GDP and alternative measures of national income (video + transcript)
As part of our “Data and aggregates” playlist for macroeconomics we’ve added a video on GDP as income, and how to think about other national accounts measures in terms of income – after all, in some circumstances different measures can make more sense for a given question.
For those who don’t want to listen to a video, we’ve popped the script below.
We’ve chatted about why we care about GDP and the different ways of measuring it – be it through expenditure on final items, the value-added in each industry, or the income paid to those providing a “factor of production” such as work time or capital equipment.
In these chats we established that however we measure it, these measures of “expenditure” “production” and “income” all give us the same result for GDP – and this tells us that the amount we produce, the amount we consume, and the amount of income we have are really all the same thing.
This is a powerful result that has been used to say “Supply creates its own demand” or, as the bloke on my t-shirt says, that “demand creates its own supply”. Behind all of this we always need to model a process to truly understand how the macroeconomy works and what trade-offs there are.
[Gulnara]
However, out of context this result is also misleading – and can lead us to get the wrong impression about how society is progressing or the opportunities available to people. Even ignoring other attributes that economists like to add in – the distribution of income, environmental change, and non-monetary value stemming from your interaction with your community – this perspective can miss important things even in terms of our narrow understanding of monetary incomes.
In this video we are going to think a little bit about that, and see what other measures we can look at from the national accounts that may give us a wider perspective on incomes.
GDP and income
[Back to Matt]
As we noted in a prior video, GDP can be measured by taking all expenditure on final items, taking all income paid to labour, capital, and through indirect taxes, or by calculating the value added in each industry and adding them up. And each of these measures will give us the same number!
This measure is amazing at helping us understand the use of society’s scarce factors of production, gives us an insight into economic progress in a country, allows us to understand and compare production and incomes between countries, and provides a useful piece of information for asking about policy trade-offs when we use it with economic models.
However, when it comes to cross-country and time based comparisons we immediately run into an issue – prices change through time, and different countries use different currencies.
If we are looking at one country or countries with the same currency everything is in the same “unit of account” which makes it easy to add up – but how do we add up a New Zealand dollar and a Japanese Yen for building a GDP measure?
When comparing across countries we need to adjust for the fact that different units of the currency can be exchanged for the same goods. We can’t just use exchange rates here as they don’t give us the full picture due to non-tradable goods and services. Furthermore,these exchange rates can be excessively volatile and as assets currencies may be valued for reasons other than the strict ability to purchase goods and services.
We aren’t going to focus on cross-country comparisons and therefore those types of measures right now, but will cover it in a future video.
Our focus here will be on the time based dimension. We know that a New Zealand dollar today cannot buy the same number of chocolate bars as a New Zealand dollar could when I was a kid – sadly. As a result, if we construct GDP just by counting the number of dollars spent on these items, then when comparing GDP numbers over time we will end up with a measure that captures both the increase in the price of goods and services as well as an increase in the actual number of them.
The measure that takes “current prices” to calculate GDP – the equivalent of just adding up the number of dollars spent – is called nominal GDP. While the measure that adjusts for the fact that prices changed and attempts to measure the volume of GDP over time is called real GDP.
Getting from nominal to real GDP involves figuring out a way to remove the price effect, or what is termed deflating nominal GDP for price growth. The GDP deflator captures the aggregate price effect through time, and by dividing nominal GDP by this deflator we get our measure of real GDP.
As we often care about the amount of stuff available to buy, rather than the number of New Zealand dollars floating around to spend on it, real GDP is normally the measure we are talking about when we talk about GDP as income. However, both measures are useful and have their place for asking different questions.
To give this all a bit of context, let’s pull up the data and look at these measures for New Zealand.
[R session]
Here we have pulled some data off the Stats NZ website and made some quick and nasty graphs. This first one shows us New Zealand GDP in nominal and real terms between 2000 and 2020.
Note how nominal GDP starts below real GDP and then climbs above it. What does this mean? Well it means the nominal GDP was growing faster than real GDP, which is what we would expect given that prices were rising!
Furthermore, they are equal during 2009 – implying that we are deflating nominal GDP to get real GDP in 2009 prices.
This is the income of the nation, but as we are looking at incomes we might want to know about the incomes per person – or per capita. As populations are growing that looks like a second graph here.
