METHODS OF NATIONAL INCOME ACCOUNTING

Objectives:
After studying this lesson, you will be able to understand

The definition of national income accounting

Different types of national income accounting methods

The main objectives of each accounting method

The importance and limitations different accounting methods in national income accounting

3.1

Introduction

3.2.1 Social Accounting

3.2.2 Input-Output Accounting 3.2.3 Flow of Funds Accounting 3.2.4 Balance of Payments Accounting 3.2 Summary

3.1 Introduction:

In the previous lesson, a mention was made about the Circular flow of income and expenditure which refers to the process whereby the national income and expenditure of an economy flow in a circular manner continuously through time. Now, in this lesson, we made an attempt to understand the various methods in national income accounting and their uses in computing national income. National income of an economy can be measured by following two methods; they are traditional methods of measurement and modern methods of measurement. The following three methods are like Product, Income and Expenditure methods fall under the first category, followed by Social accounting, input-output accounting, flow of funds accounting and balance of payments accounting methods which are belongs to the second category. In this lesson, we will cover the modern methods of measurement since the traditional measurement methods already discussed at undergraduate level.

3.2.1 Social accounting: J R Hicks first introduced the term social accounting into economics, in 1942. Social accounting is a method to present statistically the interrelationships between the different sectors of economy for a through understanding of the economic conditions of the entire economy. In the words of Edey, Peacock and Cooper, Social accounting is concerned with the statistical classification of the activities of human beings and human institutions in ways which help us to understand the operation of the economy as a whole. In other worlds, social accounting describes statistically the economic activities of the different sectors of the entire economy, indicates their mutual relationship and provides a framework for analysis. Social accounts can prepare based on two methods i.e., income and Expenditure method and Matrix method. First let us discuss social accounts under Income and Expenditure method.

We aware about the principle forms of economic activity. they are production, consumption, capital

accumulation, government transactions and transactions with the rest of the world. These in general we consider as the components of social accounting. If the incomings and outgoings of a country relating to these five activities are shown in the form of accounts, they show a closed network of flows representing the basic structure of the economy. We can arrange individual account wise activities, which are provided in the form of accounts. We classify these individual accounts flows are as follows:
a) b) c) d) e) Production Account Consumption Account Government Account Capital Account Foreign Account

Let us try to understand the meaning of each and every sub-account in the social accounting method. The production account includes all forms of productive activity i.e., manufacturing, trading etc, it covers public and private companies, proprietary firms and partnerships, and state owned business undertakings. Since all productive activity takes place within this sector, all payments flow from it the other sectors. Similarly, receipt side of the production account include sales of goods and services, government purchases etc are all flows into this sector. The total of all payment and receipts side items given GNP by income and expenditure. The second one is the consumption account, which refers to the income and expenditure account of household sector. The major items include the payments for consumption to house hold sector and, to government sector, transfer to foreigners and personal savings are all fall under expenditure side and the receipts from business and from government sector are related to the income side of consumption account.

The third sector i.e., Government account relates to the outflows and inflows of the government sector. The items on the payments side are payments to business, persons, foreigners and personal savings. Similarly, on the receipts side, receipts from business and persons. Capital account is the fourth one, which shows that saving equals domestic and foreign investment. On the side of gross investment includes gross private domestic investment and net foreign investment. Receipts include the business savings, personal savings and government surplus. Last and final account is the foreign account shows the transactions of country with the rest of the world. This account covers international movements of goods and services and transfer payments and corresponds to the current account of the international balance of payments.

The five-account system detailed above relates to flows of the economy in terms of production, consumption, government transactions, capital accumulation and transactions with the rest of the world. The accounts based on them are known as functional accounts, as they are based on a classification of transactions according to their functions. The incomings and outgoings of a country relating to these five activities are shown in the form of accounts in the below, based on which, we can prepare the social accounts table.

Table 3.1

Social Accounting Income and Expenditure method

Items Rs (in Crores) ------------------------------------------------------------------------------------1. Payments to Household sector 279 HHs Bs

Income

Exp

2. Payments to government sector 3. Business savings 4. Imports of Goods and Services 5.Consumption expenditure 6.Government purchases 7.Gross Private Domestic investment 8.Exports of Goods and Services 9.Payments to government sector by Household sector 10.Personal savings

12

9 219
36 24 45 15

Gs Bs 9 Fs Bs HHs Bs 30 Bs Cs Bs Fs Gs Cs HHs HHs

Gs

Bs

Bs

Gs

11.Transfer to foreigners

Fs

Gs

Based on the information furnished in the table, we can prepare the Sector-wise tables by following income- expenditure method. In the beginning, one has to identify sector-wise activity and its payments and receipts. Later it is easy to find out through which activity and which sector is paying and receiveing income. Once this process is over, we can prepare sector-wise activities and accounts. For simple understanding, we cam see at the production account of the business sector in the following table:

