Chapter 2

National Income Accounting

In this chapter we will introduce the fundamental functioning of a
simple economy. In section 2.1 we describe some primary ideas
we shall work with. In section 2.2 we describe how we can view
the aggregate income of the entire economy going through the
sectors of the economy in a circular way. The same section also
deals with the three ways to calculate the national income; namely
product method, expenditure method and income method. The
last section 2.3 describes the various sub-categories of national
income. It also defines different price indices like GDP deflator,
Consumer Price Index, Wholesale Price Indices and discusses the
problems associated with taking GDP of a country as an indicator
of the aggregate welfare of the people of the country.

2.1 SOME BASIC CONCEPTS OF MACROECONOMICS

One of the pioneers of the subject we call economics today, Adam
Smith, named his most influential work An Enquiry into the
Nature and Cause of the Wealth of Nations. What generates the
economic wealth of a nation? What makes countries rich or poor?
These are some of the central questions of economics. It is not
that countries which are endowed with a bounty of natural wealth
minerals or forests or the most fertile lands are naturally the
richest countries. In fact the resource rich Africa and Latin
America have some of the poorest countries in the world, whereas
many prosperous countries have scarcely any natural wealth.
There was a time when possession of natural resources was the
most important consideration but even then the resource had to
be transformed through a production process.
The economic wealth, or well-being, of a country thus does
not necessarily depend on the mere possession of resources; the
point is how these resources are used in generating a flow of
production and how, as a consequence, income and wealth are
generated from that process.
Let us now dwell upon this flow of production. How does this
flow of production arise? People combine their energies with
natural and manmade environment within a certain social and
technological structure to generate a flow of production.
In our modern economic setting this flow of production arises
out of production of commodities goods and services by millions
of enterprises large and small. These enterprises range from giant

9
National Income Accounting

corporations employing a large number of people to single entrepreneur

enterprises. But what happens to these commodities after being produced? Each
producer of commodities intends to sell her output. So from the smallest items
like pins or buttons to the largest ones like aeroplanes, automobiles, giant
machinery or any saleable service like that of the doctor, the lawyer or the financial
consultant the goods and services produced are to be sold to the
consumers. The consumer may, in turn, be an individual or an enterprise and
the good or service purchased by that entity might be for final use or for use in
further production. When it is used in further production it often loses its
characteristic as that specific good and is transformed through a productive
process into another good. Thus a farmer producing cotton sells it to a spinning
mill where the raw cotton undergoes transformation to yarn; the yarn is, in
turn, sold to a textile mill where, through the productive process, it is transformed
into cloth; the cloth is, in turn, transformed through another productive process
into an article of clothing which is then ready to be sold finally to the consumers
for final use. Such an item that is meant for final use and will not pass through
any more stages of production or transformations is called a final good.
Why do we call this a final good? Because once it has been sold it passes out
of the active economic flow. It will not undergo any further transformation at the
hands of any producer. It may, however, undergo transformation by the action
of the ultimate purchaser. In fact many such final goods are transformed during
their consumption. Thus the tea leaves purchased by the consumer are not
consumed in that form they are used to make drinkable tea, which is consumed.
Similarly most of the items that enter our kitchen are transformed through the
process of cooking. But cooking at home is not an economic activity, even though
the product involved undergoes transformation. Home cooked food is not sold
to the market. However, if the same cooking or tea brewing was done in a
restaurant where the cooked product would be sold to customers, then the
same items, such as tea leaves, would cease to be final goods and would be
counted as inputs to which economic value addition can take place. Thus it is
not in the nature of the good but in the economic nature of its use that a good
becomes a final good.
Of the final goods, we can distinguish between consumption goods and
capital goods. Goods like food and clothing, and services like recreation that
are consumed when purchased by their ultimate consumers are called
consumption goods or consumer goods. (This also includes services which are
consumed but for convenience we may refer to them as consumer goods.)
Then there are other goods that are of durable character which are used in
the production process. These are tools, implements and machines. While they
make production of other commodities feasible, they themselves dont get
transformed in the production process. They are also final goods yet they are
not final goods to be ultimately consumed. Unlike the final goods that we have
considered above, they are the crucial backbone of any production process, in
aiding and enabling the production to take place. These goods form a part of
capital, one of the crucial factors of production in which a productive enterprise
has invested, and they continue to enable the production process to go on for
continuous cycles of production. These are capital goods and they gradually
undergo wear and tear, and thus are repaired or gradually replaced over time.
The stock of capital that an economy possesses is thus preserved, maintained
and renewed partially or wholly over time and this is of some importance in the
discussion that will follow.

Introductory Macroeconomics

10

We may note here that some commodities like television sets, automobiles
or home computers, although they are for ultimate consumption, have one
characteristic in common with capital goods they are also durable. That is,
they are not extinguished by immediate or even short period consumption;
they have a relatively long life as compared to articles such as food or even
clothing. They also undergo wear and tear with gradual use and often need
repairs and replacements of parts, i.e., like machines they also need to be
preserved, maintained and renewed. That is why we call these goods
consumer durables.
Thus if we consider all the final goods and services produced in an economy
in a given period of time they are either in the form of consumption goods (both
durable and non-durable) or capital goods. As final goods they do not undergo
any further transformation in the economic process.
Of the total production taking place in the economy a large number of
products dont end up in final consumption and are not capital goods either.
Such goods may be used by other producers as material inputs. Examples are
steel sheets used for making automobiles and copper used for making utensils.
These are intermediate goods, mostly used as raw material or inputs for
production of other commodities. These are not final goods.
Now, to have a comprehensive idea of the total flow of production in the
economy, we need to have a quantitative measure of the aggregate level of final
goods produced in the economy. However, in order to get a quantitative
assessment a measure of the total final goods and services produced in the
economy it is obvious that we need a common measuring rod. We cannot
add metres of cloth produced to tonnes of rice or number of automobiles or
machines. Our common measuring rod is money. Since each of these
commodities is produced for sale, the sum total of the monetary value of
these diverse commodities gives us a measure of final output. But why are
we to measure final goods only? Surely intermediate goods are crucial inputs
to any production process and a significant part of our manpower and capital
stock are engaged in production of these goods. However, since we are dealing
with value of output, we should realise that the value of the final goods already
includes the value of the intermediate goods that have entered into their
production as inputs. Counting them separately will lead to the error of double
counting. Whereas considering intermediate goods may give a fuller description
of total economic activity, counting them will highly exaggerate the final value
of our economic activity.
At this stage it is important to introduce the concepts of stocks and flows.
Often we hear statements like the average salary of someone is Rs 10,000 or the
output of the steel industry is so many tonnes or so many rupees in value. But
these are incomplete statements because it is not clear whether the income which
is being referred to is yearly or monthly or daily income and surely that makes
a huge difference. Sometimes, when the context is familiar, we assume that the
time period is known and therefore do not mention it. But inherent in all such
statements is a definite period of time. Otherwise such statements are
meaningless. Thus income, or output, or profits are concepts that make sense
only when a time period is specified. These are called flows because they occur
in a period of time. Therefore we need to delineate a time period to get a
quantitative measure of these. Since a lot of accounting is done annually in an
economy, many of these are expressed annually like annual profits or production.
Flows are defined over a period of time.

1
This is how economists define investment. This must not be confused with the commonplace
notion of investment which implies using money to buy physical or financial assets. Thus use of
the term investment to denote purchase of shares or property or even having an insurance policy
has nothing to do with how economists define investment. Investment for us is always capital
formation, a gross or net addition to capital stock.

