International Finance Theory and Policy
by Steven M. Suranovic

Finance 5-3

The Role of Imports in the National Income Identity

It is very important to emphasize why imports are subtracted in the national income identity because it can lead to serious misinterpretations. The two main misinterpretations are presented below.

First, one might infer (incorrectly) from the identity that imports are subtracted off because they represent a cost to the economy. This argument often arises because of the typical political emphasis on jobs or employment. Thus, higher imports imply that goods which might have been produced at home are now being produced abroad. This could represent an opportunity cost to the economy and justify subtracting imports in the identity. However, this argument is WRONG!

The second misinterpretation that sometimes arises is to use the identity to suggest a relationship between imports and GDP growth. Thus it is common for some economists to report that GDP grew at a slower than expected rate last quarter because imports rose faster than expected. The identity suggests this relationship because, obviously, if imports rise, GDP falls. This argument is also WRONG!!

The correct argument, for why imports are subtracted in the national income identity, is because imports appear in the identity as hidden elements in consumption, investment, government and exports. Thus, imports must be subtracted to assure that only domestically produced goods are being counted. Let me elaborate to make this clearer.

When consumption expenditures, investment expenditures, government expenditures and exports are measured, they are measured without accounting for where the goods purchased were actually made. Thus, consumption expenditures measures domestic expenditures on both domestic and foreign goods purchased. For example, if a US resident buys a television imported from Korea, that purchase would be included in domestic consumption expenditures. If a business purchases a microscope made in Germany, that purchase would be included in domestic investment. When the government buys foreign goods abroad to provide supplies for its foreign embassies, those purchases are included in government expenditures. Finally, if an intermediate product is imported, used to produce another good, and then exported, the value of the original imports will be included in the value of domestic exports.

This suggests that we could rewrite the national income identity in the following way.

GDP = (CD + CF) + (ID + IF) + (GD + GF) + (EXD + EXF) - IM

where CD represents consumption expenditures on domestically produced goods,

CF represents consumption expenditures on foreign produced goods,

ID represents investment expenditures on domestically produced goods,

IF represents investment expenditures on foreign produced goods,

GD represents government expenditures on domestically produced goods,

GF represents government expenditures on foreign produced goods,

EXD represents export expenditures on domestically produced goods,

and EXF represents export expenditures on previously imported intermediate goods.

Finally we note that all imported goods are used either in consumption, investment, government, or are ultimately exported, thus,

IM = CF + IF + GF + EXF

Plugging this expression into the identity above yields,

GDP = CD + ID + GD + EXD

which indicates that GDP does not depend on imports at all.

The reason imports are subtracted in the standard national income identity is because they have already been included as part of consumption, investment, government spending and exports. If imports were not subtracted GDP would be overstated.. Because of the way the variables are measured, the national income identity is written such that imports are added and then subtracted off again.

This exercise should also make clear why the previously described misinterpretations, were indeed wrong. Since imports do not affect the value of GDP in the first place, they cannot represent an opportunity cost, nor do they directly or necessarily influence the size of GDP growth.

International Finance Theory and Policy - Chapter 5-3: Last Updated on 3/11/05