National Income Accounting: Important Identities

Dr. Leena Mary Eapen

 National Income Accounting: Measures the current economic activity: Production, Income, and Spending of Nations Accounting methodology is vital for identifying economic problems and formulating plans for achieving goals. Basic Measures:
Gross Domestic Product (GDP) is the value of all final goods and services produced in the country within a given period. To assess the employment opportunity in a country GDP is the best indicator.

Gross National Product (GNP) = GDP + Net factor income from abroad ((factor payments from abroad factor payments to abroad)

National income/product is that income/ product which accrues to the economic agents who are resident of the country from both domestic sources and foreign sources (e.g. remittance from nonresidents working abroad, income due to a foreign work assignment to a resident).

In your country, which would you want to be bigger, GDP or GNP? Why?

How to measure GDP?

The Product Approach: measures economic activity by adding the market values of goods and services produced. The Expenditure Approach: measures activity by adding the amount spent by all ultimate users of output. The Income Approach: measures economic activity by adding all income received by producers of output, including wages received by workers and profits received by owners of firms.

Fundamental identity of national income account: total production = total income = total expenditure

The interdependence of goods and factor markets

(3) Factor demand Rs Rs (2) Producer supply

Factor services P WF2 WF1 D2 D1 O QF1QF2 Q

HOUSEHOLDS (demanders of goods and services, suppliers of factor services)

Goods
FIRMS (suppliers of goods and services, demanders of factor services)

P S P2 P1 D2 D1

Q1 Q2

Factor services (4) Factor supply Rs

Goods Rs (1) Consumer demand

The circular flow of income

INJECTIONS

Investment (I)

Export (X)

Factor payments

Consumption of domestically produced goods and services (Cd)

Government expenditure (G) BANKS, etc GOV. ABROAD

Net saving (S)

Import Net expenditure (M) taxes (T)

WITHDRAWALS

Withdrawals [ T + S + M] = Injections [G + I + X] can be broken down to three important balances in the economy:

1. T - G: the Government's Budgetary Balance; 2. S - I: the Private Sector's Saving/Investment Balance; 3. M - X: (current account of Balance of Payments)

Exports = imports trade balance

All measurements in the circular flow model are rates of change (flows) and tell us nothing about the total amounts (stocks) of goods, services, money or anything else in the economy.

Stocks vs. Flows

Stock A stock is a quantity measured at a given point in time e.g., items on a balance sheet (assets and liabilities), the worlds oil reserves in the beginning of a year.

Flow A flow is a quantity measured per unit of time. e.g., items on an income statement (receipts and expenses), the worlds current production of oil per day.

Stocks vs. Flows

Flow

Stock

More examples:
stock a persons wealth # of people with college degrees the govt. debt flow a persons saving # of new college graduates the govt. budget deficit

The Product Approach

The production approach looks at GDP from the standpoint of value added by each input in the production process. By final we mean exclusion of all intermediate products/inputs used up in the production. Measure the Value Added summed across all firms (value added = sale price - cost of raw materials). This is to avoid double counting.

Farmer sells to Miller Miller buys wheat from farmer and converts to wheat flour and sells to baker

Sales price of raw wheat Cost of raw material to miller (Raw wheat) Processing expenses (Say cleaning and grinding) Sales price of wheat flour

Rs. 100 Rs. 100

Rs. 90 Rs. 190

Baker buys wheat flour from miller and converts to bread and sells to the Consumer

Cost of raw material to baker (Wheat Flour) Processing expenses (baking, packing) Sales price of packaged bread (Final good)

Rs.190

Rs.80 Rs.270

A question for you:

A farmer grows a bushel of wheat and sells it to a miller for Rs 10.00. The miller turns the wheat into flour and sells it to a baker for Rs 30.00. The baker uses the flour to make a loaf of bread and sells it to an engineer for Rs 60.00. The engineer eats the bread. Compute

GDP

Imagine that a bakery hires workers to produce more bread, pays their wages, and then fails to sell the additional bread. How does this transaction affect GDP?

The answer depends on what happens to the unsold bread:

bread spoils no change in GDP bread is put into inventory to be sold

later increase in GDP

Baker consumed the bread- increase

in GDP

Unsold output goes into inventory, and is counted as inventory investment whether the inventory buildup was intentional or not. In effect, we are assuming that firms purchase their unsold output.

