FISCAL POLICY: PART TWO

FISCAL POLICY: GOVERNMENT SPENDING AND TAXATION

a. When MPC = 0.75, if G and T both increase by $1,000, what will happen to equilibrium income?
b. By how much must T be increased (assuming G is increased by $1,000) so that equilibrium income does not increase?

a. The balanced-budget multiplier is 1, so equilibrium income will go up $1,000.
b. To not change equilibrium income the increase in taxes must reduce C by the amount G goes up so that total spending is unchanged. To decrease C by $1,000, DI must fall by $1,3333.33: T must increase by $1,333.33. To get the $1,333.33 figure, solve the equation: Change in C equals – MPC times increase in taxes. (the change in C is - $1,000).

If the government wants to increase equilibrium income by $4,000 when MPC = 0.8, by how much must it increase G?

• G must increase by $800 (the spending multiplier is 5: 5 x 800 = $4,000).

If the government wants to increase equilibrium income by $4,000 when MPC = 0.8, by how much must it reduce T?

• T must be reduced by $1,000 (the tax multiplier is – 4).

Suppose that in equilibrium, business firms want to invest more than households want to save. For this to be possible, what must be true about G and T?

• Injections must equal leakages in equilibrium, so I + G must equal S + T. Rewriting this, I – S = T – G. Since I is greater than S, T must be greater than G. The government must be running a surplus. This surplus retires part of the government’s debt, freeing these funds to support the excess of I over S.

Government spending goes up by $5,000 while taxes go up $3,000. What will happen to equilibrium income if the MPC = 0.6?

• The increase in G increases equilibrium income by $12,500 (2.5 x $5,000). The increase in T decreases it by $4,500 (-1.5 x $3,000). On net, equilibrium income will go up $8,000.

If the economy is at or near full employment, what will be the main impact of a reduction of government spending on real GNP and prices?

• The AD curve will shift left by the change in G times the spending multiplier. In the short run, with the AS curve unchanged, prices will fall as output falls. Unemployment will go up. In the long run, wages (and thus prices) will fall, shifting the AS curve down and right, causing output to return to its full-employment level but pushing the price level down below its short-run level.

Households decide to save $10,000 more. By how much must the government increase G if it wants to maintain the same level of national income? (Assume C is going down by $10,000).

• By $10,000.

If “deficits don’t matter,” what will happen to DI, C, and S when T goes down $5,000?

• DI goes up $5,000, savings go up $5,000, C remains unchanged (C = DI – S).

If G goes up $1,000 and equilibrium income goes up $4,000, what is the MPC?

• MPC = 0.75

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FISCAL POLICY: PART ONE

FISCAL POLICY: GOVERNMENT SPENDING AND TAXATION

Why is government spending the same as investment or consumption spending?

• Because C, G, and I will directly enter the spending stream and are received as income.

Why does a decrease in taxes have a smaller multiplier effect than the same increase in government spending?

• Because a decrease in T initially increases C by a smaller amount.
  

If the government wants to spend more without increasing equilibrium income, by how much must it increase taxes (as compared to the increase in government spending)?

• It would have to increase T more than G.

How does the income tax affect the size of the spending multiplier?

• It makes the spending multiplier smaller.

Why isn’t the actual deficit a good guide to how active the government’s fiscal policy is?

• The size of the actual deficit in a recession will be larger because of the effects of the automatic stabilizers. To measure the active component of fiscal policy these effects must be removed.

If government borrowing reduces business borrowing, how does this affect our economy’s growth?

• It reduces future growth.

If the public anticipates having to pay the future taxes implicit in any deficit, why won’t a lower tax increase consumption spending (and aggregate demand)?

• Because households will regard less taxes how as more taxes later, they will save an amount equal to the delayed tax. C will be unchanged.

Why is government spending (G) an injection? Why are taxes (T) a leakage?

• G adds to total spending, while T represents an allocation of income away from spending.

Will the multiplier effect of more government spending be larger or smaller when prices go up as output increases?

• Smaller.

