Summary Chapter 2 – Macroeconomic Accounts

2.1 Overview
- Accounting identities define the magnitudes we are interested in and how they relate to each other, by construction

2.2 Gross Domestic Product
2.2.1 Three Definitions of Gross Domestic Product
- The gross domestic product (GDP) is a measure of productive activity
- A flow variable is a variable that keeps on going. The GDP is a flow variable and is defined over a time interval, usually a year
- Stock variables are always defined with reference to a particular point in time
- The three different definitions of GDP are:
1. GDP = the sum of final sales within a geographic location during a period of time
- Final sales are goods and services sold to consumers of firms that will ultimately use them
- Intermediate sales are goods and services sold to a retailer for example who will later on sell the good to the final customer. These are not included in GDP figures as they will cause double counting
- Exports are always counted as final sales regardless of how the foreigners use them, because they leave the boarder

2. GDP = the sum of value added occurring within a given geographic location during a period of time
- A firm creates value added by transforming raw materials and unfinished goods into products it can sell in the market place
- When a final consumer purchases a good or service, the price includes all the value added to create the product. Therefore, only the final value added is counted, as otherwise, double counting will occur again

3. GDP = the sum of factor incomes earned from economic activities within a geographic location during a period of time
- All resident’s and non resident’s incomes are counted as one person’s spending is another one’s income

- Three important traits about GDP are worth mentioning
1. GDP can increase because of (1) more economic activity and (2) higher prices for the same economic activity
2. All GDP figures have to be transformed into a common currency, using the purchasing power parity for accuracy
3. GDP per capita is the GDP of a country divided by its population. It’s used to show GDP differences between countries with different sized populations

2.2.2 Real versus Nominal Quantities, Deflators versus Price Indices
Real and Nominal GDP
- The nominal GDP of a country which produces only two goods can be calculated like this:
nominal GDP= Pa×Qa+ Po×Qo
- The problem with nominal GDP is that if the price of one good rises over time, then it would show an increase in GDP though final sales did not change at all
- The real GDP corresponds to the increase in physical output produced and sold, whereas nominal GDP is computed using the actual selling price
- To measure real GDP, a base year has to be distinguished, one in which all following years will use as the base price
- Real GDP is calculated like this:
real GDP= P0a×Qta+ P0b×Qtb

Price deflators and indices
- The GDP deflator is a way of measuring the price level at some particular time:

GDP deflator=nominal GDPreal GDP
- The inflation rate can be measured by the rate of increase in the GDP deflator, which in turn can be approximated by the following formula
GDP deflator inflation=nominal GDP growth rate-real GDP growth rate
- Another measure of inflation is the consumer price index (CPI) which is based on a basket of goods that represent average consumption. The basket is used to weigh the corresponding prices

2.2.3 Measuring and Interpreting GDP
- GDP figures are most commonly collected through tax figures
- The underground economy describes economic activities from which income earned is not reported and therefore is untaxed
- As it takes a long time to produce GDP figures from all the tax returns, inaccurate data is first given out which can have negative effects on government decisions
- GDP per capita figures are not a good source when comparing two countries, as the compare incomes and not wealth
- IN many developing nations, informal economies are used, which are not detected by the authorities. These informal economies can be bargains or services provided for family members free of charge

2.3 – Flows of Incomes and Expenditures
2.3.1 – The Circular Flow Diagram
From final expenditures to net taxes and factor income
- The circular flow is a fact that each final sale of a good or service represents income to factors of production employed to produce it; similarly, income to factors of production is either spent or saved, while savings are used to finance, final purchases of goods by others
- Net taxes is the difference between taxes and transfers
- Private Income is income to the private sector which remains after taxes have been removed from, and transfers have been added to national income (more precisely, GDP plus net factor income earned abroad)

From private income to absorption plus net exports – GDP
- Private income is ultimately earned by those households which own the factors of production involved in creating value added
- Households can either save income or spend it on consumption
- Consumption is goods and services produced and sold to households for the satisfaction of wants
- Financial intermediation is the channeling of savings of households by banks and other financial institutions to those willing to undertake physical investment
- Physical capital is a factor of production consisting of durable inputs such as machines, buildings, computer hardware and software, and physical inventories
- Investments are the acquisitions of productive equipment for later use in production; also called fixed capital formation
-The excess of private savings over investments (S – I) is called net private saving
- Absorption is the total national (private and public) spending on goods and services
- The sum of absorption (C+I+G) and net exports (X – Z) represents the total final sales that occur within the geographic area

2.3.2 – Summary of the Flow Diagram
- The flow diagram can be summarized using the first and third definitions of GDP
- The GDP can be summarized as:
Y=C+I+G+X-Z
The second decomposition of GDP can be written as:
Y=T+S+C
- Public spending between developed countries can vary a lot as in some countries, some infrastructure is private while public in others

