MAC 2&3

National Income Accounting; Three

Approaches of Measuring GDP;
Numerical Examples
Three Identities : S = I, S = I + G + TR –
TA + NX, and S = I + CA
• Macroeconomics is study of economy as a whole
• GDP is the standard of measurement used for seeing how the economy is doing
• National income accounts is studied for this purpose and also because
- it provides structure for the macroeconomic theory models
- indicates numbers like income per head, earnings going to factors like labor, capital, which
help in characterizing the economy
- looks at real output, and also includes measures of the overall price level, which forms basis
of discussions of inflation
• Output (Value-Added) defined in two ways
– Production side: output paid out to labor in form of wages, to capital in form of interest and
dividends
• Division of output into factor payments provides framework for study of growth and
aggregate supply
– Demand side: output is consumed or invested for the future
• output = purchases by different sectors of the economy
• Provides framework for studying aggregate demand
• As per accounting, output measured via demand and
production equal in equilibrium
• GDP = value of all final goods and services produced within a country within a given
period. 2
 Production Side of the Economy

• The production side of the economy transforms inputs

(labor, capital) into output (GDP)
– Inputs referred to as factors of production
– Payments to these factors are referred to as factor payments
such as wages and interest payments
• The relationship between inputs and outputs is defined
by the production function 
(1)
where Y = output, N = labor, KY=capital
f (N , K )
– “Output is a function of labor and capital,” where the
functional form can be defined in various ways
– The production function is crucial to the discussion of growth
• Once output is produced, they are used for making factor
payments: payment to labor as wages, social security like
EPF; capital payments; profits, etc,
• Once output produced, make payments to labor, capital
3
• Output = factor payments (2)
GDP to factor payments
• Circular-flow diagram
• Visual model of the economy
– Shows how dollars flow through markets among households and firms
• Decision makers
– Firms & Households
• Markets
– For goods and services
– For factors of production
• Firms
– Produce goods and services and sells
– Buys and Use factors of production / inputs
• Households
– Own factors of production and sells
– Buys and Consume goods and services

5
The circular flow

6
 Measuring Gross Domestic Product
• GDP = the value of final goods and services currently produced within a
country( geographical area) over a period of time. Only count final goods and
services  NO DOUBLE COUNTING
• Ex. Would not include the full price of a car AND the tyres bought by the
manufacturer for the car  tyres and all other components bought by car
manufacturer are intermediate goods
• Wheat that goes into cake is an intermediate good ; only value of cake as
part of GDP
– Wheat sold to miller and value of flour sold to baker not counted
• Double counting avoided by value added
– At each stage only value added to the good at that stage is counted as
part of GDP
» Value of wheat produced by farmer is counted as part of GDP
» Value of flour sold by miller minus cost of wheat is miller’s value
added
» value of bread minus cost of flour is baker’s value added
» Sum of value added at each stage of processing is equal to final
7
value of bread sold
– Only count goods and services currently (in the time period
being considered) produced & exclude transactions involving
used goods
• Ex. Include the construction of new homes in current GDP,
but not the sale of existing homes
• Value of property dealer’s fees will be counted as it is for
the services rendered

– If GDP of country, Only count goods and services produced

within a country, regardless of the ownership/nationality of
the producing firm
• Ex. Include the sale of a car produced by a Japanese car
manufacturer located in India in India’s GDP

8
 Out
put
Sector 1 Sector 2 Sector 3
Total Int. Total
X1 X2 X3 Final Dd.
Sales Output

Sector 1 X1 30 80 110 220 210

INPUT Sector 2 X2 160 80 60 300 190

Sector 3 X3 110 20 140 270 200

Total Int.
Inputs 300 180 310

Value
Added

9
 Out
put
Sector 1 Sector 2 Sector 3
Total Int. Total
X1 X2 X3 Final Dd.
Sales Output

Sector 1 X1 30 80 110 220 210 430

INPUT Sector 2 X2 160 80 60 300 190 490

Sector 3 X3 110 20 140 270 200 470

Total Int.
Inputs 300 180 310

Capital 80 180 70

Labour 50 130 90
Total
output 430 490 470

10
 Ou
tpu
t
Sector
1 Sector 2 Sector 3
Total
X1 X2 X3 Int. Final Total
Sales Dd. Output

Sector GDP by Expenditure (or Final Demand)

