MacroeconomicsConcepts of National Income

Accounting

Dipankar DeMumbai, October 2007

Narsee Monjee Institute of Management StudiesUniversity

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:

OUTPUT, INCOME & EXPENDITURE

Understanding of the concepts & methods of measurement of NI is an

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 in order to ensure sustained growth in the economy.

Basic Circular Flow Model

HOUSEHOLDS

BUSINESS

Factor Incomes (wages & earnings)

Consumer Spending on goods & services

Income & Spending Flows

HOUSEHOLDS

GOVERNMENT

BUSINESS

WORLD ECONOMYFINANCIAL MARKETS

Exports

Imports

Capital Investment

Savings

Govt. Spend

Govt. Spend

Taxation

Taxation

Consumption

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 made to those abroad

Difference between GDP & GNP arises because some of the output produced within a

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,

and therefore, includes both physical & human capital

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

Expenditure Approach

Product Approach or Value-added approach

Income Approach

All three methods gives the same result

Remember, the 3 key macroeconomic variables:

OUTPUT, INCOME & EXPENDITURE

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

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

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

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

IndustryValue

Added Distribution of value 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 accounted for

– GDP growth rate would substantially reduce

Leakages & Injections in the Economic System

Savings & Imports

Investments

Outlays & Components of Demand

Total demand for domestic output is made up of 4 components

1. Consumption spending by HHs (C)

2. Investment spending by businesses & HHs (I)

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

(G)

4. Foreign demand for our net exports (NX)

Fundamental National Income Identity

Y Ξ C + I + G + NX

National Income Identities

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, Y Ξ C + I

Income allocation Y Ξ C + S

Combining, C + I Ξ C + 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

Reformulated I Ξ Y – C Ξ S Investment is identically equal to saving

National Income & GDP are used interchangeably as income or output

National Income Identities

Introducing the Government sector

Therefore, Y Ξ C + 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 & GDP are used interchangeably as income or output

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

borrow to pay for the excess spending

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 IndiaBalance of Payments of India is conveniently classified into

1. BoPs on Current Account2. 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

– Unilateral transfers – remittances, foreign aid, etc

For a nation’s GDP, a positive trade balance shows 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’