Narsee Monjee Institute of Management Studies

University

Macroeconomics
Concepts of National Income
Accounting

Dipankar De
Mumbai, October 2007
 Topics to be covered…

 What do you mean by National Income accounts? Why is it

necessary for an economy?
 Uses of national income estimates
 Basics of circular flow of income & spending
 Basic concepts in national accounts: identities, relations, &
equations
 Different approaches of measuring GDP – the Product
approach, the Income approach, & the Expenditure approach
 Problems in measuring national accounts

 Trends in India’s national income

 National Income Accounts
 Macroeconomics is ultimately concerned with the
determination of economy’s total output, the price level,
employment, etc

 To fully understand the determination of these variables,

we need to understand what they are & how they are
measured

 National income accounts give us regular estimates of

GDP, & its various components in details

 National income accounts is useful because it provides us

with a conceptual framework for describing the relation
among 3 key macroeconomic variables:
Understanding OUTPUT,
of the concepts & methods
INCOME & of measurement of NI is an
EXPENDITURE
essential prerequisite for appreciating facets of macroeconomic analysis
 Uses of National Income Estimates

 The study of NI of a country is important in order

to understand:

– The rate at which the economy is growing that would in

turn would reflect the type of economic environment
prevailing

– Why is one nation doing better than another

(international comparison)

– Which sector of the economy contributes how much in

the overall GDP & their respective shares; provides a
long-term dynamics

– Where corrective measures & policies have to be initiated

 Basic Circular Flow Model

HOUSEHOLDS

Consumer Factor
Spending Incomes
on goods & (wages &
services earnings)

BUSINESS
 Income & Spending Flows

Imports
HOUSEHOLDS

Savings
Taxation Govt. Spend

FINANCIAL
WORLD ECONOMY GOVERNMENT MARKETS

Consumption

Taxation Govt. Spend

BUSINESS
Exports Capital
Investment
 Gross Domestic Product (GDP)

 GDP refers to the value of all final goods & services produced
within the nation’s geographical territory, irrespective of the
ownership of the resources, in a particular period of time, usually
a year.

 Insistence on final goods & services is simply to make sure that

there is no ‘Double Counting’. In practice, double counting is
avoided by working with ‘value added’

 At each stage of the manufacture of a good, only the value added

to the good at that stage of manufacture is counted as a part of
GDP

 Value added is defined as the difference between value of total

output & value of intermediate goods
GDP consists of the value of output currently produced – thus excludes transactions in
existing commodities, such as existing houses.

Construction of new houses included, but not trade in existing houses

 Gross National Product (GNP)
 GDP refers to the value of all final goods & services produced by
domestically owned factors of production, within a given period of
time

 GNP is a measure of the incomes of residents of a country,

including income they receive from abroad (wages, returns on
investment, interest payments), but subtracting similar payments
Difference
made to between
thoseGDP & GNP arises because some of the output produced within a
abroad
given country is made by factors of production owned abroad. The difference corresponds
to the ‘net income earned by foreigners’

 A part of Indian GDP corresponds to the profits earned by General

Motors from its Indian operations. Again these profits are part of
the US GNP, because they are the income of US-owned capital

 When GDP >?? GNP, this means that residents of a given country
are earning less abroad than foreigners are earning in that
country
 Depreciation
 Fixed capital used in any production process is subject to wear &
tear over a period of time & generally has prescribed life.

 It is, therefore, necessary to make allowance for used-up capital

every year. Such allowance is referred to as depreciation

 Depreciation indicates the extent to which capital goods have

been consumed in the production process.

 Capital consumption allowance (CCA) is a measure of depreciation

NDP = GDP - Depreciation

 A concept related to depreciation is investment – which means

additions to the physical stock of capital. Also the concept of Gross
vs. Net Investment
 Investment is more generally considered as any current activity
that increases the productive capacity of the economy in the future,
 GDP at Market Prices & Factor Cost

 The market price of goods includes indirect taxes (e.g. sales tax,
excise tax, etc) & subsidies, and thus the market price of goods
is not the same as the price the sellers of the goods receives

 Therefore, the market value of all final goods will exceed the
total income accruing to the factors of production by an amount
equal to the indirect taxes levied on the commodity less
subsidies paid on them

