National Income Accounting

Some Basic Concepts Of Macroeconomics

Macroeconomics is the branch of economics that studies the behavior and performance of an economy as a whole. To understand national income, we first need to be familiar with some fundamental concepts.

Classification of Goods

Final Goods vs. Intermediate Goods

Final Goods: These are goods that are meant for final use and will not pass through any more stages of production or transformation. They are purchased either for final consumption by consumers (e.g., a biscuit packet purchased by a household) or for investment by firms (e.g., a machine purchased by a factory). The value of final goods is included in the calculation of national income.

Intermediate Goods: These are goods that are used up as raw materials or inputs for producing other goods during the same year. For example, the wheat used by a baker to make bread is an intermediate good. They are not included in the calculation of national income to avoid the problem of double counting (counting the value of a good more than once).

Consumption Goods vs. Capital Goods

Consumption Goods (or Consumer Goods): These are final goods that are purchased by households to satisfy their wants directly. Examples include food, clothing, and services like transportation. They are further classified into durable (e.g., cars, refrigerators), semi-durable (e.g., clothes, shoes), non-durable (e.g., milk, bread), and services.

Capital Goods: These are final goods of a durable nature which are used in the process of production for several years. They are fixed assets of the producers. Examples include machinery, tools, and factory buildings. While they are final goods, they are not directly consumed but help in producing other goods.

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Stocks and Flows

Economic variables are often classified as either stocks or flows.

A stock is a variable measured at a particular point in time. It has no time dimension. For example, the amount of money in your bank account on 31st March 2023, or the total number of factories in India as of a specific date.

A flow is a variable measured over a period of time. It has a time dimension (per hour, per day, per year). For example, your monthly income, the annual profit of a company, or the national income of a country for the financial year 2022-23.

Basis	Stock	Flow
Meaning	Quantity of a variable measured at a particular point in time.	Quantity of a variable measured over a period of time.
Time Dimension	It has no time dimension.	It has a time dimension (per unit of time).
Nature	It is a static concept.	It is a dynamic concept.
Examples	Wealth, Capital, Population, Foreign exchange reserves.	Income, Investment, National Income, Exports.

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Investment and Depreciation

Investment (or Capital Formation) is the addition to the stock of capital in an economy. It is a flow variable.

Gross Investment: The total addition to the capital stock in an economy during a year, before making any allowance for depreciation. It includes expenditure on new assets plus the expenditure on replacing worn-out assets.

Depreciation (or Consumption of Fixed Capital): This refers to the fall in the value of fixed capital goods due to normal wear and tear and foreseen obsolescence. It is the cost of using up capital in the production process.

Net Investment: The actual addition made to the capital stock of an economy in a given period. It is calculated by subtracting depreciation from gross investment.

Net Investment = Gross Investment - Depreciation

Circular Flow Of Income And Methods Of Calculating National Income

The Circular Flow of Income is a model representing the flow of money, goods, and services in an economy. In a simple two-sector economy (with only Firms and Households), households provide factor services (land, labour, capital, enterprise) to firms. In return, firms make factor payments (rent, wages, interest, profit) to households. This is the households' income. Households then spend this income on goods and services produced by the firms. This spending is the firms' revenue, which is then used to make factor payments again, and the cycle continues.

National Income can be calculated by three different methods, which correspond to the three phases of the circular flow: production, distribution (income), and disposition (expenditure). All three methods, if applied correctly, should yield the same result.

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The Product Or Value Added Method

This method measures national income by estimating the contribution of each producing enterprise to the production in the domestic territory of the country. It calculates the Gross Domestic Product (GDP) by summing up the Gross Value Added (GVA) of all firms in the economy.

Value of Output: The market value of all goods and services produced by a firm during a year. It includes sales and the change in stock.

Value Added: The contribution of a firm to the total output. It is the difference between the value of output and the value of intermediate consumption (the cost of non-factor inputs).