This shows a similar trend, but you will notice that the lines are a bit flatter (or that the Y-axis increases by a smaller proportion). This is because the population was growing during this period, so part of the increase in GDP was associated with there simply being more people.
The real GDP per capita number tells us that, in New Zealand borders, significantly more output is created per person was created in 2020 than was the case in 2000 – 38% more to be precise! This opens up a world of questions, are we using more inputs (i.e. working more, using more environmental capital, building up more physical capital) or have we just learned how to use what we have in a more efficient way – what is called multifactor productivity growth.
But we aren’t answering those here. Instead we want to ask, is this income? Over to you Gully.
What is macroeconomic “income”
[Gulnara]
Thanks again Matt.
Describing GDP and income in the way above is typical for an introductory economics course, and feels very natural. However, it is also misleading. To truly think about income we need to ask what income actually is.
In Hicks 1946, John Hicks stated that income was “the maximum value which [a man] can consume during a week, and still expect to be as well off at the end of the week as he was in the beginning.”. As one of the founders of the post-war “neo-classical synthesis”, and as a famous welfare economist, it is this definition of income that captures what an economist is thinking about when they say “income”.
It is then the equivalence between consumption + savings (potential consumption) and production at the macro level that leads us to view income as essentially GDP.
Income in this economist’s world is “potential consumption”, as it is this ability to consume final goods and services through time that generates wellbeing and welfare.
GDP on the other hand is a measure of the use of factors of production to generate value added/output – the rationale for looking at this is to understand the utilisation of factors of production, especially workers, in market activities. As noted by Matt above, the focus is also on the number of items.
In this way, much of GDP is the act of creating some value associated with a final product that is consumed – but there may be cases where the factor of production is instead used in order to “maintain how well off they are” or where the residence of the individual who claims the output differs from the residence of the factors of production. These differences will lead to a gap between our true concept of income and GDP – so let’s talk about them a bit more.
Maintaining assets
[Matt]
Thanks Gulnara. The issue I want to talk about a bit more is that of maintenance.
The “gross” in gross domestic product refers to the fact that ALL investment is included in the measure.
If you own a building and you use it to run a business then that refers to a capital item. You may invest in that building by adding an extra floor, improving the air conditioning with services like www.newcastleairconditioning.co.uk, painting the building, or replacing the showers. All this investment activity will be measured at once – however, some part of it refers to maintaining the productive use of the asset while some refers to increasing the productive use of the asset.
Why would we need to maintain anything? Well, time takes its toll on all of us – especially capital assets. This depreciation in the usefulness of the capital item is sometimes called “consumption of fixed capital”, and GDP includes investment that is solely about keeping the capital item as productive as it was before.
However, if we imagined someone producing something for themselves the decision to repair something doesn’t constitute a new thing for them to consume – so we wouldn’t view it as part of their “income” or an increase in their ability to consume while maintaining their current position. Instead, this is an expense that is required to keep themselves in that position!
The measure that tries to adjust for this given estimates of depreciation and measures of the capital stock is Net Domestic Product.
[R session]
We will construct Net Domestic Product from the Stats NZ data and graph it here as well. For this we have subtracted the Stats NZ estimate of “consumption of fixed capital” from GDP, and then used the same deflator to work out a real value. True Net Domestic Product will look a little bit different, but this gets us close enough to chat about.
So what is this graph showing?
Net Domestic Product moves in a similar way to GDP, but is lower. This makes sense as we are subtracting an “expense” that isn’t included in GDP. By taking away the part of GDP that needs to be used to maintain capital equipment we have a more genuine measure of income relative to the definition Gulnara gave above.
This figure grew by 37.7% – slightly less than the growth in GDP over the same period. Why is it different? If the capital stock per person has risen, or the types of assets we hold depreciate more quickly – such as computers – then the amount of maintenance that needs to be paid will rise. As a result, Net Domestic Product growing by less is also consistent with the changing nature of the economy over the past 20 years.
Opening the borders
[Gulnara]
Things become more complex when we open ourselves up to the rest of the world.
Three things happen when we admit there are other countries:
- Domestic residents can own assets overseas, and so are able to consume things that are produced overseas – similarly foreign residents can own domestic assets, giving them a claim on some of this domestic production that is measured by GDP.