11
National Income Accounting

In contrast, capital goods or consumer durables once produced do not wear

out or get consumed in a delineated time period. In fact capital goods continue
to serve us through different cycles of production. The buildings or machines in
a factory are there irrespective of the specific time period. There can be addition
to, or deduction from, these if a new machine is added or a machine falls in
disuse and is not replaced. These are called stocks. Stocks are defined at a
particular point of time. However we can measure a change in stock over a
specific period of time like how many machines were added this year. Such
changes in stocks are thus flows, which can be measured over specific time
periods. A particular machine can be part of the capital stock for many years
(unless it wears out); but that machine can be part of the flow of new machines
added to the capital stock only for a single year when it was initially installed.
To further understand the difference between stock variables and flow
variables, let us take the following example. Suppose a tank is being filled with
water coming from a tap. The amount of water which is flowing into the tank
from the tap per minute is a flow. But how much water there is in the tank at a
particular point of time is a stock concept.
To come back to our discussion on the measure of final output, that part
of our final output that comprises of capital goods constitutes gross
investment of an economy1. These may be machines, tools and implements;
buildings, office spaces, storehouses or infrastructure like roads, bridges,
airports or jetties. But all the capital goods produced in a year do not
constitute an addition to the capital stock already existing. A significant part
of current output of capital goods goes in maintaining or replacing part of
the existing stock of capital goods. This is because the already existing capital
stock suffers wear and tear and needs maintenance and replacement. A part
of the capital goods produced this year goes for replacement of existing capital
goods and is not an addition to the stock of capital goods already existing
and its value needs to be subtracted from gross investment for arriving at the
measure for net investment. This deletion, which is made from the value of
gross investment in order to accommodate regular wear and tear of capital,
is called depreciation.
So new addition to capital stock in an economy is measured by net investment
or new capital formation, which is expressed as
Net Investment = Gross investment Depreciation
Let us examine this concept called depreciation a little more in detail. Let us
consider a new machine that a firm invests in. This machine may be in service for
the next twenty years after which it falls into disrepair and needs to be replaced.
We can now imagine as if the machine is being gradually used up in each years
production process and each year one twentieth of its original value is getting
depreciated. So, instead of considering a bulk investment for replacement after
twenty years, we consider an annual depreciation cost every year. This is the
usual sense in which the term depreciation is used and inherent in its conception
is the expected life of a particular capital good, like twenty years in our example of
the machine. Depreciation is thus an annual allowance for wear and tear of a

capital good.2 In other words it is the cost of the good divided by number of years
of its useful life.3
Notice here that depreciation is an accounting concept. No real expenditure
may have actually been incurred each year yet depreciation is annually
accounted for. In an economy with thousands of enterprises with widely varying
periods of life of their equipment, in any particular year, some enterprises are
actually making the bulk replacement spending. Thus, we can realistically
assume that there will be a steady flow of actual replacement spending which
will more or less match the amount of annual depreciation being accounted
for in that economy.
Now if we go back to our discussion of total final output produced in an
economy, we see that there is output of consumer goods and services and
output of capital goods. The consumer goods sustain the consumption of
the entire population of the economy. Purchase of consumer goods depends
on the capacity of the people to spend on these goods which, in turn, depends
on their income. The other part of the final goods, the capital goods, are
purchased by business enterprises. They are used either for maintenance of
the capital stock because there are wear and tear of it, or they are used for
addition to their capital stock. In a specific time period, say in a year, the

Adam Smith
Adam Smith is regarded as the founding
father of modern economics (it was known
as political economy at that time). He was
a Scotsman and a professor at the
University of Glasgow. Philosopher by
training, his well known work An Enquiry
into the Nature and Cause of the Wealth of
Nations (1776) is regarded as the first
major comprehensive book on the subject.
The passage from the book. It is not from
the benevolence of the butcher, the
brewer, of the baker, that we expect our
dinner, but from their regard to their own
interest. We address ourselves, not to
their humanity but to their self-love, and
never talk to them of our own necessities
but of their advantage is often cited as
an advocacy for free market economy. The Physiocrats of France were
prominent thinkers of political economy before Smith.

Introductory Macroeconomics

12

2
Depreciation does not take into account unexpected or sudden destruction or disuse of capital
as can happen with accidents, natural calamities or other such extraneous circumstances.
3

We are making a rather simple assumption here that there is a constant rate of depreciation
based on the original value of the asset. There can be other methods to calculate depreciation in
actual practice.

total production of final goods can thus be either in the form of consumption
or investment. This implies that there is a trade-off. If an economy,
produces more of consumer goods, it is producing less of capital goods
and vice-versa.
It is generally observed that more sophisticated and heavy capital goods
raise the ability of a labourer to produce goods. The traditional weaver would
take months to weave a sari but with modern machinery thousands of pieces of
clothing are produced in a day. Decades were taken to construct the great
historical monuments like the Pyramids or the Taj Mahal but with modern
construction machinery one can build a skyscraper in a few years. More
production of newer varities of capital goods therefore would help in the greater
production of consumer goods.
But arent we contradicting ourselves? Earlier we have seen how, of the total
output of final goods of an economy, if a larger share goes for production of
capital goods, a smaller share is available for production of consumer goods.
And now we are saving more capital goods would mean more consumer goods.
There is no contradiction here however. What is important here is the element of
time. At a particular period, given a level of total output of the economy, it is
true if more capital goods are produced less of consumer goods would be
produced. But production of more capital goods would mean that in future the
labourers would have more capital equipments to work with. We have seen that
this leads to a higher capacity of the economy to produce with the same number
of labourers. Thus total input itself would be higher compared to the case when

John Maynard Keynes

13
National Income Accounting

John Maynard Keynes, British

economist, was born in 1883.
He was educated in Kings
College, Cambridge, United
Kingdom and later appointed
its Dean. Apart from being a
sharp intellectual he actively
involved in international
diplomacy during the years
following the First World War. He
prophesied the break down of
the peace agreement of the War
in the book The Economic
Consequences of the Peace
(1919). His book General Theory
of Employment, Interest and
Money (1936) is regarded as one
of the most influential
economics books of the
twentieth century. He was also a shrewd foreign currency speculator.

Introductory Macroeconomics

14

less capital goods were produced. If total output is higher the amount of
consumer goods that can be produced would surely be higher.
Thus the economic cycle not only rolls on, higher production of capital goods
enables the economy to expand. It is possible to find another view of the circular
flow in the discussion we have made so far.
Since we are dealing with all goods and services that are produced for the
market, the crucial factor enabling such sale is demand for such products backed
by purchasing power. One must have the necessary ability to purchase
commodities. Otherwise ones need for commodities does not get recognised by
the market.
We have already discussed above that ones ability to buy commodities
comes from the income one earns as labourer (earning wages), or as
entrepreneur (earning profits), or as landlord (earning rents), or as owner of
capital (earning interests). In short, the incomes that people earn as owners
of factors of production are used by them to meet their demand for goods
and services.
So we can see a circular flow here which is facilitated through the market.
Simply put, the firms demand for factors of production to run the production
process creates payments to the public. In turn, the publics demand for goods
and services creates payments to the firms and enables the sale of the products
they produce.
So the social act of consumption and production are intricately linked and,
in fact, there is a circular causation here. The process of production in an economy
generates factor payments for those involved in production and generates goods
and services as the outcome of the production process. The incomes so generated
create the capacity to purchase the final consumption goods and thus enable
their sale by the business enterprises, the basic object of their production. The
capital goods which are also generated in the production process also enable
their producers to earn income wages, profits etc. in a similar manner. The
capital goods add to, or maintain, the capital stock of an economy and thus
make production of other commodities possible.