How do built-in stabilizers help stabilize the economy?

• They reduce the multiplier effects of changes in autonomous spending.

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GETTING TO FULL EMPLOYMENT: PART TWO

AGGREGATE SUPPLY AND
GETTING TO FULL EMPLOYMENT: PART TWO

During the Great Depression, Herbert Hoover and other prominent leaders urged businesses not to cut wages, asserting that cutting wages would reduce spending. Was this good advise?

• It was the worst thing to advise. Lower wages would have shifted the AS curve out and to the right, increasing output and employment. It is true that lower wages (and lower other factor costs) will reduce nominal income and spending. But real spending will be increased as the lower prices make money holdings more valuable.

Suppose the economy is initially in a long-run full-employment equilibrium. The aggregate demand increases, shifting the AD curve to the right.
a. What will happen in the short run to employment? To real wages?
b. What will happen in the long run?

• a. Output will increase and prices will rise. Since money wages are constant in the short run, real wages will fall as prices go up. Employment will increase as employees find their real costs reduced. Workers will not like working for lower real wages, but they may be locked into a long-term contract.
• b. Workers will demand and get higher real wages. Employment will fall back to its full-employment level. Output will fall. Prices will rise even further than in the short run.

Over the last decade, more unions have been putting cost-of-living adjustment clauses into their contracts, so that their wages go up or down with the price level. How will this affect the time it takes for the economy to reach full employment if it is in a recession?

• Wages will adjust faster to changing prices, spending the economy’s return to recovery. For example, the recession in the early 1980s was shorter than would have had been predicted based upon prior wage-change patterns.

How will an economy’s recovery time be affected if workers become more militant, such that they will go on strike if the firm tries to negotiate lower wages?

• In a recession, this will slow the time it takes to reduce wages. Recovery will take longer.

State and local planners often claim that a plant being located in their area has a “multiplier” effect. The area’s residents will benefit, it is claimed, by the spending and employment the new plant adds to the community. Will this be true if the state’s resources are fully employed?

• No. At full employment, the resources used by the plant (including land and labor) must come from other uses. To get these resources, the plant (and its employees) must bud them away from others in the area by offering higher prices for them. The effect will be higher prices and a lower real income for those not directly benefited by the plant. The area as a whole will benefit only to the degree the plant on net adds resources to the area.

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GETTING TO FULL EMPLOYMENT: PART ONE

AGGREGATE SUPPLY AND
GETTING TO FULL EMPLOYMENT: PART ONE

Along the aggregate demand curve (AD), what is true about spending and income?

• They are equal.

Why does the AD curve have a negative slope?

• A lower price level increases the real value of nominal assets, which in turn causes people to increase real spending.

Can there be too much employment?

• Yes, when a shortage of workers forces wages and prices up.

Where will output always be in the long run?

• At its full-employment level (FE).

If an economy is producing less than its full-employment level of output, what will happen to wages and prices? How will this bring the economy back to full employment?

• Wages and prices will fall, shifting the AS curve to the right.

If an economy is producing more than its full-employment level of output, what will happen to wages and prices? How will this bring the economy back to full employment?

• Wages and prices will rise, shifting the AS curve to the left.

How will prices change when the economy is underemployed?

• Prices will fall

Assume for the next 3 questions that the economy is at full employment and then the following event occurs, and that the government doesn’t aid the economy’s return to full employment.

In 1981-82, the US government took steps that shifted the aggregate demand curve inward and to the left. Describe what happened and how the economy recovered.

• In the short run, output and prices fell. In the long run, output returned to its full-employment level as prices fell further.

In the 1960s, the US government shifted the aggregate demand curve outward and to the right. Describe what happened and how the economy recovered.

• In the short run, output and prices rose. In the long run, output fell back to its full-employment level as prices rose further.

In the mid 1970s, high oil prices shifted the aggregate supply curve to the left. Describe what happened and how the economy recovered.

• In the long run, output rose back to its full-employment level as prices fell back to their original level.

