CHAPTER 2
NATIONAL
INCOME ACCOUNTING
v
Basic concepts
v
Circular flow of income
v
Methods of calculating National
Income
v
Some Macro Economic Identities
v
GDP &Welfare
NATIONAL INCOME ACCOUNTING
National income is the total
money value of all final goods and services produced in an economy during an
accounting year. National income
estimates helps to understand the economic performance of a country.
Basic
Concepts
Closed
and Open Economies:
A closed economy is one which
has no economic relation with the rest of the world.
Open economy is one which has
economic relation with the rest of the world. All modern economies are open
economies.
In a closed economy GDP and GNP
would be the same.
Final
goods and intermediate goods
Final good is an item that is
meant for final use and do not pass through any more stages of production or
transformation.
Intermediate goods are those
goods which are used for producing other commodities. They are used as raw
materials or inputs.
Consumption
goods and capital goods
Final goods can be classified
into consumption goods and capital goods.
Consumption goods are directly
used for the consumption. They do not undergo any other production process
again. They are also called consumer goods.
Consumer goods can be durable
or non durables. Durable goods
are those that last long. Examples car, television, computer etc., Consumer non
durable goods extinguish with the consumption
Capital
goods
Capital goods are those goods
which once produced and do not undergo any transformation, but are used again
and again for the production of the other goods. Examples - factories,
buildings, roads, machineries etc.
On the basis of their use, a
good can be either a consumer good or capital good.
Classification of goods
Depreciation
Depreciation is the loss of
value of fixed capital assets due to normal wear tear and expected
obsolescence.
All firms keep a separate
portion of their revenue to meet depreciation, called depreciation Provision.
Depreciation is also termed as consumption
of fixed capital
Stocks
and Flows
Stock is a variable which can
be measured at a particular point of time.
Flow is a variable which can be
measured at a given period of time.
Difference between stock and
flow
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stock
|
flow
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Measured at a particular
point of time
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Measured at a given period of
time
|
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Static concept
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Dynamic concept
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Has no time limit
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Has time limit
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E.g.
Water in a reservoir, wealth,
Inventory,
money
supply,
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The
amount water flowing into the tank from the tap per minute,
Income,
Changes
in the inventory
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Double
Counting
It is the act of counting the
value of a commodity more than once in estimating national income. The value of intermediate goods shall not be
included in the calculation of NI, which may lead to double counting.
Gross
investment
It is the value of capital
goods in the total value of final goods produced in a country in an year.
Net
investment
It is the addition to the
existing capital stock in a country.
Net investment = Gross
investment – Depreciation
Inventory
It is the stock of
semi-finished goods, unsold finished goods and unused raw materials which a
firm carries from one year to the next year.
Inventory is a stock
variable. Inventory during an year is a
flow variable.
If the value of the inventory
at the end of the year is higher than the value at the beginning of the year,
it means inventory has increased.
Change in the inventory =
production of the firm during the year – sale during the year.
Inventories are treated as
investment because inventories are unsold stock.
Change inventory can be planned
or unplanned. Anticipating changes in the demand, firms make planned
accumulation or decumulation of inventory.
The unexpected fall in demand results in accumulation of unplanned inventories.
Circular
flow of income
It is the pictorial
representation of interrelationships and interdependence between different
sectors of the economy.
It shows exchange of factors of
production or goods and services or income between different sectors of the
economy.
Circular
flow of income in a two sector model
Circular flow of
income in a two sector model is based on the following assumptions,
1. There are only two sectors –
households and firms
2. Households supply factor
services to the firms.
3. Firms hire factor services from
household sector.
4. Households spend their entire
income on consumption – there is no saving
5. Firms sell their entire
products to the households.
6. There is no government sector.
7. Economy is a closed one – there
is no foreign trade
The two sector economy consist
of
1. Factor market – for factors of
production
2. Product market – for goods and
services
There are two types of flows
1. Real flow – flow of goods and
services and factors of production.