2.2 CIRCULAR FLOW OF INCOME AND METHODS

OF CALCULATING NATIONAL INCOME
The description of the economy in the previous section enables us to have a
rough idea of how a simple economy without a government, external trade or
any savings may function. The households receive their payments from the
firms for productive activities they perform for the latter. As we have mentioned
before, there may fundamentally be four kinds of contributions that can be
made during the production of goods and services (a) contribution made by
human labour, remuneration for which is called wage (b) contribution made by
capital, remuneration for which is called interest (c) contribution made by
entrepreneurship, remuneration of which is profit (d) contribution made by fixed
natural resources (called land), remuneration for which is called rent.
In this simplified economy, there is only one way in which the households
may dispose off their earnings by spending their entire income on the goods
and services produced by the domestic firms. The other channels of disposing
their income are closed: we have assumed that the households do not save, they
do not pay taxes to the government since there is no government, and neither
do they buy imported goods since there is no external trade in this simple
economy. In other words, factors of production use their remunerations to buy

15
National Income Accounting

the goods and services which they assisted in producing. The aggregate
consumption by the households of the economy is equal to the aggregate
expenditure on goods and services produced by the firms in the economy. The
entire income of the economy, therefore, comes back to the producers in the
form of sales revenue. There is no leakage from the system there is no difference
between the amount that the firms had distributed in the form of factor payments
(which is the sum total of remunerations earned by the four factors of production)
and the aggregate consumption expenditure that they receive as sales revenue.
In the next period the firms will once again produce goods and services
and pay remunerations to the factors of production. These remunerations will
once again be used to buy the goods and services. Hence year after year we
can imagine the aggregate income of the economy going through the two sectors,
firms and households, in a circular way. This is represented in Fig. 2.1. When
the income is being spent on the goods and services produced by the firms, it
takes the form of aggregate expenditure received by the firms. Since the value
of expenditure must be equal to the value of goods and services, we can
equivalently measure the aggregate income by calculating the aggregate value
of goods and services produced by the firms. When the aggregate revenue
received by the firms is paid out to the factors of production it takes the form
of aggregate income.
In Fig. 2.1, the uppermost
arrow, going from the
households to the firms,
represents the spending the
households undertake to buy
goods and services produced
by the firms. The second arrow
going from the firms to the
households is the counterpart
of the arrow above. It stands for
the goods and services which
are flowing from the firms to the
households. In other words,
this flow is what the
households are getting from the Fig. 2.1: Circular Flow of Income in a Simple Economy
firms, for which they are making
the expenditures. In short, the two arrows on the top represent the goods and
services market the arrow above represents the flow of payments for the goods
and services, the arrow below represents the flow of goods and services. The two
arrows at the bottom of the diagram similarly represent the factors of production
market. The lower most arrow going from the households to the firms symbolises
the services that the households are rendering to the firms. Using these services
the firms are manufacturing the output. The arrow above this, going from the
firms to the households, represents the payments made by the firms to the
households for the services provided by the latter.
Since the same amount of money, representing the aggregate value of goods
and services, is moving in a circular way, if we want to estimate the aggregate
value of goods and services produced during a year we can measure the annual
value of the flows at any of the dotted lines indicated in the diagram. We can
measure the uppermost flow (at point A) by measuring the aggregate value of
spending that the firms receive for the final goods and services which they produce.

Introductory Macroeconomics

16

This method will be called the expenditure method. If we measure the flow at
B by measuring the aggregate value of final goods and services produced by all
the firms, it will be called product method. At C, measuring the sum total of all
factor payments will be called income method.
Observe that the aggregate spending of the economy must be equal to the
aggregate income earned by the factors of production (the flows are equal at A
and C). Now let us suppose that at a particular period of time the households
decide to spend more on the goods and services produced by the firms. For the
time being let us ignore the question where they would find the money to finance
that extra spending since they are already spending all of their income (they
may have borrowed the money to finance the additional spending). Now if they
spend more on the goods and services, the firms will produce more goods and
services to meet this extra demand. Since they will produce more, the firms
must also pay the factors of production extra remunerations. How much extra
amount of money will the firms pay? The additional factor payments must be
equal to the value of the additional goods and services that are being produced.
Thus the households will eventually get the extra earnings required to support
the initial additional spending that they had undertaken. In other words, the
households can decide to spend more spend beyond their means. And in the
end their income will rise exactly by the amount which is necessary to carry out
the extra spending. Putting it differently, an economy may decide to spend more
than the present level of income. But by doing so, its income will eventually rise
to a level consistent with the higher spending level. This may seem a little
paradoxical at first. But since income is moving in a circular fashion, it is not
difficult to figure out that a rise in the flow at one point must eventually lead to
a rise in the flow at all levels. This is one more example of how the functioning of
a single economic agent (say, a household) may differ from the functioning of
the economy as a whole. In the former the spending gets restricted by the
individual income of a household. It can never happen that a single worker
decides to spend more and this leads to an equivalent rise in her income. We
shall spend more time on how higher aggregate spending leads to change in
aggregate income in a later chapter.
The above mentioned sketchy illustration of an economy is admittedly a
simplified one. Such a story which describes the functioning of an imaginary
economy is called a macroeconomic model. It is clear that a model does
not describe an actual economy in detail. For example, our model assumes
that households do not save, there is no government, no trade with other
countries. However models do not want to capture an economy in its every
minute detail their purpose is to highlight some essential features of the
functioning of an economic system. But one has to be cautious not to simplify
the matters in such a way that misrepresents the essential nature of the
economy. The subject of economics is full of models, many of which will be
presented in this book. One task of an economist is to figure out which model
is applicable to which real life situation.
If we change our simple model described above and introduce savings,
will it change the principal conclusion that the aggregate estimate of the
income of the economy will remain the same whether we decide to calculate it
at A, B or C? It turns out that this conclusion does not change in a
fundamental way. No matter how complicated an economic system may be,
the annual production of goods and services estimated through each of the
three methods is the same.

We have seen that the aggregate value of goods and services produced in an
economy can be calculated by three methods. We now discuss the detailed steps
of these calculations.

17
National Income Accounting

2.2.1 The Product or Value Added Method

In product method we calculate the aggregate annual value of goods and services
produced (if a year is the unit of time). How to go about doing this? Do we add
up the value of all goods and services produced by all the firms in an economy?
The following example will help us to understand.
Let us suppose that there are only two kinds of producers in the economy.
They are the wheat producers (or the farmers) and the bread makers (the bakers).
The wheat producers grow wheat and they do not need any input other than
human labour. They sell a part of the wheat to the bakers. The bakers do not
need any other raw materials besides wheat to produce bread. Let us suppose
that in a year the total value of wheat that the farmers have produced is Rs 100.
Out of this they have sold Rs 50 worth of wheat to the bakers. The bakers have
used this amount of wheat completely during the year and have produced
Rs 200 worth of bread. What is the value of total production in the economy? If
we follow the simple way of aggregating the values of production of the sectors,
we would add Rs 200 (value of production of the bakers) to Rs 100 (value of
production of farmers). The result will be Rs 300.
A little reflection will tell us that the value of aggregate production is not
Rs 300. The farmers had produced Rs 100 worth of wheat for which it did not
need assistance of any inputs. Therefore the entire Rs 100 is rightfully the
contribution of the farmers. But the same is not true for the bakers. The bakers
had to buy Rs 50 worth of wheat to produce their bread. The Rs 200 worth of
bread that they have produced is not entirely their own contribution. To calculate
the net contribution of the bakers, we need to subtract the value of the wheat
that they have bought from the farmers. If we do not do this we shall commit the
mistake of double counting. This is because Rs 50 worth of wheat will be
counted twice. First it will be counted as part of the output produced by the
farmers. Second time, it will be counted as the imputed value of wheat in the
bread produced by the bakers.
Therefore, the net contribution made by the bakers is, Rs 200 Rs 50 = Rs 150.
Hence, aggregate value of goods produced by this simple economy is Rs 100 (net
contribution by the farmers) + Rs 150 (net contribution by the bakers) = Rs 250.
The term that is used to denote the net contribution made by a firm is
called its value added. We have seen that the raw materials that a firm buys
from another firm which are completely used up in the process of production
are called intermediate goods. Therefore the value added of a firm is, value of
production of the firm value of intermediate goods used by the firm. The
value added of a firm is distributed among its four factors of production,
namely, labour, capital, entrepreneurship and land. Therefore wages, interest,
profits and rents paid out by the firm must add up to the value added of the
firm. Value added is Table 2.1: Production, Intermediate Goods and Value Added
a flow variable.
Farmer
Baker
We can represent
Total production
100
200
the example given
above in terms of
Intermediate goods used
0
50
Table 2.1.
Value added
100
200 50 =150

