MEASURING MACROECONOMIC

PERFORMANCE

Lecture 2 & 3

Concepts of National Income

Accounting
 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
 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

Consumer Factor
Spending Incomes
on goods & (wages &
services earnings)

BUSINESS
Income & Spending Flows
Imports
HOUSEHOLDS

Savings
Taxation Govt. Spend

FINANCIAL
WORLD ECONOMY GOVERNMENT 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 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’

 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

NI = 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
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

GDPMP = C+I+G+(X-M)

GDPFC = GDPMP +SUBSIDIES – INDIRECT TAX

GNPMP = GDPMP + NET FACTOR INCOME ABROAD

GNPFC = GNPMP + SUBSIDIES – INDIRECT TAXES

NI = GNPFC - DEPRECIATION
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
Personal Income &
Personal Disposable Income
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 Households, 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) = National Income + Transfer Payments

– Corporate Income Taxes – Retained Earnings – Social
Security Contributions – Insurance Premium

Disposable Personal Income (DPI) = Personal Income –

Personal Income Tax

 Personal disposable income differs from Personal Income by the

amount of direct taxes (personal taxes) paid by individuals

 DPI = 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 $ 500

• Industry B sells cotton cloth to Industry C for $ 800

• Industry C sells cotton shirts to final consumers for

$ 1000
Total of all transactions is $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.

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

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, WHY???

Distribution in factor incomes
the Value added

Value
Industry Distribution of value added
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
Outlays & Components of
Demand

• Total demand for domestic output is made up of 4 components

1. Consumption spending by House holds(C)

2. Investment spending by businesses & Households (I)

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

4. Foreign demand for our net exports (NX)

Fundamental National Income Identity

Y = 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)
National Income
Identities

Therefore, Y=C+I
Income allocation Y=C+S
Combining, C+I=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=Y–C=S
Investment is identically equal to saving
 Limitations of GDP
Changes in quality and the inclusion of new goods – higher quality and/or
new products often replace older products. Many products, such as cars
and medical devices, are of higher quality and offer better features than
what was available previously. Many consumer electronics, such as cell
phones and DVD players, did not exist until recently.

Leisure/human costs – GDP does not take into account leisure time, nor is
consideration given to how hard people work to produce output. Also,
jobs are now safer and less physically strenuous than they were in the
past. Because GDP does not take these factors into account, changes in
real income could be understated.
Limitations of GDP
• Underground economy - Barter and cash transactions that
take place outside of recorded marketplaces are referred to
as the underground economy and are not included in GDP
statistics. These activities are sometimes legal ones that are
undertaken so as to avoid taxes and sometimes they are
outright illegal acts, such as trafficking in illegal drugs.

• Harmful Side Effects - Economic "bads", such as pollution, are

not included in GDP statistics. While no subtractions to GDP
are made for their harmful effects, market transactions made
in an effort to correct the bad effects are added to GDP
Limitations of GDP
Non-Market Production - Goods and services produced but
not exchanged for money, known as "nonmarket
production", are not measured, even though they have
value. For instance, if you grow your own food, the value of
that food will not be included in GDP. If you decide to
watch TV nstead of growing your own food and now have
To purchase it, then the value of your food will be
included in GDP.
Uses of National Income
1. Standard of living comparison
2. Economic Performance over time
3. National Planning
4. Sectoral Contributions
5. Economic Policy
6. Inflationary and Deflationary Gaps
7. National expenditure
8. Public Sector
9. Distribution of Income
Difficulties in calculating
National Income

1. Problem of non financial sector

2. Problem of literacy
3. Problem of expertise in estimating NI
4. Problem of less sophisticated machinery
5. Problem of double counting
6. Problem of false information
7. Problem of multi occupations
 Real Income
Real Income/GNP
Real GNP = Base year Price Index X Nominal GNP
Current year Price Index

= Nominal GNP
GNP Deflator
Example: If current price index is 160 and the base year price
index is 100, the nominal GDP in $10,000 million, the real GDP
is $6250 million.
 Per Capita Income
Per capita income refers to average income per
head of population.

Per Capita Income = National Income

Total Population

Exp: If NI of a country with total population of 20 million

is $50,000 million. Per capita income is 50,000/20 =
$2500
 Growth Rate
It can be measured as GDP or GNP based on
real income.

It is the percentage change on the quantity of

goods and services produced from one year to
Another.
 Growth Rate
Growth rate (g) = Real GNP this year – Real GNP last year X100
Real GNP last year

This formula also be used to calculate Real GDP

Exp. If real GDP for 2008 is $232,359 million and $248,954

million for 2009. The growth rate from year 2008 to 2009 is

g = 248954 – 232359 X 100 = 7.14%

232, 359