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National Income

0 A National Income estimate measures the volume of

commodities and services turned out during a period,

counted without duplication.

0 National income of a country can be defined as the total

market value of all final goods and services produced in the

economy in a year.

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Two things to be noted:

0 One, it measures the market value of annual output, hence

national income is a monetary measure

0 Second, for calculating national income accurately, all

goods and services produced in any given year must be

counted only once.

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The Three Interpretations

0 The concept of national income has three interpretations:

0 it represents a total value of production,

0 it represents a receipts total, and

0 it represents an expenditure total.

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The Three Fold Identities

0 Because every expenditure is at the same time a receipt,

and as goods and services are valued at market prices, we

have three fold identities, namely,

0 that the value received equals the value paid equals the

value of goods and services produced and sold.

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Figure 1 The Circular-Flow Diagram

Spending

Goods andservicesbought

Revenue

Goodsand servicessold

Labor, land,and capital

Income

= Flow of inputs and outputs

= Flow of rupees

Factors ofproduction

Wages, rent,and profit

FIRMS•Produce and sellgoods and services

•Hire and use factorsof production

•Buy and consumegoods and services

•Own and sell factorsof production

HOUSEHOLDS

•Households sell•Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

•Firms sell•Households buy

MARKETSFOR

GOODS AND SERVICES

Copyright © 2004 South-Western

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Assumptions

0 Households and firms do not save from their income and

profits.

0 Government does not play any role in national economy.

0 No taxes are collected and no expenditure made.

0 There are no imports or exports of goods and services.

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Circular Flow with Saving and Investment

0 When households save, their expenditure will decline to that extent.

0 Money flow to the business will contract.

0 Firms will hire few workers or reduce factor payments.

0 This will lead to a fall in total income of households.

0 Thus, savings reduce flow of money expenditure to business and will cause a fall in economy’s total income.

0 Therefore, savings is a leakage from the money expenditure flow.

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Circular Flow with Saving and Investment

0 However, savings by households need not reduce aggregate spending and income.

0 In a free market economy there exist a financial market.

0 All the savings comes to the financial market.

0 Firms borrow from financial market for capital expenditure and future capacity.

0 Thus, the savings are brought into expenditure stream as a result flow of spending does not decrease.

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Condition for Constancy of Circular Flow

0 Planned savings must be equal to planned investment.

0 If planned investment falls short of planned savings…

0 Expenditure, income, output and employment will fall

contracting the flow of money.

0 Stock of goods will increase, owing to deficiency in demand.

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0 Consequently, smaller amount of goods will be produced

causing investment to fall.

0 The effect of fall in planned investment or planned savings

is the same, a fall in income, output, employment and prices.

0 The flow of money will contract.

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0 If the equality between planned savings and investment is

disturbed by increase in investment demand, the result will

be increase in income, output, employment.

0 As a result the flow of money will expand.

0 Thus, the flow of money income will continue at a constant

level only when the condition of equality between planned

savings and investment is satisfied.

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Classical Economist vs. Keynes

0 Classical economist believed that financial market provides a

mechanism which coordinates the savings of the households

and the investment expenditure by firms.

0 Rate of interest is determined by savings and investment.

0 If savings exceeds investment expenditure, rate of interest

falls.

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0 At a lower rate, investment increases and both becomes

equal.

0 If investment expenditure is greater than savings, rate of

interest will rise.

0 Higher rate of interest causes savings to increase and

become equal to planned investment.

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0 According to Keynes, however, in a free market economy investment is made by firms and savings by households is done for different reasons, there is no guarantee that planned investment will be equal to planned savings.

0 Thus, fluctuation in income, output and employment are inevitable.

0 The circular flow does not continue at a steady level unless certain corrective and preventive steps are taken by government to maintain stability.