2.3.3 – More Detail
- Personal disposable income is households’ net income from all sources after taxes have been paid and transfers received
- Depreciation is the loss of original value of a physical asset owing to use, age, and economic obsolescence
- Depreciation should be subtracted from GDP to give a clearer picture of the output that is really available as income
- The Net domestic product (NDP) is the national income accounts, GDP less depreciation
- After indirect taxes firms pay out the value added they generate in four primary ways: (1)wages, salaries and other compensations, (2) interest to bondholders and banks, (3) payment of corporate or business income taxes, and (4) the remaining profits are distributed as dividends or held back as retained profits
- The Gross national product (GNP) or gross national income (GNI) measures incomes and outputs of a country’s citizens and corporations no matter where they operate
GNP=GDP+net factor incomes

2.3.4 – A Key Accounting Identity
- The formulas for GDP seen in 2.3.2 can be combined:
C+S+T=C+I+G+X-Z
- Rearranging these terms and canceling out C (on both sides of the equation), we get:
S-I+ G-T=(X-Z)
- Each of the three flows is either a leakage (if positive) or an injection (if negative) (S > I - net saver, S<I - net borrower)
2.3.5- Identities versus Economics
- All goods and services produced must be purchased (see equation above)
- The formula also shows how the adjustment mechanism in the market equilibrium condition works

2.4 – Balance of Payments
- The balance of payments (BOP) is a summary of all real and financial transactions of a country with the rest of the world
- Transactions involving outflows of our money are recorded as deficit (-) items, while those involving inflows of domestic money are considered as surplus (+) items

2.4.1 – The Current Account and its Components
- The balance of goods and services includes merchandise trade as well as trade in intermediate inputs, goods repair, goods held in ports, and non-monetary gold. The balance of trade in services incorporates a wide and growing variety of invisibles such as transport and travel, communication, insurance, financial and other services. It also includes royalties and license fees
- A second account is the balance of international income, which is the net income of a nation which originates abroad: wages and salaries paid for work by individuals in countries different from their place of residence and profits or interest income received by residents less profits and interest served to foreign residents
- The third account is the balance of current transfers, which represents payments which are not associated with commercial of financial transactions. An example is the remittance of a guest worker to their home countries. When a Polish plumber living in London sends money to relatives living in Warsaw, this counts as a surplus to the Polish balance of transfers and as a deficit to the UK’s. Another example is development or emergency aid offered by one country to another
- The importance of the current account can be seen in the following formula where Y now takes the GNI:
CA=Y-C+I+G= Y- A
where (C + I + G) is shown as the absorption A

2.4.2 – The Capital and Financial Accounts
- A current account deficit implies borrowing from abroad, so financial capital is flowing into the country
- The capital account is the component of the balance of payments accounts that records financial transactions with the rest of the world
- The financial account is the net sales of foreign assets by private domestic residents (a purchase by domestic residents worsens the financial account balance, a sale improves it)
- Four categories of financial transactions which affect the capital and financial account are (1) direct investment, (2) portfolio investment, (3) other investment, and (4) reserve asset transactions
- The official account is the net transactions performed by the monetary authority on foreign exchange markets (net sales of foreign exchange)
- Monetary authorities like central banks can sell some of their foreign exchange reserves, foreign currencies held by the monetary authority for the purpose of intervening in the exchange markets, and receive domestic currency for it in return
- Foreign exchange market interventions are purchases and sales of foreign money in exchange for domestic money undertaken by monetary authorities (ECB, FED, etc.)

2.4.3 – Errors and Omissions
- By definition, the total balance of payments should be zero:
CA + FA + OFF =0

- Official intervention is the monetary authorities, which are often responsible for collecting the data and making the account
- An additional account called ‘errors and omissions’ is needed to make sure that the balance of payments adds up to zero in the end

2.4.4 – The Meaning of the Accounts
- A current account imbalance must be matched or financed by either the private financial account or official intervention by the monetary authorities
- The monetary authorities can buy excess supply of the domestic currency if they fear a depreciation of the currency due to a deficit in the financial account. This would cause the official intervention to be debited, and therefore cancel out the deficit in the financial account
- The central bank could also refuse to step in, therefore causing a reduction in the current account deficit
- The central bank determines if and to what extent, a current account imbalance translates into a change in the exchange rate
- The overall balance is the sum of the current and financial accounts (including errors and omissions), which by double-bookkeeping is the mirror image of interventions by the monetary authorities
- Ignoring errors and omissions gives:
BoP=CA+FA= -OFF
- A BoP surplus means that monetary authorities have acquired foreign exchange reserves, therefore the official account is in deficit (vice versa for BoP deficit)