Introductory Macroeconomics

18

Here all the variables are expressed in terms of money. We can think of the
market prices of the goods being used to evaluate the different variables listed
here. And we can introduce more players in the chain of production in the
example and make it more realistic and complicated. For example, the farmer
may be using fertilisers or pesticides to produce wheat. The value of these inputs
will have to be deducted from the value of output of wheat. Or the bakers may
be selling the bread to a restaurant whose value added will have to be calculated
by subtracting the value of intermediate goods (bread in this case).
We have already introduced the concept of depreciation, which is also known
as consumption of fixed capital. Since the capital which is used to carry out
production undergoes wear and tear, the producer has to undertake replacement
investments to keep the value of capital constant. The replacement investment
is same as depreciation of capital. If we include depreciation in value added
then the measure of value added that we obtain is called Gross Value Added. If
we deduct the value of depreciation from gross value added we obtain Net Value
Added. Unlike gross value added, net value added does not include wear and
tear that capital has undergone. For example, let us say a firm produces Rs 100
worth of goods per year, Rs 20 is the value of intermediate goods used by it
during the year and Rs 10 is the value of capital consumption. The gross value
added of the firm will be, Rs 100 Rs 20 = Rs 80 per year. The net value added
will be, Rs 100 Rs 20 Rs 10 = Rs 70 per year.
It is to be noted that while calculating the value added we are taking the
value of production of firm. But a firm may be unable to sell all of its produce. In
such a case it will have some unsold stock at the end of the year. Conversely, it
may so happen that a firm had some initial unsold stock to begin with. During
the year that follows it has produced very little. But it has met the demand in the
market by selling from the stock it had at the beginning of the year. How shall
we treat these stocks which a firm may intentionally or unintentionally carry
with itself? Also, let us remember that a firm buys raw materials from other
firms. The part of raw material which gets used up is categorised as an
intermediate good. What happens to the part which does not get used up?
In economics, the stock of unsold finished goods, or semi-finished goods,
or raw materials which a firm carries from one year to the next is called
inventory. Inventory is a stock variable. It may have a value at the beginning
of the year; it may have a higher value at the end of the year. In such a case
inventories have increased (or accumulated). If the value of inventories is less
at the end of the year compared to the beginning of the year, inventories have
decreased (decumulated). We can therefore infer that the change of inventories
of a firm during a year production of the firm during the year sale of the
firm during the year.
The sign stands for identity. Unlike equality (=), an identity always holds
irrespective of what variables we have on the left hand and right hand sides of it.
For example, we can write 2 + 2 4, because this is always true. But we must
write 2 x = 4. This is because two times x equals to 4 for a particular value of
x, (namely when x = 2) and not always. We cannot write 2 x 4.
Observe that since production of the firm value added + intermediate
goods used by the firm, we get, change of inventories of a firm during a
year value added + intermediate goods used by the firm sale of the firm
during a year.
For example, let us suppose that a firm had an unsold stock worth of
Rs 100 at the beginning of a year. During the year it had produced Rs 1,000

19
National Income Accounting

worth of goods and managed to sell Rs 800 worth of goods. Therefore the
Rs 200 is the difference between production and sales. This Rs 200 worth of
goods is the change in inventories. This will add to the Rs 100 worth of
inventories the firm started with. Hence the inventories at the end of the year
is, Rs 100 + Rs 200 = Rs 300. Notice that change in inventories takes place
over a period of time. Therefore it is a flow variable.
Inventories are treated as capital. Addition to the stock of capital of a firm
is known as investment. Therefore change in the inventory of a firm is treated
as investment. There can be three major categories of investment. First is the
rise in the value of inventories of a firm over a year which is treated as
investment expenditure undertaken by the firm. The second category of
investment is the fixed business investment, which is defined as the addition
to the machinery, factory buildings, and equipments employed by the firms.
The last category of investment is the residential investment, which refers to
the addition of housing facilities.
Change in inventories may be planned or unplanned. In case of an unexpected
fall in sales, the firm will have unsold stock of goods which it had not anticipated.
Hence there will be unplanned accumulation of inventories. In the opposite
case where there is unexpected rise in the sales there will be unplanned
decumulation of inventories.
This can be illustrated with the help of the following example. Suppose a
firm produces shirts. It starts the year with an inventory of 100 shirts. During
the coming year it expects to sell 1,000 shirts. Hence it produces 1,000 shirts,
expecting to keep an inventory of 100 at the end of the year. However, during
the year, the sales of shirts turn out to be unexpectedly low. The firm is able
to sell only 600 shirts. This means that the firm is left with 400 unsold shirts.
The firm ends the year with 400 + 100 = 500 shirts. The unexpected rise of
inventories by 400 will be an example of unplanned accumulation of
inventories. If, on the other hand, the sales had been more than 1,000 we
would have unplanned decumulation of inventories. For example, if the sales
had been 1,050, then not only the production of 1,000 shirts will be sold,
the firm will have to sell 50 shirts out of the inventory. This 50 unexpected
reduction in inventories is an example of unexpected decumulation of
inventories.
What can be the examples of planned accumulation or decumulation of
inventories? Suppose the firm wants to raise the inventories from 100 shirts
to 200 shirts during the year. Expecting sales of 1,000 shirts during the year
(as before), the firm produces 1000 + 100 = 1,100 shirts. If the sales are actually
1,000 shirts, then the firm indeed ends up with a rise of inventories. The new
stock of inventories is 200 shirts, which was indeed planned by the firm. This
rise is an example of planned accumulation of inventories. On the other hand
if the firm had wanted to reduce the inventories from 100 to 25 (say), then it
would produce 1000 75 = 925 shirts. This is because it plans to sell 75
shirts out of the inventory of 100 shirts it started with (so that the inventory at
the end of the year becomes 100 75 = 25 shirts, which the firm wants). If the
sales indeed turn out to be 1000 as expected by the firm, the firm will be left
with the planned, reduced inventory of 25 shirts.
We shall have more to say on the distinction between unplanned and
planned change in inventories in the chapters which follow.

Taking cognizance of change of inventories we may write

Gross value added of firm, i (GV Ai) Gross value of the output produced by
the firm i (Qi) Value of intermediate goods used by the firm (Zi)
GV Ai Value of sales by the firm (Vi ) + Value of change in inventories (Ai )
Value of intermediate goods used by the firm (Zi)
(2.1)
Equation (2.1) has been derived by using: Change in inventories of a firm
during a year Production of the firm during the year Sale of the firm
during the year.
It is worth noting that the sales by the firm includes sales not only to
domestic buyers but also to buyers abroad (the latter is termed as exports).
It is also to be noted that all the above mentioned variables are flow variables.
Generally these are measured on an annual basis. Hence they measure value
of the flows per year.
Net value added of the firm i GVAi Depreciation of the firm i (Di)
If we sum the gross value added of all the firms of the economy in a year, we
get a measure of the value of aggregate amount of goods and services produced
by the economy in a year (just as we had done in the wheat-bread example).
Such an estimate is called Gross Domestic Product (GDP). Thus GDP Sum
total of gross value added of all the firms in the economy.
If there are N firms in the economy, each assigned with a serial number
from 1 to N, then GDP Sum total of the gross value added of all the firms in
the economy
GVA1 + GVA2 + + GVAN
Therefore
GDP
The symbol

Introductory Macroeconomics

20

N
i =1

GVAi

(2.2)

is a shorthand it is used to denote summation. For example,

X i will be equal to X1 + X2 + ... + XN. In this case, i =1 GVAi stands for the
sum total of gross value added of all the N firms. We know that the net value
added of the i-th firm (NVAi ) is the gross value added minus the wear and tear of
the capital employed by the firm.
Thus,
NVAi GVAi Di
Therefore, GVAi NVAi + Di
This is for the i-th firm. There are N such firms. Therefore the GDP of the entire
economy, which is the sum total of the value added of all the N firms
(by (2.2)), will be the sum total of the net value added and depreciation of the N firms.
i =1

In other words, GDP

N
i =1

NVAi +

N
i =1

Di

This implies that the gross domestic product of the economy is the sum total
of the net value added and depreciation of all the firms of the economy. Summation
of net value added of all firms is called Net Domestic Product (NDP).
Symbolically, NDP

N
i =1

NVAi

2.2.2 Expenditure Method

An alternative way to calculate the GDP is by looking at the demand side of the
products. This method is referred to as the expenditure method. In the farmerbaker example that we have described before, the aggregate value of the output

in the economy by expenditure method will be calculated in the following way.

