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 measurement of NI is an INCOME & of 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 Spending on goods & services
Factor Incomes (wages & earnings)
BUSINESS
Income & Spending Flows
Imports
HOUSEHOLDS
Savings Taxation
WORLD ECONOMY
Govt. Spend
GOVERNMENT
FINANCIAL 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 between GDP & GNP arises because some of the output produced within a made to those 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
Industry
Value 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
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,
All output produced equal to output sold. The value of output
C+IΞC+S
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,
Output & Disposable Income
Again disposable is allocated as
Reformulated
YD - TR + TA Ξ Y Ξ C + I + G
Comparing
C + S - TR + TA Ξ C + I + G
Thus
(G + TR – TA) is the govt. budget deficit
YΞC+I+G YD Ξ Y + TR - TA YD Ξ C + S
S – I Ξ (G + TR – TA)
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 NX Ξ X - M
Where
Therefore,
The surplus in the private sector is offset by the deficit in the
S – I Ξ (G + TR – TA) + NX
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 ‘residents’ of a country & the rest of the world.
the
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 GDP, a positive trade foreign balanceaid, shows Unilateral – remittances, 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’