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THE KEYNESIAN MODEL: PART TWO

AGGREGATE DEMAND IN THE PRIVATE SECTOR:
THE KEYNESIAN MODEL: PART TWO

If (desired) investment is $1,000 no matter what output is, what will savings be when the economy is in equilibrium? How will income be affected if people want to save more?

• Savings will be $1,000 when the economy is in equilibrium. This is the only level of savings consistent with spending equaling income. If people want to save a larger share of their income, income will fall in order to reduce their savings back to $1,000.

How will the following events affect real consumption spending?
Event A: A rise in the general price level.
Event B: The real values of homes increase.
Event C: Taxes are increased.

Event A: Decreases consumption spending by reducing the real value of money holdings.
Event B: Increases consumption spending by increasing wealth.
Even C: Decreases consumption spending by decreasing disposable income.

Suppose the MPC is 0.6. If at each level of income, people want to consume $2,000 more, how will income change? How will consumption change (break C’s change into its initial autonomous increase and the induced secondary consumption respending)? Assume I is fixed.

• The multiplier is 1/0.4 (or 2.5), so income goes up by $5,000. Total consumption goes up by $5,000. This is the sum of the $2,000 initial autonomous increase and the induced $3,000 consumption respending (MPC times increase in income).

Suppose the MPC is 0.75. By how much must investment spending increase for GNP to go up $50 billion?

• The multiplier is 4 (1/0.25). So 4 times the increase in I should equal $50 billion. The increase in I needed is $12.5 billion.

Assume the following: (1) When the price level P falls from 2.00 to 1.00, real consumption spending at each level of Q increases by $2,000. (2) MPC = 0.8. (3) At P = 2, equilibrium Q is $20,000.
a. At P = 2.00, what is real income? Nominal income?
b. At P = 1.50, what is real income? Nominal income?

a. Real income = $20,000. Nominal income (P x Q) = $40,000.
b. Real income = $30,000 (increase in Q = spending multiplier times autonomous increase in C). Nominal income equals $30,000. Note that even though nominal income went down, real income went up!

Keynes assumed that people didn’t care whether their savings were invested (and earning interest) or kept in cash. This problem illustrates what happens if this isn’t true. Suppose an economy is in equilibrium at Q = $10,000. At this income, people want to hold $1,000 in cash, no more and no less. MPC = 0.8. What will happen if planned investment spending increases by $100?

• This question is answered by asking how business can get the $100 when income is still equal to $10,000. Since the economy is at equilibrium, all savings are invested. The only source of cash is from money holdings, but by assumption, people won’t reduce (or lend out) these holdings. So business will be trying to borrow more than people want to lend them. The interest rate will go up, causing business to reduce their planned investment spending back to its original level. The actual multiplier is 0, not 5 as it would be in the Keynesian model.

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THE KEYNESIAN MODEL: PART ONE

AGGREGATE DEMAND IN THE PRIVATE SECTOR:
THE KEYNESIAN MODEL: PART ONE

In the Keynesian Consumption Function, if people receive $1,000 in additional income, will they increase their consumption spending by $1,000, more than $1,000, or less than $1,000?

• Less than $1,000, since MPC <>

When the economy is in equilibrium, how are spending and income related? Investment and savings?

• Spending = Income and Investment = Savings.

What does the 45 degree line represent? How does it help you find equilibrium?

• The set of points at which the values on the vertical and horizontal axes are equal. Since income is on the horizontal axis and spending in on the vertical axis, it crosses the point on the total spending curve at which spending equals income.

What is the difference between a change in autonomous spending and an induced change in spending?

• Change in autonomous spending is the change in spending if income does not change. Induced changes in spending occur because income changes.

How can spending go up if the price level falls?

• When the price level falls, the real balance effect causes an increase in real spending. So even if nominal spending falls (such that fewer dollars are spent), more real dollars will be spent.

What is the leakage from the economy described in this chapter? What is the injection?

• Saving is a leakage, and desired investment spending is an injection.

What is the main variable that changes in the Keynesian model to ensure that the economy reaches equilibrium?