Table 3.2: Production account of business sector

Payments

Receipts

(1)Payments to household sector (2) Payments to Govt Sector (3) Business (4)Imports of Goods and Services -----

(5) consumption Expenditure 219 (6) Govt Purchases 30 9 (7) Gross Private Domestic Inv (8) Exports of Goods and Services 24 -----

279 12

36

Gross National Income

309

Gross National Expenditure 309

Taking it as an example, we can prepare sector-wise accounts for remaining activities in an economy from the data furnished in table 1. Having discussed Income and expenditure method, now present Social accounts in the form of transaction matrix. A transaction matrix is used for social accounts in which each row contains payments to their sectors and each column contains receipts from other sectors. Every single entry is observed both in a particular row and in a particular column. For balancing social accounts a row- total must equal its corresponding column-total. A matrix of social accounts is shown in the following table prepared based on the information furnished in the table 1:

Receipts Payments 1

Accounts

ProductTion

Consumptio n

Govt

Capital

Foreign

Total

Production

279

12

309

Consumption

219

45

15

285

Government

30

15

57

Capital

36

39

Foreign

24

24

Total

309

285

57

39

24 714

The social accounts matrix presented in table reveals three things. First, each cell shows the equality of the payments to one sect oral account and the receipts from another sect oral account. For example payment of Rs. 279 crores by the production sector to the consumption sector, reading row-wise in the table is shown as the receipt of the consumption sector, reading column wise, second, the total payments of each sect oral account equal the total receipts of this sector, for example the payments of the production sector, reading row-wise amount to Rs. 309crores which equal the total receipts of this sector, reading column wise. Third, the total payments of all sectors equal the total receipts of all sectors in the social accounting matrix. They are Rs. 714crores both row-wise and column wise in the table. Importance of Social accounting: Its importance involves here is due to the innumerable transaction takes place in a country relating to buying and selling, paying and receiving income, exporting and importing, paying taxes etc. the great merit of social accounting lies in classifying and summarising these different kinds of transactions properly, and deriving from these such aggregates as national income ,national expenditure, saving etc., and throw light on the relative importance of different sectors and flows in the economy.

Difficulties in social accounting: In preparing social accounts, imputation is essential but there are many goods and services which are difficult to impute in terms of money. Another important difficulty in preparing social accounts is of double counting. It arises from the failure to distinguish between final and intermediate goods. Not only these, there are several problems like estimation of a number of public services in social accounts, inventory adjustments in the firms production and estimation of depreciation rate of a capital asset. 3.2.2 Input-Output Accounting: The input-output analysis was first developed by W W Leontief. It explains about the industrial interrelationships and inter-dependencies in the economic system. It means that the inputs of one industry are the outputs of another industry and vice versa, and in the process of production, not only inputs, outputs but also intermediate goods production also takes place for further use in the producing outputs. so that ultimately their mutual relationships lead to equilibrium between supply and demand in the economy as a whole. However, the input-output analsyis implies that in equilibrium the money value of aggregate output must equal the sum of the money values of inter industry inputs plus the sum of the money values of inter industry outputs.

The input-output analysis analyses the inter-indusry flows of outputs and their relationships with the gods and services demananded. It is, thus, an improvement over the national income accounting method. Input-Output Table Estimation of the national income by following input-output accounting method is presented based on a transaction matrix. A transactions matrix depicts how the total output of one industry is distributed to all other industries as inputs and for final demand. In the table, industrial breakdowns of the final expenditure and income payments that enter into the national income accounts are provided. A hypothetical input-output matrix is shown in table. In which presented the breakdown of industries both horizontally & vertically, and in the table rows show the amount of each industrys output sold to every other industry and to final buyers. Similarly, the columns show the amount of each industrys inputs bought from every other industry, and from imports and factor services, known as primary inputs because they are not produced by the industries in the country.