 The factor cost is the amount received by the factors of

production that manufactured the product

GDPMP = GDPFC + (Indirect Taxes – Subsidies)

Or, Net Indirect Taxes = GDPMP - GDPFC
 GDP at Market Prices & Factor Cost

 Total amount paid by the final consumers must be equal to

the total amount earned by the factors of production for
their contribution to the final output

Similarly,
GNPMP = GNPFC + (Indirect Taxes – Subsidies)
Or, Net Indirect Taxes = GNPMP - GNPFC

Thus,
NNPFC Ξ National Income
Why???
 Personal Income & Personal Disposable
Income
 Total income that all individuals actually receive is Personal Income. It
represents the flow of aggregate income to the household (HH) sector
from other sectors

 Thus, national income, which is the total income accruing to the factors
of production is not same as personal income. There are some
adjustments needed, as govt. & business sectors enter to make it more
complex
Adjustments…

 Part of total factor income that is deducted or retained are through corporate
taxes, retained or undistributed profit

 Payments that individuals receive, which are not payments made for any directly
productive activity called Transfer Payments, increases individual income. Transfer
Payments are pensions, gifts, relief payments, unemployment dole, etc

 Remember… Transfer Payments do not constitute current productive activity, &

hence not included in National Income

 Not all of GDP is available as income for HHs, because a part of output is kept
aside to maintain the economy’s productive capacity, to replace depreciating capital
 Personal Income & Personal Disposable
Income
Personal Income (PI)

 GDP + NIFA = GNP

 GNP – Depreciation = NNP at Factor Cost
 NNPFC Ξ National Income

 NI – corporate taxes – undistributed profits + transfer payments

= Personal income

Personal Disposable Income (PDI)

 Personal disposable income differs from Personal Income by the

amount of direct taxes (personal taxes) paid by individuals

 PDI = PI – Personal Taxes

Methods of Estimating National Income

Remember, the 3 key macroeconomic variables:

OUTPUT, INCOME & EXPENDITURE

 Expenditure Approach

 Product Approach or Value-added approach

 Income Approach

All three methods gives the same result

 An Example

 Consider the following economy in which the only

transactions are:
– Industry A sells raw cotton to Industry B for Rs. 500

– Industry B sells cotton cloth to Industry C for Rs. 800

– Industry C sells cotton shirts to final consumers for Rs.

1000

Total of all transactions is Rs. 2300… what is the national

product???
 Expenditure Approach

 We can estimate national product by simply ignoring all the

intermediate inputs and measuring the total value of ‘final
product’ or ‘final demand’ of the economy

 By not counting all the transactions at every stage, we are not

duplicating any particular transaction more than once. This is
to avoid the problem of ‘double counting’

 Double counting means counting the value of a commodity

more than once, and it leads to over-estimation of the value
of goods & services produced. This is because of intermediate
goods, which are used up in the process of the final products

 To avoid the problem of double counting, we can use Value

Added Method to NI accounting
 Product (Output) Approach

 In this method, we calculate the value added by each industry

to the raw materials or other goods & services that it bought
from the other industries before passing on the products to
the next link in the whole chain of production

VA = Value of output at MP – Value of intermediates goods

at MP
 In this method, the intermediate goods/ inputs are not
ignored, but since only the value added embodied in each
activity is included in the final total, there is no DC.

Common sense…

Equivalence of the two methods of estimation follows from that the sum
of what the economy gets out of all its activity in the end must be equal
to the sum what all the individual industries contributed to it
 Income Approach

 Income method measures NI from the side of payments to the

factors of production for their productive services in an
accounting year
 Value of final output of a commodity = Total factor earnings from
this output

 Out of the value added by each industry, payments have to be

made to the factors of production producing the national product
National Income = wages + Rent + Interest + Profit

 We exclude from this Transfer payments, Capital gains, and

also Depreciation to arrive at National Income. WHY???
Distribution in factor incomes the Value
added

Value
Industry Distribution of value added
Added
Wages Profits
A 500 300 200
B 300 200 100
C 200 100 100
Total 1000 600 400
 Revisiting Expenditure Approach

 Another way to measure national product is by aggregating

flows of expenditure on final goods & services

Expenditure incurred by 3 sectors

Final Expenditure on GDP = EHouseHold + EBusiness + EGovt

 Final expenditure consists of :