• Income (and output). Keynes assumed that businesses facing inadequate demand would reduce their output and employment ( and thus reduce the income they pay out) instead of reducing their prices.

How will an increase in wealth shift the total spending curve?

• The total spending curve will shift up and to the left.

How will an increase in the real interest rate shift the total spending curve?

• Investment spending will fall: The total spending curve will shift down and to the right.

How will an increase in the price level shift the total spending curve?

• The real balance effect will reduce real consumption spending. The total spending curve will shift down and to the right.

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AGGREGATE DEMAND AND SUPPLY: PART TWO

Previously we learned that total spending always equals total output in national income accounting. How can aggregate demand be different from aggregate supply in this lesson?

• In national income accounting, unsold output is counted as a “sale” to the firm producing it. But aggregate demand reflects the true quantity demanded and so excludes unsold and unwanted output.

An economy produces bread and clothing. In 1980, bread cost $2 a loaf and clothing cost $20 a unit. In the same year, the economy produced 20,000 loaves of bread and 5,000 of clothing. In 1981, bread cost $1 and clothing $10.
a. If in 1981, the quantities of goods were produced, what happened to nominal income? To real income (letting 1980 be the base year)? To relative prices?

b. Was output the same in 1981 as it was in 1980 (assuming aggregate demand equaled aggregate supply in 1980)?

a. In 1980, nominal income was $140,000. With the same output, 1981’s nominal income was $70.000 but its real income was still $140,000 ($70,000/0.50, where 0.50 is the 1981 price level since prices are one-half of what they were in 1980). Relative prices did not change. For example, the relative price of a loaf of bread was one-tenth of a unit of clothing in both 1980 and 1981.

b. The lower price level in 1981 increased the real value of people’s nominal assets, causing people to demand more. The economy will move down and to the right along its aggregate demand curve.

According to some economists, the government can stimulate output growth with tax cuts. If this is the case, what will happen to the price level?

• The price level will fall.

A recent headline read “Renewed Growth Will Fuel More Inflation.” This headline reflects a common notion in the press that a high growth rate in GNP causes higher inflation rates. Use the aggregate demand and supply diagram to show when this is incorrect.

• An increase in output (growth) will cause inflation to decrease, not increase. So if the output growth it caused by an increase in aggregate supply; the headline is wrong. But if the output growth is caused by an increase in aggregate demand, the higher output will be accompanied by higher inflation, and the headline will be correct. So it is important to know whether output is going up because of an increase in aggregate demand or in aggregate supply. This is a distinction that many economic commentators ignore.

If aggregate supply shifts to the right each year due to technological progress, then what must be the government do to maintain a stable price level?

• If the government does nothing, then prices will fall when output grows. To keep prices stable, aggregate demand must be increased along with aggregate output (so both shift right by the same amount).

Many economic commentators state that “recessions cause prices to fall.” If they mean that reduced output (i.e., reduced aggregate supply) causes lower prices, are they correct?

• No. Reduced aggregate supply will increase the price level.

When will reduced output be accompanied by lower prices?

• When aggregate demand is reduced. The reduced output in this case is a result of a decrease in aggregate demand, not a cause of the reduced output.

What will happen if, at the same time, workers demand and get higher wages and consumers decide to increase their real consumption spending?

• The price level will rise. The effect on output cannot be predicted without more information as to how much aggregate demand and supply shift.

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AGGREGATE DEMAND AND SUPPLY: PART ONE

On the aggregate demand and supply diagram, what do output and price represent?

• Output is real GNP and the price level is the GNP Deflator.

How can the price level go up and yet the “price” of each good remain unchanged?

• An increase in the price level that raises all prices and equal percentage amount will leave the relative price of all goods unchanged.

How does a lower price level increase the aggregate output demanded?

• A lower price level increases the purchasing power of money; bonds, and other nominally fixed assets. This increase in wealth causes people to buy more goods.

When prices are lower, total dollar spending may fall. Does this contradict the fact that lower prices increase aggregate demand?