1 X1 30 80 110 220 210 430 method = 600

INPUT Sector 2 X2 160 80 60 300 190 490

Sector 3 X3 110 20 140 270 200 470 GDP by Income method = 600
Total
Int.
Inputs 300 180 310
GDP by Value-Added
Capital 80 180 70 method = 600

Labour 50 130 90
Total
output 430 490 470
Value-
Added 130 310 160

11
 Composition of final demand
I I
C (investm (invento G X -M Final
ent) ry) Dd.
160 10 60 20 40 210
160 40 40 30 80 190
160 10 60 50 80 200

12
• In case of India National Accounts statistics the first I-O table was for year 1968-69
with 60 sectors
• Raised to 115 sectors in 73-74 till 98-99
• For 03-04 and thereafter 130 sectors.
• For ex first 37 sectors relate to primary production like agriculture, animal
husbandry; next 68 to manufacturing industries, and remaining deal with services
(tertiary) sector
• Base year shifted from 2004-05 to 2011-12 in 2015.
• Methodology also changed. Private sector data taken from MOC affairs MCA-21,
which is from balance sheet of company and performance after adjusting for
inflation. Earlier actual data from manufacturing sector
• Crop production data. Financial data taken from SEBI, PFRDA, IRDA also included.
• For unorganized sector data based on survey done every 5 years, and in between
proxy based on organized sector data( demonetization ?)
• NSSO reports 36% of active companies in MCA-21 untraceable shell cos?.
• Data also taken at market prices
• CSO collects data, coordinates with state and other govt agencies
• India’s GDP : two methods
• At factor cost, and at market prices(expenditure method)
• At factor cost: eight industry sectors-
– Agriculture, forest and fishing
– Mining and quarrying
– Manufacturing
– Electricity, gas, water supply, other utilities
– Construction
– Trade , hotels, transport, communication
– Financial, real estate and professional services
– Public administration, defense and other services
• GDP(Production /Income Approach): GVA at basic price+ Net taxes on
Products
14
• Data from
– Index of Industrial Production
– Financial performance of listed companies in private
sector
– Advance estimates of crop production
– Production of major livestock products
– Production of various products like steel, cement,
etc
– Accounts of Central Govt/State Govts
• Quarterly estimates are prepared
• For April-June 23-24, announced on 31/08/23
15
• Expenditure method involves summing the
domestic expenditure of final goods and services
– Private final consumption expenditure
– Govt final consumption expenditure
– Gross fixed capital formation
– Change in stocks
– Valuables
– Exports
– Less imports
– Discrepancies
16
• For the year 22-23, the data is as follows:
• PFCE- 58.5%
• GFCE- 9.9%
• GFCF- 34.0%
• CIS - 0.8%
• Valuables- 1.4%
• EXPORTS- 23.5%
• IMPORTS- 25.6%
• DISCREPANCIES- -2.4%
• Discrepancies refer to gap between GDP (Production/Income
Approach) and GDP( Expenditure Approach)

17
 Problems of GDP Measurement
• There are three major criticisms of the GDP measure:
1. Omits non-market goods and services
– Ex. Work of stay-at-home mothers and fathers not included in GDP
– So bread made at home not counted but that by baker would be, even it is
inferior in quality( not a good example of welfare, quality)
– Women’s participation would increase GDP with no offsetting for decreased
production at home (one reason for growth of Asian tigers)
– Govt services not priced in market, so whatever is spent is counted as GDP even if
its value to consumer is either less or more
2. No accounting for “bads” such as crime and pollution
– Ex. Crime is a detriment to society, but there is no subtraction from GDP to
account for it
– Resources used to avoid or contain crime or risks to national security counted as
part of GDP
– Do not subtract for environmental pollution and degradation
3. No accounting for quality improvements
– Computers quality has gone up , but prices have fallen sharply: pulls down GDP
– Applies to other goods also such as cars
• Despite these drawbacks, GDP is still considered one of the best economic indicators18for
estimating growth in an economy
 Nominal vs. Real GDP
• GDP is measured in terms of value and not quantity
• Why because it comprises of several goods, so that the common denominator can be in
value terms
• Implies that any change in prices would change GDP even if quantity remains
unchanged- doubling of prices would double the GDP
– Brings in concept of nominal GDP

