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National Income Accounting

General Goal of the Economy: Promote the economic well-being of the people. The provision of
goods and services is of primary importance. Whether or not the economy is successful in the
attainment of goals is a very important concern that must be made known.

National Income - also referred to as net national product

- defined as a measure of the money value of the total flow of goods and
services produced in an economy over a specified period of time

National Income consists of the following:

1. wage or salary- generated by labor

2. interest- generated by lenders of funds
3. rent- generated by owners of real estate
4. profit- generated by entrepreneurs
5. net factor- income from abroad

National Income Accounting- set of rules and statements of meaning for measuring economic
activity in the aggregate economy, that is, the entire economy.

Important terms used in Measuring National Income

1. Gross Domestic Product- is a measure of the total flow of goods and services produces by
the economy over a particular time period. It is also the aggregate market value of all final
goods and services in economy in a one-year period.
2. Gross National Product- is a measure of the market value of the final goods and services
produced by nationals or citizens of a country in a particular time period. It is also the total final
output of citizens and businesses of an economy in a one year period.

Exclusions from the GNP

The GNP is a measure of the total production of the economy for a specified year. It follows
therefore, that the non productive transactions must be excluded. Non productive transactions
consist of the following:

1. Purely financial Transactions

Public Transfer Payments- given by the government to individual or households but which
do not contribute to current production in return for them.
Private transfer payments- involve the transfer of funds from one private individual to
another and which does not entail production
Buying and selling of securities- do not directly involve current production

2. Secondhand sales- do not involve current production and so, they are also excluded from the
GNP. For example, when an appliance was bought last year, that transaction was included in last
years computation of the GNP. That is expected because that specific activity producing the
appliance must be recognized. When the owner of appliance gets tired of it and sells it as
secondhand, no further production activity is made on that account, that particular transaction
must be excluded from the GNP.

3. Market Value- refers to the current price of goods and services produced in the economy
4. Value Added- refers to the difference between the value of goods produced and the cost of
materials and supplies used in producing them.
5. Consumption- refers to expenditure by consumers on final goods and services
6. Investment- is an activity that resources now in such a way that they allow for greater
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production in the future and, hence, greater consumption in the future. It includes output of
capital goods, net change in business inventories and residential construction.

Investments are two types:

1. Fixed investment- a good that is purchased to be used in order to make other goods and
services. Example: Equipment
2. Inventory investment- are those used to increase the amount of inventories of finished
products

7. Consumer Durables- are consumer goods, such as appliances and furniture that usually
last for several years.
8. Government Expenditures- refer to the sum of government pay rolls and purchases,
which is the cost of government output.
9. Net factor income from abroad- this is the difference between the income earned by
citizens who own resources used in the production process abroad and the income of foreigners
who own resources used in the production process here in the Philippines.

Calculating GDP

Total final output (GDP) consists of thousands of various services and products.
To reach aggregate output, we have to add them all into composite measure.
You can only add like things measured in the same units. For example, 7 mangoes+3
mangoes=10 mangoes. To add unlike things, we must convert them into like things by
multiplying each goods by its price.
1. GDP is a flow notion- this refers to the total amount of final output a country produces per
year.
2. GDP measures ultimate output- GDP does not measure total transactions in an economy;
it measures final output.
Final output- goods and services bought for final use
Intermediate products- products used as input in the production of some other
product.
3. Eliminating intermediate goods- refers to the two ways to eliminate intermediate goods
from the measure of GDP
Add up only final sales- business companies would have to set apart goods they sold
to consumers from intermediate goods used to produce other goods.
Guided by the value added approach- rise in value that a business company helps to
bring about a product or service.

Table 2: Value Added Approach Excludes Double Counting

I II III
Participants Cost of Value of Sales Value Added Row
Materials
Farmer 0.00 1,000.00 1,000.00 1
Cone factory 1,000.00 2,500.00 1,500.00 2
and Ice
Cream maker
Middle person 2,500.00 4,000.00 1,500.00 3
(final sales)
Vendor 4,000.00 5,000.00 1,500.00 4
Total 7,500.00 12,500.00 5,000.00 5

Modes of Calculating GDP

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GDP can be calculated in two ways:

1. the expenditure method

2. the income method

National Income Accounting Identity

Accounting is a method of keeping tract of things. For a business company, cost plus profit equals
incomes since cost plus profit is identical to incomes. In the national income accounting, whenever
a good or service (output) is produced, somebody receives income for producing it. The equality of
output and income is an accounting identity in the national income accounts.