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Saving-Investment Identity in NI Accounts

0 The planed or intended investment and savings often differ and affect circular flow.

0 In national income account we are concerned with actualsavings and investment.

0 In a simple economy, the value of output produced, denoted by Y is equal to the value of output sold.

0 The value of output sold is equal to sum of consumptionexpenditure and investment expenditure, we have:

Y = C + I ………………………………. (i)

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0 The unsold output leads to the increase in inventories, and

in national income accounting, increase in inventories is

treated as part of actual investment.

0 This may be considered as the firm selling the goods to

themselves to add to their inventories.

0 Thus, gross national product is used either for consumption

or for investment.

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0 Since national income (= GNP), can be either consumed or saved, we have:

Y = C + S……………………………(ii)

0 From the identities (i) and (ii) we get,

C + I = Y = C + S ………………………… (iii)

0 The left hand side of the identity, C + I = Y shows the component of aggregate demand.

0 The right-hand side of the identity, Y = C + S shows the allocation of NI to either consumption or savings.

0 Thus, identity (iii) shows that the value of output produced or sold is equal to the total income received.

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0 Now subtracting the consumption (C) from both side of the identity (iii) we have

I = S

0 Thus, in two sector economy, investment is identically equal to savings.

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Three Sector Model of Circular Flow0 The inclusion of government sector significantly affects the

overall economic situation.

0 Total expenditure flow in the economy is now the sum of

consumption expenditure (C), investment expenditure (I)and government expenditure (G), Thus,

0 Total Expenditure (E) = C + I + G………………. (i)

0 Total income (Y) received is allocated to consumption, savings and taxes. Thus,

Y = C + S + T ……………………… (ii)

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Three Factor Model of Circular Flow0 Since expenditure made must be equal to income received

(Y), from equation (i) and (ii), we have,C + I + G = C + S + T ………………….. (iii)

0 Since C occurs on both sides of the equation and will be cancelled out, we have

I + G = S + T…………………… (iv)0 By rearranging we obtain,

G – T = S – I …………………….. (v)0 Equation (v) depicts what would be the consequence if

government budget is not balanced.

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Three Factor Model of Circular Flow

0 If (G) is greater than tax revenues (T), the government will

have a deficit budget

0 To finance the deficit, govt. will borrow from the financial

market.

0 Then private investment (I) must be less than savings (S).

0 Thus, govt. borrowings reduces private investment, i.e. govt.

borrowing crowds out private investment.

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Aggregate Output

0 National income and product accounts are an accounting system used to measure the aggregate economic activity.

0 The measure of aggregate output in the national income accounts is gross domestic product, or GDP.

0 In India, Central Statistical Organisation (CSO) along with the Planning Commission calculates GDP and components of the National Accounts.

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Four Factor Model of Circular Flow

0 There are four agents that we will focus on when

constructing a model of the economy:

Households

Firms

Government

“The Rest of the World”

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Markets

0 There are three markets that we focus on:

The Factor Market

The Goods Market

The Financial Market

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Four Factor Model of Circular FlowFirms hire factors of production from households. The blue

flow, Y, shows total income paid by firms to households.

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Households buy consumer goods and services. The red flow, C, shows consumption expenditures.

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Four Factor Model of Circular FlowHouseholds save, S, and pay taxes, T. Firms borrow some of

what households save to finance their investment.

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Firms buy capital goods from other firms. The red flow represents this investment expenditure by firms.

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Governments buy goods and services, G, and borrow or repay debt if spending exceeds or is less than taxes.

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Four Factor Model of Circular FlowThe rest of the world buys goods and services from us, X, and

sells us goods and services, M—net exports are X - M

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Four Factor Model of Circular FlowAnd the rest of the world borrows from us or lends to us

depending on whether net exports are positive or negative.

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Four Factor Model of Circular FlowThe blue and red flows are the circular flow of expenditure

and income. The green flows are borrowing and lending.

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The sum of the red flows equals the blue flow.

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That is: Y = C + I + G + X - M

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Four Factor Model of Circular Flow0 Thus, in an open economy 0 National Income = C + I + G + Xn (X –M)0 Since National Income can be either consumed, saved or

paid as taxes, we have:0 C + I + G + Xn = C + S + T0 Since C is common on both side of the equation, we have:0 I + G +Xn = S + T0 The above equation shows that sum of private investment,

government expenditure and net exports is equal to the sum of savings and tax revenue.

