Measuring National Income

• National Income Accounting is an exercise followed by

many countries to analyze the performance of the
economy every year
• Just like how a firm makes its account statements at the
end of the financial year, the economy (Ministry of
Finance) computes a national account statement at the
end of the financial year
• How is National Income computed
• It is a measure of the total output generated in the economy
• Output is divided into two components: demand side (what
is consumed) & supply side (paid as wages, interest and
dividends)
• Computing the output of an economy is vital for various reasons
• It serves as a benchmark for policy-making in the future
• It serves as a comparison tool for benchmarking across
various economies
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services
produced within a country
in a given period of time.

Goods are valued at their market prices, so:

• GDP measures all goods using the same units (e.g.,
dollars in the U.S.), rather than “adding apples to
oranges.”
• Things that don’t have a market value are excluded,
e.g., housework you do for yourself.
• Includes all items produced in the economy and legally
sold in markets
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services
produced within a country
in a given period of time.

Final goods are intended for the end user.

Intermediate goods are used as components
or ingredients in the production of other goods.
GDP only includes final goods, as they already
embody the value of the intermediate goods
used in their production.
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services
produced within a country
in a given period of time.

GDP includes currently produced goods,

not goods produced in the past.
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services
produced within a country
in a given period of time.

GDP includes tangible goods

(like DVDs, mountain bikes, beer)
and intangible services
(dry cleaning, concerts, cell phone service).
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services
produced within a country
in a given period of time.

GDP measures the value of production that occurs within

a country’s borders, whether done by its own citizens or
by foreigners located there.
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services
produced within a country
in a given period of time.

usually a year or a quarter (3 months).

The Components of GDP
• Recall: GDP is total spending.
• Four components:
• Consumption (C)
• Investment (I)
• Government Purchases (G)
• Net Exports (NX)
• These components add up to GDP (denoted Y):

Y
Y =
= C
C +
+ II +
+ G
G +
+ NX
NX
Consumption (C)
• is total spending by households on g&s.
• Include household spending on durables such as cars and
appliances like washing machines and fridges, and non-
durable goods such as food and clothing. Purchase of a new
house is not included under consumption.
• Services include intangibles like spending on entertainment,
medical care, education etc.
Investment (I)
• is total spending on goods that will be used in the
future to produce more goods.
• includes spending on
• capital equipment (e.g., machines, tools)
• structures (factories, office buildings, houses)
• inventories (goods produced but not yet sold)

Note:
Note:“Investment”
“Investment”doesdoesnot
notmean
mean
the
thepurchase
purchaseof offinancial
financialassets
assetslike
like
stocks
stocksand
andbonds.
bonds.
Government Purchases (G)
• is all spending on the g&s purchased by govt
at the federal, state, and local levels.
• G excludes transfer payments, such as
Social Security or unemployment insurance benefits.

These payments represent transfers of income, not

purchases of g&s.
Net Exports (NX)
• NX = exports – imports
• Exports represent foreign spending on the
economy’s g&s.
• Imports are the portions of C, I, and G
that are spent on g&s produced abroad.
• Adding up all the components of GDP gives:

Y
Y =
= C
C +
+ II +
+ G
G +
+ NX
NX
U.S. GDP and Its Components, 2005

billions % of GDP per capita

Y $12,480 100.0 $42,035

C 8,746 70.1 29,460

I 2,100 16.8 7,072

G 2,360 18.9 7,950

NX –726 –5.8 –2,444

 GDP Calculation Methods
• NIA is computed using three different methods

• Product Method

• Income Method

• Expenditure Method

• Product Method: Also known as the value-added method. The national income is computed by
calculating the net value added at each stage of production

• Income Method: The income method is calculated by computing the net income received from various
sectors of the economy. These include wages from labor, rent from capital and other income sources

• Expenditure Method: This method is calculated by computing the expenditure incurred by various
stakeholders (consumption by households, investment by firms, and expenditure by government)
 Value Added Method
• The product method looks at the value of its final products
• It calculates the value of the final products by deducting the value of intermediate inputs
• Think of output as a pie worth INR 50
• To make the pie, the first step would be to use flour. Assume flour was produced for INR 10
• The other inputs such as sugar, honey and other ingredients once added to the flour become INR
30
• Lastly, the baking cost and labour cost amounts to INR 50
• Using the value-added approach, the GDP for the pie would be INR 10 (1 ST stage ) + INR 20 (2nd
stage) + INR 20 (3rd stage)
• Value added method is calculated as the difference between the value of output and the value of
intermediate goods. The value-added method is a widely used method for calculating national
income as it avoids double counting, which is quite a serious error while estimating national
income.
Income Method
• Every earning citizen is a part of the national economy