- Domestic products might be sold overseas (exports), and foreign products may be purchased and consumed domestically (imports). Imports are part of consumption, and must be funded to some degree by exports. If the relative price of exports and imports increases , domestic residents can now consume more for the same amount of production.
- Transfers, such as charitable giving and intermittences, involves residents in one country sacrificing consumption to provide those opportunities to others overseas.
In this way, GDP remains as a measure of what is “produced” within a country – it measures what is made with factors of production within national boundaries. But this does not immediately mean that it reflects the claim on products for people who live within those borders!
Gross National Product or GNP is the measure that attempts to adjust for the income of domestic residents overseas, and the income of foreign residents that is generated in the domestic economy. This is very similar to Gross National Income, or GNI – conceptually they should be the same, but in some accounts the residency definition or definition of primary income (income from factors of production) that are included can vary between the two.
However, secondary income (such as the intermittences noted above) are missing in these measures. Adding in net transfers from above provides a measure termed GNDI (gross national disposable income) as an aggregate income measure. By capturing all foreign transactions, the construction of this measure also captures changes in the terms of trade as “income” – in a way that GDP does not. (isi_box1_jun_2015.pdf (banrep.gov.co))
Taking GNDI, we run into the same issue that Matt talked about above – there is some investment that is just about maintaining the stock of capital. Subtracting this depreciation then leaves us with two other measures that you may hear about, NNI or Net National Income, and NNDI or Net National Disposable Income.
Do all of these adjustments change much? Let’s look at the New Zealand data with Matt!
[Matt on R part and summing up]
For these figures we are going to stick with the nominal data provided by Stats NZ. This is because real figures are not provided, and trying to back out the appropriate price deflators for these different indices will take a bit of time without necessarily adding much value.
With that out of the way, let’s plot everything from the Stats NZ experimental national accounts.
As we can see here there are potentially a few data issues in this experimental series – so I want us to focus on the relativities rather than the individual series shape over time.
GDP is at the top, with GNI and GDI catching up through time. GNI and GNDI are also very close to each other. NDI is then significantly lower than the others – which does make sense.
So why is GNI below GDI in New Zealand? Remember that we get from one to the other by subtracting the domestic production that is claimed by foreign residents and adding in foreign production that is claimed or owned by New Zealand residents. New Zealand on average borrows from the rest of the world, and it is the income flows associated with this that explains the gap!
However, the deflator does matter when we want to think about the key differences between GNDI and GDP – namely changes in the relative price of exports and imports, or the terms of trade. For this we do want to consider how real measures may look different solely on this basis.
Here we get a much sharper change in the relative value of GDP and GNDI than when we looked at the nominal values. Why is that? In this instance New Zealand has seen a very substantial increase in its terms of trade – or the price of exports relative to the price of imports – over this period. When we deflate the two income series, that terms of trade difference shows up as another part of the change in these measures.
Between 1992 and 2021 real GDP per capita rose 58% while real GNDI per capita rose 77% – as a result this is a very significant difference. So how do we think about which income measure to use?
The fact that New Zealand can now buy a lot more imports from the exports it sells is an increase in income in the GNDI sense – and it is not captured directly by real GDP. How does this work? If exports remained fixed and more imports were purchased for consumers to consume, then both C and M would increase in the GDP equation – cancelling each other out.
However, this is real income – having people overseas give New Zealanders more products for the same exports is exactly the same as exports becoming more productive in terms of the amount of goods and services available for New Zealanders to use. As a result, understanding this change is extremely important!
Conclusion
As we’ve noted above, looking at national accounts to get an idea of material wellbeing can be complex – and MOTU has been undertaking work trying to get a more detailed understanding of this in recent years: Motu-Note-21-Material-Wellbeing-of-NZ-Households.pdf
However, by clearly articulating what GDP is, and how it may measure some things we don’t truly see as “income or potential consumption” we’ve been able to work out some alternative measures that already exist in the data to chat about what is happening.
These measures give us additional information which may change the way we see New Zealand’s productivity performance, inequality within the country, New Zealand’s wealth and income relative to other countries and a multitude of other narratives that are given in the media and common discussion. However, we’ll leave it here and we would be eager to hear if this perspective is useful in helping you understand a little more about our beautiful little island.