What happens to GDP later when the firm sells the bread out of inventory?

This case is much like the sale of a used good.

There is spending by bread consumers, but there is inventory disinvestment by the firm. The negative spending by the firm offsets the positive spending by consumers, so the sale out of inventory does not affect GDP. However, the value of the services of the firm in the sale is part of GDP, because those services are provided in the current period.

Spending/Expenditure Approach
The spending approach divides GDP into four areas:

Spending by households (consumption) (C) Spending by businesses (investment) (I) Spending by government (G) and Net Spending by foreign sector (net exports, NX = X-M).

Y = C + I + G + NX

Consumption (C)
def: the value of all goods and services bought by households. Includes:
durable goods last a long time ex: cars, home appliances non-durable goods last a short time ex: food, clothing services work done for consumers ex: dry cleaning, air travel.

Consumption is the largest proportion of GDP.

Gross Private Domestic Investment (I) or Gross Capital Formation

def1: spending on [the factors of production] capital.

def2: spending on goods bought for future use.

Includes: business fixed investment: spending on plant and equipment that firms will use to produce other goods & services residential fixed investment: spending on housing units by consumers and landlords inventory investment: the change in the value of all firms inventories (or) it is the difference between goods produced and goods sold.

Sales = production inventory investment Very small proportion of GDP some times even negative.

Investment in shares is the financial investment

which is not included.

Stock market transactions are not included because it represent only the exchange of certificates of ownership (stocks) and not actual new production.

Investment vs. Capital

Capital is one of the factors of production. At any given moment, the economy has a certain overall stock of capital. Investment is spending on new capital.

Example (assumes no depreciation): 1/1/2010: economy has $500b worth of capital during 2010: investment = $37b 1/1/2011: economy will have $537b worth of capital

Government Spending (G)

G includes all government spending on goods and services.

G excludes transfer payments. Transfer payments are transactions wherein one party is not obliged to deliver a good or service in return for the payment. Examples: retirement benefits, unemployment benefits, scholarships, donations etc.

Similarly, interest payments on the national debt are not counted.

Can exports exceed GDP?

Yes. For example, a country that imports intermediate goods for Rs 1000. Suppose it then transforms them into final goods using only labor. Say that labor is paid only Rs 200 and that there are no profits. The value of these final goods is thus equal to Rs 1200. Assume that these goods are exported. Then GDP = Rs 200 and the ratio of exports to GDP = 1200/200 = 6. In 2010, the ratio of exports to GDP in Singapore was 157%. India in the same year only 13%.

The Income Approach

Income is what you earn from working plus what you receive in interest and dividends. The income approach divides GDP according to who receives the income from the spending flow. In addition to aggregate income, national income and personal income are also used as measures of income.

Income Method: Labor Income (wages/salary) + Capital Income (rent, net interest, dividends, profits)+ Government Income (taxes) + Depreciation.

The Income Approach

The Income Components Include:

Wages and salaries (largest component)

Corporate profits (Corporate income taxes + Dividends Undistributed corporate profits)

Proprietors income (the profits of partnerships and solely owned businesses, like a family restaurant)

Farm income
Rental income of persons Net Interest (only the interest payments made by business firms are included and the interest payments made by government are excluded). Taxes on production and imports Depreciation (consumption of fixed capital )

How Much Does Mario Add to GDP?

Mario works at Pizza Hut and earns an annual wage plus tips of Rs 15,000. He sold 4,000 pizzas at Rs 10 per pizza during the year. He was unemployed part of the year, so he received unemployment compensation of Rs 3,000. During the past year, Mario bought a used car for Rs10,000. Using the expenditure approach, how much has Mario contributed to GDP?

Other Indicators

Per capita GNP = GNP/Population.

It represents the average income of a country.

It indicates the level of economic development or living standard of individuals in comparison to other countries.

Net Domestic Product (NDP) is GDP minus depreciation. Depreciation is usually 11%. NDP=89% of GDP National Income (NI) or NDP at factor cost is NDP-Indirect taxes that Business pay + subsidy.
Indirect taxes that Business pay nearly 10%. NI is nearly 90% of NDP

 Personal Income (PI) = NI - indirect taxes - corporate profits - net interest - contributions for social insurance + income from assets + personal transfers. Personal Disposable Income (DI) = PI personal tax and non-tax payments (user charges, royalty from minerals etc) It is also equal to personal consumption expenditures plus personal saving.

