications of
ownership.

Covernment purehases,
or more specifically, govern-
ment consumption and gross
investment, inciude govern-
ment spending for goods
and services-from clear-
ing snowy roads to clearing
court dockets, from buy-
ing library books to paying

c*nsurr:pti*n
h*uc*fu {,ki pur *}lat*,r:
t:f {in*i gi:::e!* and
s*v”ric*t” *Ei:+fit !*l **vT
?’is,!ni::iilt*5, trviri+l: r:r:urti
;!i ;r]rii;:slfi1*!’r i

investr:renl
ilr* ;:i.;r’:iias* *i :rr-ror’;
3:1i:r:t*, c*v.; +’.lir ip,rriittt,
r’;eiv i:*i!rttng::, ,rlirrJ ::*v;
r*r;it**n**:s. i:ltts ti;:l ;:1:i-
{f iL!*:1:i t$ i}}v*ill*ril}{i

pl’rysicai capital
r *anil i:;*i;rr*r.! it+rrrs
:;:+::d t* *l*riL:;*: 1;*i:*:
c ;l’! ;;*r* i*es ; ir”l*ii:,i*g
!-1&’,rV i.]lii*ts irr-!d ii*’;f
*til:ix?rt,rn’1;

residential
construetion
liu i! riiltl nt*. lltrt!;rt,q r.ji’
iw*i!!:’;i; p:ar;r::

inr;entsries
1:r*rJ i:**l s’ st.J+:ra: {:f
ii*i*h*ci ariil !* “pr*+*s’:
9.1*:’rd:;

gBVernment
purchascs
:i;.r*lr *ir;g +$l fi ,t],rt.ili ;,t-l{i
**:r.j’!:*:: h”d aii ievi:i:; li
i:*,,i*i{!!nf ?:i; ii*?*:’l:.
rrir:ri t *i: f !a7s i-ilin *s
tra:: r*i*i il,ii yirl*i1i!i

CF{APTIR 7 lirrr:ir:L; ]il:r ii.:;, irir)mr11ri/ 1O1

librarians. Government purchases averaged a bit less

than one-fifih of U.S. GDP during the last decade’

r Government purchases, and therefore GDP’ exclude

transfer payments’ such as Social Securily’ welfare

benefits, and unemployment insurance’ Such pay-

ments are not true purchases by the government or

true earnings bY the reciPients’
The final spending component, net exports’

reflects international trade in goods and services’
Goods, oT merchandise traded, include physical items

such as bananas and DVD players (stuffyou can put

in a box). Services, or so-
cal1ed inuisibles, include
intangible items, such
as European tours and
online customer service
from India. Foreign Pur-
chases of U.S. goods and
services are counted as
part of U.S. GDP. But U.S.
purchases of foreign
goods and services are
subtracted from U’S. GDP.
lrli:t expoli.$ equal the
value of U.S. exPorts of

rl*f :’ihe ldntlct’:i

by resource suppliers in the economy’ Thus’ we can

say that

Aggregate expenditure : GDP : Aggregate income

A prod.uct usually goes through several stages
involving different firms on its way to the consumer’

a woodJn desk, for example, starts as raw timber’
which is typically cut by one firm, milied by another’

made into a aest< by a third, and retailed by a fourth'

We avoid double counting either by including only

the market value of the desk when it is sold to the

ffiffiF Se*cd #ffi t$?c
6ms*swe &PPr*ateh
The expenditure aPProach
sums, or aggregates, sPending

on production. The income
approach sums, or aggregates’

income arising from that Pro-
duction. Again, double-entry
bookkeeping ensures that
the value of aggregate outPut

equals the aggregate income
paid for resources used to Pro-
duce that output: the wages,
interest, rent, and Profit aris-

ing from Production.The Price
of a HersheY bar reflects the
income earned bY resource
suppliers along the way’
Aggregait int’;t:’le equals the
sum of all the income earned

GDP based on the income approach’ For example’ sup-

pose you buy a wooden desk for $zoo’ This final mar-

let vatue gets added directly into GDP’ Consider the
history of it,at desk. Suppose the treethal-gave its life

for your studies was cut into a iog and sold to a miller

for
-$zo,

who converted the log to lumber that sold for

$5o to a desk maker, who made the desk and
sold it

for $rzo to a retailer, who sold it to you for $zoo’
Column (I) of Exhibit r lists the selling price at

each stage of production’ If all these transactions
were add-*ed .,p, ttt” total of $39o wouid exceed the

$zoo market value of the desk’ To avoid double
count-

ing, we inciude oniy the value added at each stage’

lisied in column (3) as the difference between the
pur-

ch”r” pric” ana ihe seliing price at that stage’ Again’

:r,;.1:’i,ri

I

Computation of Value Added lor a New Desk

fina1 user ot bY summmg
the value added at each
stage of Production. The
vaiue added bY each fi,rm
equals that firm’s seliing
price minus Payments
for inputs from other
firms. The value added at
each stage is the income
earned by resource suPPli-

ers at that stage. The ualue
added at all staqes sums to
the market value of the fnal
good., and the ualue added

for all final goods sums to

(31

Value
Added

(3)={1}-(2}

$20

30

-A gg: * gatt IixP* l :r:

With the expenditure approach, the nati0n’s ngsregate

expexdittre sums consurnption, invesiment, gavernment

Burchases, aad net exPorts’

C + I + G + (X -Ml : Aggregateexpenditure : GDP
C : Consumption
/ : lnvestment
6 = Government Purchases