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The circular flow of incomeThe circular flow of income

Consumption, injections, withdrawals and equilibrium

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Factorpayments

Factorpayments

Consumption ofdomestically

produced goodsand services (Cd)




Firms

Households

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Factorpayments

Factorpayments





Investment (I)Investment (I)Government

expenditure (G)Government

expenditure (G)

Exportexpenditure (X)

Exportexpenditure (X)

BANKS, etc

Netsaving (S)

Netsaving (S)

GOV.

Nettaxes (T)

Nettaxes (T)

ABROAD

Importexpenditure (M)

Importexpenditure (M)


WITHDRAWALS

INJECTIONS

National Income

0 National income is the single most important macro variable that represents the ‘economy as a whole’.

0 The level of national income determines the level of all other macroeconomic variables—aggregate consumption, savings and investment, employment and the price level.

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National Income

0 In general sense of the term, national income refers to the aggregate money value of all final goods and services resulting from the economic activities of the people of a country over a period of one year.

Economic Production

0 Economic production refers to the production of those goods and services which are meant for sale and have market value, and those goods and services which are produced and provided jointly to the people by the government and public organisations, for which people pay indirectly through tax payment.

0 All marketable production is economic production but all economic production is not marketable.

For Eg: Services rendered by Govt. , NGOs, charitable services..

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Non Economic Production

0 Non-economic production includes the production of goods and services that are not meant to be sold, nor is there any market for them, nor do they have a market price.

0 To this category belong mainly the following services:i. Services rendered to selfii. Services provided to the family membersiii. Services provided by the neighbours to each other

0 These services are not included in the measurement of the national income.

Intermediate and Final Goods

0 Intermediate goods- The goods that flow from one stage to another in the process of production of a good, with their form changing.

0 Final goods- The goods that reach the final stage of production and flow to their ultimate consumers/ users.

0 The need for distinction between the intermediate and final products arises because of the problem of double counting.

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Intermediate and Final Services

0 The classification of services under the intermediate and final product categories depends on the purpose of their use.

0 When used for production purpose, these services are treated as intermediate products and when used for private consumption, they are treated as final products.

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Transfer Payments

0 Transfer payments are the payments made by people to the people, and by people to the government, without corresponding transfer of goods and services or addition to the total output.

0 Transfer payments are not taken into account while counting the national income.

Consumer and Producer Goods

0 Consumer goods- The goods and services that are consumed by the people to directly satisfy their needs and yield utility to the consumer.

0 Producer goods- The category of final products which are used for enhancing the production capacity of the national economy with the purpose of increasing the flow of income in the future.

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Gross Domestic Product (GDP)

0 The Gross Domestic Product (GDP) can be defined as the sum of market value of all final goods and services produced in a country during a specific period of time, generally one year.

0 It includes income earned by the foreigners in the country and excludes income earned abroad by the residents.

0 The market value of domestic product is obtained at both constant and current prices.

Gross National Product (GNP)

0 The concept of GNP includes the income of the resident nationals which they receive abroad, and excludes the incomesgenerated locally but accruing to the non-nationals.

GNP = Market value of domestically produced goods and services plus incomes earned by the residents of a country in foreign countries minus incomes earned by the foreigners in the country.

GDP = Market value of goods and services produced by the residents in the country

plus incomes earned in the country by the foreignersminus incomes received by residents of a country from abroad.

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Gross National Product (GNP)

0 GNP is generally valued at current market prices representing the final products ready for consumption.

0 Each finished product is multiplied by its price. Hence, changing prices bring about changes in the GNP.

0 To know real GNP, a given GNP at market prices has to be converted to constant prices.

Net National Product (NNP)

0 Net national product (NNP) is gross national product minus capital consumption allowance.

Alternatively,

NNP is the value of total consumption plus the value of net investment of the community.