In this method we add the final expenditures that each firm makes. Final
expenditure is that part of expenditure which is undertaken not for intermediate
purposes. The Rs 50 worth of wheat which the bakers buy from the farmers
counts as intermediate goods, hence it does not fall under the category of final
expenditure. Therefore the aggregate value of output of the economy is Rs 200
(final expenditure received by the baker) + Rs 50 (final expenditure received by
the farmer) = Rs 250 per year.
Firm i can make the final expenditure on the following accounts (a) the final
consumption expenditure on the goods and services produced by the firm.
We shall denote this by Ci. We may note that mostly it is the households which
undertake consumption expenditure. There may be exceptions when the firms
buy consumables to treat their guests or for their employees (b) the final
investment expenditure, Ii , incurred by other firms on the capital goods produced
by firm i. Observe that unlike the expenditure on intermediate goods which is
not included in the calculation of GDP, expenditure on investments is included.
The reason is that investment goods remain with the firm, whereas intermediate
goods are consumed in the process of production (c) the expenditure that the
government makes on the final goods and services produced by firm i. We shall
denote this by Gi . We may point out that the final expenditure incurred by the
government includes both the consumption and investment expenditure (d) the
export revenues that firm i earns by selling its goods and services abroad. This
will be denoted by Xi .
Thus the sum total of the revenues that the firm i earns is given by
RVi Sum total of final consumption, investment, government and exports
expenditures received by the firm i
Ci + Ii + Gi + Xi
If there are N firms then summing over N firms we get
N

RVi Sum total of final consumption, investment, government and

exports expenditures received by all the firms in the economy
i =1

N
i =1

Ci +

I +

i =1 i

N
i =1

Gi +

N
i =1

Xi

(2.3)

Let C be the aggregate final consumption expenditure of the entire

economy. Notice that a part of C is spent on imports of consumption goods
N

C = i = 1 C i + Cm. Let Cm denote expenditure on the imports of consumption

goods. Therefore C Cm denotes that part of aggregate final consumption
expenditure that is spent on the domestic firms. Similarly, let I Im stand for
that part of aggregate final investment expenditure that is spent on domestic
firms, where I is the value of the aggregate final investment expenditure of the
economy and out of this Im is spent on foreign investment goods. Similarly
G Gm stands for that part of aggregate final government expenditure that is
spent on the domestic firms, where G is the aggregate expenditure of the
government of the economy and Gm is the part of G which is spent on imports.
Therefore,

N
i =1

Ci

Sum total of final consumption expenditures

N

received by all the firms in the economy C Cm; i =1 I i Sum total of final
investment expenditures received by all the firms in the economy I Im;

21
National Income Accounting

Gi Sum total of final government expenditures received by all the firms

in the economy G Gm. Substituting these in equation (2.3) we get
i =1

N
i =1

RVi C Cm + I Im + G Gm +

C+I+G +

N
i =1

N
i =1

Xi

X i (Cm + Im + Gm)

C+I+G+X M
N

Here X i = 1 X i denotes aggregate expenditure by the foreigners on the

exports of the economy. M Cm + Im + Gm is the aggregate imports expenditure
incurred by the economy.
We know, GDP Sum total of all the final expenditure received by the firms
in the economy.
In other words
N

GDP i =1 RVi C + + G + X M
(2.4)
Equation (2.4) expresses GDP according to the expenditure method. It may
be noted that out of the five variables on the right hand side, investment
expenditure, I, is the most unstable.

Introductory Macroeconomics

22

2.2.3 Income Method

As we mentioned in the beginning, the sum of final expenditures in the economy
must be equal to the incomes received by all the factors of production taken
together (final expenditure is the spending on final goods, it does not include
spending on intermediate goods). This follows from the simple idea that the
revenues earned by all the firms put together must be distributed among the
factors of production as salaries, wages, profits, interest earnings and rents. Let
there be M number of households in the economy. Let Wi be the wages and
salaries received by the i-th household in a particular year. Similarly, Pi, Ini, Ri
be the gross profits, interest payments and rents received by the i-th household
in a particular year. Therefore GDP is given by
GDP
Here,

M
i =1

M
i =1

Wi +

Wi W,

M
i =1

M
i =1

Pi +

Pi P,

M
i =1

In i +

M
i =1

M
i =1

In i In,

Ri W + P + In + R

M
i =1

(2.5)

Ri R.

Taking equations (2.2), (2.4) and (2.5) together we get

GDP

N
i =1

GV Ai C + I + G + X M W + P + In + R

(2.6)

It is to be noted that in identity (2.6), I stands for sum total of both planned
and unplanned investments undertaken by the firms.
Since the identities
N
XM
P
i =1GVA i
(2.2), (2.4) and (2.6) are
G
In
different expressions of the
I
R
same variable, namely
GDP, we may represent
C
W
GDP
the equivalence by Fig. 2.2.
It may be worth
examining how the
households dispose off
Income
Product
Expenditure
their earnings. There
Method
Method
Method
are three major ways
Fig. 2.2: Diagramtic Representation of GDP by the Three Methods

in which they may do so. Either they consume it, or they save it, or pay taxes
with it (assuming that no aid or donation, transfer payment in general, is
being sent abroad, which is another way to spend their incomes). Let S stand
for the aggregate savings made by them and T be the sum total of taxes paid
by them. Therefore
GDP C + S + T
(2.7)
Comparing (2.4) with (2.7) we find
C+I+G+XMC+S+T
Cancelling final consumption expenditure C from both sides we get
I+G+XMS+T
In other words
(I S) + (G T) M X

(2.8)

In (2.8), G T measures by what amount the government expenditure

exceeds the tax revenue earned by it. This is referred to as budget deficit.
M X is known as the trade deficit it measures the excess of import
expenditure over the export revenue earned by the economy (M is the outflow
from the country, X is the inflow into the country).
If there is no government, no foreign trade then G = T = M = X = 0.
Hence (2.8) yields
IS
(2.9)

2.3 SOME MACROECONOMIC IDENTITIES

Gross Domestic Product measures the aggregate production of final goods and
services taking place within the domestic economy during a year. But the whole
of it may not accrue to the citizens of the country. For example, a citizen of India
working in Saudi Arabia may be earning her wage and it will be included in the
Saudi Arabian GDP. But legally speaking, she is an Indian. Is there a way to
take into account the earnings made by Indians abroad or by the factors of
production owned by
Indians? When we try
to do this, in order to
maintain symmetry,
we must deduct the
earnings of the
foreigners who are
working within our
domestic economy, or
The foreigners have a share in your domestic economy.
the payments to the
Discuss this in the classroom.

