Much of any country's economic well-being flows from natural, rather than human-made, assets land, rivers and oceans, natural resources (such as oil and timber), and indeed the air that everyone breathes. Ideally, for the purposes of economic and environmental planning, the use and misuse of natural resources and the environment should be appropriately measured in the national income accounts. Unfortunately, they are not. There are at least two important conceptual problems with the way the national income accounts currently handle the
economic use of natural resources and the environment.
1 . Natural resource depletion. When an oil driller pumps oil from an under
ground field, the value of the oil produced is counted as part of the nation's GDP; there is no offsetting deduction to account for the fact that nonrenewable resources are being depleted. In principle, the draining of the oil field can be thought of as a type of negative inventory investment because in a sense it reduces the inventory of oil. If it were included in the national income
accounts, this negative inventory investment would reduce the computed value of GDP.
2. The costs and benefits of pollution control. Imagine that a company has the
following choices: It can produce $100 million worth of output and in the process pollute the local river by dumping its wastes; alternatively, by using 10°/o of its workers to dispose properly of its wastes, it can avoid polluting but will get only $90 million of output. Under current national income accounting rules, if the firm chooses to pollute rather than not to pollute, its contribution to GDP will be larger ($100 million rather than $90 million) because the national income
accounts attach no explicit value to a clean river. In an ideal accounting system, the economic costs of environmental degradation would be subtracted in the calculation of a firm's contribution to output, and activities that improve the environment because they provide real economic benefits would be added to output.
Discussing the national income accounting implications of resource depletion and pollution may seem to trivialize these important problems. Actually, because GDP and related statistics are used continually in policy analyses, abstract ques tions of measurement often may turn out to have significant real effects. For example, economic development experts have expressed concern that some poor countries, in attempting to raise measured GDP as quickly as possible, have done so in part by overexploiting their natural resources and harming the environ ment. Conceivably, explicitly incorporating "hidden" resource and environmen tal costs into official measures of economic growth might cause these policies to be modified. Similarly, in industrialized countries, political debates about the environment at times have emphasized the impact on conventionally measured GDP of proposed pollution control measures, rather than their impact on overall economic welfare. Better accounting for environmental quality might serve to refocus these debates to the more relevant question of whether, for any particular environmental proposal, the benefits (economic and noneconomic) exceed the costs.
30 Part 1 Introduction
by domestic factors of production during the current period, whereas GDP is production taking place within a country.
When U.S. capital and labor also called factors of production are used abroad, they produce output and earn income. This output and income are included in U.S. GNP but not in U.S. GDP because they don't represent production taking place within the United States. So, for example, the value of roads built by a U.S. construction company in Saudi Arabia, as measured by the fees that the construction company receives from the Saudi government, is counted in U.S. GNP but not in U.S. GDP. Similarly, when foreign capital or labor is used in the United States, the output produced and the income earned are part of U.S. GDP (because the production occurs within the United States) but not of U.S. GNP (they are counted in the foreign country's GNP instead). For example, the portion of the value of Japanese cars built in the United States that is attributable to Japanese capital and management counts in Japanese GNP and U.S. GDP, but not in U.S. GNP.
We define net factor payments from abroad (NFP) to be income paid to domestic factors of production by the rest of the world minus income paid to for eign factors of production by the domestic economy. Using this concept, we express the relationship between GDP and GNP as
GDP == GNP - NFP. (2.2)
For the United States, GDP and GNP give similar measures of economic activity. For example, in 2008 the U.S. GDP was $14,441 billion and the U.S. GNP was $14,583 billion, a difference of about 1 °/o. The distinction between GNP and GDP is more important for countries such as Egypt and Turkey that have many citizens working abroad. The reason is that income earned by workers abroad is
part of a country's GNP but not its GDP.
The Expenditure Approach to Measuri n g G D P
A different perspective on the components of GDP is obtained by looking at the expenditure side of the national income accounts. The expenditure approach measures GDP as total spending on final goods and services produced within a nation during a specified period of time. Four major categories of spending are added to get GDP: consumption, investment, government purchases of goods and services, and net exports of goods and services. In symbols,
Y == GDP == total production (or output) == total income
== total expenditure;
C == consumption;
I == investment;
G == government purchases of goods and services;
NX == net exports of goods and srevices.