The Circular Flow

Wages, rents, interest, profits (1)

Factor

Household Firms (production)

Goods

Taxes (2) Government (2) Government Spending

Saving (3) Financial markets Investment (3)

Personal Consumption (4)

Imports (5) Other Countries Exports (5)

Expenditure Approach

Gross Domestic Product is equal to the quantity of four expenditure categories:

1. Consumption ( C)- refers to the individuals receive income. They can spend it on domestic
or foreign goods, pay taxes, or save it. These options are the ways of approach through
which income is brought back into the spending operation. The considerable and the most
important of the flows is personal consumption expenditures, which are payment by
households for goods and services (flow 4). It is likewise the most palpable way in which
income take in is brought back to business companies.
2. Investment (I)- saving or investment refers to the financial sector (flow 3) is the part of the
income that individuals save. This money departs from the spending stream and goes into
financial markets. If the financial markets operating properly, they transfer that saving back
into the spending flow by lending it to individuals who want to expend. Gross private
investment includes business expenditure on equipment, inventories, and household
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expenditure on new occupied housing. Assets such as plants and equipment. Economists call
this wearing out process depreciation, a decline in an assets value. Depreciation is the
amount by which plants and equipments decrease in value, as they grow older. Economists
use the term net private investment to distinguish between aggregate or gross private
domestic investment and the new investment that is above and beyond replacement
investment. Net private investment- gross private domestic investment less depreciation
3. Government Expenditures (G)- government payments for goods and services and
investment in equipment and structures. When individuals pay taxes (flow 2), those taxes
are spent by government on goods and services or are brought back to individuals in the
form of transfer payments.
4. Net exports (X-M)- Individuals spending on foreign goods flows out and does not add to
domestic production. Spending on foreign goods, imports is subtracted from total
expenditures. That flow out is made up for by a flow in (flow 5). Exports are counted in to
total expenditures. In many instances these flows are put together and we talk over the net
exports, exports minus imports.

So, by adding up these four categories, we get the total expenditures.

Gross Domestic Product (GDP)= C + I + G (X-M)

Net Domestic Product (NDP)- aggregate amount of consumption spendin, government
expenditures, net foreign expenditures, and investment minus depreciation. A shorthand
way of saying this is: NDP= [C + I + G + (X-M]-Depreciation

Income Approach

The income approach to measuring NDP adds up payments by business companies to households,
called factor payments, to reach National Income (NI). National Income is the total income taken
by individuals and firms.

Compensation of Employees- refers to the employee compensation compose of wages

and salaries paid to individuals, along with those provided by an employer in addition to
wages and government taxes for national revenue.
Rents- the earnings from property taken in by households
Interests- the earnings private businesses pay to household that have lent the business
money, usually by buying bonds sent out by the businesses.
Profits- residues after compensation to employees, rents, and interests have been paid out.

Identical Income and Expenditure

The amount of the employee compensation, rents, interest, and profits equals the value of goods
purchased (the flow along the top and the bottom in figure 10). How these amounts are kept
exactly equal?

Example: A business company has a total output of 800,000.

Wages- 400,000
Rent-200,000
Interest- 100,000
Profit:
800,000-700,000= 100,000

Total output is the total income enable us to calculate GDP by finding the total of all values of
final outputs (the expenditures approach) and by finding the total of all values of all earnings (the
income approach).

Equality of Expenditure and Income

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The National Income accounting has three qualifications. These are:

1. National and domestic- National income is all income taken in by citizens of a country and
is equivalent to GNP, to go from domestic to national; we add net foreign factor income.
2. Net Domestic Product (NDP)- NDP is GDP minus depreciation.
3. Indirect business taxes- these are reflected in all prices and, as a result of this, in the
value of total expenditures (GDP). They are not paid out to owners of production as income
and are not part of national income. To go from GDP to national income, we must likewise
subtract indirect business taxes from GDP.

