. © 1999-2003
Douglas A.Ruby

Business Cycles



Aggregate Demand

Macroeconomic Theory

Macroeconomic Principles
National Income Accounting
and the GDP Deflator

In order to perform macroeconomic analysis in support of economic policy, it is necessary to collect data over time on key  economic variables related to income, employment of resources, price levels, and other indicators of the direction of the business cycle. This collection and analysis of data is called National Income Accounting which represents the tools and methods by which economists and policy-makers measure economic activity and economic growth over time.

There are two types of economic variables used in our analysis: flow variables--economic activity measured per unit of time and stock variables--measures of economic activity at a point in time. For example:

Flow Variables

  • Income (Household, Per-Capita, National)
  • Budget Deficits
  • Investment Expenditure
  • Consumption Expenditure
  • Any Income Statement measures (Sales Revenue, Gross Profit, Expenses)

Stock Variables

  • Wealth (an accumulation of Savings over time)  
  • Debt (an accumulation of borrowing over time)
  • Capital Stock (Factories, Machinery, Inventory, Infrastructure)
  • The Money Supply
  • Any Balance Sheet measures (Assets, Liabilities, Owner's Equity)

Typically most of the common, although not necessarily relevant, measures of economic activity are flow variables. It is important to note that in order to interpret the magnitude of any flow variable, a corresponding time period must be attached (i.e., consumption spending per month, quarter, or year).

The evaluation of economic activity is really about measures of output or changes in output in a given period of time. The expectation is that any past additions to the wealth of a nation, whether it be physical capital or human capital, will lead to growth in current output. These output measures, when stated on a per-capita basis (output per person) can be interpreted as a measure of regional or national standard of living. (SoL) If the growth rate in output exceeds the growth rate in population then living standards are assumed to be rising

SoL = Output per Capita = Output / Population
such that if:
%ΔOutput > %ΔPopulation,

Interactive Bar Chart

There are difficulties in attempts  to measure output in the aggregate. It is impossible to add different quantities of goods and services together as a single aggregate measure. The quantity of autos produced added to the quantity of apples and quantity of houses gives a meaningless measure:

Qautos + Qapples + ... + Qhouses + ..... + QnΣQi = ???

To overcome this problem of aggregation, economists transform the above sum to a common unit of measure in currency terms. This is accomplished by pre-multiplying each item by its current market price 'Pi '. Thus, instead of adding individual quantities together, economists sum the expenditure for each ith good together:

PautosQautos + ... + PhousesQhouses + ..... + PnQn = ΣPiQi 
Aggregate Expenditure

As will be seen below, the use of market prices and expenditure measures to evaluate economic activity causes other problems in attempts to accurately measure growth in a nation's output over time.

The topic of National Income Accounting begins with the use of two methods to determine this measure of aggregate expenditure:

  1. directly via the expenditure approach (through spending on final goods and services) or
  2. indirectly via the compensation approach (through payments made to the factors of production in producing goods and services).

The Expenditure Approach involves collecting data on the major components of spending in a given time period. This spending is in the form of consumption expenditure 'C', investment expenditure 'I', government expenditure 'G', and net-export expenditure 'NX'. When added together these four forms of spending make up what is known as the Gross Domestic Product or GDP for a given economy:

C + I + G + NX = ΣPiQi = GDP

Formally defined, GDP represents a measure of the market value of all final goods and services produced and purchased in a given year. In the table below, data are provided for the time period 1960-2000 (in billions of $):

Table 1, Expenditure Categories
Year Consumption
Net Export
Source: Economic Report of the President 2002

The Compensation Approach involves measuring the amount of compensation paid to the various factors of production (land, labor, capital, entrepreneurship) used as inputs in the production process. For example in 2000 (est.):

Table 2, Income Categories
Category Amount (%)
Compensation of Employees (labor) $5715.2 (71.6%)
Proprietor's Income (entrepreneurship) 715.0 (9.0%)
Corporate Profits (capital) 876.4 (11.0%)
Net Interest (capital) 532.7 (6.7)
        Gross Rental Income 202.5  
         less depreciation expense -61.0  
Net Rental Income (land) 141.6 1.8
 National Income $7980.9 (100%)
Source: Economic Report of the President 2002

Note that about three-quarters of  National Income represents the return to labor and the remaining one-quarter is known as the return to capital. Historically, the percentage of national income allocated between labor and the other factors of production has remained relatively constant over the past century.

The difference between gross domestic product and national income ($1,892.00) is due to depreciation expense, indirect business taxes (sales and excise taxes), and business transfers to individuals (through donations to the United Way and the like). For example, some of the payments (expenditure) to capital and land are made to cover the consumption of capital and equipment (to allow for wear and tear on the equipment). However, these payments are not received directly by the owners of capital and land in that they must allow for eventual replacement of these items. In the case of indirect business taxes, expenditure on some items like gasoline, liquor, and telephone calls, include the provision for a per-unit tax in the price of these items. These per-unit or excise taxes are transferred to some government agency and do not represent direct compensation to the owners of factor inputs.

One goal of national income accounting is to measure growth in these income measures over time. Both the gross national product and national income measures are used to determine the rate of overall economic growth. However, the interest  is with growth in output, not necessarily growth in expenditure.

Given that aggregate measures include both quantities and prices, changes in expenditure might come about either due to true changes in output, changing prices or both! As stated above, Gross Domestic Product represents the market value of all final goods and services produced. In an inflationary environment (one where the absolute price level in increasing) these market values will also increase and thus lead to an overstatement of the true rate of economic growth.

Any economic dollar variable may be expressed either in measured nominal terms (not adjusted for changes in the price level) or in real terms (calculated using constant prices). Nominal GDP  (NGDP) may be expressed using the aggregate expression from above:

NGDP = ΣPi,tQi,t

In contrast Real GDP (RGDP) is calculated using the same composition of goods and services Qi,t evaluated at base-period (constant) prices Pi,o:

RGDP = ΣPi,oQi,t

Interactive Table -- The GDP Deflator -- Click here

Measures of economic growth are measured by calculating the percentage change in real GDP ( or in terms of output growth since the price term is held constant).

Growth Rate = %Δ(RGDP)
= (RGDPt-RGDPt-1) / RGDPt-1
= (RGDPt/RGDPt-1) -1

A comparison of nominal and real growth rates for GDP in the U.S. are given in the table below (note: the Implicit GDP Deflator is calculated as the ratio of NGDP and RGDP):

Table 3, Economic Growth
Year Nominal
Rate (%)
GDP Deflator
Source: Economic Report of the President 2002

*Recession years

As can be seen in the above numbers, what appears to be robust economic growth (6% per year in NGDP) may be largely due to inflation and corresponding change in market values. Over the past twelve years in real terms GDP in the U.S. has been growing on average by 2.5 to 3.0 percent annually.

Concepts for Review:
  • Aggregate Measures
  • Compensation Approach
  • Economic Growth
  • Expenditure Approach
  • Flow Variables
  • GDP Deflator
  • Gross Domestic Product (GDP)
  • National Income (NI)
  • National Income Accounting
  • Nominal Gross Domestic Product (NGDP)
  • Real Gross Domestic Product (RGDP)
  • Standard of Living
  • Stock Variables