Economics Chapter 1.2 – National Income Accounting

Chapter 1.2 – National Income Accounting

Chapter 1.2 – National Income Accounting

1. Introduction to National Income Accounting

• Fundamental Functioning of a Simple Economy:
  • The chapter starts by introducing the key concepts of national income and how it relates to the flow of production in an economy.
  • The focus is on understanding how the resources in an economy are used to generate production and how income and wealth are derived from that process.
• Production and Final Goods:
  • Production in a modern economy involves millions of enterprises, large and small, producing goods and services to be sold to consumers.
  • A final good is a product that is purchased for consumption or investment and will not undergo any more production processes.
  • Capital goods like tools, machines, and buildings are final goods, but unlike consumer goods, they are used to enable production and last over time, undergoing depreciation.
• Intermediate Goods:
  • Not all goods produced are final goods. Some goods are used as inputs for further production, known as intermediate goods.
  • The distinction between final goods and intermediate goods is critical for accurate national income accounting, as intermediate goods are not counted separately to avoid double counting.
• Stocks and Flows:
  • In economics, production can be measured in terms of flows (variables measured over a period of time) and stocks (variables measured at a specific point in time).
  • For instance, a firm’s output is a flow variable, while its inventory of raw materials or finished goods is a stock variable.
• Depreciation:
  • Over time, capital goods experience wear and tear, a process known as depreciation. This means that a portion of the economy’s current output must go toward replacing or maintaining the existing capital stock.
  • Net investment is calculated as:
    Net Investment = Gross Investment – Depreciation.

2. Circular Flow of Income

• The circular flow of income describes how income moves between firms and households in a simplified economy.
  • Households provide labor and other resources to firms in exchange for wages, rents, and profits, which they then spend on goods and services produced by firms.
  • This creates a continuous cycle of income and expenditure, with no leakage in the system.
• Circular Flow and National Income Measurement:
  • National income can be measured using three different methods based on the circular flow:
    1. Product Method: Measures the value of all goods and services produced.
    2. Expenditure Method: Measures the total expenditure on final goods and services.
    3. Income Method: Measures the total income earned by factors of production.

3. Methods of Calculating National Income

• Product (Value Added) Method:
  • This method involves calculating the total value added at each stage of production to avoid double counting.
  • For example, the value of wheat produced by a farmer and the value added by a baker using that wheat to produce bread must be calculated separately.
• Expenditure Method:
  • This method sums up the final consumption expenditure, investment expenditure, government spending, and net exports (exports minus imports).
  • The equation for GDP using this method is:
    GDP = C + I + G + (X – M), where C is consumption, I is investment, G is government spending, and (X – M) represents net exports.
• Income Method:
  • This method sums the incomes earned by the factors of production: wages, rents, interest, and profits.
  • GDP = Wages + Profits + Interest + Rents.

4. Distinctions in National Income Measurement

• Factor Cost vs Market Prices:
  • GDP at Factor Cost includes only payments to the factors of production (wages, rents, etc.), while GDP at Market Prices includes indirect taxes and subsidies.
  • GVA (Gross Value Added) at Basic Prices includes production taxes but excludes product taxes.
• Gross vs Net Measures:
  • Gross Domestic Product (GDP) measures the total value of all final goods and services produced in the economy.
  • Net Domestic Product (NDP) subtracts depreciation from GDP to account for the loss of capital due to wear and tear.

5. Macroeconomic Identities

• Gross National Product (GNP):
  • GNP measures the total value of goods and services produced by the residents of a country, both domestically and abroad.
  • GNP = GDP + Net Factor Income from Abroad (income earned by residents from foreign investments minus income earned by foreigners in the domestic economy).
• Net National Product (NNP):
  • NNP = GNP – Depreciation. This measures the net production after accounting for capital wear and tear.
• National Income (NI):
  • National Income (NI) is the NNP after adjusting for indirect taxes and subsidies.
    NI = NNP at Market Prices – (Indirect Taxes – Subsidies).
• Personal Income (PI) and Personal Disposable Income (PDI):
  • Personal Income is the income actually received by households after adjusting for corporate taxes and undistributed profits.
  • Personal Disposable Income is personal income after paying taxes, representing the income available for households to spend or save.

6. Nominal vs Real GDP

• Nominal GDP is measured at current market prices, without adjusting for inflation. This can give a distorted view of economic growth if prices rise significantly.
• Real GDP adjusts for inflation by using constant prices, giving a more accurate measure of changes in production volume.
• GDP Deflator measures the change in prices by comparing nominal and real GDP.

7. Other Price Indices

• Consumer Price Index (CPI):
  • The CPI measures the average change in prices paid by consumers for a fixed basket of goods and services, often used to measure inflation.
• Wholesale Price Index (WPI) or Producer Price Index (PPI):
  • These indices track the price changes of goods traded in bulk or by producers, such as raw materials.

8. GDP and Welfare

• Limitations of GDP as a Welfare Indicator:
  • GDP measures the total value of production but does not account for income distribution or non-economic factors that contribute to well-being, such as environmental quality or leisure time.

An increase in GDP might benefit only a small portion of the population, leaving others worse off, which would not reflect an improvement in overall welfare.