With these symbols, we express the expenditure approach to measuring GDP as
Y == C + I + G + NX. (2.3)
Equation (2.3), like Eq. (2.1), is one of the basic relationships in macroeconomics.
Equation (2.3) is called the income-expenditure identity because it states that income, Y, equals total expenditure, C + I + G + NX. Recent U.S. data for the four
Chapter 2 The Measurement and Structure of the National Economy 3 1
Table 2.1
Expenditure Approach to Measuring GOP in the United States, 2008
Personal consumption expenditures (C) Consu mer dura bles
Nondurable goods
Services
Gross private domestic investment (I)
Business fixed investment Nonresidential structures Equi pment and software Residentia I i nvestment
I nventory i nvestment
Government purchases of goods and services (G)
Federal
National defense Nondefense
State and local
Net exports (NX) Exports
I m ports
Total (equals GDP) (Y)
Note: Numbers may not add to totals shown owing to rounding.
Billions of dollars 1 0 1 30 1 095 2308 6727 2 1 36 1 694 6 1 0 1 084 477 -35 2883 1 083 738 345 1 80 1 -708 1 83 1 2539 1 4441
Source: Bureau of Economic Analysis Web site, www.bea.gov, Table 1 . 1 .5, July 3 1 , 2009
Percent of GOP 70.1 7.6 1 6.0 46.6 1 4.8 1 1 .7 4.2 7.5 3 .3 -0.2 20.0 7.5 5 . 1 2.4 1 2.5 -4.9 1 2.7 1 7.6 1 00.0
categories of spending, along with some major subcategories, are given in Table 2.1.
As you read the rest of this section, you should look at Table 2.1 to get a feel for the relative sizes of different components of spending in the U.S. economy.
Consumption. Consumption is spending by domestic households on final goods and services, including those produced abroad.6 It is the largest component of expenditure, usually accounting for about two-thirds of GDP in the United States. Consumption expenditures are grouped into three categories:
1. consumer durables, which are long-lived consumer items, such as cars, televi
sions, furniture, and major appliances (but not houses, which are classified under investment);
2. nondurable goods, which are shorter-lived items, such as food, clothing, and fuel; and 3. services, such as education, health care, financial services, and transportation.
Investment. Investment includes both spending for new capital goods, called
fixed investment, and increases in firms' inventory holdings, called inventory investment. Fixed investment in turn has two major components:
1. business fixed investment, which is spending by businesses on structures (facto ries, warehouses, and office buildings, for example) and equipment (such as machines, vehicles, computers, and furniture) and software; and
6Later, we subtract imports from total expenditures and add exports to calculate total spending on the goods and services produced by the domestic economy.
32 Part 1 Introduction
2. residential investment, which is spending on the construction of new houses
and apartment buildings. Houses and apartment buildings are treated as cap ital goods because they provide a service (shelter) over a long period of time. Like consumption, investment includes spending on foreign-produced goods.
Overall, fixed investment in the United States usually is about one-sixth of GDP.
As we have mentioned, increases in inventories are included in investment spending, regardless of why inventories rose. In particular, if a firm produces goods that it can't sell, the resulting rise in inventories counts as investment by the firm. For the purposes of national income accounting, the firm has, in effect, purchased the unsold goods from itself. This accounting rule is useful because it guarantees that production and expenditure will always be equal in the national income accounts. Anything that is produced must, by definition, either be bought by a customer or "purchased" by the firm itself.
Government Purchases of Goods and Services. Government purchases of goods and services, which include any expenditure by the government for a currently produced good or service, foreign or domestic, is the third major component of spending. Government purchases in the United States recently have been about one-fifth of GDP. Note in Table 2.1 that in the United States the majority of government purchases are made by state and local governments, not
the Federal government.
Not all the checks written by the government are for purchases of current goods and services. Transfers, a category that includes government payments for Social Security and Medicare benefits,7 unemployment insurance, welfare payments, and so on, are payments (primarily to individuals) by the government
that are not made in exchange for current goods or services. As a result, they are excluded from the government purchases category and are not counted in GDP as calculated by the expenditure approach. Similarly, interest payments on the national debt are not counted as part of government purchases.