$GVA = \text{Value of Output} - \text{Intermediate Consumption}$

Summing up the GVA of all resident producing units gives the Gross Domestic Product at Market Prices ($GDP_{MP}$).

$GDP_{MP} = \sum GVA_{MP}$ (of all producing units)

This method avoids the problem of double counting.

Answer:

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Expenditure Method

This method measures GDP by summing up all the final expenditure incurred in the economy during a year. The sum of all final expenditures is equal to the Gross Domestic Product at Market Prices ($GDP_{MP}$).

The components of final expenditure are:

1. Private Final Consumption Expenditure (C): Expenditure by households and private non-profit institutions on final goods and services.
2. Government Final Consumption Expenditure (G): Expenditure by the government on various administrative services, defence, education, etc.
3. Gross Domestic Capital Formation (I): This is the investment expenditure. It has two components:
   • Gross Fixed Capital Formation: Expenditure on fixed assets like machinery, buildings.
   • Change in Stocks (Inventory Investment): The difference between closing stock and opening stock of a year.
4. Net Exports (X-M): The difference between the value of exports (X) and the value of imports (M) of a country. Exports are expenditure by foreigners on our domestic goods, so they are added. Imports are our expenditure on foreign goods, so they are subtracted.

The formula is:

$GDP_{MP} = C + I + G + (X - M)$

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Income Method

This method measures national income by summing up all the factor incomes earned by the normal residents of a country in the form of wages, rent, interest, and profit during a year. The sum of these incomes gives the Net Domestic Product at Factor Cost ($NDP_{FC}$), also known as Domestic Income.

The components of factor income are:

1. Compensation of Employees (COE): Wages and salaries in cash and kind, and employers' contribution to social security schemes.
2. Operating Surplus (OS): Income from property and entrepreneurship. It is the sum of rent, interest, and profit.
3. Mixed Income of Self-Employed (MI): Income of self-employed persons (like doctors, shopkeepers) which is a mix of wage, rent, interest, and profit and cannot be separated.

The formula is:

$NDP_{FC} = COE + OS + MI$

To arrive at GDP at Market Prices from $NDP_{FC}$, we need to make adjustments for depreciation and net indirect taxes.

$GDP_{MP} = NDP_{FC} + \text{Depreciation} + \text{Net Indirect Taxes}$

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Factor Cost, Basic Prices And Market Prices

These are different valuation concepts for national income aggregates, distinguished by their treatment of taxes and subsidies related to production.

• Factor Cost (FC): This represents the total cost of factors of production (wages, rent, interest, profit) incurred by a firm. It does not include any taxes and excludes any subsidies received by the firm.
• Basic Prices (BP): This is the amount receivable by the producer from the purchaser for a unit of a good or service produced as output, minus any tax payable, and plus any subsidy receivable on that unit as a consequence of its production or sale. It includes production taxes but excludes product taxes.

  $GVA_{BP} = GVA_{FC} + (\text{Production Taxes} - \text{Production Subsidies})$

• Market Prices (MP): This is the price at which a product is actually sold in the market. It includes both production and product taxes and excludes both production and product subsidies.

  $GVA_{MP} = GVA_{BP} + (\text{Product Taxes} - \text{Product Subsidies})$

Production Taxes/Subsidies: These are paid or received in relation to production and are independent of the volume of production (e.g., land revenues, stamp duty, registration fees).

Product Taxes/Subsidies: These are paid or received per unit of the product (e.g., GST, excise duty, customs duty).

The overall relationship is:

$GDP_{MP} = GDP_{FC} + \text{Net Indirect Taxes (NIT)}$

Where, NIT = Indirect Taxes - Subsidies = (Product Taxes + Production Taxes) - (Product Subsidies + Production Subsidies).

Some Macroeconomic Identities

Based on the concepts discussed, we can define several important macroeconomic aggregates and the relationships between them.

The four main aggregates are GDP, GNP, NDP, and NNP. Each can be measured at Market Price (MP) or Factor Cost (FC).

• Gross vs. Net: The difference is Depreciation.

