Different concepts and measurement of national income accounting

National Income Accounting: National income accounting measures the economy’s overall
performance. It does for the economy as a whole what private accounting does for the
individual firm or for the individual household.

Why need national income accounting:

This accounting enables economists and policymakers to:

• Assess the health of the economy by comparing levels of production at regular intervals.

• Track the long-run course of the economy to see whether it has grown, been constant, or
declined.

• Formulate policies that will safeguard and improve the economy’s health

There are different ways to measure the national income accounting. Such as:

Gross Domestic Product (GDP)

Gross Domestic Product (GDP) defines aggregate output as the dollar value of all final goods
and services produced within the borders of a given country during a given period of time,
typically a year.

Under this definition, the value of the cars produced at the Toyota factory in Ohio clearly
count as part of U.S. aggregate output rather than Japanese aggregate output because the cars
are made within the borders of the United States.

GDP (a monetary measure)

If the economy produces three sofas and two computers in year 1 and two sofas and three
computers in year 2, in which year is output greater? We can’t answer that question until we
attach a price tag to each of the two products to indicate how society evaluates their relative
worth. That’s what GDP does. It is a monetary measure. Without such a measure we would
have no way of comparing the relative values of the vast number of goods and services
produced in different years. In Table 24.1the price of sofas is $500 and the price of computers
is $2000. GDP would gauge the output of year 2 ($7000) as greater than the output of year 1
($5500) because society places a higher monetary value on the output of year 2. Society is
willing to pay $1500 more for the combination of goods produced in year 2 than for the
combination of goods produced in year 1.
GDP (avoiding multiple counting)

To measure aggregate output accurately, all goods and services produced in a particular year
must be counted once and only once. Because most products go through a series of
production stages before they reach the market, some of their components are bought and
sold many times. To avoid counting those components each time, GDP includes only the
market value of final goods and ignores intermediate goods altogether. Intermediate
goods are goods and services that are purchased for resale or for further processing or
manufacturing. Final goods are consumption goods, capital goods, and services that are
purchased by their final users, rather than for resale or for further processing or
manufacturing. Why is the value of final goods included in GDP but the value of
intermediate goods excluded? Because the value of final goods already includes the
value of all the intermediate goods that were used in producing them. Including the value
of intermediate goods would amount to multiple counting, and that would distort the value of
GDP. To see why, suppose that five stages are needed to manufacture a wool suit and get it to
the consumer—the final users.

Table shows that firm A, a sheep ranch, sells $120 worth of wool to firm B, a wool processor.
Firm A pays out the $120 in wages, rent, interest, and profit. Firm B processes the wool and
sells it to firm C, a suit manufacturer, for $180. What does firm B do with the $180 it
receives? It pays $120 to firm A for the wool and uses the remaining $60 to pay wages, rent,
interest, and profit for the resources used in processing the wool. Firm C, the manufacturer,
sells the suit to firm D, a wholesaler, which sells it to firm E, a retailer. Then at last a
consumer, the final user, comes in and buys the suit for $350. How much of these amounts
should we include in GDP to account for the production of the suit? Just $350, the value of
the final product. The $350 includes all the intermediate transactions leading up to the
product’s final sale. Including the sum of all the intermediate sales, $1140, in GDP would
amount to multiple counting. The production and sale of the final suit generated just $350 of
output, not $1140. Alternatively, we could avoid multiple counting by measuring and
cumulating only the value added at each stage. Value added is the market value of a firm’s
output less the value of the inputs the firm has bought from others. At each stage, the
difference between what a firm pays for inputs and what it receives from selling the product
made from those inputs is paid out as wages, rent, interest, and profit. Column 3 of Table
24.2 shows that the value added by firm B is $60, the difference between the $180 value of its
output and the $120 it paid for the input from firm A. We find the total value of the suit by
adding together all the values added by the five firms. Similarly, by calculating and summing
the values added to allthe goods and services produced by all firms in the economy, we can
find the market value of the economy’s total output—its GDP.

GDP Excludes Nonproduction Transactions

Although many monetary transactions in the economy involve final goods and services, many
others do not. These nonproduction transactions must be excluded from GDP because they
have nothing to do with the generation of final goods.

Nonproduction transactions are of two types: purely financial transactions and second hand
sales.

Financial Transactions Purely financial transactions include the following:

• Public transfer payments:

These are the social security payments, welfare payments, and veterans’ payments that the
government makes directly to households. Since the recipients contribute nothing to current
production in return, to include such payments in GDP would be to overstate the year’s
output.

• Private transfer payments:

Such payments include, for example, the money that parents give children or the cash gifts
given at Christmas time. They produce no output. They simply transfer funds from one
private individual to another and consequently do not enter into GDP.

• Stock market transactions:

The buying and selling of stocks (and bonds) is just a matter of swapping bits of paper. Stock
market transactions create nothing in the way of current production and are not included in
GDP. Payments for the services provided by a stockbroker are included, however, because
their services are currently provided and are thus a part of the economy’s current output of
goods and services.

Second hand Sales

Second hand sales contribute nothing to current production and for that reason are excluded
from GDP. Suppose you sell your 1965 Ford Mustang to a friend; that transaction would be
ignored in reckoning this year’s GDP because it generates no current production. The same
would be true if you sold a brandnew Mustang to a neighbour a week after you purchased it.
What is the GDP Formula?

There are two primary methods or formulas by which GDP can be determined:

1. Expenditure Approach

The expenditure approach is the most commonly used GDP formula, which is based on the
money spent by various groups.