Table 3.4:

Input-Output Transaction Matrix

(Rs in Crores)

Purchasing sector Selling Sector

Inputs to ---------------------------------------------Agriculture Manufac Others Final Output turing demand ------------------------------ ---------------------------------------------------------------Agriculture 15 5 Manufacturing 12 17

Total Gross

22 16 45

42

Others Imports Primary inputs

8 7 15

12 5 13

8 20 -

30 7

50 27 48

Gross total inputs

42

45

50

75

212

For example, in this table, first row (horizantally) explains about the agricultural sectors output . It consists of Rs.15 crores to the manufacturing sector, Rs. 5 crores to the other sectors, and RS.22 crores to satisfy the final demand, which comprises exports, capital. Government and personal consumption thus the total gross output of the agriculture sector is Rs 42 crores. Of which Rs 20 crores of intermediate products and Rs 22 crores of final demand. Similarly other rows also depict the same. It may be noted that the row total must equal the column total of the economy in the input output table. It means that total gross output must equal the total gross input of the economy. Importance of Input-Output Accounting: The input output table has come to be used for national income accounting because it provides a more detailed break-down of the macro aggregates and money flows. This analysis is also used for national economic planning. The input-output model provides the necessary information about the structural co-efficient of the various sectors of the economy during a period of time or at a point of time, which can be utilized for the optimum allocation of the economys resources towards a desired end.

Shortcomings of input-output accounting analysis: The analysis rests on the assumption of constant co-efficient of production is unrealistic. In fact, individual industrialists may use different capital structures so that also assumption is not valid. Secondly, it does not tell us why the inputs and outputs are of a particular pattern in economy. Thirdly, the assumption of fixed coefficients of production ignores the possibility of factor substitution.

3.2.3 Flow of funds Accounts: Professor Morris Copeland developed the flow of funds accounts in 1952.. National income accounts do not tell anything about monetary or financial transactions whereby one sector places its saving at the disposal of the other sectors of the economy by means of loans, capital transfers, etc the flow of funds accounts were developed to overcome this weakness of the national income accounting. The flow of funds accounts shows the financial transactions among different sectors of the economy and the link between saving and investment aggregates with lending and borrowing by them. Further, this sort of accounts is concerned with the sources and uses of funds by the various sectors of the economy. Each sectors account reveals all the sources of funds and all the uses to which the funds are put this way of looking at transactions in their entirety has come to be known as the flow of funds approach, or sources and uses of funds. As was presented in Input-Output Accounting, here in this method also, accounts are presented in the form of matrix, which is dividied into a number of sectors, such as household, corporate business, non corporate business etc.,

But for simple understanding, we take a hypothetical flow of funds accounts in the matrix form which is divided into for sectors: households, nonfinancial corporations, financial institutions and government. Same are presented in table.

Table 3.5:
Sectors transactions Category

Flow of Funds Accounts Matrix

House Holds NonFinancia l Corporat ions U S FinnCoal Institut eTins U S GovernMint Savin g Invest Mint

1 Gross saving 2 Gross Investment 3 Net Financial Investment 4 Financial uses (net) (6+7+8+9+10) 5 Financial Sources (net) (6+7+8+9+10) 6 Demand Deposits 7GovernementSecuritie s 8 Corporate Securities 9 Mortgages 10 Net increase in foreign assets

- 27 12 15 25 10 7 4 14 10 -

- 17 28 -11 3 14 -1 2 2 14 -

6 6 6 -2 8 + -

- 40 -4 -

40 40 0 34 34

4 2 -2 -4 0 0 0 0 0 0

U= Use : S= Sources

In the table, sectors were given horizantally and, transactions presented in vertically. For example in the table, row I relates to gross saving which is a source of funds for households and non-financial corporations and the minus figure for the govt which indicates deficit in its budget. Row II relates to gross investment, which is a use of funds by households and non-financial corporations. The last column of the table shows that saving and investment are equal to Rs. 40 each. The figures of saving and investment are supposed to have been taken from the national income accounts of the economy. Based on the above analysis, we can understand other rows. From the above analysis, two important points should be noted : first, financial uses and financial sources of the economy must equal. They are Rs. 34 crores in our table. Second, changes in assets and liabilities of each type of fund must total up to zero. The last column of the table in relation to rows 6,7,8,9,10 reveals this. In the case of row 10 we have taken net increase in foreign assets to be zero for the sake of convenience. If it is a positive figure the balance will show surplus in the international current account of the national income accounts, and a negative figure will show a deficit. Importance of flow of funds accounts: The flow of funds accounts present a comprehensive and systematic analysis of the financial transactions of the economy. Even though national income accounts are fairly comprehensive, yet they do not reveal the financial transactions of the economy.