• So, the total earning of the economy can be measured in terms of total income earned by all factors

• Households earn in the form of

• Wages – from labor
• Interest – from capital
• Rent – from land
• Profits – from firm

• So, Total income = Wages + Interest + Rent + Profits

 Expenditure Method
• The total demand of the economy can be divided into different expenditure segments
• Consumption: This includes consumption of goods and services from households. While
consumption holds the largest proportion of total GDP, this percentage varies across nations
• Investment: This includes the investments made by firms in setting up factories to produce the
goods and services. We do not talk about financial investments here. Investment means adding to
the stock of physical and human capital
• Fixed capital formation + change in inventories + Residential Investment
• Government expenditure: These include expenditures on public goods such as roads, PDS,
national defence, and other state infrastructure.
• Net Exports: This is the difference between exports and imports of an economy. If NX is positive,
we say that the economy has a positive trade balance
• The total output produced by the economy is defined by the term Gross Domestic

Product (GDP)

• GDP measures the final value of goods and services produced in the economy

• The word final is important: we do not incorporate intermediate inputs

• This is done to avoid double-counting

• GDP is divided into consumption (C), investment (I), government expenditure (G),

and net exports (NX)

• Consumption forms the highest proportion of total income in all economies (~55%)
 GDP

Production Expenditure
Approach Income
Approach Approach

Value of Final goods

Consumption +
and services Wages + Rent +
Investment + Govt
(-) Interest + Profits
Exp + Net Exports
Intermediate Inputs
 A C T I V E L E A R N I N G 1:
GDP and its components
In each of the following cases, determine how much GDP and each of its
components is affected (if at all).
A. Debbie spends $200 to buy her husband dinner at the finest restaurant in
Boston.
B. Sarah spends $1800 on a new laptop to use in her publishing business. The
laptop was built in China.
C. Jane spends $1200 on a computer to use in her editing business. She got last
year’s model on sale for a great price from a local manufacturer.
D. General Motors builds $500 million worth of cars, but consumers only buy
$470 million worth of them.

22
 A C T I V E L E A R N I N G 1:
Answers
A. Debbie spends $200 to buy her husband dinner
at the finest restaurant in Boston.
Consumption and GDP rise by $200.
B. Sarah spends $1800 on a new laptop to use in her publishing business. The
laptop was built in China.
Investment rises by $1800, net exports fall
by $1800, GDP is unchanged.

23
 A C T I V E L E A R N I N G 1:
Answers
C. Jane spends $1200 on a computer to use in her editing business. She got
last year’s model on sale for a great price from a local manufacturer.
Current GDP and investment do not change, because the computer was built
last year.
D. General Motors builds $500 million worth of cars, but consumers only buy
$470 million of them.
Consumption rises by $470 million,
inventory investment rises by $30 million,
and GDP rises by $500 million.

24
Problems in measuring GDP
• The computation and comparison of GDP makes it a very vital statistic. However, many
economists/politicians have addressed their concerns about solely basing growth and
welfare on GDP alone
• Domestic Labor and other such services is not included in computing GDP
• Certain activities which harm the growth of the nation are not considered. For instance,
bads such as pollution/degradation are not counted.
• Difficult to account for changes in the qualities of products and services. Over time,
almost all products and services have improved in quality and efficiency, but this has not
been incorporated in the GDP calculation.
Then Why Do We Care About GDP?
• Having a large GDP enables a country to afford better schools, a cleaner
environment, health care, etc.
• Many indicators of the quality of life are positively correlated with GDP. For
example…
- GDP does not measure the health of our children, but nations with larger GDP can
afford better health care for their children.
- GDP does not measure the beauty of our poetry, but nations with larger GDP can
afford to teach more of their citizens to read and enjoy poetry.
- GDP does not take account of our intelligence, integrity, courage, wisdom, or
devotion to country, but all of these laudable attributes are easier to foster when
people are less concerned about being able to afford the material necessities of life.
- In short, GDP does not directly measure those things that make life worthwhile,
but it does measure our ability to obtain the inputs into a worthwhile life.
GDP and Life Expectancy in 12 Countries
90
Life
expectancy 85
Japan
(in years)
80 U.S.
75 Mexico Germany
China
70 Brazil
Indonesia
65 India Russia
60 Pakistan
Bangladesh
55
Nigeria
50
$0 $10,000 $20,000 $30,000 $40,000
Real GDP per capita, 2002
GDP and Adult Literacy in 12 Countries