2. Money flow – monetary payment
for the factor services and goods and services
The following
figure explains the circular flow of income and expenditure in a two sector
model -
The lower part of the diagram
shows the factor market in which households sell their factor services and
receive incomes.
The upper part of the diagram represents product market in
which households buy goods and services produced by the firms.
From the diagram it can be seen
that,
Total
income = total production = total expenditure.
The value of the flow of the
product in an economy at point A, B and C in an year can be calculated. At point A we measure the value of the
product through Expenditure method, at point B we measure the value of flow by
Product method. At C we can calculate
total factor payments, it is income method.
Each of these methods will give the same value of GDP. Therefore there are three methods to
calculate national income.
1. Product method or value added
method
2. Expenditure method
3. Income method
Methods
of measuring National Income
National Income estimates are necessary
to assess the performance of the economy and for the formulation of appropriate
economic policies.
There are three main methods
for measuring the national income.
1. Product method
2. Expenditure method
3. Income method
1.
Product method
Under this method GDP (Gross
Domestic Product) is measured by adding the money value of all final goods and
services produced within the domestic territory of a country during a year.
According to the product
method, GDP is the sum of the Gross Value Added by the entire production units
in the economy.
Suppose there are N production
units in the economy. GDP is the sum total of the gross value added of all
firms in the economy.
GDP =
GVA1+GVA2+ …………. + GVAN
Where GVA means
Gross Value Added
Therefore
GDP is 
GVAi
GVAi
Here GDP is calculated on the
basis of market price.
Gross value of output of firm i
= quantity of output produced by the firm i× market price.
If the Depreciation cost of the
firm is Di
NVAi = GVAi – Di
GVAi = NVAi + Di
Therefore GDP = 
i +
i
i +
i
2.
Expenditure method
Under the expenditure method GDP
is calculated from the demand side of the products. Here GDP is calculated by adding the final
expenditures incurred in the economy.
Final expenditure includes.
1. Consumption expenditure.
2. Final investment expenditure
3. Final government expenditure
4. Export expenditure
All the final expenditures are
identical to revenues denoted by RV (Revenue Value)
RVi = Ci+
Ii+ Gi+ Xi
If there are N firms in the
economy then,
i =
i +
i +
i +
i
In an open economy we have to
consider both domestics and foreign expenditures. So expenditure on final goods and services in
an economy consists of
1. Private final consumption
expenditure (C)
2. Final investment expenditure (G)
3. Government expenditure on final
goods (G)
4. Net exports (X – M)
Therefore
the GDP = C+I+G+X-M
GDP is the sum total of all
final expenditure received y all the firms in the domestic economy that is the
total value of the four components of final expenditure gives us the value of GDP.
3.
Income method
Under this method, GDP is
calculated by adding up all the incomes received by all the factors of
production. This means that the national
income is the sum total of all factor incomes – rent, wage, interest and
profit.
Let there be N numbers of
households in the economy,
Wi be the wages and
salaries received by ith households
Pi be the gross
profit received by ith households
Ini be the interest
received by ith households
Ri be the rent received by ith households,
Then,
GDPMP = 
i + 
i + 
i +
i
i + i + i +
i
It means GDP = W +
P + In + R
Reconciliation
of the three methods
GDP can be calculated by using
three methods – Product method, expenditure method and income method. Each of
these methods will give same value of GDP.
Expenditure Method Income Method Product Method
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C
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=
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P
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=
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 |
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I
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In
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|||
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G
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R
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|||
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X-M
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W
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Budget
Deficit and Trade Deficit
Households spend their income for consumption or for saving
or to pay taxes.
GDP = C+S+T
According to the expenditure
method
GDP =
C+I+G+X-M
Therefore C+S+T = C+I+G+X-M
Solving this equation, we will get
M-X = (I-S)
+ (G-T)
M-X shows difference between imports and exports. The excess of imports over the exports is
referred to as trade deficit.
G-T shows the difference between government expenditure and
tax revenue. The excess of government
expenditure over its revenue is referred to as budget deficit.
When there is not government and foreign trade
X=0, M=0 and T=0, then
I - S = 0
I = S
This means that aggregate
saving is equal to aggregate expenditure.