0 The NNP divided by the population of the country gives the per capita income.

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Various Concepts of National IncomeNet factor income from abroad Less Depreciation

Less net direct taxes

Gross private investment

Gross private investment

Net private investment

Wages

Net exports Net exports Net exports Profits

Government purchases



Interest

Consumption expenditure



Rent

GNP GDP NDPMP NDPFC

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NNPMP

0 GNP – Consumption of fixed capital

0 When depreciation is deducted from GNP we get NNP.

0 It means the market value of all final goods and services after providing for depreciation.

0 It is also called national income at market price.

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NNPFC

0 The sum of all incomes earned by resources suppliers for their contribution of land, labour, capital and enterprise which go into a year’s production.

0 The difference between national income at factor cost and national income at market price arises from the fact that indirect taxes and subsidies cause market price to be different from the factor income resulting from it.

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Example

0 A tax causes market price to be more than the factor cost.

0 A meter of mill cloth sold for Rs. 200 includes Rs. 25 on account of excise and sales tax.

0 While the market price of the cloth is Rs. 200, the factors engaged in its production received Rs. 175.

0 The value of cloth at factor cost would be equal to its value at market price less indirect taxes.

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0 A subsidy causes market price to be less than the factor cost.

0 Suppose handloom cloth is subsidized at Rs. 10 and sells at Rs. 90 a meter.

0 While the consumer pays Rs. 90, the factors will receive Rs. 100.

0 The value of handloom cloth at factor cost would thus be equal to its market price plus the subsidies paid.

0 Thus national income is equal to net national product minus taxes plus subsidies

Example

Personal Income (PI)

0 Personal income (PI) can be defined as the sum of all kinds of incomes received by the individuals from all sources of incomes.

0 PI = NI + Transfer Payments – Income earned but not received .

0 Transfer payment is the income transferred from one citizen, who is earning income, to another citizen.

0 Transfer payments are not taken into account while counting the national income.

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Disposable Income and Private Income

0 Disposable income- refers to personal income of the income earners against which they do not have any legally enforceable payment obligations.

0 Private income-Broadly, all personal incomes are private incomes. However, the term private income is used in contrast to public income.

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Personal Income

0 In moving from national income as an indicator of income earned, to personal income, as an indicator of income actually received, we must subtract from National Income those three types of income which are earned but not received and add those incomes which are received but currently not earned.

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National Income to Disposable Income

Net Factor Income from Abroad

Less

Personal Income

Less Personal Taxes

Profits Undistributed Corporate Profits

Corporate taxesSocial security

contributions

PlusTransfer

Payments

ConsumptionPlus

Savings(C + S)

Disposable Income (DI)

Interest

Rent

Wages and Salaries

Nominal and Real GNP

0 The GNP estimated at current prices is called nominal GNP and GNP estimated at constant prices in a chosen year is called real income.

0 Real GNP gives national income estimates free from distortion caused by inflation or deflation.

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Nominal GDP and Real GDP

0 Nominal GDP ( or money GDP) is GDP measured in current Rupees.

0 Real GDP is the GDP with price effect removed (Sometimes stated as GDP measured in constant Rupees )

0 Real GDP = Nominal GDP X 100GDP Deflator

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Calculating Real GDP

2008 2013

Product Quantity Price Quantity Price

Wheat 80 40 100 50

Onions 90 11 80 10

Textbooks 15 90 20 100

Nominal GDP 7,800

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Calculating Real GDP

Product Quantity Price (in 2008)

Value

Wheat 100 40 4000

Onions 80 11 880

Textbooks 20 90 1800

The quantities of each goods produced in 2008 were irrelevant for calculating real GDP in 2013.