• NGDP is the value of output in a given period measured in current dollars

N

2007   Pi
– NGDP in 2007 is the sum
NGDPof the value of all outputs
2007
*Q measured
i
2007
in 2007 dollars:
i 1

• Nominal GDP changes from year to year for two reasons

– Physical output changes
– Market prices change
• Changes in nominal GDP resulting from price changes would tell
nothing about the performance of the economy in producing goods
and services

– Changes in NGDP could be purely due to changes in prices  if GDP is to be used as19
a measure of output, need to control for prices
• Brings in the concept of Real GDP
• Use real GDP as basic measure of comparing output in different
years for the same country
• RGDP measures change in physical output in the economy by
valuing all goods produced between two time periods in
constant dollars  scaled by a base year price, so that any
change in GDP is due to change in production, not prices
– If PB is the price in the base year for good i, RGDP in 2007 is:
N
RGDP2007   Pi B * Qi2007
i 1

• If different countries are to be compared then bring in exchange

rate 20
 Price Indexes: GDP Deflator
• GDP deflator is the ratio of NGDP in a given year to RGDP of that year
– Since GDP deflator is based on a calculation involving all goods
produced in the economy, it is a widely based price index that is
frequently used to measure inflation
– Measures the change in prices between the base year and the
current year
• Ex. If NGDP in 2012 is Rs 6.25 and RGDP in 2012 is
Rs 3.50, then the GDP deflator for 2012 is Rs 6.25/Rs 3.50 = 1.79 
prices have increased by 79% since the base year (2005)

21
 Nominal vs real GDP

2009 Nominal GDP 2016 Nominal GDP 2016 Real GDP*

Beer 1 at $1.00 $1.00 2 at $2.00 $4.00 2 at $1.00 $2.00
Skittles 1 at $0.50 0.50 3 at $0.75 2.25 3 at $0.50 1.50
$1.50 $6.25 $3.50

Table 2-3 Real and Nominal GDP, an Illustration

*Measured in 2009 prices.
 Price Indexes: CPI

• CPI measures the cost of buying a fixed basket of goods and services
representative of the purchases of urban consumers
– Measure of the cost of living for the average household
• Differs from GDP deflator in three ways:
1. CPI measures prices of a more limited basket of goods and services
(only household goods and services)
2. The bundle of goods in the consumer basket is fixed from year to year,
while that of the deflator varies from year to year depending on what
is produced in the economy in each year
-weightage also varies in case of GDP: when wheat crop is large it
receives a relatively large weight in computation of GDP deflator
3. CPI includes prices of imports, while GDP deflator only considers those
goods produced within the concerned country.
- GDP and CPI differ in behavior from time to time. If price of
imported oil rises, CPI would rise faster. However over long periods
the two produce similar measures of inflation
• Personal Consumption expenditure deflator(PCE) measures inflation in
consumer purchases based on consumption sector.
 Price Indexes: PPI