It also shows how the government finances its deficit or surplus budget and acquires financial assets. They also show the results of transactions in government and corporate securities net increase in deposit and foreign assets in the economy. 3.2.4 Balance of payments accounting:

Balance of payments account of a country is a systematic record of all its economic transactions with the outside world in a given year. It is a statistical record of the character and dimensions of the countrys economic relationships with the rest of the world. In this respect, it is similar to flow of funds accounting except that it is limited to transactions between nations rather than within the nation. As we aware the balance of payments account of a country is constructed on the principle of double-entry bookkeeping like business accounts. But balance of payments accounting differ from business accounting in one respect, business accounting debits are shown on the left side and credits on the right side of the balance sheet whearas, in balance of payments accounting the practice is to show credits (payments received) on the left side and debits (payments paid) on the right side of the balance sheet.

In the balance of payments account, the principal items shown on the credit side are ; a) exports of goods and services, unrequited receipts in the form of gifts etc. from foreigners, b) borrowings from abroad, investments by foreigners in the country, and c) official sale of reserve assets including gold to foreign countries or international agencies. The principal items on the debit side are: a) import of goods ands services, b) transfer payments to foreigners, including to foreign countries, investments by residents to foreign countries, and c) official purchase of reserve assets or gold to foreign countries or international agencies. In the balance of payments account, these debit and credit items are shown vertically according to the principle of doubleentry book keeping. Horizontally, they are divided into three categories the current account, the capital account, and official settlements account or the official reserve assets account. Above mentioned three accounts of a country A are shown in table 6.

Table 3.6 :

Balance of Payments Account of Country A

1. CURRENT ACCOUNT Credits a) Exports of Goods and Services: Merchandise exports ----+30 +30

Travel & Transportation Services:

+2.5

Income on investments abroad Other Total exports of goods and services

+4.5

+2.4
----+39.4 +9.4

Debits B) Imports of goods and services -25.5 -------Services: Travel and Transportation Income from foreign investments in the Country Other -4.6 -25.5

-2.4
-4.8 -------11.8 -37.3

Total imports of goods and services Balance on goods and services (total of A-B) Unilateral Transfers ( net) Current account balance

+2.1 -0.9 --------------===---------+1.2 --------------------------------------

2. CAPITAL ACCOUNT

A) Transaction in country As assets and investments abroad(net) a)Private Direct Portfolio Short term
a) Government excluding official reserve Assets Total (a+b) B)Transaction in foreign assets and investments In country A (net) relate to Credits a) Private Direct Portfolio Short term b) government excluding official reserve assets Total (a+b) capital account balance (A-B) Credits

-2.5 -1.6 -0.8 ---------- -4.9

-1.7
-----6.6 -----

+0.2 +1.8 +2.4 -----+1.2 ----+5.6 ------1.0

+4.4

1 OFFICAIL SETTLEMENTS ACCOUNT Transactions in country As Official Reserve assets Errors and Omissions (net)

+0.5 -----0.7

The most importnat items. In the current account are, merchandise exports and imports. The difference between exports and imports of a country is its balance of trade. If exports exceed imports, the balance of trade is favourable in the opposite case it is unfavourable. In our table, the balance of trade is favourable. In the capital account two types of transactions have been shown, private and government excluding official reserve assets. Private transactions include all types of investments: direct : portfolio and short term. Government investments consist of loans to and from foreign official agencies. The capital account balance shows a deficit. The official settlement account show a transaction in country As official reserve assets (net). It has been shown as a credit item. However, total credits and debits of the three accounts must equal in accordance with the theory of double-entry book-keeping because the balance of payments of a country always balances in the accounting sense.

3.3 Summary In this lesson you learnt about the various methods of national accounting pursued by an economy. The important methods are : Social accounting, input-output accounting, flow of funds accounting and balance of payments accounting. Each method has its own limitations and importance from the point of view of national income accounting. Social accounting helps in understanding the structure of an economy and relative importance of the different sectors and flows whear as the input-output method provides the necessary information about the structural co-efficients of the various sectors of the economy during a period of time and the flow of funds accounts present a comprehensive and systematic analysis of the financial transactions of the economy but the balance of payments account is systematic record of all transactions of not only the economy but also with the outside world in a given year. Therefore, in the estimation of national income of a particular economy, one can use any one of the methods which is most suitable to their economy

3.6 Self Assessment Questions Short answer questions

what are the different types of national accounting methods? Explain the various sub component of production account? what do you mean by double counting? write a note on capital account?
Long answer questions

State the importance of a Social Accounting method? Explain the input-output transactions analysis of national income accounting? Discuss the need and importance of flow of funds accounts? Explain, how the balance of payments accounts are relation
to national income accounts?

3.7 Suggested Readings:

Hicks, J R: Social Frame Work Shapiro Edward: Macro Economic analysis Abraham, WI: National Income and Economic Accounting Rao VKRV: National income Accounting Jhingon ML: Macro economic theory, 11/e