1.1 National Income Accounting: Concepts and Definitions for a Closed Economy
We mean "closed" to the outside world: there is no trade, and no cross-border financial flows. There are no nations like this in the real world; we start by using this simplifying assumption so that we don't have to learn everything at once.
The stock/flow distinction
There are two basic kinds of quantities. A flow is any quantity that must be measured over a period of time. Income is a flow. A stock is any quantity that is measured at a single instant in time. The amount of orange juice I drink in a month is a flow. The amount of orange juice I have right now in my refrigerator is a stock. The amount of water that passes over Niagara Falls in an hour is a flow. The amount of water in all the world's oceans is a stock. The number of sheets of 3/4 inch plywood in the warehouse of Snavely Lumber is a stock. The number it sells in a typical week is a flow.
Income is a flow, whether for an individual, or with all the individuals added up to get national income. Everything that is done with income is also a flow: paying taxes, saving, consuming. The entire framework that we are putting together is a system of flows.
So why even mention stock quantities at this point? To emphasize what this framework does not show. It does not show money. The amount of money in existence is a stock quantity, not a flow quantity. Money changes hands to carry out the transactions recorded in our income framework but it is not the same thing as those transactions (income is not the same thing as money). It does not show wealth, which is another stock concept. When we talk about "saving" below we mean new saving during a given period, not the total stock of a household's wealth which you might also call "savings" in everyday speech. We do not show the total stock of capital assets owned by firms -- when we talk about capital investment below, we mean new acquisitions of capital goods.
What counts as output
We add up all of the stuff produced in a country in a period of time, but we need to be a little more precise than that. A country's Gross Domestic Product is the market value of all final goods and services produced within a period of time (a year, normally) by factors of production located within that country. Let's go through the definition concept by concept:
Market value: because we must add everything up using one unit (otherwise how do you add potatoes plus haircuts) we add them up according to their market price.
Final goods and services: We measure output when it ends up with its final purchaser. If we counted sales of intermediate goods as well as final sales to consumers we would double-count some output. (We also do not count sales of used goods as part of output -- they were counted when they were first sold.)
Within a period of time: reminding us that this is a flow concept
Factors of production located within that country: this just emphasizes that we are talking about output physically produced within the borders of a country. Output of a U.S.-owned firm in Mexico is part of Mexico's GDP.
Suggested further Reading: Suranovic: The National Income and Product Accounts
Why income equals output
When people who make goods sell them, the money received is their income. Income is received by selling goods and services. Thus total national output is the same as national income.
We can look at any transaction from two sides: from the side of the buyer, and from the side of the seller. The buyer is exercising demand for goods, so from the buyer's viewpoint total output will equal total (or "aggregate") demand. From the viewpoint of the people selling stuff, all the stuff sold counts as total output, also called "aggregate supply."
So Aggregate Supply is the total amount of output produced
and supplied in the economy in a given period. Aggregate Income is the
total amount of income received by all factors of
production in an economy in a given period. The two of them are always equal at any
period of time, so we can refer to both of them as aggregate national income. Traditionally, the symbol Y is used for national income.
Suggested further reading: Suranovic: The National Income or Product Identity
What happens to income
Three, and only three, things can happen to income once people get it.
Taxes: first, some of it may be taken by government in the form of taxes. (To keep our framework simple we will assume that all government revenue comes from income taxes.) After-tax income is also called disposable income, mening that you can dispose of it as you please. Disposable income will sometimes be represented with the symbol Yd.
Consumption: For most people, the major use of after-tax income is consumption, which just means all the purchases of goods and services that you make: cars, car repair, groceries, air travel, shoes etc. What is left after that must be:
Saving: This simply means not spending income. Normally, saving will be used to acquire some sort of financial asset, like a higher bank balance or a security like a bond or share. But saving also includes dropping coins in a drawer -- it means whatever part of total household after-tax income is not spent on goods and services.
Who buys goods
Goods end up in one of three places:
Consumption: This means just what it did above: purchases of goods and services by individuals or households.
Government purchases: Things government buys like roads, bombs, and social work. This does not include transfer payments, like social security, whereby government takes income from one person and gives it to another.
Investment: in the context of macroeconomics this means capital investment. Capital means goods which are used to produce other goods or services. This category includes:
Inventory Investment: If positive, this means firms are increasing the inventories of goods they hold. If negative, those inventories are falling.
Residential Fixed Investment: New housing purchased by landlords or households. We will not worry much about this category.