Session 2-3 National Income Accounting 1

8/3/2019 Session 2-3 National Income Accounting 1

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National Income Accounting:

Important Identities

Dr. Leena Mary Eapen


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National Income Accounting: Measures the currenteconomic activity: Production, Income, andSpending of Nations

Accounting methodology is vital for identifyingeconomic problems and formulating plans forachieving goals.

Basic Measures:

Gross Domestic Product (GDP) is the value of all

final goods and services produced in the countrywithin a given period.

To assess the employment opportunity in a countryGDP is the best indicator.


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

National income/product is that income/ productwhich accrues to the economic agents who are

resident of the country from both domestic sourcesand foreign sources (e.g. remittance from non-residents working abroad, income due to a foreignwork assignment to a resident).


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In your country,

which would you wantto be bigger, GDP or GNP?

Why?


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How to measure GDP?

The Product Approach: measures economic activity byadding the market values of goods and services produced.

The Expenditure Approach: measures activity by adding theamount spent by all ultimate users of output.

The Income Approach: measures economic activity byadding all income received by producers of output,including wages received by workers and profits receivedby owners of firms.

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


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Q1

P1

QF2

WF2

Q2

P2WF1

QF1

D2D2

The interdependence of goods and factor markets

P

Q

P

Q

RsRs

RsRs

Factorservices

Goods

GoodsFactor

services

S S

D1 D1

(1)

Consumerdemand

(4)Factor

supply

(3)Factor

demand

(2)Producer

supply

OO

FIRMS(suppliers of goods and

services,demanders of factor

services)

HOUSEHOLDS

(demanders of goodsand services,

suppliers of factorservices)


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Factorpayments

Consumption ofdomestically

produced goodsand services (Cd)

Investment (I)

Government

expenditure (G)

Export (X)

BANKS, etc

Netsaving (S)

GOV.

Nettaxes (T)

ABROAD

Importexpenditure (M)

The circular flow of income

WITHDRAWALS

INJECTIONS


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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.


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Stock A stock is a quantity measured at a givenpoint 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


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Stocks vs. Flows

stock flow

a persons wealth a persons saving

# of people with # of new college

college degrees graduates

the govt. debt the govt. budget deficit

Flow Stock

More examples:


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The Product Approach

The production approach looks at GDP from thestandpoint of value added by each input in the

production process.

By final we mean exclusion of all intermediateproducts/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.


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Farmer sells to

Miller Sales price of raw wheat Rs. 100

Miller buys wheat

from farmer and

converts to wheat

flour and sells to

baker

Cost of raw material to miller

(Raw wheat)

Processing expenses (Say

cleaning and grinding)

Sales price of wheat flour

Rs. 100

Rs. 90

Rs. 190

Baker buys wheat

flour from miller

and converts tobread 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


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A question for you:

A farmer grows a bushel of wheatand sells it to a miller for Rs10.00.

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 anengineer for Rs 60.00.

The engineer eats the bread.ComputeGDP


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Imagine that a bakery hires workers toproduce more bread, pays their wages,

and then fails to sell the additional bread.How does this transaction affect GDP?


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The answer depends on what happens tothe unsold bread:

bread spoils no change in GDP

bread is put into inventory to be soldlater increase in GDP

Baker consumed the bread- increase

in GDP


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Unsold output goes into inventory,

and is counted as inventoryinvestment

whether the inventory buildup was intentional

or not.

In effect, we are assuming that firms purchase

their unsold output.


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


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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 positivespending by consumers, so the sale out of inventory

does not affect GDP.

However, the value of the services of the firm in thesale is part of GDP, because those services are

provided in the current period.


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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


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Consumption (C)

durable goodslast a long timeex: cars, homeappliances

non-durablegoodslast a short timeex: food, clothing

services

work done forconsumersex: dry cleaning,air travel.

def: the value of all goodsand services bought byhouseholds. Includes:

Consumption is the largest proportion of GDP.