Savings

National savings, S= Spvt+ Sgovt

Spvt = private corporate sector + household savings Sgovt is also called as govt budget surplus.
If Sgovt is negative then it is known as govt budget deficit.

Household savings

Household savings.

savings:

Financial

and

physical

Financial savings in the household sector comprise savings in the form of currency, net deposits, shares and debentures, life insurance funds, PFs, pension funds etc. Savings in physical assets consist of net addition to physical assets of the household, comprising investment in land, houses, cattle, machinery and equipment, change in stocks etc.

Period

1970-71

savings as share share of financial to GDP savings to total saving 1.5 per cent 28.1 per cent

1980-81 1990-91
1998-99 2006-07

4.9 per cent 14.2 per cent

18.5 per cent 34.8per cent

39.4 per cent 56.8 per cent

59.1 per cent Less than percent 50

International Comparisons of GDP

In any attempt to compare GDP between countries, some account must be taken of differences in prices.

Purchasing power parity exchange rates attempt to adjust exchange rates for differences in the prices of goods across borders through the use of a ratio of price indexes.
The exchange rate is adjusted to reflect this ratio. Purchasing Power Parity Exchange Rate (PPPER) = e Pf/Pd

Here e is $/`.

How NI arrived at in India?

NI estimates are arrived by dividing the economy into a few broad sectors and use estimates of value added by them to arrive at a figure for NI. The major sectors considered by the Central Statistical Organisation of India include the following.

http://mospi.nic.in/t1_income_at _current_price_7april05.htm

Sectoral Composition of GDP

Year 1950-51 1960-61 Primary 59.2 54.8 Secondary 13.3 16.6 Tertiary 28.0 29.0

1970-71 1980-81
1990-91 2000-01 2003-04 March 2010

48.1 41.8
34.9 26.2 23.9 19.57

19.9 21.6
24.5 23.5 23.4 25.88

32.2 36.6
40.6 50.3 52.7 54.56

Problems with NI Estimation in India

Weaknesses in respect of data used for estimating NI. Gaps in data (e.g. no data are collected for unauthorized removal of forest produce and felling of trees outside the regular forests).

Multiple jobs sector?? Unpaid activities

not marketed

Oil spill wave

Negative externality

Quality excluded

Services of durable goods excluded.

Unorganized sector- guess work

Education input or output?

Is NI correct indicator of economic development?

Due to following reasons, NI fails complete/adequate index of welfare.

to

serve

as

(a) Income distribution is not reflected at all in NI. Even a very high GDP may not contribute much to the well-being of a nation if it is not distributed equally. (b) Apart from income there are many other factors such as better education, health and drinking water facilities, the value of leisure, declining work week, nice week end etc. which determine human welfare. We cant ignore them. (c)Environmental pollution in the process of production has serious effects on the well-being/quality of life of the society/citizens.

P: 141

CP

Nominal vs Real GDP

Nominal

GDP is GDP measured in current

prices.
Real

GDP is GDP measured at constant prices to compare economys performance over time.

Real GDP controls for inflation

Changes in nominal GDP can be due to: changes in prices changes in quantities of output produced or a combination of these two.

Changes in real GDP can only be due to changes in quantities, because real GDP is constructed using constant base-year prices.

Items

Current year (2011) production 10

Current year prices 5

Base year (1993) prices 4

Wheat

Car
Computer

6
15

9
6

8
5

Compute the nominal and real GDP in 2011 and 1993.

Price Indexes

The inflation rate is the percentage increase in the overall level of prices. An inflationary situation does not mean that all prices are rising without exception.
Since many goods & services are produced in economy, some prices may actually be falling and others may be rising at any point of time. But note that if the price of only one/very few goods goes up, then it is not inflation. It is inflation, if the prices of most goods go up.

Price Indexes

A price index is a measure of the average level of prices for some specified set of goods and services, relative to the prices in a specified base year. Different prices indexes are:
1.GDP Deflator 2.Consumer 3.Wholesale

price index price index

GDP Deflator

GDP Deflator is a price index that measures the overall level of prices of goods and services included in GDP and is defined by the formula

Nominal GDP GDP deflator = 100 Real GDP

Inflation Practice problem

2001 P good A good B 30 100 Q 900 192 P 31 102 2002 Q 1,000 200 P 36 100 2003 Q 1,050 205 P 34 100 2004 Q 1,050 205

Compute nominal GDP in each year Compute real GDP in each year using 2001 as the base year. The base period has no particular significance.

