CHAPTER 2

NATIONAL INCOME ACCOUNTING

I  Some Basic Concepts of Macro Economics

• Consumer: Consumer may be an individual or an enterprise and the goods and services purchased by that entity might be for final use or for use in final production.
• Final good :A good that is meant for final use and will not pass through any more stages of production or transformation
• Consumption goods: Goods that are consumed when purchased by their ultimate consumers are called consumption goods. Eg. food , clothing etc.

        In other words, goods which are not subjected to a further process of production and  used by the consumer directly are called consumption goods or consumer goods.

Consumer goods may be durable or non durable

• Consumer durables are those goods which are for ultimate consumption, which have a long life and also undergo wear and tear with gradual use. Eg. Tv, Automobiles, Home computers etc. These goods have to be preserved, maintained and renewed. In other words durable goods are those that last long and can be used again and again.
• Consumer non durable goods are goods that last only for a short time. Eg. Fruits, Vegitables, Milk  etc.
•  Capital goods: The durable goods which do not get transformed in the production process and which undergo wear and tear are called capital goods. In other words goods once produced and which can be used again for production are called Capital goods.
• Depreciation: The existing capital stock suffers wear and tear and needs maintenance or replacement. The wear and tear of capital is called depreciation. In other words the loss of value of fixed assets due to normal wear and tear is called depreciation or consumption of fixed capital.
• Deprecation is an annual allowance for wear and tear of capital good. It is the cost of the good divided by number of years of its useful life. Depreciation is an accounting concept.
• Production units every year set aside a special fund for maintaining capital goods in productive condition called as depreciation allowance.
• Expenses connected with repair and replacement of capital goods are called depreciation costs.
•  Intermediate good: Intermediate goods are those goods which are mostly used as raw materials or input for production of other commodities.

         Eg. Steel sheets for making automobile

•   National Income is the income of a nation. It is the sum total of the money value of all final goods and services produced in a country during a year.

       It reflects the economic status of a nation. It is an index of economic growth and    also helps in policy formulation and planning.

·            Stock and Flow

Stocks are defined at a particular point of time while flows are defined over a period of time. Stock is a static concept while flow is a dynamic concept.

Eg. Stock: supply of money, bank deposit, foreign currency reserves , wealth, investment, water in tank etc

Eg Flow: National income, imports and exports, capital formation, water in a river etc

•  Gross Investment: That part of the final output that comprises of capital output constitutes gross investment of an economy. Eg. Machines, Tools , Buildings, Infrastructure like road, bridges etc.
•  Indirect taxes are taxes imposed by the government on goods and services. Eg. Import duty, Sales tax, Value added tax, Excise duty etc.
•  Subsidies are financial help given to the producers by the government.
•  Transfer payments are unilateral payments for which no services are rendered.
•   Double counting: When the value of output of a good or service is added more than once in the calculation of National income, it is called double counting.

II Circular flow of Income and Methods of calculating National Income.

• Circular flow of income and expenditure is the pictorial illustration of the interrelationship and interdependence among the different sectors of the economy.
•  Simple economy: Simple economy means an economy without government, external trade and no savings
•  Macro Economic Models : Models which are framed for simplifying the complex economic issues based on certain assumption are called Macro Economic Models.

Four kinds of contributions made during the production of goods and services

1. Contribution made by human labour, remuneration for it is wage.

2. Contribution made by Capital, remuneration for it is Interest.

3. Contribution made by entrepreneur, remuneration for it is Profit.

4. Contribution made by fixed natural resources, called as land, remuneration for it is rent.

·        In the simplified economy, the households spend their entire income on goods and services produced by the domestic firms. Households neither save nor pay tax to the government.

·        The aggregate consumption by the household of the economy is equal to the aggregate expenditure on goods and services produced by the firms in the economy.

The aggregate income of the economy goes through two sectors, firms and households, in a circular way. This is shown in the following diagram below.

                                      

•  The upper most arrow going from households to firms represents spending the household undertake to buy goods and services produced by the firms.
•  The second arrow just below uppermost one, going from firms to households shows the goods and services from firms to households.
•  Thus the two arrows on the top represent the goods and services market (payment for goods and services and the flow of goods and services).
•  The lower most arrow going from households to firms symbolize the services that the households are rendering to the firms. Using these services firms manufacture goods.
• The arrow just above the lower most one, going from firms to households represents payments made by the firms to households for their services.
•  Thus the two arrows at the bottom of the diagram represent factors of production market.
• The flow of factors of production, flow of factor payment or factor income, flow of expenditure or spending and flow of goods and services between households and firms is called the circular flow of Income.
• There are two types of flows namely money flow and real flow. The flow of money from firms to households and from households to firms is called Money flow.
•  The flow in the form of goods and services from one sector to another is called real flow.