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Gross Private Domestic Investment (I) orGross 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 equipmentthat firms will use to produce other goods & services

residential fixed investment: spending on housing units byconsumers and landlords

inventory investment: the change in the value of all firmsinventories (or) it is the difference between goods produced andgoods sold.


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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 itrepresent only the exchange of certificates of

ownership (stocks) and not actual new production.


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Investment vs. Capital

Capital is one of the factors of production.At any given moment, the economy has a certain overallstock 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

G S di (G)


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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.


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Can exports exceed GDP?


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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 was157%. India in the same year only 13%.


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The Income Approach

Income is what you earn from working plus what youreceive in interest and dividends.

The income approach divides GDP according to whoreceives the income from the spending flow.

In addition to aggregate income, national income andpersonal 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.


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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 ownedbusinesses, 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 areexcluded).

Taxes on production and imports

Depreciation (consumption of fixed capital )

The Income Approach


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Mario works at Pizza Hut and earns an annualwage plus tips of Rs 15,000. He sold 4,000pizzas at Rs 10 per pizza during the year. Hewas unemployed part of the year, so he

received unemployment compensation of Rs3,000. During the past year, Mario bought aused car for Rs10,000. Using theexpenditure approach, how much has Mariocontributed to GDP?

How Much Does Mario Add to GDP?


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Other Indicators Per capita GNP = GNP/Population.

It represents the average income of a country.

It indicates the level of economic development orliving standard of individuals in comparison to other

countries.


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Net Domestic Product (NDP) is GDP minusdepreciation. Depreciation is usually

11%.

NDP=89% of GDP

National Income (NI) or NDP at factor cost isNDP-Indirect taxes that Business pay +subsidy.

Indirect taxes that Business pay nearly 10%.

NI is nearly 90% of NDP


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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 fromminerals etc)

It is also equal to personal consumption expenditures

plus personal saving.


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National savings, S= Spvt+ Sgovt

Spvt = private corporate sector + householdsavings

Sgovt is also called as govt budget surplus.

IfSgovt is negative then it is known as govt

budget deficit.

Savings


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Household savings

Household savings: Financial and physical

savings.

Financial savings in the household sectorcomprise savings in the form of currency, net

deposits, shares and debentures, life insurancefunds, PFs, pension funds etc.

Savings in physical assets consist of net addition

to physical assets of the household, comprisinginvestment in land, houses, cattle, machineryand equipment, change in stocks etc.


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Period savings as share

to GDP

share of financial

savings to total

saving

1970-71 1.5 per cent 28.1 per cent




2006-07 34.8per cent Less than 50

percent

I t ti l C i f GDP


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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 priceindexes.

The exchange rate is adjusted to reflect this ratio.

Purchasing Power Parity Exchange Rate (PPPER)

= e Pf/Pd

Here e is $/`.


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How NI arrived at in India?

NI estimates are arrived by dividing the economy into

a few broad sectors and use estimates of value addedby them to arrive at a figure for NI.

The major sectors considered by the CentralStatistical Organisation of India include the

following.

http://mospi.nic.in/t1_income_at

_current_price_7april05.htm
http://mospi.nic.in/t1_income_at_current_price_7april05.htmhttp://mospi.nic.in/t1_income_at_current_price_7april05.htmhttp://mospi.nic.in/t1_income_at_current_price_7april05.htmhttp://mospi.nic.in/t1_income_at_current_price_7april05.htm


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Sectoral Composition of GDP

Year Primary Secondary Tertiary

1950-51 59.2 13.3 28.0

1960-61 54.8 16.6 29.0

1970-71 48.1 19.9 32.2

1980-81 41.8 21.6 36.6

1990-91 34.9 24.5 40.6

2000-01 26.2 23.5 50.3

2003-04 23.9 23.4 52.7

March

2010 19.57 25.88 54.56


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Problems with NI Estimation in India

Weaknesses in respect of data used for estimatingNI. Gaps in data (e.g. no data are collected forunauthorized removal of forest produce and fellingof trees outside the regular forests).