  Net = Gross - Depreciation

• Domestic vs. National: The difference is Net Factor Income from Abroad (NFIA). NFIA is the difference between factor income received from the rest of the world and factor income paid to the rest of the world.

  National = Domestic + NFIA

• Market Price vs. Factor Cost: The difference is Net Indirect Taxes (NIT).

  Market Price = Factor Cost + NIT

Key Identities:

• $GNP_{MP} = GDP_{MP} + NFIA$
• $NNP_{MP} = GNP_{MP} - \text{Depreciation}$
• $NDP_{MP} = GDP_{MP} - \text{Depreciation}$
• $NNP_{FC} = NNP_{MP} - \text{NIT}$
• $NDP_{FC} = NDP_{MP} - \text{NIT}$
• $GDP_{FC} = GDP_{MP} - \text{NIT}$

The most important aggregate is National Income, which is defined as Net National Product at Factor Cost ($NNP_{FC}$).

National Income ($NNP_{FC}$) = $NDP_{FC}$ + NFIA

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National Disposable Income And Private Income

National Disposable Income (NDI)

This represents the maximum amount of goods and services the domestic economy has at its disposal. It is the income available to the whole country from all sources for consumption and saving. It includes not just factor income but also net current transfers from the rest of the world.

Net National Disposable Income ($NNDI$) = National Income ($NNP_{FC}$) + Net Indirect Taxes + Net Current Transfers from Rest of the World

Since $NNP_{FC} + NIT = NNP_{MP}$, the formula can also be written as:

$NNDI = NNP_{MP} + \text{Net Current Transfers from Rest of the World}$

Private Income

Private Income is the total income that accrues to the private sector from all sources, both within the domestic territory and from abroad. It includes both factor incomes and transfer incomes.

Derivation of Private Income from National Income:

Private Income = National Income ($NNP_{FC}$)

(-) Income from property and entrepreneurship accruing to government departmental enterprises

(-) Savings of non-departmental enterprises of the government

(+) National debt interest (interest paid by the government on public debt)

(+) Current transfers from government (e.g., scholarships, old-age pensions)

(+) Net current transfers from the rest of the world

From private income, we can derive Personal Income (by subtracting corporate tax and retained earnings) and Personal Disposable Income (by subtracting personal taxes and miscellaneous receipts of the government).

Nominal And Real Gdp

When we calculate GDP, we multiply the quantity of goods and services produced by their market prices. Since prices change over time, it's important to distinguish between GDP calculated at current prices and GDP calculated at constant prices.

Nominal GDP

Nominal GDP (or GDP at Current Prices) is the market value of the final goods and services produced within the domestic territory of a country during a financial year, as estimated using the current year's prices. A change in Nominal GDP can be due to a change in the quantity of goods and services produced, a change in their prices, or both.

Nominal GDP = Current Year's Quantity ($Q_1$) × Current Year's Price ($P_1$)

Real GDP

Real GDP (or GDP at Constant Prices) is the market value of the final goods and services produced within the domestic territory of a country during a financial year, as estimated using the prices of a base year. It changes only when the quantity of goods and services changes. Therefore, Real GDP is considered a true indicator of economic growth.

Real GDP = Current Year's Quantity ($Q_1$) × Base Year's Price ($P_0$)

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GDP Deflator

The GDP Deflator is a measure of the overall level of prices of all new, domestically produced, final goods and services in an economy. It is calculated as the ratio of Nominal GDP to Real GDP.

GDP Deflator = $\frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100$

The GDP deflator is used to "deflate" the nominal GDP to arrive at the real GDP. It provides an economy-wide measure of inflation.

$\text{Real GDP} = \frac{\text{Nominal GDP}}{\text{GDP Deflator}} \times 100$

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Gdp And Welfare

Welfare refers to the overall well-being of the people in a country. Real GDP per capita is often used as an indicator of welfare. A higher Real GDP per capita is generally taken to mean a higher level of welfare. However, GDP is not a perfect measure of welfare due to several limitations.