Figure 11

Real and Nominal GDP

To separate rises in GDP brought about by inflation from rises in GDP that stand for real rises in
production and income, economists differentiate between real and nominal GDP.

Nominal GDP- GDP calculated at existing prices.

Real GDP- nominal GDP adjusted for inflation

To adapt nominal output for inflation we lead to a price index. Price index is a measure of how
much the price level has increased from one year to the next, and divided nominal GDP by that
price index. That price index is the GDP deflator.

Example: Price level has increased 10% from a GDP deflator of 1 to a GDP deflator of 1.1, and
nominal GDP increases Php8 billion to Php9 billion. Part of that, increase in nominal GDP stands for
the 10% increase in the price level. If you divide nominal GDP, Php9 billion by the new GDP deflator
1.1, you get Php8.18 billion. That Php8.18 billion is called real GDP. So we can infer that the real
economy has grown by 18/800 or 2.5%.

Remember: Real GDP is important to a society because it measures what is really produced.
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Measurement and Inaccuracies

All market economic activities are supposed to be measured by GDP figures, but they do not. Non-
reported sales, work accomplished and paid for in cash to avoid income tax, illegal drug sales,
under-the-counter sales taxes, prostitution and illegal gambling are all markets activities, yet none
of them is contained in GDP figures. If we were able to stop underground activity and channel those
efforts to the economy of a country, GDP would increase significantly.

Misinterpretation of Components

Another delimitation of national income accounting relates to possible misinterpretation of the sub
categories. In establishing the accounts, numerous arbitrary decisions had to be made:

What to put into investment?

What to consist in consumption?
How to deal with government spending?

The decisions arrived at were generally reasonable but they were not the only ones that could have
been formulated. Once made, they influence our interpretations of events. For instance, at the time
we perceive that an investment increases; we usually think that our future productive capacity is
increasing, but remember that investment, which does not raise our future productive capacity.

My Explanation

GDP- one method of understanding a countrys income and allows for comparison to other
countries.

Value-added describes the enhancement a company gives its product or service before offering
the product to customers. Value-added applies to instances where a firm takes a product that may
be considered a homogeneous product, with few differences (if any) from that of a competitor, and
provides potential customers with a feature or add-on that gives it a greater sense of value.

Strong Branding

Companies that build strong brands add value just by adding their logo to a product. Nike Inc. can
sell shoes at a much higher price than some competitors, even though their production costs are
similar. The Nike brand, which shows up on athletic apparel and uniforms of the top college and
professional sports teams, represents a quality enjoyed by elite athletes.

Superior Service and Additional Features and Benefits

Buyers of luxury cars from BMW and Mercedes-Benz are willing to pay a premium price for their
vehicles because of the ongoing maintenance programs that the companies offer.

Amazon has been at the forefront of e-customer service with its policies of issuing automatic
refunds for poor service, free shipping and price guarantees on pre-ordered items. Consumers have
become so addicted to their services that they are willing to pay annual fees for Amazon Prime
memberships because they value the two-day turnaround on orders.

This can be as simple as adding a brand name another wise generic product or as complex s
assembling different parts into unique way that no one else thought of before.

The Importance of Consumption

Every time you purchase food at the drive-thru or pull out your debit or credit card to buy
something, you are adding to consumption. Consumption is one of the bigger concepts in
economics and is extremely important because it helps determine the growth and success of the
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economy. Businesses can open up and offer all kinds of great products, but if we don't purchase or
consume their products, they won't stay in business for very long! If they don't stay in business,
many of us won't have jobs or the income to buy goods and services.

Consumption can be defined in different ways, but is best described as the final purchase of goods
and services by individuals. The purchase of a new pair of shoes, a hamburger at the fast food
restaurant or services, like getting your house cleaned, are all examples of consumption. It is also
often referred to as consumer spending. Many topics in economics explore how the income of
families and individuals affects consumption and spending habits.

The term "investment" can be used to refer to any mechanism used for the purpose of generating
future income. In the financial sense, this includes the purchase of bonds, stocks or real estate
property. Additionally, the constructed building or other facility used to produce goods can be seen
as an investment. The production of goods required to produce other goods may also be seen as
investing.