23
National Income Accounting

(2.9) is simply an accounting identity. Out of the GDP, a part is consumed

and a part is saved (from the recipient side of the incomes). On the other
hand, from the side of the firms, the aggregate final expenditure received by
them ( GDP) must be equal to consumption expenditure and investment
expenditure. The aggregate of incomes received by the households is equal
to the expenditure received by the firms because the income method and
expenditure method would give us the same figure of GDP. Since consumption
expenditure cancels out from both sides, we are left with aggregate savings
equal to the aggregate gross investment expenditure.

factors of production owned by the foreigners. For example, the profits earned
by the Korean-owned Hyundai car factory will have to be subtracted from the
GDP of India. The macroeconomic variable which takes into account such
additions and subtractions is known as Gross National Product (GNP). It is,
therefore, defined as follows
GNP GDP + Factor income earned by the domestic factors of production
employed in the rest of the world Factor income earned by the factors of
production of the rest of the world employed in the domestic economy
Hence, GNP GDP + Net factor income from abroad
(Net factor income from abroad = Factor income earned by the domestic factors
of production employed in the rest of the world Factor income earned by the
factors of production of the rest of the world employed in the domestic economy).
We have already noted that a part of the capital gets consumed during the
year due to wear and tear. This wear and tear is called depreciation. Naturally,
depreciation does not become part of anybodys income. If we deduct
depreciation from GNP the measure of aggregate income that we obtain is called
Net National Product (NNP). Thus
NNP GNP Depreciation

Introductory Macroeconomics

24

It is to be noted that all these variables are evaluated at market prices.

Through the expression given above, we get the value of NNP evaluated at
market prices. But market price includes indirect taxes. When indirect taxes
are imposed on goods and services, their prices go up. Indirect taxes accrue to
the government. We have to deduct them from NNP evaluated at market prices
in order to calculate that part of NNP which actually accrues to the factors of
production. Similarly, there may be subsidies granted by the government on
the prices of some commodities (in India petrol is heavily taxed by the
government, whereas cooking gas is subsidised). So we need to add subsidies
to the NNP evaluated at market prices. The measure that we obtain by doing
so is called Net National Product at factor cost or National Income.
Thus, NNP at factor cost National Income (NI ) NNP at market prices
(Indirect taxes Subsidies) NNP at market prices Net indirect taxes (Net
indirect taxes Indirect taxes Subsidies)
We can further subdivide the National Income into smaller categories. Let us
try to find the expression for the part of NI which is received by households. We
shall call this Personal Income (PI). First, let us note that out of NI, which is
earned by the firms and government enterprises, a part of profit is not distributed
among the factors of production. This is called Undistributed Profits (UP). We
have to deduct UP from NI to arrive at PI, since UP does not accrue to the
households. Similarly, Corporate Tax, which is imposed on the earnings made
by the firms, will also have to be deducted from the NI, since it does not accrue
to the households. On the other hand, the households do receive interest
payments from private firms or the government on past loans advanced by them.
And households may have to pay interests to the firms and the government as
well, in case they had borrowed money from either. So we have to deduct the net
interests paid by the households to the firms and government. The households
receive transfer payments from government and firms (pensions, scholarship,
prizes, for example) which have to be added to calculate the Personal Income of
the households.
Thus, Personal Income (PI) NI Undistributed profits Net interest
payments made by households Corporate tax + Transfer payments to
the households from the government and firms.

However, even PI is not the income over which the households have complete
say. They have to pay taxes from PI. If we deduct the Personal Tax Payments
(income tax, for example) and Non-tax Payments (such as fines) from PI, we
obtain what is known as the Personal Disposable Income. Thus
Personal Disposable Income (PDI ) PI Personal tax payments Non-tax
payments.
Personal Disposable Income is the part of the aggregate income which
belongs to the households. They may decide to consume a part of it, and
save the rest. In Fig. 2.3 we present a diagrammatic representation of the
relations between these major macroeconomic variables.
A table of some of the principal macroeconomic variables of India (at current
prices, for the years 1990-91 to 2004-05) has been provided at the end of the
chapter, to give the reader a rough idea of their actual values.
D

NFIA
GDP

GNP

NNP
ID - Sub
(at
Market NI
Price)
(NNP at
FC)

UP + NIH
+ CT
TrH
PI

PTP +
NP
PDI

Fig. 2.3: Diagrammatic representation of the subcategories of aggregate income. NFIA: Net
Factor Income from Abroad, D: Depreciation, ID: Indirect Taxes, Sub: Subsidies, UP: Undistributed
Profits, NIH: Net Interest Payments by Households, CT: Corporate Taxes, TrH: Transfers recived
by Households, PTP: Personal Tax Payments, NP: Non-Tax Payments.

The idea behind National Disposable Income is that it gives an idea of

what is the maximum amount of goods and services the domestic economy
has at its disposal. Current transfers from the rest of the world include items
such as gifts, aids, etc.
Private Income = Factor income from net domestic product accruing
to the private sector + National debt interest + Net factor income from
abroad + Current transfers from government + Other net transfers
from the rest of the world

2.4 GOODS

AND

PRICES

One implicit assumption in all this discussion is that the prices of goods and
services do not change during the period of our study. If prices change, then
there may be difficulties in comparing GDPs. If we measure the GDP of a country

25
National Income Accounting

National Disposable Income and Private Income

Apart from these categories of aggregate macroeconomic variables, in India,
a few other aggregate income categories are also used in National Income
accounting
National Disposable Income = Net National Product at market prices
+ Other current transfers from the rest of the world

Introductory Macroeconomics

26

in two consecutive years and see that the figure for GDP of the latter year is
twice that of the previous year, we may conclude that the volume of production
of the country has doubled. But it is possible that only prices of all goods and
services have doubled between the two years whereas the production has
remained constant.
Therefore, in order to compare the GDP figures (and other macroeconomic
variables) of different countries or to compare the GDP figures of the same country
at different points of time, we cannot rely on GDPs evaluated at current market
prices. For comparison we take the help of real GDP. Real GDP is calculated in
a way such that the goods and services are evaluated at some constant set of
prices (or constant prices). Since these prices remain fixed, if the Real GDP
changes we can be sure that it is the volume of production which is undergoing
changes. Nominal GDP, on the other hand, is simply the value of GDP at the
current prevailing prices. For example, suppose a country only produces bread.
In the year 2000 it had produced 100 units of bread, price was Rs 10 per bread.
GDP at current price was Rs 1,000. In 2001 the same country produced
110 units of bread at price Rs 15 per bread. Therefore nominal GDP in 2001
was Rs 1,650 (=110 Rs 15). Real GDP in 2001 calculated at the price of the
year 2000 (2000 will be called the base year) will be 110 Rs 10 = Rs 1,100.
Notice that the ratio of nominal GDP to real GDP gives us an idea of how the
prices have moved from the base year (the year whose prices are being used to
calculate the real GDP) to the current year. In the calculation of real and nominal
GDP of the current year, the volume of production is fixed. Therefore, if these
measures differ it is only due to change in the price level between the base year
and the current year. The ratio of nominal to real GDP is a well known index of
prices. This is called GDP Deflator. Thus if GDP stands for nominal GDP and
GDP
gdp stands for real GDP then, GDP deflator = gdp .
Sometimes the deflator is also denoted in percentage terms. In such a case
GDP
deflator = gdp 100 per cent. In the previous example, the GDP deflator is
1,650
1,100 = 1.50 (in percentage terms this is 150 per cent). This implies that the
price of bread produced in 2001 was 1.5 times the price in 2000. Which is true
because price of bread has indeed gone up from Rs 10 to Rs 15. Like GDP
deflator, we can have GNP deflator as well.
There is another way to measure change of prices in an economy which is
known as the Consumer Price Index (CPI). This is the index of prices of a
given basket of commodities which are bought by the representative consumer.
CPI is generally expressed in percentage terms. We have two years under
consideration one is the base year, the other is the current year. We calculate
the cost of purchase of a given basket of commodities in the base year. We also
calculate the cost of purchase of the same basket in the current year. Then we
express the latter as a percentage of the former. This gives us the Consumer
Price Index of the current year vis-a-vis the base year. For example let us take
an economy which produces two goods, rice and cloth. A representative
consumer buys 90 kg of rice and 5 pieces of cloth in a year. Suppose in the
year 2000 the price of a kg of rice was Rs 10 and a piece of cloth was Rs 100.
So the consumer had to spend a total sum of Rs 10 90 = Rs 900 on rice in
2000. Similarly, she spent Rs 100 5 = Rs 500 per year on cloth. Summation
of the two items is, Rs 900 + Rs 500 = Rs 1,400.