• PPI measures the cost of buying a fixed basket of goods and services : but
differs from CPI in terms of coverage
– Captures the cost of production for a typical firm
– Market basket includes raw materials and semi-finished goods
• PPI is constructed from prices at an earlier stage of the distribution
process than the CPI(which measures prices at retail level)
• PPI signals changes to come in the CPI and is thus closely watched by
policymakers
® Over long periods of time, the two measures yield similar values and
trends for inflation
• Core inflation excludes prices of food and energy, which are volatile and
temporary. Helps policy makers in measuring ongoing inflationary trends.
24
• GDP and GNP
• GDP includes output produced by foreign companies in the country, say,
Honda, in India
• Similarly GDP in Japan would include output produced by Indian company
there
• The net factor payments, i.e., outgo and incoming receipts is called Net factor
income from abroad
– It can be positive or negative
• GNP= GDP+ Net factor income from abroad
• Normally GDP is higher than GNP,
– as in case of Ireland, Switzerland, or the two may nearly be the same
– In 2021 for instance, the United States estimated its GDP at $23.12 trillion, and its
GNP at $23.37 trillion.
– Real GDP or Gross Domestic Product (GDP) at constant (2011-12) prices in the year
2021-22 was ₹147.4 lakh crore for India
• GNI (Gross National Income) and NNI (Net National Income) of India are estimated at
₹133.85 lakh crore, and ₹ 117.46 lakh crore, respectively at constant prices; and Rs
195.61 lakh crore and Rs174.62 lakh crore at current prices
• India’s GNP is at $ 3.127 trillion at current prices
25
 /

• Real GDP or Gross Domestic Product (GDP) at constant

(2011-12) prices in the year 2022-23 is estimated at ₹160.06
lakh crore showing a growth rate of 7.2% over GDP for the
year 2021-22 of ₹149.26 lakh crore ( 9.1% growth in 21-22).
• Nominal GDP or GDP at current prices in the year 2022-23
is estimated at Rs. 272.41 lakh crore, showing a growth of
16.1% over GDP for the year 2021-22 of Rs 234.71 lakh cr.
• At 2011-12 prices GNI (Gross National Income) and NNI
(Net National Income) of India are estimated at ₹156.81
lakh crore, and ₹ 136.04 lakh crore, respectively.
• Per capita GDP is Rs 1,15,746
• Per capita GNI is Rs 1,13,395
• Per capita NNI is Rs 98,374

26
 From GDP to National Income
– There are a few crucial distinctions between them:
1. Capital wears down over time or depreciates while it is being used in the
production process
2. Net domestic product = GDP – depreciation
» NDP is the total value of production minus the value of the amount of
capital used up in producing that output
» NDP may be 89% of GDP( Depreciation 11%)
3. Businesses pay indirect taxes (i.e. taxes on sales, property, and
production) that must be subtracted from NDP before making factor
payments
4. National Income = NNP – net indirect taxes
» Indirect taxes may account for nearly 10% of NDP in USA; In India GST
mainly
» National income or factor payments is roughly 80% of GDP in case of
USA

27
The circular flow

28
 Components of Demand
• Total demand for domestic output is made
up of four components:
1. Consumption spending by households (C)
2. Investment spending by firms (I)
3. Government spending (G)
4. Foreign demand for our net exports (NX)

® The fundamental national income accounting identity is

Y  C  I  G  NX
(3)

29
 Consumption
• Consumption = purchases of
goods and services by the
[Insert Figure 2-2 here]
household sector
– Includes spending on durable (ex.
Cars spending that may be
regarded as investment ), non-
durable (ex. Food), and services
(ex. Medical services)
– Consumption is the primary
component of demand
– 70% in US
• Consumption as a share of
GDP varies by country
– Figure compares consumption as
a share of GDP for the U.S. to
Japan
30
Consumption
 Investment
• Investment = additions to the physical stock of capital (i.e.
building ,machinery, construction of factories, additions to firms
inventories)
• Investment is considered as any activity that increases economy’s
ability to produce output in future
– By this logic education which is investment in human capital
should be included as investment
– However it is treated as consumption, and public education
expenditure as govt spending
• In the national income accounts, investment associated with business
sector’s adding to the physical stock of capital, including inventories
– Household’s building up of inventories is considered consumption,
– EXCEPT new home constructions considered part of I, not C
• Gross investment included in GDP measure, which is net investment
plus depreciation
 Government
• Government spending are purchases of goods and services which
include items such as national defense expenditures, costs of road
paving by state and local governments, and salaries of government
employees
• Government also makes transfer payments = payments made to
people without their providing a current service in exchange
– Ex. Social security, unemployment benefits
– Transfer payments are NOT included in GDP since not a part of
current production
– Government expenditure = transfers + purchases