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Unpaid activitiesMultiple jobs sector??

not marketed Oil spill wave Negative externality


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Quality excluded Services of durable goods excluded.

Unorganized sector- guess work Education input or output?

Is NI correct indicator of economic development?


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Due to following reasons, NI fails to serve as acomplete/adequate index of welfare.

(a) Income distribution is not reflected at all in NI. Even a veryhigh GDP may not contribute much to the well-being of anation if it is not distributed equally.

(b) Apart from income there are many other factors such asbetter education, health and drinking water facilities, thevalue 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 hasserious effects on the well-being/quality of life of thesociety/citizens.

Is NI correct indicator of economic development?


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P: 141 CP


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Nominal vs Real GDP

Nominal GDP is GDP measured in currentprices.

Real GDP is GDP measured at constantprices to compare economys performance

over time.


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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.

It C t (2011) C t B (1993)


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Items Current year (2011)

production

Current year

prices

Base year (1993)

prices

Wheat 10 5 4

Car 6 9 8

Computer 15 6 5

Compute the nominal and real GDP in 2011 and

1993.

Price Indexes


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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.


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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 price index

3.Wholesale price index


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GDP Deflator

GDP Deflator is a price index that measures theoverall level of prices of goods and services included

in GDP and is defined by the formula

Nominal GDPGDP deflator = 100

Real GDP


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Inflation Practice problem

Compute nominal GDP in each year

Compute real GDP in each year using 2001 asthe base year.

The base period has no particular significance.

2001 2002 2003 2004

P Q P Q P Q P Q

good A 30 900 31 1,000 36 1,050 34 1,050

good B 100 192 102 200 100 205 100 205

P ti bl


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Practice problem

Compute the GDP deflator in each year.

Use GDP deflator to compute the inflation rate from 2001 to2002, from 2002 to 2003 and from 2003 to 2004.

Nom.GDP

RealGDP

GDPDeflator

inflation

rate

2001 46,200 46,200 n.a.

2002 51,400 50,000

2003 58,300 52,000

2004 56,200 52,000

GDP L l V G th R t


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GDP: Level Versus Growth Rate

GDP growth equals:

1

1)(

t

tt

Y

YY

Periods of positive GDP growth are called expansions.

Periods of negative GDP growth are called recessions.


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Calculate the percentage growth of nominal and real

GDP in 2002.

Nom. GDP Real GDP

2001 46,200 46,200

2002 51,400 50,000

2003 58,300 52,000

2004 56,200 52,000

C P i I d (CPI)


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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 remainfixed over time.

Consumer Price Index (CPI):


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How CPI is constructed?

Household survey is conducted to find outconsumption of a typical household.

CPI is released on monthly basis.

Used to

track changes in the typical households cost of

living adjust many contracts for inflation

allow comparisons of currency from different years

C P i I di


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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 Governmentand in the organized sectors (2001 as base year).

CPI UNME series is published by the CentralStatistical Organisation, the others are publishedby the Department of Labour.

Consumer Price Indices


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CPI vs. GDP DeflatorPrices 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

h fl


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Reasons why CPI may overstate inflation

Substitution bias: The CPI uses fixed weights, so itcannot reflect consumers ability to substitute toward

goods whose relative prices have fallen.

Introduction of new goods: The introduction of newgoods 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.


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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 derivedbased on the value of

quantities traded in the domestic market.

It is, therefore, the most comprehensive measure of economy-

wide inflation available with high frequency.

CPI measures prices at retail level, WPI is constructed atwholesale level. WPI measures average level of prices of goods

sold by producers.

Wholesale Price Index (WPI):


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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.


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WPI in India

Description

Weights

1981-82 1993-94 2004-05

I. Primary Articles 32.30 22.02 20.1

II. Fuel, Power, Light &

Lubricant 10.66 14.23 14.9

III. Manufactured Products 57.04 63.75 64.9

All Commodities 100 100 100


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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! Non-

transparency 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 andservices 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.


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Thank You

Session 2-3 National Income Accounting 1

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