Adult Literacy 100 Russia

China Japan U.S.
90 Mexico
(% of Germany
population) Brazil
80
Indonesia
70 Nigeria
60 India

50
Pakistan
40
Bangladesh
30
$0 $10,000 $20,000 $30,000 $40,000
Real GDP per capita, 2002
GDP and Internet Usage in 12 Countries
60
Internet
U.S.
Usage
50
(% of
Japan
population)
40 Germany

30

20
China Mexico
10
Brazil
Russia
0
$0 $10,000 $20,000 $30,000 $40,000
Real GDP per capita, 2002
National Income Identities
• GDP is defined as the final value of goods and services produced within an economy

• Given the nature of globalization, many firms and individuals reside in one country (domestic) and do
business (work) in another

• How is the NIA in these cases accounted

• Gross National Product is the final value of goods and services produced by domestic
residents/machinery working both within and across countries

• What differentiates GDP from GNP

• Net factor income from abroad (NFIA)
• NFIA = Income earned by residents of India abroad – Income earned by foreign residents in India
• GDP + NFIA = GNP
GDP at Factor Cost and Market Price
• Factor cost is the input cost to the producer while producing the goods and services
which include factor payments such as labor, capital etc. If GDP is calculated at this level
it is called GDP (Factor Cost)

• Market price is derived once indirect taxes are taken into account. Once the products
enter the market, taxes are added to the cost of production. If GDP is calculated at this
level it is called GDP (Market prices)

• How do the two differ?

• GDP (Factor Cost) = GDP (Market Price) + Subsidies – Indirect Taxes

GDP and NDP
• Many goods that are considered while computing the GDP undergo depreciation over time

• These assets could be machinery, land, and other assets that undergo wear and tear due to

continuous use

• Thus, it is imperative that this depreciation is taken into account while computing the

national income of the economy

• The difference between GDP and NDP is that NDP considers the depreciation of these assets

• NDP is defined as Net Domestic Product.

• Mathematically, GDP and NDP is related as

https://economictimes.indiatimes.com/news/economy/
indicators/bright-spot-unctad-raises-india-growth-estimate-to-
6-6-for-2023/articleshow/104168136.cms?from=mdr

https://www.worldbank.org/en/news/press-release/
2023/10/03/india-s-growth-to-remain-resilient-despite-global-
challenges

https://www.deccanherald.com/opinion/sustaining-growth-
needs-higher-savings-2709751

https://www.deccanherald.com/business/economy/indias-
growth-story-may-not-have-a-happy-ending-2710003
Inflation and GDP
• GDP data generally comes in two forms

• Real GDP: Output of final goods and services measured in a ‘base year’ price

• Nominal GDP: Output of final goods and services measured in current prices

• It is important that we look at real GDP while assessing the actual growth of the economy,

as this metric adjusts for inflation.

• Nominal GDP keeps changing as prices changes, and the basket of goods change year on

year.
Real Vs Nominal GDP

• If there are apples and oranges produced in an economy in a year, then GDP is

• (Price_Apple*Quantity_Apple + Price_Orange*Quantity_Orange)

• If we want to compare the GDP of the current year (say 2020) with the previous year (2019)

the real and nominal GDP will be

• Nominal GDP = (2020 Price_App)*(2020 Qty_App)+(2020 Price_Orange)*(2020 Qty_Orange)

• Real GDP = (2019 Price_App)*(2020 Qty_App)+(2019 Price_Orange)*(2020 Qty_Orange)

• The GDP deflator basically tells you what is happening to the price levels of goods in an economy

• In other words, it is the ratio of current prices to base year prices

• Rearranging we get

• Thus, the GDP Deflator deflates the nominal GDP to get the real GDP

• Eg: If the GDP Deflator is 1.79 between 2005 & 2010, we can say that the inflation between both

years is 79%