33
Government
 Net Exports
• Accounts for domestic
purchases of foreign goods
[Insert Fig. 2-4 here]
(imports) and foreign purchases
of domestic goods (exports) 
NX = Exports – Imports
– When foreigners purchase goods ,
adds to demand for domestically
produced goods
– similarly imports to be deducted
from total demand for
domestically produced goods
– Net exports component of total
demand for our goods
• NX can be >, <, or = 0
– India : NX has mostly been
negative  trade deficit
Net exports
 Some Identities: A Simple Economy

• Assume national income equals GDP, and thus use terms income and output
interchangeably (for convenience ignore depreciation, indirect taxes, and business
transfer payments)
• Begin with a simple economy: closed economy with no public sector
• Output produced equals output sold 
• Output Sold: output is either consumed, or unsold as accumulation of inventories
which is taken as investment
Y CI (4)

• Only two things can do with income: part consume and part save ;national income
expressed as
Y CS (5), where S is private savings

• Combine (4) and (5):  

C  I Y C
  S (6)
demand income

• Rearrange (6) s.t. I Y C  S (7),

or , investment = savings

Investment is identically equal to saving

• Y=C+I+G+(X-M)
• YD=Y-TA+TR
• YD= C+S
• C+S=Y-TA+TR
• C+S+TA-TR=Y=C+I+G+(X-M)
• S=I+(G+TR-TA)+(X-M)
• S=I+BD+TS
• I=S+BS+TD
38
• Output sold for consumption.
• Unsold output assumed as if firms sold the goods to themselves
to add to their inventories. This is taken as part of investment.
• Therefore all output sold is either consumed or invested.
• Value of output produced is equal to income allocated
• Part of income will be consumed and part will be saved. C+I = C+
S.
• The left hand identity shows components of demand, and the right
hand shows allocation of income.
• The identity emphasizes that output produced is equal to output
sold.
• The value of output produced is equal to income received, and
income received is spent on goods or saved.
• Thus the only way an individual can save is by undertaking an act
of physical investment like storing grains.
• In a real economy one can think of investors financing investment
by borrowing from individuals. 39
 Introducing : G and NX
• G is govt purchases of goods and services
• TA is all taxes
• TR are transfers to private sector(including
interest on public debt)
• NX is net exports( exports minus imports)
• Identity between output produced and sold,
taking into account all components of demand
now becomes Y  C  I  G  NX
• Total spending on domestic goods, Y, can be split
into spending by domestic residents, C+I+G, and
net demand for domestic goods from foreigners,
NX 40
 Introducing : G and NX
• When government and the foreign sector are added(i.e. all
components of demand), the fundamental identity becomes
Y  C (8)I  G  NX
• Disposable (after-tax) income, YD, is what consumers split
between C and S when we have a public sector, or
YD  Y  TR  TA
(9), where
YDTR =Ctransfer
S payments and TA
= taxes  (10)

• Rearrange (9) and substitute (8) for Y, then

YD  TR  TA  C  I  G  NX
(11)

• Substituting
C  S  TR  (10)
TA  into
C  I(11):
 G  NX
(12)
S  I  (G  TR  TA)  NX
• Rearranging: (13)

41
 I, S, Budget Deficit and Trade Deficit

S  I  (G  TR  TA )  
NX
      TradeSurplus
BudgetDeficit

• S- I =budget deficit + trade surplus

• Budget deficit and trade surplus are taken as positive numbers
(budget deficit is negative budget surplus)
• where G + TR is total government expenditure
• Excess of savings over investment is equal to govt budget
deficit plus trade surplus
• If savings= investment, then budget deficit is reflected in equal
external deficit(borrowing from abroad to finance the deficit)
42
– Any sector that spends more than it receives
in income has to borrow to pay for the excess
spending
• Private sector can dispose of savings in
three ways:
1. Make loans to the government: so as to
pay for excess of spending over taxes (pay
for budget deficit)
2. Private sector can lend to foreigners: as
they are buying more from us than we
are buying from them(trade surplus)
- Foreigners are earning less from us
than they need in order to pay for the
goods they buy from us, and so we have
to cover the difference
3. Private sector can lend to firms who use
the funds for Investment 43
Savings(S) Investment(I) Budget Deficit(BD) Net Exports(NX)
1000 1000 0 0
1000 850 150 0
1000 900 0 100
1000 950 150 -100

