National Income Accounting

2.1 Some Basic Concepts of Macroeconomics

Wealth of Nations

Adam Smith's work, An Enquiry into the Nature and Cause of the Wealth of Nations, explores the generation of economic wealth.
A country's wealth is not solely determined by natural resource abundance.
The key lies in utilizing resources to generate production, income, and wealth.

Production

Production involves combining human effort, natural resources, and man-made environment within a social and technological structure.
Commodities, both goods and services, are produced by various enterprises.
Producers aim to sell their output to consumers, who may be individuals or enterprises.
Goods and services can be used for final use or further production.

Final Goods

Final goods are meant for final use and do not undergo further production stages.
They exit the active economic flow after being sold, although purchasers may transform them (e.g., tea leaves).
The economic nature of use, not the good itself, determines if it's a final good.
Examples of final goods include consumption goods and capital goods.

Consumption Goods vs. Capital Goods

Consumption goods (food, clothing, recreation) are consumed when purchased by ultimate consumers.
Capital goods (tools, machines) are durable goods used in the production process.
Capital goods are final goods that enable continuous production cycles.
They undergo wear and tear, requiring repair or replacement.

Consumer Durables

Consumer durables (televisions, automobiles, computers) share characteristics with capital goods due to their durability and need for maintenance.
Final goods and services are categorized as consumption goods (durable and non-durable) or capital goods.

Intermediate Goods

Intermediate goods (steel sheets, copper) are used as material inputs by other producers and are not final goods.

Measuring Total Production

A quantitative measure of aggregate final goods produced is needed, using money as a common measuring rod.
Only final goods are measured to avoid double counting, as their value includes the value of intermediate goods.

Stocks and Flows

Economic measurements require specifying a time period (e.g., income, output, profits).
Flows occur over a period of time, while stocks are defined at a particular point in time.
*Flows are defined over a period of time.
Changes in stocks over time are also flows.
For example, water flowing into a tank is a flow, while the water in the tank at a specific time is a stock.

Gross Investment and Depreciation

Capital goods constitute gross investment.
Depreciation accounts for wear and tear of existing capital stock.
Net investment (new capital formation) is calculated as: $Net Investment = Gross investment – Depreciation$
Depreciation is an annual accounting concept based on the expected life of a capital good.

Production of Consumer and Capital Goods

Total final output comprises consumer goods and services and capital goods.
Consumer goods depend on people's income.
Capital goods are purchased by business enterprises for maintenance or addition to capital stock.
There is a trade-off between producing consumer goods and capital goods.

The Economic Cycle

More capital goods can lead to greater future production of consumer goods.
Higher production of capital goods enables economic expansion over time.
Demand, backed by purchasing power, is crucial for enabling sales.
Income earned as wages, profits, rents, or interests is used to meet demand.
Production generates factor payments, and income creates capacity to purchase goods and services.
Consumption and production are intricately linked in a circular causation.

2.2 Circular Flow of Income and Methods of Calculating National Income

Simple Economy

In a simple economy without government, external trade, or savings, households receive payments from firms for productive activities.
Contributions can be made by human labor (wages), capital (interest), entrepreneurship (profit), and land (rent).
Households spend their entire income on domestic goods and services.

Circular Flow of Income

Factors of production use their remunerations to buy goods and services they helped produce.
Aggregate consumption equals aggregate expenditure.
The economy's entire income returns to producers as sales revenue.
Firms produce goods and services and pay remunerations, which are used to buy goods and services.
Aggregate income circulates between firms and households.

Measuring Aggregate Income

Aggregate income can be measured by calculating the aggregate value of goods and services produced.
Aggregate revenue received by firms is paid out as aggregate income.
The circular flow can be measured at different points: expenditure method (aggregate spending), product method (aggregate value of goods and services), and income method (sum of factor payments).
Aggregate spending equals aggregate income.

Change in Spending

If households spend more, firms produce more, leading to higher factor payments.
Additional factor payments equal the value of additional goods and services produced.
The economy's income rises to match the higher spending level.
A rise in flow at one point leads to a rise in flow at all levels of the circular flow.

Macroeconomic Model

A simplified story describing the functioning of an imaginary economy is called a macroeconomic model.

Methods of Calculating National Income

Despite the complexity of an economic system, the annual production of goods and services estimated through each of the three methods remains the same.
The product or value added method, expenditure method and income method are used to calculate the GDP.

2.2.1 Product or Value Added Method

The product method calculates the aggregate annual value of goods and services produced.
Value added is the net contribution made by a firm.
For example, consider wheat producers (farmers) and bread makers (bakers).
Farmers produce $Rs 100$ worth of wheat, selling $Rs 50$ worth to bakers.
Bakers produce $Rs 200$ worth of bread.
The aggregate production value is not $Rs 300$ , as that would involve double counting.
The net contribution of bakers is $Rs 200 – Rs 50 = Rs 150$ .
The aggregate value of goods produced is $Rs 100 + Rs 150 = Rs 250$ .
The value added of a firm is the value of its production minus the value of intermediate goods used.
Value added is distributed among factors of production: labor, capital, entrepreneurship and land.
Wages, interest, profits, and rents add up to the value added of the firm.
Value added is a flow variable.
The raw materials bought and used up in production are called intermediate goods.