• Aggregate demand refers to total desired real spending. So it is possible for total dollar spending to fall, but if prices fall even more, real spending (i.e., the real quantity of goods bought) will go up.

Does output always go up when prices go up?

• No. If aggregate supply decreases, output can fall when prices rise.

In the Great Depression, prices and output fell. What shift in aggregate demand and supply would best describe the cause of this event?

• A decrease in aggregate demand.

What changes in wages will cause the short-run aggregate supply curve to shift to the left?

• An increase in wages.

How should the government shift the aggregate demand curve if it wants to raise output? What will happen to the price level?

• The government should increase aggregate demand so that the curve shifts right. Prices will rise.

How should the government shift the aggregate demand curve to reduce inflation? What will happen to output?

• To reduce inflation, the government should decrease aggregate demand so that the curve shifts left. Output will fall.

How will wages and other input costs tend to change when unemployment is above its natural rate?

• Wages and other factor costs will fall.

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INFLATION AND UNEMPLOYMENT: PART TWO

The ABC Corporation had a nominal profit of $300,000 in 1980 and a nominal profit of $330,000 in 1982. The CPI was 246.8 in 1980 and 289.1 in 1982. How much did ABC’s real profits change?

• ABC’s real profits in 1980 were $121,556 ($300,000/2.468), and in 1982 $114,147 ($330,000/2.891). Real profits went down by $7,409.

If inflation continues for twenty years at a 6% rate, by how much will prices increase?

• If the price level starts at 1, then at the end of one year, it will be at 1.06. Then prices will grow 6% more, or 1.06 times 1.06, to 1,1236 by the end of the second year. By the end of twenty years, the price level will grow to 1.06 times itself twenty times, or to 3.21. Prices will have risen 221%.

In 1981, the news media was alarmed over high interest rates when the Treasury Bill rate equaled 14%. But many economists said that interest rates were not high. Use the concepts of real and nominal interest rates to explain this apparent paradox.

• Nominal (or “the newspaper”) interest rates were very high in 1981. But what matters to the economy is the real rate, which equals the nominal rate minus the rate of inflation. The rate of inflation was 10% in 1981, so the real rate of interest was only 4% (and probably lower since many people were expecting higher rates of inflation).

Indicate the labor-force status of the following persons:
a. A doctor who is too sick to work.
b. A mechanic who couldn’t find a job needing this skills and is waiting for the economy to improve before he looks for work again.
c. A full-time student.
d. A laid-off steel worker waiting to return to work.
e. A laid-off executive who is making ends meet by working at a car wash.
f. An executive given a year off to have a baby.

a. The doctor is employed.
b. The mechanic is not in the labor force (and is a discouraged worker).
c. The student is not in the labor force.
d. The steel worker is unemployed.
e. The laid-off executive is employed.
f. The executive having a baby is not in the labor force.

This example illustrates the index number problem. Suppose John consumes only bread. In Year 0, John buys four loaves of white bread and four of dark bread, all at $1 each. John likes both equally. In Year 1, white bread costs $2 but dark bread still costs $1. So John switches to dark bread.
a. What has happened to John’s cost of living?
b. What will the values be for a price index using Year 0 as the base year?

a. John’s cost of living remains unchanged since John has avoided the price rise bychanging his consumption pattern.
b. The calculated price index overstates the true increase in the cost of living (which in this case didn’t go up at all).

In 1982-83, real GNP was below its potential (full-employment) level by about 4% each year. According to Okun’s Law, how much should the unemployment rate have changed?

• The unemployment rate should have increased by two percentage points each year, or by four percentage points over the two-year period. It actually increased from 7.5% to 10.4%, an increase of about 3%.