44
 I

•
S  I  (G  TR  TA
,
)  NX
      TradeSurplus
BudgetDeficit

where G + TR is total government

expenditure
I – S ≡ [ TA – (G+TR) ] – NX
I – S ≡ [ TA – (G+TR) ] – ( X – M )
I – S ≡ [ TA – (G+TR) ] + ( M – X )
I – S ≡ ( M – X ) + [ TA – (G+TR) ]
I – S ≡ ( M – X ) ‐ [ (G+TR) ‐ TA ]
I – S ≡ T.D. ‐ B.D.
( I – S ) + B.D. ≡ T.D.
Excess of investment over savings (I > S) in the
private sector plus excess of government
expenditure over its revenues implies that there is a
trade deficit (i.e. , excess of imports over exports)
45
 Inflation and Prices

Pt  Pt 1
• Inflation, , is the rate of change of prices: t 
Pt 1
where Pt is today’s price and Pt-1 is last period’s price

• Additionally, Pt  Pt ,1  ( Pt 1 *  )
or today’s price equals last year’s price, adjusted for inflation
• Price level is the cumulation of past inflation, it may be 2-3% but if it is
continually growing then prices may be much higher than say 30 years back
• If  > 0, prices are increasing over time  inflation
• If  < 0, prices are decreasing over time  deflation
• How do we measure prices?
• For the macro economy, need a measure of overall prices = price index
– There are several price indexes, but most common are CPI, PPI, and the
GDP deflator: none of the measure are perfect
 Unemployment
• The unemployment rate measures [Insert figure 2-8 here]
the fraction of the workforce that is
out of work and looking for a job or
expecting a recall from a layoff(if
someone too discouraged to find
work and has given up, no longer
officially unemployed)
• So official rate may be on lower side
– Important indicator of well-being of an
economy as being without a job
suggests a reduction in income and
purchases
– Optimal unemployment rates differ
from country to country  optimal
unemployment rate linked to the
potential level of output for a given
economy (see figure 2-8)
– Normally taken as around 4-5% 47
Unemployment
 Interest Rates and Real Interest Rates
• Interest rate = rate of payment on a loan or other investment over
and above the principle repayment in terms of an annual
percentage
– Cost of borrowing money OR benefit of lending money
– Many interest rates, depends on credit worthiness, period for which
taken; but talk of “the” interest rate which is normally nominal- rate 10
year bond of Govt
• Nominal interest rate = return on an investment in current Rupees
• Real interest rate = return on an investment, adjusted for inflation
• If R is the nominal rate, and r is the real rate, then we can define
the nominal rate as:
R  r inflation
• Inflation indexed bonds. In US TIPS(treasury  protected
securities)

49
Interest rates
 Exchange Rate
• Each country has its own currency in which prices are quoted
– In India prices are quoted in INR, while in the U.S. prices are
quoted in USD and most of Europe uses the EURO
• Exchange rate = the price of a foreign currency
– Ex., Say, One USD is worth 70 INR
(That does not necessarily imply that the cost of a basket of goods
which can be bought for $ 1.00 in USA is Rs 70 in India)
– Floating exchange rate  price of a currency is determined by
supply and demand of foreign exchange.
• Fixed exchange rate  price of a currency is fixed
– Ex. A Bermuda dollar is always worth one U.S. dollar, but that
does not necessarily imply that one Bermuda dollar is at par with
one USD in terms of purchasing power.
 Concept of purchasing power parity used to compare GDP across
countries
 Economist magazine uses concept of Mac burger 51