Gross Value Added

Including depreciation in value added yields Gross Value Added (GVA).
Subtracting depreciation from GVA yields Net Value Added.

Example

A firm produces $Rs 100$ worth of goods per year.
Intermediate goods value is $Rs 20$ . Capital consumption is $Rs 10$ .
Gross value added $= Rs 100 – Rs 20 = Rs 80$ per year.
Net value added $= Rs 100 – Rs 20 – Rs 10 = Rs 70$ per year.

Inventories

Firms may have unsold stock at year-end or initial unsold stock at the beginning.
Unused raw materials are also considered.
Inventory is the stock of unsold finished goods, semi-finished goods, or raw materials.
Inventory is a stock variable.
Change of inventories during a year ≡ production of the firm during the year – sale of the firm during the year.
Accounting identitiy: $2 + 2 ≡ 4$
Since production of the firm ≡ value added + intermediate goods used by the firm, change of inventories of a firm during a year ≡ value added + intermediate goods used by the firm – sale of the firm during a year.

Inventories Example

A firm has unsold stock worth $Rs 100$ at the beginning of the year.
It produces $Rs 1,000$ worth of goods and sells $Rs 800$ worth.
Change in inventories is $Rs 200$ . Inventories at year-end are $Rs 100 + Rs 200 = Rs 300$ .
The change in inventories is a flow variable and is treated as investment, specifically, addition to the stock of capital.

Categories of Investment

Categories of investment include: rise in the value of inventories, fixed business investment (addition to machinery, factory buildings, and equipment), and residential investment (addition of housing facilities).

Planned Accumulation and Decumulation of Inventories

Change in inventories may be planned or unplanned.
Example: A shirt firm starts with 100 shirts, expects to sell 1,000, and produces 1,000, expecting to end the year with 100.
If sales are unexpectedly low (600 shirts), the firm is left with 400 unsold shirts, ending the year with 500 shirts.
A firm wanting to reduce inventories from 100 to 25 produces $1000-75=925$ shirts. IT plans to sell 75 shirts from its inventory of 100 shirts.

Summation Notation

The summation notation $∑$ is used to denote summation.

Calculation of GDP

Gross value added of firm i (GVAi) ≡ Gross value of the output produced by the firm i (Qi) – Value of intermediate goods used by the firm (Zi).
Also, $GVAi ≡ Value of sales by the firm (Vi) + Value of change in inventories (Ai) – Value of intermediate goods used by the firm (Zi)$
Here, Change in inventories of a firm during a year ≡ Production of the firm during the year – Sale of the firm during the year.
The sales by the firm includes sales to domestic buyers and buyers abroad (exports).
Net value added of the firm i ≡ GVAi – Depreciation of the firm i (Di).
Summing the gross value added of all the firms yields Gross Domestic Product (GDP).

$GDP ≡ ∑{i=1}^{N} GVAi$

2.2.2 Expenditure Method

GDP can be calculated from the demand side of products.
Add final expenditures that each firm makes.
Final expenditure excludes intermediate purposes.
For example, in the farmer-baker economy, the calculation is $Rs 200 + Rs 50 = Rs 250$ per year.

Components of Final Expenditure

Final consumption expenditure on goods and services $Ci$ by households, investment expenditure $Ii$ by other firms on the capital goods, government expenditure $Gi$ on the final goods and services, export revenue $Xi$ .

$RVi ≡ Ci + Ii + Gi + X_i$

Summing over $N$ firms:

$∑{i=1}^{N} RVi ≡ ∑{i=1}^{N} Ci + ∑{i=1}^{N} Ii + ∑{i=1}^{N} Gi + ∑{i=1}^{N} Xi$

Final expenditure on Domestic Firms

*Let $C$ be the aggregate final consumption expenditure of the entire economy, this includes spending on imports of consumption goods ( $Cm$ ) *Therefore, $C-Cm$ is final consumption expenditure that is spent on domestic firms.
*Similarly, $I – Im$ stand for that part of aggregate final investment expenditure that is spent on domestic firms, where I is the value of the aggregate final investment expenditure of the economy and out of this $Im$ is spent on foreign investment goods. Also, $G – Gm$ stands for that part of aggregate final government expenditure that is spent on the domestic firms, where G is the aggregate expenditure of the government of the economy and $Gm$ is the part of G which is spent on imports.

≡ Sum total of final consumption expenditures received by all the firms in the economy ≡ $C – C_m$
≡ Sum total of final investment expenditures received by all the firms in the economy ≡ $I – I_m$
≡ Sum total of final government expenditures received by all the firms in the economy ≡ $G – G_m$

$∑{i=1}^{N} RVi ≡ C + I + G + ∑{i=1}^{N} Xi – (Cm + Im + G_m) ≡ C + I + G + X – M$

Here, $X ≡ ∑{i=1}^{N} Xi$ denotes aggregate expenditure by the foreigners on the exports of the economy and $M ≡ Cm + Im + G_m$ is the aggregate imports expenditure incurred by the economy.