Now suppose the prices of a kg of rice and a piece of cloth has gone up to
Rs 15 and Rs 120 in the year 2005. To buy the same quantity of rice and clothes
the representative will have to spend Rs 1,350 and Rs 600 respectively (calculated
in a similar way as before). Their sum will be, Rs 1,350 + Rs 600 = Rs 1,950.
1,950
The CPI therefore will be
1,400 100 = 139.29 (approximately).
It is worth noting that many commodities have two sets of prices. One is
the retail price which the consumer actually pays. The other is the wholesale
price, the price at which goods are traded in bulk. These two may differ in
value because of the margin kept by traders. Goods which are traded in
bulk (such as raw materials or semi-finished goods) are not purchased by
ordinary consumers. Like CPI, the index for wholesale prices is called
Wholesale Price Index (WPI). In countries like USA it is referred to as
Producer Price Index (PPI). Notice CPI (and analogously WPI) may differ
from GDP deflator because
1. The goods purchased by consumers do not represent all the goods which
are produced in a country. GDP deflator takes into account all such goods
and services.
2. CPI includes prices of goods consumed by the representative consumer, hence
it includes prices of imported goods. GDP deflator does not include prices of
imported goods.
3. The weights are constant in CPI but they differ according to production
level of each good in GDP deflator.

2.5 GDP

AND

WELFARE

27
National Income Accounting

Can the GDP of a country be taken

as an index of the welfare of the
people of that country? If a person
has more income he or she can buy
more goods and services and his or
her material well-being improves. So
it may seem reasonable to treat his
or her income level as his or her level
of well-being. GDP is the sum total
of value of goods and services
created within the geographical
boundary of a country in a
particular year. It gets distributed
among the people as incomes
(except for retained earnings). So we
may be tempted to treat higher level
of GDP of a country as an index of
How uniform is the distribution of GDP? It still
greater well-being of the people of
seems that a majority of the people are poor
that country (to account for price
and few benefited.
changes, we may take the value of
real GDP instead of nominal GDP). But there are at least three reasons why this
may not be correct
1. Distribution of GDP how uniform is it: If the GDP of the country is rising,
the welfare may not rise as a consequence. This is because the rise in GDP may

Introductory Macroeconomics

28

be concentrated in the hands of very few individuals or firms. For the rest, the
income may in fact have fallen. In such a case the welfare of the entire country
cannot be said to have increased. For example, suppose in year 2000, an
imaginary country had 100 individuals each earning Rs 10. Therefore the GDP
of the country was Rs 1,000 (by income method). In 2001, let us suppose the
same country had 90 individuals earning Rs 9 each, and the rest 10 individual
earning Rs 20 each. Suppose there had been no change in the prices of goods
and services between these two periods. The GDP of the country in the year 2001
was 90 (Rs 9) + 10 (Rs 20) = Rs 810 + Rs 200 = Rs 1,010. Observe that
compared to 2000, the GDP of the country in 2001 was higher by Rs10. But
this has happened when 90 per cent of people of the country have seen a drop in
their real income by 10 per cent (from Rs 10 to Rs 9), whereas only 10 per cent
have benefited by a rise in their income by 100 per cent (from Rs 10 to Rs 20).
90 per cent of the people are worse off though the GDP of the country has gone
up. If we relate welfare improvement in the country to the percentage of people
who are better off, then surely GDP is not a good index.
2. Non-monetary exchanges: Many activities in an economy are not evaluated
in monetary terms. For example, the domestic services women perform at
home are not paid for. The exchanges which take place in the informal
sector without the help of money are called barter exchanges. In barter
exchanges goods (or services) are directly exchanged against each other.
But since money is not being used here, these exchanges are not registered
as part of economic activity. In developing countries, where many remote
regions are underdeveloped, these kinds of exchanges do take place, but
they are generally not counted in the GDPs of these countries. This is a
case of underestimation of GDP. Hence GDP calculated in the standard
manner may not give us a clear indication of the productive activity and
well-being of a country.
3. Externalities: Externalities refer to the benefits (or harms) a firm or an
individual causes to another for which they are not paid (or penalised).
Externalities do not have any market in which they can be bought and
sold. For example, let us suppose there is an oil refinery which refines
crude petroleum and sells it in the market. The output of the refinery is
the amount of oil it refines. We can estimate the value added of the refinery
by deducting the value of intermediate goods used by the refinery (crude
oil in this case) from the value of its output. The value added of the refinery
will be counted as part of the GDP of the economy. But in carrying out
the production the refinery may also be polluting the nearby river. This
may cause harm to the people who use the water of the river. Hence their
well being will fall. Pollution may also kill fish or other organisms of the
river on which fish survive. As a result the fishermen of the river may be
losing their livelihood. Such harmful effects that the refinery is inflicting
on others, for which it will not bear any cost, are called externalities. In
this case, the GDP is not taking into account such negative externalities.
Therefore, if we take GDP as a measure of welfare of the economy we shall
be overestimating the actual welfare. This was an example of negative
externality. There can be cases of positive externalities as well. In
such cases GDP will underestimate the actual welfare of
the economy.

Summary
Key Concepts

At a very fundamental level, the macroeconomy (it refers to the economy that we
study in macroeconomics) can be seen as working in a circular way. The firms
employ inputs supplied by households and produce goods and services to be sold to
households. Households get the remuneration from the firms for the services
rendered by them and buy goods and services produced by the firms. So we can
calculate the aggregate value of goods and services produced in the economy by
any of the three methods (a) measuring the aggregate value of factor payments
(income method) (b) measuring the aggregate value of goods and services produced
by the firms (product method) (c) measuring the aggregate value of spending received
by the firms (expenditure method). In the product method, to avoid double counting,
we need to deduct the value of intermediate goods and take into account only the
aggregate value of final goods and services. We derive the formulae for calculating
the aggregate income of an economy by each of these methods. We also take note
that goods can also be bought for making investments and these add to the productive
capacity of the investing firms. There may be different categories of aggregate income
depending on whom these are accruing to. We have pointed out the difference between
GDP, GNP, NNP at market price, NNP at factor cost, PI and PDI. Since prices of goods
and services may vary, we have discussed how to calculate the three important
price indices (GDP deflator, CPI, WPI). Finally we have noted that it may be incorrect
to treat GDP as an index of the welfare of the country.

Final goods

Consumption goods

Consumer durables
Intermediate goods

Capital goods
Stocks

Flows
Net investment

Gross investment
Depreciation

Wage

Interest

Profit
Circular flow of income

Rent
Product method of calculating
National Income
Income method of calculating
National Income

Macroeconomic model
Value added

Input
Inventories

Planned change in inventories

Unplanned change in inventories

Gross Domestic Product (GDP)

Gross National Product (GNP)

Net Domestic Product (NDP)

Net National Product (NNP)
(at market price)

NNP (at factor cost) or

National Income (NI)

Undistributed profits

Net interest payments made

by households

Corporate tax

Transfer payments to the

households from the government
and firms

Personal Income (PI)

Personal tax payments

Personal Disposable Income (PDI)

Non-tax payments
National Disposable Income

National Income Accounting

Expenditure method of calculating

National Income

29

Exercises

Private Income
Real GDP
GDP Deflator
Wholesale Price Index (WPI)

Nominal GDP
Base year
Consumer Price Index (CPI)
Externalities

1. What are the four factors of production and what are the remunerations to

each of these called?

2. Why should the aggregate final expenditure of an economy be equal to the

aggregate factor payments? Explain.

