4.

3 ANALYSES ALTERNATIVE APPROACHES

TO NATIONAL ACCOUNTING USING THE
CIRCULAR FLOW OF NATIONAL INCOME
The preparation of national accounts is relatively old concepts in economics. The national accounts
guide to prepare government policies for the macroeconomic management.

National Account preparation can be defined as estimation of value of main macroeconomic flows
which shows the behavior and economic performance and total economic structure in a certain
situation.

In 1936 J.M. Keynes pries has provides the theoretical background for the preparation of national
accounts and most countries prepared accordingly

Accordingly Sri Lanka started the preparation of national accounts officially in 1949. It has
conducted by the Census Department. But from 1951 it has conducted by the Central Bank.
Currently from 2007 national accounts are prepared by Census Department.

THE CIRCULAR FLOW

Any economy operates according to the activities and behavior of main economic units or agents.
The behavior of these groups can be explained using a macroeconomic model. There are four main
active economic units.

1. Households 3. Government
2. Business Firm 4. Foreign Sector

THE DECISIONS MADE BY THE ECONOMIC AGENTS

HOUSEHOLD SECTOR

Houesholds are small family unit that satisfy the needs with a common budget and lives
under a one roof.
Main functions of household are
o Supplying factors of production and earn factor earnings.
o Income earned is use for the consumption and savings
o Purchase goods and services for the consumption

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 PRODUCTION SECTOR

Decisions related to goods and service production

Decisions related to the selection of production techniques
Decisions relevant to purchase factors from households

GOVERNMENT SECTOR

Decisions related to provide public goods, merit goods and minimize externalities
Establish law and peace
Increase the infrastructure supply
Confirm the macroeconomic stability
Decisions related to Provide subsidies and imposing taxes

FOREIGN SECTOR

This includes the transactions with external sector.

Receipt income from exports

Decisions related to the import trade
Inflows and outflows of foreign capital(loans, investments)
Receipts and payments of factor income
Determination of foreign exchange rate

The interrelationships with economic units or the value of economic flows are included in the
national accounts in a country. The values of economic flows can be calculated based on the
interrelationships with main economic units in the economic system.

THE CIRCULAR FLOW OF INCOME AND EXPENDITURE

Following figure represents the interrelationships between four main economic agents. Two main
flows can be identified.

1. Factor exchange between factor providers and producers

2. Goods and service exchange between household sector and business sector

The exchange of production factors and exchange of gods and services depicts by outside flows and
these are known as Real Exchange or Real Flows

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The factor income received by the households and payments to purchase goods and services and
factor payments by the business sector and the income earned by business sector from selling
goods and services are known as Financial Exchange or flows.

This clearly indicates that according to the interrelated process financial flows and real flows
activate opposite directions.

According to the circular flow can identify the output, income and expenditure and income
determination in a country in a certain situation.

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 APPROACHES OF NATIONAL ACCOUNTING

MEASUREMENT OF NATIONAL INCOME

There are mainly 3 approaches to measure GNP.The relationship of the 3 approaches is
shown by the diagram below.

THE CIRCULAR FLOW OF ECONOMIC ACTIVITIES

Based on these 3 directions of flows, i.e. a flow of income, a flow of output, & a flow of
expenditures, economists develop 3 approaches to measure GNP.

1. Output or Value-Added Approach

The total value of all final goods & services ( i.e. outputs ) can be found by adding up the total
values of outputs produced at different stages of production.

This method is to avoid the so-called double-counting or an over-estimation of GNP.

2. Expenditure Approach

The amount of expenditures refers to all those spending on currently-produced final goods &
services only.
In an economy, there are 3 main agencies which buy goods & services. They are the
households, firms and the government.

In economics, we have the following terms:

C = Private Consumption Expenditure ( of all households )

I = Investment Expenditure ( of all firms)

G = Government Consumption Expenditure ( of the local government )

The expenditure approach is to measure the GNP. We could not buy all our outputs because
some are exported to overseas. Similarly, our consumption expenditures may include the
purchases of some imports. In order to find the GNP, the value of exports must be added to C,
I & G whereas the value of imports must be deducted from the above amount.

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 Finally, we have :

G N P AT MARKET PRICES = C + I + G + X - M
3. Income Approach

The income approach tries to measure the total flows of income earned by the factor-owners in the
provision of final goods & services in a current period. There are 4 types of factors of production
and 4 types of factor incomes accordingly.

National Income = Wages + Interest Income + Rental Income + Profit

ITEMS TO BE EXCLUDED FROM NATIONAL ACCOUNTING

Transfers- Government and Private Transfers

These payments only unilateral payment and there is no productive activities and not included
in national income accounting.
Transactions which with net monetary nature
Purchase and sale of treasury bills such as securities and business shares is not included. There
is no actual production. But when there is payment for brokers or intermediaries related to the
securities transaction is included
Transactions related to sale of used goods
They are included when they produced and if it is included again their may be over valuation.
Non observable Economy.
o Underground production, defined as those activities that are productive and legal but are
deliberately concealed from the public authorities to avoid payment of taxes or complying
with regulations;
o Illegal production, defined as those productive activities that generate goods and services
forbidden by law or that are unlawful when carried out by unauthorized producers;
o Informal sector production, defined as those productive activities conducted by
unincorporated enterprises in the household sector that are unregistered and/or are less
than a specified size in terms of employment, and that have some market production;

o production of households for own final use, defined as those productive activities that
result in goods or services consumed or capitalized by the households that produced them

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