Practice problem
Nom. GDP 46,200 51,400 58,300 Real GDP 46,200 50,000 52,000 GDP Deflator inflation rate n.a.

2001 2002 2003

2004

56,200

52,000

Compute the GDP deflator in each year. Use GDP deflator to compute the inflation rate from 2001 to 2002, from 2002 to 2003 and from 2003 to 2004.

GDP: Level Versus Growth Rate

GDP growth equals:

(Yt Yt 1 ) Yt 1
Periods of positive GDP growth are called expansions. Periods of negative GDP growth are called recessions.

Nom. GDP 2001 2002 2003 2004 46,200 51,400 58,300 56,200

Real GDP 46,200 50,000 52,000 52,000

Calculate the percentage growth of nominal and real GDP in 2002.

Consumer Price Index (CPI):

CPI is a measure of inflation based on what average consumer pays. It measures cost of buying a fixed basket of goods and services by consumers. The CPI is a weighted average of prices. The weight on each price reflects that goods relative importance in the CPIs basket. Note that the weights remain fixed over time.

How CPI is constructed?

Household survey is conducted consumption of a typical household. CPI is released on monthly basis.

to

find

out

Used to track changes in the typical households cost of living adjust many contracts for inflation allow comparisons of currency from different years

Consumer Price Indices

The four consumer price indices are: CPI-IW for industrial workers; CPI-UNME for urban non-manual employees; CPIAL for agricultural laborers; and, CPI-RL for rural laborers.

CPI-IW used for wage indexation in Government and in the organized sectors (2001 as base year).
CPI UNME series is published by the Central Statistical Organisation, the others are published by the Department of Labour.

CPI vs. GDP Deflator

Prices of capital goods
included in GDP deflator (if produced domestically) excluded from CPI

Prices of imported consumer goods included in CPI excluded from GDP deflator Basket of goods CPI: fixed GDP deflator: changes every year

Reasons why CPI may overstate inflation

Substitution bias: The CPI uses fixed weights, so it cannot reflect consumers ability to substitute toward goods whose relative prices have fallen. Introduction of new goods: The introduction of new goods makes consumers better off and, in effect, increases the real value of the currency. But it does not reduce the CPI, because the CPI uses fixed weights. Unmeasured changes in quality: Quality improvements increase the value of the currency, but are often not fully measured.

Wholesale Price Index (WPI):

Like CPI, WPI is a measure of cost of a given basket of goods.

WPI is an economy-wide index covering 676 commodities. Weights of the commodities are derived based on the value of quantities traded in the domestic market.
It is, therefore, the most comprehensive measure of economywide inflation available with high frequency.

CPI measures prices at retail level, WPI is constructed at wholesale level. WPI measures average level of prices of goods sold by producers.

WPI is useful because it gives us an idea of what will happen to consumer prices in the near future it signals changes in CPI/general price level.
How? If producers receive higher prices from sale to wholesalers, then retailers will charge higher prices, which will reflect in CPI. WPI is released on weekly basis. In India, we use WPI as our official measure of inflation. India constituted the last WPI series of commodities in 2004-05.

WPI in India
Weights Description I. Primary Articles II. Fuel, Power, Light & Lubricant 1981-82 32.30 1993-94 22.02 2004-05 20.1

10.66

14.23

14.9

III. Manufactured Products

57.04

63.75

64.9

All Commodities

100

100

100

Pros and Cons of WPI & CPI

CPI takes time to get published (monthly). But, WPI is released on weekly basis. WPI data is more transparent compared to CPI data CPI for all commodities taken together is not available! Nontransparency has encouraged mistrust of CPI. CPI measures increase in price that a consumer will ultimately have to pay for. But WPI not. Many commodities included in WPI have ceased to be important from consumption point of view. In WPI, fuel group gets a much higher weightage and services not included. In CPI, food gets maximum weightage. Also, WPI differs from CPI in coverage - e.g. WPI includes raw materials and semi-finished goods.

Thank You