Much like the distinction between private-sector consumption and investment, some part of government purchases goes toward current needs (such as employee salaries) and some is devoted to acquiring capital goods (such as office buildings). In the U.S. national income and product accounts, government spending on capi
tal goods (buildings, equipment, and software) has been broken out from other government purchases. Investment by the government is fairly sizable more than
$400 billion annually in recent years, or about one-fifth of the amount invested annually by the private sector. When we speak of "investment" in the national income accounts, however, we are generally referring to investment by the private sector, I; for simplicity, we include government investment with other government purchases of goods and services, G.
Net Exports. Net exports are exports minus imports. As discussed in Chapter 1, exports are the goods and services produced within a country that are purchased
7 Although it might seem that Medicare benefits are a current expenditure by the government and not a transfer, in the NIP As the medical expenditure is considered consumption spending by households, and the government payment to cover the medical expenditure is a transfer payment from the
Chapter 2 The Measurement and Structure of the National Economy 33
by foreigners; imports are the goods and services produced abroad that are purchased by a country's residents. Net exports are positive if exports are greater than imports and negative if imports exceed exports.
Exports are added to total spending because they represent spending (by foreigners) on final goods and services produced in a country. Imports are sub tracted from total spending because consumption, investment, and government purchases are defined to include imported goods and services. Subtracting imports ensures that total spending, C + I + G + NX, reflects spending only on output produced in the country. For example, an increase in imports may mean that Americans are buying Japanese cars instead of American cars. For fixed total spending by domestic residents, therefore, an increase in imports lowers spending on domestic production.
The I n come Approach to Measuring G D P
The third and final way to measure GDP is the income approach. It calculates GDP by adding the incomes received by producers, including profits, and taxes paid to
the government. A key part of the income approach is a concept known as nation al income. National income is the sum of eight types of income (see Table 2.2 for recent U.S. data).
1. Compensation of employees. Compensation of employees is the income of
workers (excluding the self-employed) and includes wages, salaries, employee benefits (including contributions by employers to pension plans), and employer contributions to Social Security. As you can see from Table 2.2, compensation of employees is the largest component of national income, accounting for 55.7°/o of GDP in 2008.
2. Proprietors' income. Proprietors' income is the income of the nonincorpo
rated self-employed. Because many self-employed people own some capital (exam ples are a farmer 's tractor or a dentist's X-ray machine), proprietors' income includes both labor income and capital income. Proprietors' income was 7.7°/o of GDP in 2008.
3. Rental income of persons. Rental income of persons, a small item, is the
income earned by individuals who own land or structures that they rent to others. Some miscellaneous types of income, such as royalty income paid to authors, recording artists, and others, also are included in this category. Rental income of persons was about 1 .5°/o of GDP in 2008.8
4. Corporate profits. Corporate profits are the profits earned by corporations and represent the remainder of corporate revenue after wages, interest, rents, and other costs have been paid. Corporate profits are used to pay taxes levied on cor porations, such as the corporate income tax, and to pay dividends to shareholders.
The rest of corporate profits after taxes and dividends, called retained earnings, are kept by the corporations. Corporate profits generally are a modest fraction of GDP
(9.4°/o of GDP in 2008), but the amount of profits earned by corporations may change dramatically from year to year or even from quarter to quarter.
8Rental income of persons is a tiny fraction of GDP because it represents net rental income, or rents
received minus the cost of replacing worn-out or depreciated structures. Also, rental income of persons does not include all rents paid in the economy because it excludes rents received by corporations.
34 Part 1 Introduction
Table 2.2
I ncome Approach to Measuring GOP in the United States, 2008
Compensation of employees Proprietors' income
Rental income of persons Corporate profits
Net interest
Taxes on prod uction and im ports
Business cu rrent transfer payments
Current surplus of government enterprises Total (eq uals National I ncome)
Plus Statistical discrepancy
Equals Net National Product (NNP) Plus Consumption of fixed capital
Equals Gross National Product (GNP)
Less Factor income received from rest of world Plus Payments of factor income to rest of world
Equals Gross Domestic Product (GOP)
Note: Numbers may not add to totals shown owing to rounding.