Real GDP 6,680

Notice that the value of Rs 6680 for real GDP in 2013 is lower than the value of Rs 7800 for nominal GDP in the same year

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Practice problem, part 1

0 Compute nominal GDP in each year.

0 Compute real GDP in each year using 2008 as the base year.

2008 20010 2012

P Q P Q P Q

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

good B Rs100 192 Rs102 200 Rs100 205

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Answers to practice problem, part 1

nominal GDP multiply Ps & Qs from same year2008: Rs 46,200 = Rs 30 900 + Rs 100 192 2010: Rs 51,400 2012: Rs 58,300

real GDP multiply each year’s Qs by 2008 Ps2008: Rs 46,2002010: Rs 50,000 2012: Rs 52,000 = Rs 30 1050 + Rs 100 205

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GDP Deflator

100GDP Real

GDP Nominal=deflator GDP

The GDP deflator is calculated as follows:

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Using GDP Deflator

2009 (Rs in billion)

2010 (Rs in billion)

Nominal GDP

10,971 11,734

Real GDP 10,321 10,756

100GDP Real

GDP Nominal=deflator GDP

10010,32110,971=deflatorGDP

In 2009

= 106

10010,75611,734=deflatorGDP

= 109

In 2010

100106

109 - 106=Price Index

2.8%=

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Practice problem, part 2

0 Use your previous answers to compute the GDP deflator in each year.

0 Use GDP deflator to compute the inflation rate from 2006 to 2007, and from 2007 to 2008.

Nom. GDP Real GDP GDP deflator

Inflationrate

2006 Rs 46,200 Rs 46,200 n.a.

2007 51,400 50,000

2008 58,300 52,000

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The GNP Deflator

0 The GNP deflator is essentially an adjustment factor used to convert nominal GNP into real GNP.

0 PIN- Price Index Number of the base year0 The formula for converting nominal GNP of a year into

real GNP

GNP Implicit Deflator

0 GNP implicit deflator is the ratio of nominal GNP to real GNP.

0 The GNP implicit deflator can be used for:(a) To construct price index number, and (b) To measure the rate of change in prices

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Methods of Measuring National Income

0 Net Product Method 0 Value Added Method0 Factor Income Method, and 0 Expenditure Method

Net Product Method

0 This method consists of three stages-

i. Estimating the gross value of domestic output in the various branches of production;

ii. Determining the cost of material and services used and also the depreciation of physical assets; and

iii. Deducting these costs and depreciation from gross value to obtain the net value of domestic output.

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Value Added Method

0 In the net product method, the problem of double counting is often confronted. Value added method is used to avoid double counting.

0 For estimating value added-

i. Identifying the production units and classifying them under different industrial activities.

ii. Estimating net value added by each production unit in each industrial sector.

iii. Adding up the total value added of each final product to arrive at GDP.

Factor Income Method

0 In this method, the national income is treated to be equal to all the “incomes accruing to the basic factors of production used in producing the national products.”

0 In modern economy, the national income is considered to be comprised of three components:

i. Labour incomes,ii. Capital incomes, and iii. Mixed incomes.

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Expenditure Method

0 The expenditure method, also known as the final product method, measures national income at the final expenditure stage.

GDP = C+ I + G + X

0 In order to estimate the aggregate expenditure, any of the following two methods may be followed:

i. Income Disposal Methodii. Product Disposal Method

History of National Income Measurement in India

0 In the pre-independence phase, the first attempt ever to measure national income of India was made by Dadabhai Naoroji in 1867-68.

0 The first systematic attempt to estimate India’s national income was made by Prof. V.K.R.V. Rao for the year 1925-29 and again for the year 1931-32.

0 In the post-independence phase, the first official estimate of India’s national income was made in 1949 by the Ministry of Commerce, Government of India.

0 Since 1967, the task of estimating national income has been assigned to the Central Statistical Organisation (CSO).

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Estimates of India’s GNP, NNP and Per Capita Income at Factor Cost

Annual Growth Rate (%) of India’s GNP, NNP and Per Capita NNP-2000-01 to 2007-08

(All at Factor Cost)

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2_measurement of national income

Documents

flow of money expenditure

money expenditure flow

expenditure total

money flow

total income of households

value of goods

national income estimate

concept of national