GDP = C + G + I + NX

C = consumption or all private consumer spending within a country’s economy,

G = total government expenditures, including salaries of government employees, road

I = sum of a country’s investments spent on capital equipment, inventories, and housing.

NX = net exports or a country’s total exports less total imports.

2. Income Approach

This GDP formula takes the total income generated by the goods and services produced.

GDP = Total National Income + Sales Taxes + Depreciation + Net Foreign Factor Income

Total National Income – the sum of all wages, rent, interest, and profits.

Sales Taxes – consumer taxes imposed by the government on the sales of goods and services.

Depreciation – cost allocated to a tangible asset over its useful life.

Net Foreign Factor Income – the difference between the total income that a country’s citizens
and companies generate in foreign countries, versus the total income foreign citizens and
companies generate in the domestic country.

Example 1: Expenditure Approach

Suppose we have the following data for a hypothetical country in a given year:

- Consumption (C): $500 billion

- Government Expenditures (G): $200 billion

- Investments (I): $150 billion

- Net Exports (NX): $-50 billion (indicating imports exceed exports)

Using the expenditure approach formula:

GDP = C + G + I + NX
= 500 + 200 + 150 – 50

= 800

Example 2: Income Approach

Suppose we have the following data for the same hypothetical country:

- Total National Income: $600 billion (sum of wages, rent, interest, and profits)

- Sales Taxes: $50 billion

- Depreciation: $100 billion

- Net Foreign Factor Income: $-10 billion (indicating foreign income is less than the income
from abroad)

Using the income approach formula: GDP = Total National Income + Sales Taxes +
Depreciation + Net Foreign Factor Income

= 600 + 50 + 100 - 10

= 740 billion dollars

These examples show how different components contribute to the overall GDP of a country
using both the expenditure and income approaches.

Other national accounts

Net Domestic Product

How much new output was available for consumption and for additions to the stock of
capital. To determine that, we must subtract from GDP the capital that was consumed in
producing the GDP and that had to be replaced. That is, we need to subtract consumption of
fixed capital (depreciation) from GDP. The result is a measure of net domestic product
(NDP):

NDP= GDP - consumption of fixed capital (depreciation)

National Income

Sometimes it is useful to know how much Americans earned for their contributions of land,
labor, capital, and entrepreneurial talent. Recall that U.S. national income (NI) includes all
income earned through the use of American-owned resources, whether they are located at
home or abroad. It also includes taxes on production and imports. To derive NI from NDP,
we must subtract the aforementioned statistical discrepancy from NDP and add net foreign
factor income, since the latter is income earned by Americans overseas minus income earned
by foreigners in the United States. For the United States in 2007:

We know, too, that we can calculate national income through the income approach by simply
adding up employee compensation, rent, interest, proprietors’ income, corporate profit, and
taxes on production and imports.

Personal Income

Personal income (PI) includes all income received, whether earned or unearned. It is likely to
differ from national income (income earned) because some income earned—taxes on
production and imports, Social Security taxes (payroll taxes), corporate income taxes, and
undistributed corporate profits—is not received by households. Conversely, some income
received—such as Social Security payments, unemployment compensation payments, welfare
payments, disability and education payments to veterans, and private pension payments—is
not earned. These transfer payments must be added to obtain PI.

In moving from national income to personal income, we must subtract the income that is
earned but not received and add the income that is received but not earned. For the United
States in 2007:
Disposable Income

Disposable income (DI) is personal income less personal taxes. Personal taxes include
personal income taxes, personal property taxes, and inheritance taxes. Disposable income is
the amount of income that households have left over after paying their personal taxes. They
are free to divide that income between consumption (C) and saving (S): DI = C+S

For the United States in 2007:

Circular flow of income and expense:

Real Income Vs Nominal Income: Key Differences

Real Income Nominal Income

Real income is the inflation-adjusted earnings Nominal income does not consider inflation
of an entity, individual or nation. rates while calculating an entity's or
individual's earnings.

Real wage represents the purchasing power of A nominal wage indicates only the earnings of
an individual an individual

It varies over the years It can remain fixed over the years

Real earnings are a valuable indicator of an Nominal earnings only denote an individual's
individual's well being as it assesses the current earnings that are not adjusted to the
number of goods and services bought from changes in inflation rates. Hence, it does not
that income. represent the well-being of an individual.

GDP Deflator and Consumer Price index

GDP Deflator

The GDP Deflator is an index number that compares the nominal GDP to real GDP for a
given year. It is more comprehensive than CPI since it includes all domestically produced
goods and services in a country. Changes in consumer preference and the arrival of new
goods/services in the market are also reflected in the GDP deflator.

GDP Deflator=

If the GDP deflator for 2010 is 105.1 and the base year is 2005, this means that the price level
has risen 5.1% since 2005. Another way to say it is that the 2005 dollar could buy 5.1% more
than the 2010 dollar.

CPI

The CPI is another index number calculated using a specific set, or basket, of 600 retail goods
and services. Each good in the basket is weighted according to the proportion of average
household expenditure accounted for by that good. The CPI indicates the change in prices of
the basket from the base year (which is normalized to 100) to the given year: a CPI of 98
indicates that price levels have decreased 2% from the base year.

To calculate CPI, take the ratio of the cost of the CPI basket at current prices to the CPI
basket at base year prices.
 CPI=

CPI has some drawbacks in analyzing price level changes. First, CPI is calculated using a
specific set and percentage of CONSUMER goods. It is a fixed basket not often adjusted to
reflect changes in goods available or consumer preferences. Also, things like machinery and
medical equipment are not included. CPI also does not reflect the change in the quality of
goods, only the prices of goods. Although a laptop costs less today than 3 years ago, the
quality has improved significantly.