(X’ M)= Netexports = Exporls -‘lmports

goods and services minus
ihe valr-,e of U.S. imports of goods and services U’S’

imports have exceeded U’S exports nearly every
year since the r96os, meaning U’S’ net exports have

teen negative. During the last decade’-net exports

“rr”r”g”J
a negative 2 percent of GDP, but this has

becorie u ,,”gitiu” 5 or 5 percent of GDP in recent
years.

r:*t eHP*ii;*
ch* ,;*iile *{ a *r:i.in:i1’s
cxp{,’$s :::in*n the v;llt’;;:
*l its imp'”rris
iit-rp’r’ee?te
c!-ii’.:frlil”rit e
i:r,e.ll *Fr,:t’:dilig +rr i!ir*i
g**{is ;}nd s*rvi**s i* an
n-ic{}:t{,:fi rlr’ ei *r! :: g a g ive*
p*;’i,:*i, rrsi:*llY * Y*ar

aggregiit* itrer:i:r:e
e {i *ai*ir”lgs r:l iese ur**
*i:pgti!ers i* i:r’i *r:*:t**:r7
ci.rinq a givr:r: 1:*ri*C,
ilsx*iiy a Tesr
va]ue a<1derl a! *ach ittfi** *f ;:r*ciu:= iia!!, t** s*[liirg ;:ri;:r: *i a 6:r+#u'rt rrlnils th{i *sst *f inlsrt}1*iiiai* 6o**s Pl;rcl:aseil f r*t* *ther firri:;

r Stage of
i Production

(1) l2l
Sale Cost of
Value lntermediate

Goods

$ 20 \–\…-
bo –.-.- \$ zo–

\

120 -\_\=-t-r 50
200 \ t20

Market value of final good

Logger

Miller

Manufacturer

Betailer

70

80

$200

1o.2 lr,i\il.’l : i’llrllin:llliiiais tf rt/i:lliiltli;’-:tl”t:llrr’:’

–‘i -:;iue added at each stage equals the income earnedby
–‘”i,-:: r-irho supply their resources at that sta.ge.For exam-

:-: -.:-le $ao in value added by the retailer consists
:: .:-come to resource suppiiers at that stage, from
.:,: ;ai.esperson to the janitor who cleans
::-: >hcwroom to the trucker who
: ::'” -:es “free delivery” of Your
r::,:::. The value added at a1l
:::::s totals $zoo, which is
:.: -*: :”ne f,nal market value of
-‘::

-esk and the total income
i.-:-:i by all resource suPP1iers
i””:a–i:ne way.

.: reinforce your understanding of the equality
:: -:-::rne and spending, let’s return to something
-:::;;ced in the first chapter, the circular-flow
_- _ i —

– _ -=-.

retain no earnings), we can say that GDP equals aggre-
gate income. The circular flow is a continuous pro-
cess, but the iogic of the model is clearest if we begin

at juncture (l) in Exhibit z, where U’S’ firms make

ii
I

production decisions. After all, production
must occur before output can be

sold and income earned. As
Henry Ford explained, “lt is
not the emploYer who PaYs
the wages-the emPloYer

only handies the moneY. It
is the Product that PaYs wages.”

Households supply their labor, capital, nat-
ural resources, and entrepreneurial ability to make
prod.ucts that sell to pay wages, interest, rent, and
profit. Production of aggregate output, or GDP, gives
rise to an equal amount of aggregate income’

Thus, at juncture (I), aggregate output equals
aggegate income. But not all that income is available

to spend. At juncture (z), governments coilect taxes’
Some of these tax dollars return as transfer payments

i,

tl

t,

I
I
:

I
i

l#2 ilir*re3me’ r3*wf *rf 3ffirr:e:?*
.ib

:” :'” ; Ixpr*::#”tt *t:’*
*-… -:*dei in Exhibit 2 out-
,-:.:; :he cire ular flow of
-.r::r::3 and spending in
‘:*.. ::cnomy for not only
-:;=tcclds and firtns, as
*.= :1: case in Chapter r,
: *: :5’/ernments and the
:::i ii the world. The main
irr:irr: iows clockwise around
–: ::::re, first as income from
:j-:: : :: households (in the
:;;=: :-alf of the circle), and

‘-.:.::, 1; spending from house-
: : :. =ack to firms (in the
.-::.:: ialf of the circle). For
i;:,– i.:r,, of money, there is
“,…. =:—. and opPosite flow of
::..,: -::s or resources. Here we
: .,::- :he money.

‘{n{tl*”le tr-*aXf CIf
tfu* eira*xlar Ffrsruv
— –:-: process of develop-
..- = ‘ :-::ular flow of income
.,- : =:=::ding, we must make
r’: — : :-:=plifrTing assumPtions.
::=’::::=:i-r., by asSuming that
:.: .:.:a, :apital does not wear
.:*’ -.. no capital deprecia-
: – – .::: rhat firms pay out ali
:* : :, -. :: irm owners (i.e., firms

Iixi:il:ii,

::.

Circular Flow ol lncome and Expenditure

6&
6&
Households

b.H
o

6:t, iixg
l{41r., -r9.:lx,eIXr

+
\9
“fi:””t:.” r:q

,a ::.
.;.. r .a

\
!. 10

,,,$:’

“^-
i

^n$ i”
.rd .6\/ .,e

lqE
:’- .. I :rL.-

\.
o–%

\

The value added at each stage equals

the ineorne earned bY those who

supply their resources at that stage.

m
Government

r
“F?

lj:
l;t,

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L.
iil
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rilri

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;:l

::.

C1-{AP’I’ER 7 lritcki;tq; lhl iJ.ll. Lri:orlcrn:’r 103

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