Limitations of GDP as an Index of Welfare

1. Distribution of GDP: If the rise in GDP is concentrated in the hands of a few individuals, the overall welfare of the country may not increase. A rising GDP with increasing income inequality can lead to a fall in social welfare for the majority.
2. Non-Monetary Exchanges: Many activities in an economy, especially in rural India, are not evaluated in monetary terms. For example, the services of a homemaker, kitchen gardening, and barter exchanges are not included in GDP calculations, but they certainly contribute to welfare.
3. Externalities: Externalities refer to the positive or negative impacts of an economic activity on others, for which no price is paid or penalty is imposed.
   • Negative Externalities: A factory may produce goods (adding to GDP) but also create air and water pollution, which harms public health and reduces welfare. This negative impact is not accounted for in GDP.
   • Positive Externalities: A person maintaining a beautiful garden provides pleasure (welfare) to neighbours, but this is not included in GDP.
4. Composition of GDP: The composition of goods and services produced matters for welfare. An increase in GDP due to higher production of defence goods or police services does not directly improve the consumption and well-being of the people in the same way as an increase in the production of food or healthcare services.
5. Rate of Population Growth: If the rate of population growth is higher than the rate of GDP growth, the per capita availability of goods and services will fall, leading to a decrease in economic welfare, even if the total GDP is rising.

Therefore, while GDP is a vital economic indicator, it should be used with caution as a measure of social welfare.

Key Concepts

• Final Goods: Goods used for final consumption or investment.
• Intermediate Goods: Goods used as raw material for further production.
• Stock: A variable measured at a point in time.
• Flow: A variable measured over a period of time.
• Depreciation: Consumption of fixed capital.
• Investment: Addition to the stock of capital.
• Circular Flow of Income: The flow of payments and receipts for goods, services, and factor services between different sectors of the economy.
• Value Added: Value of Output - Intermediate Consumption.
• Gross Domestic Product (GDP): The market value of all final goods and services produced within the domestic territory of a country in a year.
• Net Factor Income from Abroad (NFIA): Factor income earned by our residents from abroad minus factor income earned by non-residents in our country.
• Gross National Product (GNP): GDP + NFIA.
• National Income ($NNP_{FC}$): The sum total of factor incomes (rent, wages, interest, profit) earned by the normal residents of a country in a year.
• Nominal GDP: GDP measured at current prices.
• Real GDP: GDP measured at constant (base year) prices.
• GDP Deflator: A measure of the price level, calculated as (Nominal GDP / Real GDP) × 100.
• Externalities: The positive or negative economic impact of an activity on a third party who is not directly involved in that activity.

Summary

National Income Accounting is a framework for measuring the economic activity of a nation. The process begins with understanding basic concepts like final and intermediate goods, stocks and flows, and investment and depreciation.

The core of the economy is represented by the Circular Flow of Income, which shows money moving between firms and households. This flow gives rise to three methods of calculating national income:

1. Product (Value Added) Method: Sums up the gross value added by all producing units in the economy.
2. Income Method: Sums up all the factor incomes earned within the country.
3. Expenditure Method: Sums up all final expenditure on goods and services in the economy.

All three methods should theoretically give the same result, the Gross Domestic Product (GDP). From GDP, various other aggregates can be derived, such as GNP, NNP, and NDP, by adjusting for depreciation and Net Factor Income from Abroad (NFIA). The most comprehensive measure of a nation's income is the National Income ($NNP_{FC}$).

To account for the effect of inflation, we distinguish between Nominal GDP (at current prices) and Real GDP (at constant prices). Real GDP is a better indicator of economic growth. The GDP Deflator measures the change in the overall price level.

Finally, while GDP is a crucial indicator of economic performance, it has significant limitations as a measure of social welfare. Factors like income distribution, non-monetary activities, and externalities are not captured by GDP, meaning a high GDP does not automatically translate to high well-being for all citizens.