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For the economy as a whole total spending equal total income for a given period of time. What one party buy/spends another sells and thereby receives income.
Spenders and corresponding income earners can be individuals, corporations or macroeconomically constructed entities like these:
- the domestic government sector, which includes federal, state and local governments as well as public sector organizations;
- the domestic private sector, which is made up of private businesses and households; or
- the rest of the world (also called the foreign or external) sector, since foreign individuals, businesses and governments can buy goods and services produced in the domestic economy.
Total spending equals total income is a proposition that is true for the economy as a whole but not necessarily for household, corporations or macroeconomically constructed sectors.
A household, for instance, may spend more than it receives in income — by drawing down on savings or by borrowing. Conversely, it may spend less than its income, thus saving some money.
A household will use its income to pay taxes, or to engage either in consumption or in saving:
Some of the income will go to taxes. The amount left over is called ‘disposable income’.
The household can use its disposable income for consumption or saving.
Consumption is a form of spending. It involves the purchase of goods and services.
Saving is defined simply as the act of not consuming. It is that part of disposable income not consumed.
If the household leaves some of its income in a savings account at a bank, this income is not consumed but saved.
Or the household might purchase some shares or bonds. Since shares and bonds are not goods or services, buying them does not count as spending, and so does not create income. Rather, holding shares or bonds are different ways of saving.
Some of the household’s income might be used to pay off debt, such as principal and interest on a home loan. This also counts as saving, because it is income not spent on goods and services.
So, part of income goes to taxes. Part can be consumed. And the rest will be saved.
Flows accumulate over an extended period of time, have temporal extension. Stocks do not, they are snapshots taken at a given point in time.
A flow is a process that occurs through time. To measure it, we need start and end points.
Spending and income are key economic flows. We measure them as amounts that occur over a period of time, such as a year.
Other examples of economic flows include saving and depreciation. Saving, as we saw in the previous post, is the amount of disposable income not consumed. Depreciation is the reduction in value of an asset over time due to wear and tear as the asset is used. For instance, a machine that costs a business $10,000 to purchase might last five years, suggesting depreciation of $2,000 per year.
A stock is something that is measured at a particular point in time. For example, the number of hats you currently own is a stock.
A notable economic stock is the amount of wealth currently possessed by the community. Another key stock is the amount of fixed capital equipment that has been accumulated and is currently available for use in production. Still another important stock is the number of people currently in the labor force.
A fundamental point is that flows add to (or subtract from) stocks. It is said that “flows accumulate into stocks”.
For example, saving is a flow that adds to the stock of financial wealth.
A prominent flow measure for the economy as a whole is Gross Domestic Product (GDP). This is a measure of the total output produced within the domestic economy over a year.
In the National Accounts, total output is evaluated at market prices. Conceptually, it is as if the quantity of each good or service produced is multiplied by its price, with the products then summed to give a figure for total output or ‘nominal GDP’.
The figure for nominal GDP can be adjusted for changes in the average price level to arrive at a measure of ‘real GDP’. This measure is intended to give us a sense of how the physical output of goods and services compares with other periods.
Although real GDP is intended to shed light on the level of physical production, clearly it is a monetary measure just like nominal GDP. It is just that real GDP is a monetary measure that has been corrected for price changes.
The reason real output (or real GDP) is measured in monetary terms is that there is no good way to add up physical quantities of different goods and services to arrive at a single number. For example, imagine an economy that produces just three goods with the following physical output:
Physical Output = 50 computers + 75 motor vehicles + 40,000 apples
We cannot add up these quantities to arrive at a single measure of physical output. The goods have different units of measurement. They are incommensurable.
But if we know prices, we can express the output of each good in monetary terms. All output will then be measured in a common monetary unit and can be added together. Suppose the prices are $1,000 for a computer, $10,000 for a car and $1 for an apple. Given these prices, nominal output can be calculated as:
Nominal Output = $1,000 x 50 + $10,000 x 75 + $1 x 40,000 = $840,000
This is our measure of nominal GDP.
Perhaps it is known that prices on average rose by 5 percent over the year. The figure for nominal GDP can then be converted into real GDP by deflating the nominal figure by 5 percent. This is done by dividing the nominal figure by 1+p, where p is the rate of increase in prices over the period. Accordingly:
Real GDP = $840,000 / (1 + 0.05) = $800,000
If we denote real output by Q and the average price level by P, then nominal output is PQ.
There is a very important connection – in fact, an identity – between total output and two other major macroeconomic flows, namely total income and total spending.
First, total output Q is identically equal to total income Y. The reason for this is that output priced in monetary terms generates income of an equal monetary amount.
It is easy to see why this must be true in the case of output that is sold. The amount paid for the output goes as income to the sellers.
The identity is not so obvious in the case of unsold output. It holds because in the National Accounts this unsold output is treated, for accounting purposes, as if it has been purchased by the firms that produced it. This accounting treatment ensures that total output equals total income, even though some output is unsold.
Second, we know from part 4 that total spending equals total income. Put simply, all spending goes to somebody as income.
Putting these observations together enables us to arrive at an important accounting identity:
GDP = Total Output = Total Income = Total Spending
Since total output Q and total income Y are the same when measured in monetary terms, both are often denoted simply by Y.
This identity is at the heart of National Accounting. In particular, it informs various methods of measuring GDP.
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