Determination of National Income using Expenditure method , product method and Income method from the diagram.

• We can estimate the value of goods and services produced during a year by measuring the annual value of the flows at the point A,  that is, measuring the value of spending that firms receives for the final goods they produce. This method is called Expenditure method.
•  If we measure the flow at B by measuring the aggregate value of final goods and services produced by the firms, it is called product method.
•  At C, measuring the sum total of all factor payments, it is called Income method.

III. Estimation of National Income using three methods

1.Product method or Value Added Method

• In the product method, we calculate the aggregate annual value of goods and services produced in a year. Here calculation is made from the output side. The final goods and services produced by the production units is called output.
• The term that is used to denote the net contribution made by a firm is called its value added.
• Raw materials that a firm buys from another firm which are completely used up in the process of production are called Intermediate goods.

      Value added of a firm = value of production of the firm - value of intermediate goods used by the firm

Eg.Suppose there are only two kinds of producers in the economy namely wheat producer (farmer) and bread makers (baker)

• The total value of wheat produced in a year is Rs.100
• The farmer sells Rs.50 worth of wheat to baker
• Baker sells bread worth Rs.200
• Total value of production is 200+100=Rs.300
• Net contribution of baker is 200-50=Rs 150
• Value added is a flow variable

     If we include depreciation in value added, then the measure of value that we obtain is called Gross Value Added.

    If we deduct the value of depreciation from Gross Value Added, we obtain Net Value Added

Eg. A firm produced Rs 100 worth of goods per year.

• Rs 20 is the value of intermediate goods.
• Rs.10 is the value of capital consumption (depreciation).
• Gross Value Added=100-20=Rs 80 per year.
• Net Value Added =100-20-10=Rs 70 per year

Inventory

• The stock of unsold finished goods or semi finished goods or raw materials which a firm carries from one year to the next is called inventory.
• Inventory is a stock variable
• If the value of inventory at the end of year is more than the value of inventory at the beginning of the year, it is called accumulation of inventory .
• If the value of inventory at the end of the year is less than the value of inventory at the beginning of the year it is called decumulation of inventory.
• The change in the inventories of a firm during a year=production of the firm during a year minus sale of the firm during the year.
• Production of the firm=value added +intermediate goods
• Change of inventories of a firm during a year = value added + intermediate goods - sale of the firm during a year.

Eg. Firm had an unsold stock worth Rs 100 at the beginning of a year.

• During the year firm produced Rs 1000 worth goods.
• It managed to sell Rs 800 worth of goods.
• Rs.200 is the difference between production and sales.
• Rs.200 worth of goods is the change in inventory.
• This Rs.200 will added to Rs 100 , the inventories with which the firm started.
• The inventories at the end of the year is Rs.300.

Change in inventories

• Change in inventories take place over a period of time. Therefore it is a flow Variable.
• Inventories are treated as capital.

Investment

• Addition to stock of Capital of a firm is known as Investment.
• Change in the inventory of a firm is treated as Investment.
• That part of final output that comprises capital goods is called  gross Investment of an economy. eg.Road, Bridges, Machines etc.
• Net investment is the addition to the existing stock of capital. It is obtained by deducting depreciation from gross investment.

Three major categories of Investment

• 1   Investment expenditure undertaken by firm
• 2   Fixed business investment ie, addition to the machinery, factory, buildings,  capital employed by firms
• 3     Residential investment , which refers to the addition of housing facilities

Changes in inventories may be planned or unplanned

• The deliberate increase in the stock of goods of a firm is called planned accumulation of Inventories and a deliberate decrease in the stock of goods of a firm is called planned decumulation of inventories.
• When there is an unexpected increase in the stock of goods, due to an unexpected fall in sales, the firms will have unsold stock of goods which it had not anticipated. Hence there will be an unplanned accumulation of inventories.
• The unexpected increase in the stock of goods due to the fall in sales is called Unplanned accumulation of inventories.
• If there is an unexpected rise in sales, there will be unplanned decumulation of inventories.
• The unexpected decrease in the stock of goods due to the rise in sales is called unplanned decumulation of inventories.