Taking an action in the hopes of raising future revenue can also be an investment. Choosing to
pursue additional education can be considered an investment, as the goal is to increase knowledge
and improve skills in the hopes of producing more income.

Investment and Economic Growth

Economic growth can be encouraged through the use of sound investments at the business level.
When a company constructs or acquires a new piece of production equipment in order to raise the
total output of goods within the facility, the increased production can cause the nations gross
national product (GDP) to rise. This allows the economy to grow through increased production,
based on the previous equipment investment.

Investment Banking

An investment bank provides a variety of services designed to assist an individual or business in

increasing associated wealth. This does not include traditional consumer banking. Instead, the
institution focuses on investment vehicles such as trading and asset management. Financing
options may also be provided for the purpose of assisting with the these services.

Fixed- an investment in fixed assets, such as buildings or machinery. (fixed capital)

Thus, fixed investment is investment in physical assets such as machinery, land, buildings,
installations, vehicles, or technology. Normally, a company balance sheet will state both the
amount of expenditure on fixed assets during the quarter or year, and the total value of the stock
of fixed assets owned.

The more fixed capital is used per worker, the more productive the worker can be, other things
being equal. For example, a worker who tills the soil only with a spade is normally less productive
than a worker who uses a tractor-driven plough to do the same work, because with a tractor one
can plough more land in less time, and thus produce more in less time, even if a tractor costs more
than a spade. Obviously one would not normally use a tractor to plough a small garden, but in
large-scale farming the income earned using a tractor by far outweighs the expense of using a
tractor. It is not economical to use a spade for large-scale ploughing, unless the labour is extremely
cheap, and the supply of labour is plentiful.

Inventory investment is a component of gross domestic product (GDP). What is produced in a

certain country is naturally also sold eventually, but some of the goods produced in a given year
may be sold in a later year rather than in the year they were produced. Conversely, some of the
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goods sold in a given year might have been produced in an earlier year. The difference between
goods produced (production) and goods sold (sales) in a given year is called inventory investment.
The term can be applied to the economy as a whole or to an individual firm.

Definition of inventory investment

Inventory investment = production - sales

Thus, if production per unit time exceeds sales per unit time, then inventory investment per unit
time is positive; as a result, at the end of that period of time the stock of inventories on hand will
be greater than it was at the beginning. The reverse is true if production is less than sales.

BREAKING DOWN 'Expenditure Method'

The expenditure method is the most widely used approach for estimating GDP, which is a measure
of the economy's output produced within a country's borders irrespective of who owns the means
to production. The GDP under this method is calculated by summing up all of the expenditures
made on final goods and services. There are four main aggregate expenditures that go into
calculating GDP: consumption by households, investment by businesses, government spending on
goods and services, and net exports, which are equal to exports minus imports of goods and
services.

Main Components under Expenditure Method

In the United States, the most dominant component in the calculations of GDP under the
expenditure method is consumer spending, which accounts for the majority of U.S. GDP.
Consumption is typically broken down into purchases of durable goods (such as cars and
computers), nondurable goods (such as clothing and food), and services.

The second component is government spending, which represents expenditures by state, local and
federal authorities on defense and nondefense goods and services, such as weaponry, health care
and education.

Business investment is one of the most volatile components that goes into calculating GDP. It
includes capital expenditures by firms on assets with useful lives of more than one year each, such
as real estate, equipment, production facilities and plants.

The last component included in the expenditure approach is net exports, which represents the
effect of foreign trade of goods and service on the economy.

Limitation of GDP Measure

GDP, which can be calculated using numerous methods, including the expenditure approach, is
supposed to measure a country's standard of living and economic health. Critics such as the Nobel
Prize-winning economist Joseph Stiglitz caution that GDP should not be taken as an all-
encompassing indicator of a society's well-being, since it ignores important factors that make
people happy. For example, while GDP includes monetary spending by private and government
sectors, it does not consider work-life balance or the quality of interpersonal relationships in a
given country.