Billions of dollars 803 7 1 1 06 2 1 0 1 360 8 1 5 994 1 1 9 -7 1 2635 1 0 1 1 2736 1 847 1 4583 809 667 1 4441
Source: Bureau of Economic Analysis Web site, www.bea.gov, Tables 1 .7.5 and 1 .1 2, July 3 1 , 2009
Percent of GOP 55.7 7.7 1 .5 9.4 5.6 6.9 0.8 0.0 87.5 0.7 88.2 1 2.8 101.0 5.6 4.6 1 00.0
5. Net interest. Net interest is interest earned by individuals from businesses
and foreign sources minus interest paid by individuals. Net interest has varied from 4°/o to 8°/o of GDP each year over the past 25 years.
6. Taxes on production and imports. Taxes on production and imports include
indirect business taxes, such as sales and excise taxes, that are paid by businesses to Federal, state, and local governments, as well as customs duties and taxes on res idential real estate and motor vehicle licenses paid by households. These taxes have averaged about 7°/o of GDP for the past 25 years.
7. Business current transfer payments (net). Business current transfer payments
are payments made by businesses to individuals or governments or foreigners, but not for wages or taxes or as payment for services. Instead, such transactions as charitable donations, insurance payments, FDIC insurance premiums paid by banks, and legal settlements are covered by this category of income. Business cur
rent transfer payments have been between 0.5°/o and 0.9°/o of GDP each year for the past 25 years.
8. Current surplus of government enterprises. Current surplus of government
enterprises is essentially the profit of businesses that are owned by governments, such as water, electric, and sewer companies, trash companies, mass transit firms, and housing firms. Current surplus of government enterprises is often negative when the firms suffer losses, as has occurred in 7 of the past 25 years, though the losses have never been more than 0.11 °/o of GDP.
In addition to the eight components of national income just described, three other items need to be accounted for to obtain GDP:
statistical discrepancy; depreciation; and
Chapter 2 The Measurement and Structure of the National Economy 35
Statistical discrepancy arises because data on income are compiled from dif ferent sources than data on production; the production measure minus the income measure equals the statistical discrepancy. Thus, a positive statistical discrepancy means that the income measure adds up to less than the production measure. National income plus the statistical discrepancy equals net national product (NNP), as indicated in Table 2.2.
Depreciation (also known as consumption of fixed capital) is the value of the capital that wears out during the period over which economic activity is being measured.9 In the calculation of the components of national income
(specifically, proprietors' income, corporate profits, and rental income), depre ciation is subtracted from total, or gross, income. Thus, to compute the total or gross amount of income, we must add back in depreciation. The sum of net national product and depreciation is gross national product (GNP). Gross
national product and gross domestic product are called gross because they mea sure the nation's total production or output of goods and services without sub tracting depreciation.
As we discussed earlier, to go from GNP to GDP we have to subtract net factor payments from abroad, NFP (see Eq. 2.2). As we have already mentioned and as you can see from Table 2.2, for the United States net factor payments are relatively small and so GDP and GNP are very close.
Private Sector and Government Sector I ncome. In this section we have measured economic activity as the sum of all the incomes received in an economy. Sometimes, however, economists need to know how much of total income was received by the private sector (households and businesses) and how much accrues to the government sector, which in the United States consists of Federal, state, and local governments. For example, in trying to predict the demand for consumer goods, focusing on the income available to the private sector might be more useful than focusing on the income of the economy as a whole.
The income of the private sector, known as private disposable income, mea sures the amount of income the private sector has available to spend. In general, as for an individual family, the disposable income of the private sector as a whole equals income received from private-sector activities, plus payments received by the private sector from the government, minus taxes paid to the government. The precise definition is
where
private disposable income == Y + NFP + TR + INT - T, (2.4)
Y == gross domestic product (GDP);
NFP == net factor payments from abroad;
TR == transfers received from the government;
INT == interest payments on the government's debt;
T == taxes.
9Depreciation (consumption of fixed capital) includes both capital that physically wears out and capi tal that is scrapped because it is no longer economically useful. For instance, still-functioning comput