Eg: suppose firm producing shirts have an inventory of 100 shirts

• In the year it expects to sell 1000 shirts and expects an inventory of 100 shirts at the end of the year
• Unexpectedly firm could sell only 600 shirts
• In the year end firm has 500 shirts (400+100)
• The unexpected rise of inventories by 400 will be an example of unplanned accumulation of inventories
• On the other hand if the sales is more than 1000 shirts. Then we have unplanned decumulation of inventories
• (If the sales had been 1050, the firm will have to sell 50 shirts out of inventory).
• Gross value Added of a firm i (GVAi) ≡ Gross value of output produced by the firm i(Qi) – value of intermediate goods bused by the firm i (Zi)
• GVAi ≡ value of sales by the firm + value of change in inventories(Ai) – value of intermediate goods used by the firm (zi)
• Change in inventories of a firm during a year=production of the firm during the year –sales of the firm during the year.
• Net value added of firm i= GVAi- Depreciation of the firm i (Di)

Gross Domestic Product

• If we sum the gross value added of all firms of the economy in a year, we get a measure of the value of aggregate amount of goods and services produced by the economy in a year. Such an estimate is Gross Domestic Product (GDP)
• GDP= sum total of gross value added of all firms in the economy

≡ GVA₁+GVA₂+….+GVA_N  

Expenditure Method

• Expenditure method looks at the demand side of the products.
• In this method we add the final expenditures that each firm makes.
• The method of calculating National Income on the basis of the final expenditure on domestic product is called the expenditure method or outlay method.

Firm i can make the final expenditures on the following accounts

• a)     The final consumption expenditure on the goods and services produced by the firm (Ci)
• b)    The Final investment expenditure (Ii)
• c)     The expenditure that the government makes on the final goods and services produced by the firm i (Gi). It includes consumption and investment expenditure
• d)    The export revenues that firm i earns by selling goods and services abroad (Xi)

Sum total of the revenue that the firm i earns  RVi ≡ Ci + Ii + Gi + Xi

If there are N firms we get

 Let C be the aggregate final consumption expenditure of the entire economy. Notice that a part of C is spent on imports of consumption goods. C_m denotes expenditure on the imports of consumption goods.

There for C-C_m denotes that part of aggregate final consumption expenditure spend on the domestic firms 

I-I_m denotes that part of aggregate final investment expenditure spent on domestic firms

G-G_m stands for that part of aggregate government expenditure that is spend on domestic firms

 

≡ C+I+G+X-M

Here

  denotes aggregate expenditure by the foreigners on the exports of the economy.

M ≡ C_m+I_m+G_m is the aggregate import expenditure incurred by the economy.

Gross domestic product is the sum total of all the final expenditure received by the firms in the economy

This is GDP according to expenditure method. Investment expenditure is the most unstable.

Income Method

• The sum total of final expenditures in the economy must be equal to the incomes received by all the factors of production taken together.
• The revenues earned by all the firms put together must be distributed among the factors of production as Salaries, Wages, Profit, Interest earning and Rents.

Let there are M number of households in the economy.

Wi be the wages and salaries received by i th household in the economy in a year

Pi, Ini, Ri be the gross profits, interests and rents received by the ith household in a year

Here   

  ,    ,           ,      

GDP ≡ W + P + In + R

Find out GDP using three methods

• There are two firms A and B
• A uses no raw material, produces cotton worth Rs.50
• A sells cotton to firm B to produce cloth
• B sells the cloth to consumers for Rs.200

• GDP using Value Added Method
• VA_A 50-0=50
• VA_B=200-50=150
• Thus GDP=VA_A+VA_B=50+150=200
• GDP using Expenditure method
• It is the sum of final expenditure on goods and services for end use
• Expenditure by consumer on cloth=200
• GDP using Income method
• Firm A receives Rs 50
• Gives Rs.20 as wages to workers
• Remaining profit Rs.30
• Firm B gives Rs.60 as wages to workers
• Remaining profit Rs.90
• GDP  by income method is sum total of factor income
• (20+60)+(30+90)
• 80+120=200 