Some
Macro Economic Identities
Gross
Domestic Product (GDP)
The total money value of all final goods and
services produced within the domestic territory of a country during an year.
It can be expressed on the
basis of market price or at factor cost.
GDPMP = GDPFC + Net Indirect Tax
GDPFC = GDPMP
- Net Indirect Tax
Net
Indirect Tax = Indirect Tax – Subsidies
GDPMP
= Depreciation + Domestic Factor Income + NIT
Gross
National Product (GNP)
It is the total money value of all final goods and services
produced in a country during an year.
GNP includes and GDP and Net
Factor Income from Abroad.
GNP = GDP + Net Factor Income from Abroad.
Net factor income is the difference between factor income
received by the residents of the country from abroad and the factor income paid
to the non-residents in the domestic territory.
GNPMP = GNPFC
+ NIT
GNPFC = GNPMP - NIT
Net
National Product (NNP)
It is the total money value of goods and services produced
by a country during an year less depreciation.
NNPMP = GNPMP - Depreciation
NNPFC = GNPFC - Depreciation
NNPMP = NNPFC + NIT
NNPFC = NNPMP – NIT
NNPFC = GDPMP – Depreciation + Net
Factor Income from abroad – NIT
Personal
Income (PI)
It is the income received actually by the households of a
country from national income.
PI = NNPFC – Undistributed
Profits – Net Interest Payments – Corporate Tax + Transfer payments to the
households.
Net interest payments =
interest paid by the households – interest received by the households.
Transfer payments include
pension, scholarship, pension etc. received by the households.
Personal
Disposable Income (PDI)
PDI is the part of personal income which is actually
available to the individuals and households for consumption.
PDI = PI – Personal tax and non tax payments.
Personal tax payments include
direct taxes. Non tax payments include fines, penalties etc.
Per
Capita Income
It is the income per head of the population.
Per Capita Income =
GDP
at current price
If GDP is measured on the basis of current market prices,
it is known as GDP at current price or nominal GDP. GDP at current price doesn’t show real
growth as it may increase due to the increase in prices.
GDP
at constant prices
If GDP is calculated on the basis of a base year price, it
is known as GDP at constant price or real GDP.
Base year is a selected past year.
Base year price is known as constant price.
GDP
Deflator
GDP Deflator is the ratio between Nominal GDP to Real GDP,
expressed as percentages.
GDP Deflator = 
It gives an idea of how prices have moved from the base
year to the current year.
Consumer
Price Index
It shows the changes in retail price of goods consumed by a
consumer between two years.
CPI = 
×
100
×
100
Wholesale
Price Index
It shows the change in wholesale price between two
different time periods.
It is referred to as producer’s price index.
GDP
Deflator and CPI
GDP deflator involves the value of all goods and
services. CPI includes only goods
consumed by a normal consumer. GDP
deflator doesn’t include the value of imported goods. CPI includes the value of
imported goods consumed by a normal consumer.
GDP and Welfare
GDP can be considered as a measure of welfare. Higher GDP growth rate indicates higher
welfare. But this argument is criticized
on the following grounds.
1.
Unequal distribution of income
As GDP increase welfare may not
increase. Suppose, the income of a few
increases on a large scale and the income of the most of the people decreases,
and then also GDP may increase. But
welfare of the people doesn’t increase due to the increase in GDP.
2.
Non – monetary transaction
Many non-monetary transactions
like services of housewives, barter transactions are not included in GDP. Here GDP is underestimated.
3.
GDP and externalities
Externalities are unintended
consequences of an action. Externalities can be beneficial or harmful. Construction of a road in village- comforts
in the journey is an example of positive externality.
Functioning of a factory
creates pollution and health problems. It
is an example of negative externality.
These externalities are not included in GDP.
4.
Production of harmful goods
In the calculation of GDP,
value of harmful products like cigarettes, alcohols etc. are too included.
Their production increases, GDP also increases, but it may not increase the welfare.
Note : Equations are not visible in their actual form as they are not compatible with this format
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