Thursday, November 01, 2007

A National Income Accounting Puzzle

Here is a surprising headline:

Inflation was low because oil prices surged

In GDP math, sometimes one plus one equals zero

Teachers of undergraduate macro could hand out the article and ask students: Is national income accounting as counterintuitive as this article makes it seem?

My suggested answer: No.

The article makes a lot out of the fact that imports are subtracted to get GDP. That is true, but there is nothing odd about it.

Recall the identity:

Y = C + I + G + X - M.

Imports M are subtracted to obtain domestic production Y because they are already included in consumption C, investment I, or government purchases G.

To me, it is not especially illuminating to say that inflation is low because imported oil prices are surging. A better description is more prosaic. The prices of domestically produced goods are rising more slowly than the prices of imported goods. So the GDP deflator, which reflects the prices of domestic goods, is rising more slowly than price indexes that include imports.

The national income accounting here is straightforward and unobjectionable. The more interesting question is which measure of the inflation rate policymakers, such as those at the Fed, should be focused on.