Factor Cost, Basic Prices and Market Prices

• The Central Statistical Office (CSO) report GDP at factor cost and market prices. In January 2015 CSO replaced GDP at factor cost with GVA at basic prices and GDP at market prices as GDP.
• GVA is the value of total output produced in the economy less the value of intermediate consumption.
• The distinction between factor cost, basic prices and market prices is based on the distinction between Net production taxes (production taxes-production subsidies) and Net product taxes (product tax-product subsidies).
• Production taxes and subsidies are paid or received in relation to production and are independent of the volume of production. Eg. land revenues, stamp, registration fee etc.
• Product taxes and subsidies are paid or received per unit of product. Eg. excise tax, service tax, import and export duties etc.
• Factor cost includes only the payment to factors of production (No tax is included)
• GVA at Basic prices =GVA at factor cost - Net production taxes.
• GVA at market prices=GVA at Basic prices + Net product prices.

                                  Some Macro Economic Identities

• Gross Domestic Product (GDP) measures the aggregate production of final goods and services taking place within the domestic economy during a year.
• It is the money value of all final goods and services produced in the domestic territory of a country in a year. 
• Gross Domestic product at Market prices (GDP_MP) : All production  done by the national residents or the non- residents in a country gets included, regardless whether that production is owned by a local  company or a foreign company. Everything is valued at market prices.
•  GDP _MP = C+I+G+X-M
• Gross Domestic Product at Factor Cost (GDP_FC): GDP at factor cost measures money value of output produced by the firms within the domestic boundaries of a country in a year. Factor cost refers to the prices of products as received by the producers. Factor cost is equal to market prices, minus Net Indirect Taxes 
•      GDP_FC= GDP_MP  - NIT 

• Gross National Product (GNP).It includes aggregate income made by all citizens of the country.
• GNP=GDP+ Net factor income from abroad.
• It is the sum of GDP and Net factor income from abroad. 

• Gross National Product at Market Prices (GNP _MP): It is the value of all the final goods and services that are produced by the normal residents of a country and is measured at the market prices, in a year.

• GNP_MP = GDP_MP + NFIA (Net Factor Income from Abroad)

• Gross National Product at Factor Cost (GNP_FC): GNP at factor cost measures value of output received by the factors of production belonging to a country in a year.        

•  GNP _FC = GNP _MP  -  Net Product taxes - Net production taxes.

• Net National Product (NNP):It is the aggregate income that we obtain after we deduct depreciation from GNP
• NNP=GNP-Depreciation
• It is the total money value of all final goods and services produced in a country in a year less depreciation.

• Net National Product at Market prices (NNP_MP): This is a measure of how much a country can consume in a given period of time.

  NNP_MP  =  GNP_MP - Depreciation

  NNP_MP = NDP_MP  + NFIA  (Net Factor Income from Abroad)

• Net National Product at Factor Cost (NNP_FC) or National Income (NI): It is the sum of income earned by all factors in the production in the form of wages, profits, rent and interest etc belonging to a country in a year.

  NI=NNP_MP  -  Net Product Taxes - Net Production Taxes

  = NDP _FC + NFIA= NNP _FC

• Net Domestic Product (NDP) : Aggregate value of goods and services produced within the domestic territory of a country which does not include the depreciation of capital stock.
• NDP=GDP- Depreciation.

• Net Domestic Product at Market Prices (NDP_MP): This measure allows policy makers to estimate how much the country has to spend just to maintain their current GDP.   

•    NDP _MP = GDP _MP  - Depreciation 

• Net Domestic Product at Factor Cost (NDP _FC): NDP at factor cost is the income earned by the factors in the form of wages, profit, interest, rent etc within the domestic territory of a country