– Private Final Consumption Expenditure (PFCF)
– Govt. Final Consumption Expenditure (GFCF)
– Gross Capital Formation (GCF)
• Gross Fixed Capital Formation (GFCF)
• Change in stocks (inventories)
– Net exports of goods & services
 Problems in Measuring National Accounts
 Measuring the quality improvements that
occur every year
– E.g. anti pollution device leads to increase in car price. Increased cost
reflected in quality improvement & effectively added to real GDP
– computer especially not possible to exactly account for such
improvements

 Measuring service output

– Defining & measuring service output is increasingly becoming difficult
– ATM 24X7
– Not sold services, e.g. govt. produced services, efficiency of govt.
employees
– All these reduces costs & GDP may go down even though actual output is
unchanged

– Non traded goods in the markets

– E.g. volunteer work, Housewife’s service
– Leads to underestimation of true value of production

– Environmental degradation & pollution is not

Leakages & Injections in the Economic
System

 Savings & Imports

 Investments
 Outlays & Components of Demand

 Total demand for domestic output is made up of 4 components

2. Consumption spending by HHs (C)

3. Investment spending by businesses & HHs (I)

4. Government (Central & State) purchases of goods & services

(G)

5. Foreign demand for our net exports (NX)

Fundamental National Income Identity

Y Ξ C + I + G + NX
 National Income Identities
National Income & GDP are used interchangeably as income or output

 We consider a simple economy – No Govt., No external sector

 Output produced equals output sold
– All output is either consumed or invested (unsold output
treated as accumulation of inventories as part of
investment)
 Therefore, YΞC+I
 Income allocation YΞC+S
 Combining, C+IΞC+S
 All output produced equal to output sold. The value of output
produced is equal to income received, that in turn spent on
goods or saved
 National Income Identities
National Income & GDP are used interchangeably as income or output

 Introducing the Government sector

 Therefore, YΞC+I+G
 Output & Disposable Income YD Ξ Y + TR - TA
 Again disposable is allocated as YD Ξ C + S

 Reformulated YD - TR + TA Ξ Y Ξ C + I + G
 Comparing C + S - TR + TA Ξ C + I + G
 Thus S – I Ξ (G + TR – TA)
 (G + TR – TA) is the govt. budget deficit
 National Income Identities

 S – I Ξ (G + TR – TA)
 The surplus in the private sector is offset by the deficit in the
govt. sector
 Introducing the external sector, we have, Y Ξ C + I +
G + NX
 Where NX Ξ X - M
 Therefore, S – I Ξ (G + TR – TA) + NX
 The surplus in the private sector is offset by the deficit in the
govt. sector plus trade surplus
 If private sector saving equals investment, then the govt.
budget deficit (surplus) is reflected in an equal external deficit
(surplus)
 Any sector that spends more than it receives in income has to
 Balance of Payments: concepts
 Balance of payments is an integral part of the National
Income accounts
 The Balance of Payments of a country is a systematic
record of all economic transactions between the
‘residents’ of a country & the rest of the world.
 It represents a classified record of all receipts on account
of goods exported, services rendered & capital received
by ‘residents’ and payments made by them on account of
goods imported & services received from the capital
transferred to ‘non-residents’ or foreigners.
~ Reserve Bank of India
Balance of Payments of India is conveniently classified into

2. BoPs on Current Account

3. BoPs on Capital Account
 Balance of Payments: concepts
Current Account
 The current account of BoP refers to the monetary value
of international flows associated with transactions in
goods & services, investment income, and unilateral
transfers.

 Components are:
– Exports/ Imports of goods (merchandise)
– Exports/ Imports of services (including travel, software
exports)
– Earnings/ Income receipts on investment abroad
For– a nation’s transfers
Unilateral GDP, a positive trade foreign
– remittances, balanceaid,
shows
etc excess of
exports over imports, and this difference should be added to the
GDP
 Balance of Payments: concepts
Capital Account
 The capital account of BoP refers to the monetary value of
all international purchases or sales of assets
 The capital account includes both private & official
(Central Bank) transactions
 Components are:
– Foreign investment (FDI + Portfolio Investment)
– Loans
• External assistance + Commercial borrowing
• Short term loans
– Banking capital (Commercial banks, NRI deposits)

Capital inflows are treated as ‘credit’, while Capital outflows are

treated as ‘debit’