BREAKING DOWN 'Income Approach'

When using the income approach for purchasing a rental property, an investor considers the
amount of income generated and other factors to determine how much the property may sell for
under current market conditions. In addition to determining whether the investor may profit from
the rental property, a lender will want to know its potential risk of repayment if it extends a
mortgage to the investor.
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Determining Capitalization Rate

When determining the propertys net operating income (NOI), an investor uses market sales of
comparable properties for choosing a capitalization rate. For example, when valuing a four-unit
apartment building in a specific county, the investor looks at the recent selling prices of similar
properties in the same county.

After determining a capitalization rate, the investor adjusts the rate based on the propertys
characteristics. For example, the property may have higher-quality tenants than other nearby
properties, which would slightly reduce the capitalization rate. On the other hand, the property may
be less appealing than others in the area, which would slightly increase the rate. The capitalization
rate should be set within 50 basis points of the market average. For example, an average market
capitalization rate of 8% most likely values the property between 7.5% and 8.5%.

After calculating the capitalization rate, the investor can divide the rental propertys NOI by that
rate. For example, a property with an NOI of $700,000 and a chosen capitalization rate of 8% is
worth $8.75 million.

Other Property Considerations With the Income Approach

When using the income approach for purchasing a rental property, an investor must also consider
the condition of the property. Potential large repairs that may be needed can substantially cut into
future profits.

In addition, an investor should consider how efficiently the property is operating. For example, the
landlord may be giving tenants rent reductions in exchange for completing yardwork or other
responsibilities. Perhaps specific tenants are facing economic difficulties that should turn around in
the next few months, and the landlord does not want to evict them. If rent being collected is not
greater than current expenses, the investor will most likely not purchase the property.

An investor must also ascertain how many units on average are empty at any given time. Not
receiving full rent from every unit will affect the investors income from the property. This is
especially important if a property is in great need of repairs and many units are vacant. If the units
are not filled on a regular basis, rent collection will be lower than it could be, and purchasing the
property may not be in the investors best interest.

What is the 'Net Domestic Product - NDP'

The net domestic product (NDP) is an annual measure of the economic output of a nation that is
adjusted to account for depreciation, calculated by subtracting depreciation from the gross
domestic product (GDP).

BREAKING DOWN 'Net Domestic Product - NDP'

Net domestic product accounts for capital that has been consumed over the year in the form of
housing, vehicle, or machinery deterioration. The depreciation accounted for is often referred to as
capital consumption allowance and represents the amount needed in order to replace those
depreciated assets.

The main difference between nominal and real values is that real values are adjusted for inflation,
while nominal values are not. As a result, nominal GDP will often appear higher than real GDP.

BREAKING DOWN 'Indirect Tax'

Import duties, fuel, liquor and cigarette taxes are all considered examples of indirect taxes.
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Indirect taxes are defined by contrasting them with direct taxes. In the case of direct taxes, the
person immediately paying the tax is the person that the government is seeking to tax. Income tax
is the clearest example of a direct tax, since the person earning the income is the one immediately
paying the tax. Admission fees to a national park is another clear example of direct taxation.

Examples of Indirect Taxes

The most common example if an indirect tax is import duties. The duty is paid by the importer of a
good at the time it enters the country. If the importer goes on to resell the good to a consumer, the
cost of the duty in effect is hidden in the price that the consumer pays. The consumer is likely to be
unaware of this, but he will nonetheless be indirectly paying the import duty.

Essentially, any taxes or fees imposed by the government at the manufacturing or production level
is an indirect tax. In recent years, many countries have imposed fees on carbon emissions to
manufacturers. These are indirect taxes, since their costs are passed along to consumers.

Sales taxes can be direct or indirect. If they are imposed only on the final supply to a consumer,
they are direct. If they are imposed as value-added taxes along the production process, then they
are indirect.

The main difference between nominal and real values is that real values are adjusted for
inflation, while nominal values are not. As a result, nominal GDP will often appear higher than real
GDP.

Nominal values of GDP (or other income measures) from different time periods can differ due to
changes in quantities of goods and services and/or changes in general price levels. As a result,
taking price levels (or inflation) into account is necessary when determining if we are really better
or worse off when making comparisons between different time periods. Values for real GDP are
adjusted for differences in prices levels, while figures for nominal GDP are not.