This problem illustrates what is called "bracket creep": the increase in income taxes through inflation. Suppose the first $5,000 earned is tax-free, the next $5,000 is taxed at 10%, and the next $5,000 at 20%.
a. A worker earned $7,000 in 1980. Calculate the worker’s taxes, average tax rate (taxes/income), and after-tax income.
b. Now suppose that over the next five years, all prices and earnings doubled (so) the worker earned $14,000). The tax system is still the same. Calculate the worker’s taxes, average tax rate, after-tax income, and real after-tax income (using 1980 as the base year).

a. In 1980, the worker paid $200 in taxes (10% of the income exceeded $5,000), an average tax rate of 2.86%, and had an after-tax income of $6,800.
b. In 1985, the worker paid $1,300 in taxes, an average tax rate of 9.29%, and had an after-tax income of $12,700. The worker’s real after tax income is $6,350 ($12,700/2.00, where 2.00 reflects the doubling of prices since 1980). Even though the worker earns the same real before-tax income, the worker’s after-tax income has gone down due to inflation pushing the worker into a higher tax bracket.

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INFLATION AND UNEMPLOYMENT: PART ONE

How does inflation hurt those on fixed incomes?

• It reduces their real income.

How can savers protect themselves from inflation?

• They can demand a higher nominal interest rate. Recently, some savers have been demanding a variable interest rate based upon short-term interest rates, which usually reflect current inflation rates.

Why do interest rates eventually go up during a period of inflation?

• As savers come to expect higher rates of inflation, they demand higher nominal interest rates to compensate them for their loss in purchasing power.

When inflation causes greater uncertainty in the economy, workers often demand higher real wages as compensation for the higher uncertainty. How does this hurt the economy?

• Applying the laws of demand and supply to labor, this event causes the supply curve of labor to shift left. As a result, employment falls. With less employment, output and GNP fall.

If real GNP is constant while the GNP Deflator increases, what will happen to nominal GNP?

• Nominal GNP will increase.

What does a price index of 180 mean? How much have prices risen since the base year?

• The cost of a basket of goods is 180% of its base-year cost. Prices have risen 80% since the base year.

Why does an improvement in quality causes a price index to overstate how much prices have gone up?

• An improvement in quality gives the consumer more value per dollar, so that even if the price of the item is unchanged, its cost-per-unit value is reduced.

What are the different ways someone can become unemployed?

• A person can quit, be fired, or be laid off. Also, a person can be an entrant or reentrant into the labor force.

If the unemployment rate is 10% and 90 million workers are employed, how many are unemployed?

• 10 million.

What is the main cost associated with cyclical unemployment?

• The loss due to decreased output.

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MEASURING NATIONAL OUTPUT: PART TWO

Which of the following are counted in GNP?

(a) Purchase of $2,000 of IBM stock.
(b) $3,000 payment to a lawyer to sue a neighbor to keep his dog quiet.
(c) $500 in unemployment compensation collected by an unemployed worker.
(d)$600 paid by a student for a used car.
(e) The purchase of a bottle of French wine.
(f) $5,000 earned by an American in Paris.
(g) $5 million worth of new computers produced by AT&T that AT&T can’t sell.

• Only b, f, and g are included in GNP. The other transactions do not reflect the production of goods and services by U.S. owned factors in the current year.

Suppose GNP=$3,000, C=$2,400, G=$100 and NX(net export)=$80
(a) What is I?
(b) If exports equal $350, what are imports?
(c) If depreciation is $150, what is NNP?
(d) If taxes equal $200 and transfer payments equal $120, what is the deficit equal to? What are savings equal to?
(e) If indirect business taxes equal $70, what is national income?

(a) I = $420
(b) Imports = $270
(c) NNP=$2,850
(d) The deficit = $20, and savings = $520
(e) National income is $2,780

What are net exports equal to when GNP=$1,000, I=$100, C=$600, and G=$150? If taxes=$100 and there are no transfer payments, what do savings equal? And if imports equal $80, what do exports equal?

• Net exports = $150, savings = $300, and exports = $230

Indicate how the following will affect measured GNP and the national welfare:
(a) An oil spill occurs and is cleaned up at cost of $2 million.
(b) The government requires all house persons be paid for their work.
(c) The Army Corps of Engineers builds a dam at a cost of $5 billion that is worth only $2 billion.
(d) A teenager quits work and goes back to school, which she regards as much more worthwhile.