  NDP_FC = NDP_MP  - Net Product taxes  - Net production taxes

• National Disposable Income: It is the income from all sources available to the residents of a country for consumption expenditure and saving for one year.
• Personal Income: That part of the national income which is received by households.
• Undistributed Profit: A part of the profit not distributed among factors of production.
• Personal Disposable Income: It is that part of the aggregate income which belongs to the households. It is the income which individuals and households can spend as they wish.
• Personal Disposable income (PDI)= PI –Personal tax payments-Non tax payments.
• Per capita Income: It is the annual average per head income of the people of a country.It is calculated by dividing National income by population.
• Private Income: Factor income from net domestic product accruing to the private sector plus national debt interest plus net factor income from abroad plus current transfers from government plus other net transfers from the rest of the world.
• Nominal and Real GDP
•  In order to compare GDP figures of different countries or the same country at different points of time, we take the help of Real GDP
•  Real GDP is calculated in such a way that the goods and services are evaluated at some constant set of prices (constant Prices).
• Gross Domestic product in which the money value of goods and services calculated on the basis of constant prices is called real GDP and is denoted by gdp.
•  Nominal GDP is the value of GDP at the current prevailing price.
• The Gross Domestic Product in which the money value of goods and services calculated on the basis of current price is called Nominal GDP and is denoted by GDP.
• Eg. Suppose a country only produces bread.
• In the year 2000 it produced 100 units of bread and the price was Rs.10 per bread
• In 2001 the same country produced 110 units of bread. Price was Rs.15 per bread
• Nominal GDP is 110 x 15=1650
• Real GDP in 2001 calculated at the price of the year 2000 will be 110 x 10=1100
• We can see how prices have moved away from Base Year.
• Base Year means the year whose prices are being used to calculate the real GDP.
• GDP deflator: It gives an idea of how the prices have moved from the base year to current year. It is a index for measuring price level.
• The ratio of nominal GDP  to real GDP is called Index of price or GDP deflator
• GDP deflator= GDP/gdp
• GDP deflator is denoted also in percentage
• GDP deflator = 1650/1100=1.50 or 150 percentage
• This implies that prices of bread produced in 2001 was 1.5 times the price in 2000.(Price gone up from Rs 10 t o Rs 15)
• Like GDP deflator, we can have GNP deflator also
• Another way to measure change of prince in an economy known as Consumer Price Index (CPI)
• CPI is the index of prices of a given basket of commodities which are bought by the representative consumer.
• Here only goods usually bought by consumers are included. Imported goods are also included and weights are constant.
• CPI is expressed in percentage terms.
• CPI =cost of basket of commodities in the current year/cost of same commodities in the base year  multiplied by 100.

Eg. An economy produced 2 goods, rice and cloth

• Consumer buys 90 kg  rice and 5 pieces of cloth in the year 2000.
• Price of a kg of rice was Rs. 10 and a piece of cloth was Rs.100.
• Then consumer spends a total sum of Rs 1400.
• (10 x 90) + (5 x 100) =1400
• Now suppose price of a kg of rice gone to Rs.15 and cloth to Rs.120 in the year 2005.
• Consumer spends Rs.1950
• (15 x 90) + (120 x 5) =1950
• CPI =1950/1400= 1.39285 (Approximately 139.29%) 

• Commodities have two sets of prices namely wholesale price and the price that consumers actually pay.
• The index of whole sale prices is called Wholesale price index (WPI). Wholesale price index is calculated on the basis of the price existing in the wholesale market where goods or semi finished goods or raw materials are traded in bulk.
• In WPI all goods and services in the economy are included. Imported goods are not included and weights may differ.
• In America WPI is referred as Producers Price Index (PPI).

How does CPI differ from GDP Deflator

1.The goods purchased by consumers do not represent all the goods which are produced in a country.

GDP deflator takes into account all such goods and services.

2. CPI includes prices of goods consumed by the representative consumer, hence it includes imported goods.

GDP deflator does not include prices of imported goods.

3. The weights are constant in CPI but they differ according to production level of each good in GDP deflator.

GDP and Welfare

Why GDP of a country cannot be taken as an Index of the welfare of the people of that country?

1. Distribution of GDP is not uniform

The rise in GDP may be concentrated in the hands of a few individuals or firms. For the rest, the income may in fact fall. In such a case the welfare of the entire country cannot be said to have increased.

2. Non monetary Exchanges

Many activities in the economy are not evaluated in monetary terms. (eg. Domestic services women perform at home are not paid for). The exchanges which take place in the informal sector without the help of money are called Barter exchanges. These exchanges are not registered as part of economic activity. Therefore GDP calculated in standard manner may not give us clear indication of productive activity and well being of a country.

3. Externalities

Externalities refer to the benefits (or harms) a firm or an individual cause to another for which they are not paid(or penalized). Externalities do not have any market in which they can be bought and sold.

Eg. An oil refinery refining crude petroleum and sells it in the market. It may cause pollution to the nearby river and this harm the people who use it. Pollution may kill fish and other organisms. Fishermen may lose their livelihood.

In the case of positive externalities,  GDP will underestimate the actual welfare of the country. 

Reference :Introductory Macro Economics  textbook for class XII, SCERT, Kerala.