National Product measures the value of how much is produced in the economy, and national income measures the value of the inputs used in that production. Because one person's expenditure is another's income, in equilibrium NI=NP. The circular model illustrates this fact -- the flow of dollars from households to firms (NP, the value of what is produced) equals the flow of dollars from firms to households (NI, the value of inputs used in production). If there is full employment (which you should recall from the PPF lesson means the economy is operating efficiently -- on the PPF) NP can roughly be thought of as a measure of the PPF. Notice, this true only when there is full employment. When there is less than full employment, NP measures a point below the PPF.
(A side-note: Full employment does not mean an unemployment rate of zero. There is what is known as the "natural rate of employment" which reflects the unemployment that occurs from people changing jobs, businesses opening and closing, and other normal labor force related activities. Economists think this rate is in the 3.5% to 5.5% range. Full employment is often thought of as the "natural rate of employment." Notice that it is possible for unemployment to fall below the natural rate if people take less time in changing jobs, fewer businesses close, and other such things. We'll do more on this later in the semester.)
One problem with measuring NP and NI in dollars is that we can't tell if any change comes from changes in quantity or changes in prices, because NP essentially equals prices x quantities. So if NP goes up, it could be because quantities went up - an actual increase in economic activity - or just because prices went up - what we call inflation. So we need a way to measure inflation, and then a way to adjust the dollar measure of NP (or NI) for the price changes we find.
First to measure inflation. We use an index. The two most common are the consumer price index (CPI) and the Gross Domestic Product (GDP) deflator. GDP is a special measure of NP. An index measures how much prices have changed from the base year. Currently the base year is 1987, although from time to time the government has changed the base year. If an index exceeds 100, that means that prices are higher (so the dollar is worth less) than in the base year. If the index is less than 100, that means that prices are lower (so the dollar is worth more) than in the base year.
Now inflation is measured with the simple formula
change in index / value of the index the previous year
which is the percentage change in the index. So if in 1993 the GDP deflator had a value of 123.5 and in 1994 it had a value of 126.1 then inflation from 1993 to 1994 equaled about 2.6/123.5 or 2.1 percent.
Now to make sure we are measuring the change in NP so we see a real change in economic activity. When we measure NP or NI without adjusting for inflation we have what is called a nominal measure. That means any change can be due to changes in output or changes in prices. If we adjust for changes in prices we have what is called a real measure, and any change is due only to changes in output. So we are really interested in real NP.
We have the following formula that links real and nominal measures:
real NP = (nominal NP/price index) x 100
so if nominal NP = 6,343.3 billions of dollars in 1993, and the price index = 123.5 then real NP = 5,136.27 billions of dollars. In 1992, nominal NP = 6020.2, while real NP = 4979.3. Notice how the change in nominal NP was 5.37 percent, while the change in real NP was 3.15 percent. Inflation made it seem like there was a lot more growth in economic activity than there really was.
Finally, link all this back to the PPC. Remember that we are interested in how efficient we are (how close to the PPC we are) and whether or not the PPC is moving out. Either way, if we look only at nominal NP, we overestimate our efficiency or growth. So real NP is what we really want to measure.
This is a picture of the more complete circular flow diagram of an economy. Besides households and (domestic) firms we've added three additional sectors: the financial system, the government, and other countries. This means there are opportunities for dollars to leave or come into the circular flow. Dollars that leave the economy are called leakages, and there are three of them: taxes, savings and imports. When a household saves, it isn't spending the money on goods or services, so national product (NP) is smaller. Similarly, if the household spends the money on goods from other countries (imports) the dollars don't go around the circular flow. And if the government takes the taxes, again the consumer doesn't (can't) spend it on domestically produced goods.
Injections do the opposite - they increase the flow of dollars around the circle. So when the financial system invests in the economy, buying goods produced domestically, the economy grows. The same happens when the government buys goods and services, or when people from other countries buy things made in the USA (exports).
In sum, we have that NP = C + I + G + NX
where NP =national product, C = consumption by households, I = investment, G = government purchases of goods and services, and NX = net exports = exports-imports. Leakages and injections come in either directly (the imports part of NX) or indirectly by cutting C. If taxes go up, households have less money to spend, so C falls. And if they save more (S increases) then they consume less, and C falls again. You may be interested in how large the economy is. Here is the national product (Gross Domestic Product - GDP) for the United States economy for 2002, measured in nominal and real terms, in billions of dollars:
| Nominal (billions of 2002 dollars) | Real (in billions of 1996 dollars) | |
|---|---|---|
| Household consumption | 7303.7 | 6600.1 |
| Gross Private Domestic Investment | 1593.2 | 1439.7 |
| Net Exports | - 423.6 | - 382.8 |
| Government purchases | 1972.9 | 1782.8 |
| Total (GDP) | 10446.2 | 9439.9 |
| CPI (1996=100) | 110.66 | - |
Note: numbers may not sum due to rounding.