3. Distinguish between stock and flow. Between net investment and capital which

is a stock and which is a flow? Compare net investment and capital with flow of
water into a tank.
4. What is the difference between planned and unplanned inventory

accumulation? Write down the relation between change in inventories and value
added of a firm.
5. Write down the three identities of calculating the GDP of a country by the

three methods. Also briefly explain why each of these should give us the same
value of GDP.
6. Define budget deficit and trade deficit. The excess of private investment over saving

of a country in a particular year was Rs 2,000 crores. The amount of budget deficit
was ( ) Rs 1,500 crores. What was the volume of trade deficit of that country?
7. Suppose the GDP at market price of a country in a particular year was Rs 1,100 crores.

Net Factor Income from Abroad was Rs 100 crores. The value of Indirect taxes
Subsidies was Rs 150 crores and National Income was Rs 850 crores. Calculate
the aggregate value of depreciation.
8. Net National Product at Factor Cost of a particular country in a year is

Introductory Macroeconomics

30

Rs 1,900 crores. There are no interest payments made by the households to the
firms/government, or by the firms/government to the households. The Personal
Disposable Income of the households is Rs 1,200 crores. The personal income
taxes paid by them is Rs 600 crores and the value of retained earnings of the
firms and government is valued at Rs 200 crores. What is the value of transfer
payments made by the government and firms to the households?
9. From the following data, calculate Personal Income and Personal Disposable

Income.
Rs (crore)
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)

Net Domestic Product at factor cost

Net Factor Income from abroad
Undisbursed Profit
Corporate Tax
Interest Received by Households
Interest Paid by Households
Transfer Income
Personal Tax

8,000
200
1,000
500
1,500
1,200
300
500

10. In a single day Raju, the barber, collects Rs 500 from haircuts; over this day,

his equipment depreciates in value by Rs 50. Of the remaining Rs 450, Raju

pays sales tax worth Rs 30, takes home Rs 200 and retains Rs 220 for
improvement and buying of new equipment. He further pays Rs 20 as income
tax from his income. Based on this information, complete Rajus contribution

to the following measures of income (a) Gross Domestic Product (b) NNP
at market price (c) NNP at factor cost (d) Personal income (e) Personal
disposable income.
11. The value of the nominal GNP of an economy was Rs 2,500 crores in a particular

year. The value of GNP of that country during the same year, evaluated at the
prices of same base year, was Rs 3,000 crores. Calculate the value of the GNP
deflator of the year in percentage terms. Has the price level risen between the
base year and the year under consideration?

12. Write down some of the limitations of using GDP as an index of welfare of a

country.

Suggested Readings

Table 2.2: Various macroeconomic aggregates of India at constant 2004-05

prices (unit: billion rupees)

31
Year

GDP at
Factor
Cost

Consumption of
fixed
capital

NDP at
factor
cost

Indirect
taxes
less
subsidies

GDP at
market
prices

Net
factor
income
from
abroad

GNP at
factor
cost

NNP at
factor
cost

GNP at
market
price

4
(2-3)

6
(2+5)

8
(2+7)

9
(8-3)

10
(8+5)

Per
capita
GNP at
factor
cost*

Per
capita
NNP at
factor
cost*

11

12

(8/population) (9/population)

2000-01

23484.81

2441.16

21043.65

2112.3

25597.11

238

23246.81

20805.65

25359.11

22813

20418

2001-02

24749.62

2599.44

22150.18

2082.28

26831.9

213.71

24535.91

21936.47

26618.19

23592

21093

2002-03

25709.35

2733.67

22975.68

2143.23

27852.58

189.6

25519.75

22786.08

27662.98

24166

21578

2003-04

27757.49

2910.27

24847.22

2284.41

30041.9

206.93

27550.56

24640.29

29834.97

25700

22985

2004-05

29714.64

3198.91

26515.73

2707.45

32422.09

223.75

29490.89

26291.98

32198.34

27081

24143

2005-06

32530.73

3508.93

29021.8

2901.71

35432.44

248.96

32281.77

28772.84

35183.48

29188

26015

2006-07

35643.64

3857

31786.64

3071.25

38714.89

295.15

35348.49

31491.49

38419.74

31505

28067

2007-08

38966.36

4276.29

34690.08

3543.11

42509.47

171.79

38794.57

34518.29

42337.68

34090

30332

2008-09

41586.76

4689.04

36897.72

2576.74

44163.5

253.84

41332.92

36643.88

43909.66

35817

31754

2009-10

45160.71

5219.06

39941.65

2747.76

47908.47

277.57

44883.14

39664.08

47630.9

38362

33901

2010-11

49185.33

5703.01

43482.32

3638.53

52823.86

546.47

48638.86

42935.85

52277.39

41011

36202

2011-12

52475.3

6278.34

46196.96

3855.2

56330.5

463.67

52011.63

45733.29

55866.83

43271

38048

2012-13

54821.11

6878.84

47942.27

4177.36

58998.47

654.52

54166.59

47287.75

58343.95

44508

38856

2013-14

57417.91

7536.74

49881.16

4540.51

61958.42

679.34

56738.57

49201.83

61279.08

46017

39904

Source: Handbook of Statistics on Indian Economy, Reserve Bank of India *Unit = rupees

National Income Accounting

Appendix 2.1

1. Bhaduri, A., 1990. Macroeconomics: The Dynamics of Commodity Production,

pages 1 27, Macmillan India Limited, New Delhi.
2. Branson, W. H., 1992. Macroeconomic Theory and Policy, (third edition), pages
15 34, Harper Collins Publishers India Pvt Ltd., New Delhi.
3. Dornbusch, R and S. Fischer. 1988. Macroeconomics, (fourth edition) pages
2962, McGraw Hill, Paris.
4. Mankiw, N. G., 2000. Macroeconomics, (fourth edition) pages 1576, Macmillan
Worth Publishers, New York.

Table 2.3: Components of Gross Domestic Product (at market price), at constant
2004-05 prices (unit: billion rupees)
Year

Private Final Government

Consumption
final
Expenditure consumption
expenditure

Gross
fixed
capital
formation

Change in
stocks

Valuables

Exports of
goods and
services

Imports of
goods and
services

Discrepancies

GDP at
market
price

10
(2+3+4+5+)
6+7+8+9)

2000-01

15792.01

3247.27

5916.1

173.2

172.78

3232.88

3901.32

907.13

25540

2001-02

16732.09

3323.69

6821.43

34.81

163.49

3372.21

4016.19

440.88

26802.8

2002-03

17212.38

3317.53

6791.7

200.49

156.71

4083.24

4498

586.09

27850.1

2003-04

18232.27

3409.62

7509.4

216.68

261.08

4474.5

5122.5

1081.5

30062.5

2004-05

19175.08

3545.18

9310.28

801.5

410.54

5690.51

6259.45 251.54

32422.1

2005-06

20833.09

3860.07 10817.91

1015.11

404.14

7174.24

8299.26 372.88

35432.4

2006-07

22598.92

4005.79 12312.65

1335.56

459.33

8634.59 10081.98 549.98

38714.9

2007-08

24713.97

4389.19 14307.64

1754.11

472.63

9146.28 11109.63 1164.7

42509.5

2008-09

24496.1

4844.59 14809.44

852.9

599.88

10481.4 13633.02 287.77

44163.5

2009-10

28453.03

5517.03 15944.75

1430.52

945.24

2010-11

30923.73

5835.45 17697.92

2011-12

33785.07

6235.74 19866.45

2012-13

35475.83

2013-14

37195.68

9990.3

13341.8 1030.6

47908.5

2069.53

1251.91 11950.03 15424.28 1480.5

52823.8

1171.11

1309.81 13811.26 18672.49 1176.5

56330.5

6620.33 20020.47

1066.08

1812.07 14498.03 19895.78 598.52

58998.5

6873.89 19999.37

1083.49

1239.41 15722.22 19388.61 767.02

61958.4

Source: Handbook of Statistics on Indian Economy, Reserve Bank of India

Introductory Macroeconomics

32