GDP ≡ $C + I + G + X – M$

2.2.3 Income Method

The sum of final expenditures must equal incomes received by all factors of production.
Revenues earned by all firms are distributed among salaries, wages, profits, interest, and rents.

Calculation of GDP

Let $Wi, Pi, Inti, Ri$ be the wages, profits, interest payments, and rents received by the $i$ -th household.

$GDP ≡ ∑{i=1}^{M} Wi + ∑{i=1}^{M} Pi + ∑{i=1}^{M} Inti + ∑{i=1}^{M} Ri$

Here,∑{i=1}^{M} Wi ≡ W, ∑{i=1}^{M} Pi ≡ P, ∑{i=1}^{M} Inti ≡ Int, ∑{i=1}^{M} Ri ≡ R.

$GDP ≡ ∑{i=1}^{N} GVAi ≡ C + I + G + X – M ≡ W + P + Int + R$

GDP Methods

All of the above methods of estimating GDP give the same answer.

Example

Firm A uses no raw material and produces cotton worth $Rs 50$ . It sells its cotton to firm B, who uses it to produce cloth. B sells the cloth produced to consumers for $Rs 200$ .

Product Method

$V_A = 50 – 0 = 50$
$V_B = 200 – 50 = 150$
$GDP = VAA + VAB = 200$

Expenditure Method

GDP = Sum of final expenditure, which is, equal to expnditure by consumers on cloth = $200$

Income method

Of the 50 received by A, the firm gives Rs. 20 to the workers as wages, and keeps the remaining 30 as its profits. Similarly, B gives 60 as wages and keeps 90 as profits.
$GDP = sum of total factor incomes = 80 + 120 = 200$

2.2.4 Factor Cost, Basic Prices and Market Prices

GDP at factor cost has been replaced by GVA at basic prices.
*Distinction between factor cost, basic prices and market prices is based on difference between net production taxes and net product taxes.
Production taxes and subsidies are independent of the volume of production (e.g., land revenues).
Product taxes and subsidies are per unit (e.g., excise tax, import duties etc.).
Factor cost includes payment to factors of production only.
Market prices include factor cost + total indirect taxes – total subsidies.
Basic prices includes the production taxes (less production subsidies) but not product taxes.

Formula

GVA at factor costs + Net production taxes = GVA at basic prices

GVA at basic prices + Net product taxes = GVA at market prices

2.3 Some Macroeconomic Identities

Gross National Product

Gross National Product (GNP) accounts for earnings by domestic factors of production abroad and subtracts earnings of foreign factors in the domestic economy.

*GNP ≡ GDP + Factor income earned by the domestic factors of production employed in the rest of the world – Factor income earned by the factors of production of the rest of the world employed in the domestic economy.

GNP ≡ GDP + Net factor income from abroad.

Net National Product

Net National Product (NNP) is obtained by deducting depreciation from GNP.

$NNP ≡ GNP – Depreciation$

National Income

*NNP at factor cost ≡ National Income (NI ) ≡ NNP at market prices – (Indirect taxes – Subsidies) ≡ NNP at market prices – Net indirect taxes (Net indirect taxes ≡ Indirect taxes – Subsidies)

Personal Income

Personal Income (PI) is the part of NI received by households.
Deduct Undistributed Profits (UP) and Corporate Tax from NI.
Deduct net interest payments made by households.
Add transfer payments to the households.

$PI ≡ NI – UP – Net interest payments made by households – Corporate tax + Transfer payments to the households$

Personal Disposable Income

Personal Disposable Income (PDI) is the income households have complete control over.
*it is deducted from Personal tax payments and Non-tax payments from PI

$PDI ≡ PI – Personal tax payments – Non-tax payments$

National Disposable Income and Private Income

National Disposable Income = Net National Product at market prices + Other current transfers from the rest of the world.
*This provides an idea of what is the maximum amount of goods and services the domestic economy has at its disposal.
Private Income = Factor income from net domestic product accruing to the private sector + National debt interest + Net factor income from abroad + Current transfers from government + Other net transfers from the rest of the world.

2.4 Nominal and Real GDP

Nominal GDP is the value of GDP at current prices.
Real GDP values goods and services at constant prices.
Comparison of GDPs is done using real GDP to account for price changes.
GDP deflator is the ratio of nominal GDP to real GDP.

$GDP deflator = \frac{GDP}{gdp}$

Consumer Price Index (CPI) measures the change in prices of a basket of commodities bought by a representative consumer.

Example

Base year (2000): 90 kg rice @ $Rs 10$ and 5 pieces of cloth @ $Rs 100 = Rs 1,400$
Current year (2005): 90 kg rice @ $Rs 15$ and 5 pieces of cloth @ $Rs 120 = Rs 1,950$
CPI = $\frac{1950}{1400} × 100 = 139.29$

Wholesale Price Index

Wholesale Price Index (WPI) is the index for wholesale prices.

2.5 GDP and Welfare

GDP may not be a good index of welfare because:
1. . Poor Distribution of GDP.
2. . Non-monetary exchanges are not counted.
3. Externalities are not accounted for (positive or negative).