(a) Increases GNP, reduces national welfare.
(b) Increases GNP, had no effect on national welfare.
(c) Increases GNP, reduces national welfare.
(d) Decreases GNP, increases national welfare.

Should a welfare recipient’s payments from the government be included in GNP?

• No. The welfare recipient is not producing any goods or services for the welfare payment. The welfare payment is a transfer payment.

Suppose that savings are fixed at 15% of GNP. Also assume that net exports are zero. If the government’s deficit equals 5% of GNP, what percentage of GNP in investment?

• Investment plus the government’s deficit equals savings. So investment equals 10% of GNP.

A farmer grows corn, which she sells for $10; a miller buys the corn, grinds it, and sells it as corn meal for $15; a baker buys the corn mean and sells it as corn muffin for $22. How much was contributed to GNP in these transactions? What was the value added of each person?

• The final good sold for $22; this is the contribution to GNP. It also equals the sum of the value added: $10 for the farmer, $5 for the miller, and $7 for the baker.

An economy produces $15 billion in investment goods and $100 billion in consumption goods. All investment good were sold, but only $90 billion of the consumption goods were sold. There is no government or international trade. What was GNP? What was consumption and investment?

• GNP was $115 billion, the sum of output produced. Consumption was $90 billion (the amount households spent), while investment was $25 billion. $15 billion was for the investment goods produced. The other $10 billion of investment was the increased inventory due to the unsold consumption goods

In an economy, households consume $600 and save $400. The government spends $200 and taxes $150. There are no transfer payments or foreign trade. What is I? what is GNP?

• With no foreign trade or transfer payments, we have: (a) I + G - Taxes = Savings. So I = $350. (b) GNP = C + I + G = $1,150.

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MEASURING NATIONAL OUTPUT: PART ONE

NATIONAL INCOME ACCOUNTING FORMULAS

Gross National Product (GNP) = C+Gross investment+G+NX

Net National Product (NNP):
(a) NNP = GNP - Depreciation
(b) NNP = C + Net Investment + G +NX

Net Investment = Gross Investment - Depreciation

National Income (NI)
(a) NI = NNP - Indirect business Taxes)
(b) NI = Sum of Factor Payments

Personal Income (PI)
(a) PI = NI - Social Security Contributions - Corporate Income Taxes -
Undistributed Corporate Profits + Transfer payments
(b) PI = Household Income

Personal Disposable Income (DI)
(a) DI = PI - Personal Taxes
(b) DI = After Tax Household Income
(c) DI = Consumption Expenditures + Personal Savings + Interest Payments
to Business

where:

C = household consumption spending

DI = disposable income

G = government spending

GNP = gross national product

NI=national income

NNP = net national product

NX = foreign net export spending

Why are only final goods and services counted in GNP?

• Because all other sales (of intermediate products that are resold within the year) are reflected in the price of final goods.

Why do changes in real GNP better reflect how total output is changing than changes in nominal GNP?

• Changes in real GNP reflect changes in real output only. Nominal GNP changes when prices and/or output changes.

What makes GNP gross and NNP net?

• “Net” refers to subtracting depreciation. “Gross” includes depreciation.

Which national income account best reflects total factor payments?

• NI: National Income.

Which national income account best reflects the income households receive? The after-tax income that households receive?

• PI: Personal Income. DI: Personal Disposable Income.

How do households dispose of disposable income?

• They consume or save it.

In a simple economy without international trade for government, how are investment (I) and savings related?

• I = Savings

With a government sector, how do business and the government in a sense compete for savings?
When we added the government sector, we had :

• Investment + Government Deficit= Savings

Business borrow to finance their investment spending, and the government borrows to finance its deficit. Thus, to the degree that savings are fixed in size, the more the government borrows, the less business can borrow for investment.

Does GNP measure national welfare?

• No. It is a measure of output and spending.

Copyright 2008 by Sujanto Rusli
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