LECTURE TWO

NATIONAL INCOME
ACCOUNTING
THOMAS OSEI BONSU DANKWAH
• Because macroeconomics is the study
of the economy at large, economists
must have ways of measuring the
total output of the economy.
• Our first goal will be to explain the
ways the overall production
performance of an economy can be
measured.
• This comes under the heading NI
accounting, which does for the
economy as a whole what private
accounting will do for an
individual business.
 WHY NI ACCOUNTING

1. NI allows us to keep a finger on

the economic purse of the nation.
2. Again, by comparing NI accounts
over a number of years, we can
track the long-run course of the
economy to see if it has grown,
been steady or stagnated.
 WHY NI ACCOUNTING
CONT’D
3. Finally, NI accounts enable us
to formulate appropriate
economic policies to improve
performance.
 WHY NI ACCOUNTING
CONT’D
• Thus, the NI accounting provides
basis for assessing the economic
performance, for designing public
policy and for understanding how
all the sectors of an economy
interact.
 NI ACCOUNTING DEFINED

• NI accounting is the study of the

methods of measuring the aggregate
output and aggregate income of an
economy.
• Precisely, it is an accounting
framework used in measuring current
economic activity in an economy over
a period of time.
 NI ACCOUNTING DEFINED
CONT’D
• NI accounting may also be
defined as the measurement of
the output and income flows of
an economy over a given period
of time.
 GDP VRS GNP
• There are different methods of
measuring the economic
wellbeing of a society. The best
available however is the annual
total output of goods and
services or as it is sometimes
called, the economy’s aggregate
output.
 2 WAYS OF MEASURING OUTPUT

• There are two ways of

measuring total output of goods
and services: Gross Domestic
Product (GDP) and Gross
National Product (GNP).
 GDP DEFINED

• GDP is the sum total of the money

value of total national product or
output of a country produced by
either citizen-supplied or foreign-
supplied resources employed within
the country but excludes
contributions of the nation’s citizens
abroad over a period of time.
 GNP DEFINED

• GNP on the other hand, consist of the

total money value of national output
or income of the normal residents or
nationals of a country whether within or
outside the country and excludes the
contributions or incomes of foreigners
within the country over a period of time.
• GNP does consider the money value of
products produced by normal residents of
a country alone.
• Adjusting GDP with the Net Factor Income
from Abroad (NFI) gives the GNP.
• Net Factor Income is the difference
between earnings of normal residents
abroad and that of foreign nationals within
the country.
 NOTE THE
FOLLOWING
ABOUT GDP
 A MONETARY
MEASURE
• Our economy produces a number of products. If for
simplicity sake we assume that our economy
produces three sofas and two computers in any year
how do we sum these products.
• 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
summing the various goods and services that we
produce in an economy.
 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.
 GDP EXCLUDES NON-PRODUCTION
TRANSACTIONS

• Although many monetary transactions in the

economy involve final goods and services,
many others do not. Those 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 secondhand
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 of a security
broker are included, however, because
those services do contribute to current
output.
 SECONDHAND SALES
• Secondhand 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 brand new
Laptop to a room mate a week after you purchased it.
 MEASURING GDP: THE
CIRCULAR FLOW OF
INCOME
• NI accounting is based upon the
principle of the circular flow of
income and output and the various
approaches for measuring and their
link can be deduced from a Circular
Flow Diagram as follows:
THE CIRCULAR-FLOW DIAGRAM
 THE COMPLEX CIRCULAR FLOW
Wages, rents, interest,
profits

Factor services

Goods
Firms (production)
Household
S pending
Government nt
Taxes ov ernme
G
Savin
gs Financial markets nv es tment
I
Imp Personal consumption
orts
rts
Expo
Other countries

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All

Rights Reserved.
 THE THREE APPROACHES

1. The Expenditure Approach – measured

in terms of the amount of spending done
by the ultimate purchasers of output.
 THE THREE APPROACHES

2. The Income Approach - This

takes account of incomes that
accrue to factors of production,
thus in terms of incomes received
by the producers of output.
 THE THREE APPROACHES

3. The Product/Output Approach –

This is measured in terms of the
amount of final output that firms
produce. This excludes output used
up in intermediate stage of
production.
THE EXPENDITURE APPROACH

• The expenditure approach

to calculating GDP leads
us to the final users of our
output.
 THE EXPENDITURE APPROACH

• All goods produced in our

economy are purchased by
a) Consumers (C)
b) Business investors (I)
c) Government (G)
d) Foreigners (X, M)
 THE EXPENDITURE APPROACH

• This approach measures the

total expenditure needed to
purchase output produced in
the economy within a year.
 COMPONENTS OF EXPENDITURE
APPROACH
• Generally, national income under the expenditure
approach is made up of the following:
Y = GDP = AE = C + I + G + (X – M),
where:
Y = Total expenditure or national income
AE = Aggregate expenditure
C = Consumption expenditure
I = Investment expenditure
G = Government expenditure
X-M = Net exports (X=exports, M= Imports)
PERSONAL CONSUMPTION EXPENDITURE
(C):

• It includes expenditures by
households on:
• durable goods (automobiles, refrigerators,
video recorders etc.),
• non-durable goods (bread, milk, vitamins,
pencil, shirts, etc) and
• services (of lawyers, doctors, mechanics)
 GROSS PRIVATE DOMESTIC
INVESTMENT EXPENDITURE (IG):
• Investment as used by economists refers to
the acquisition of physical capital rather
than to the flows of money that we term as
financial investment.
• Economists exclude the buying of stocks
and bonds from their definition of
investment, because such purchases
merely transfer ownership of existing
assets.
 GROSS PRIVATE DOMESTIC
INVESTMENT EXPENDITURE (IG):

• Investment is the construction or

manufacture of new capital assets.
The production of these assets
create jobs and income; the
exchange of claims to existing
goods does not.
 GROSS PRIVATE DOMESTIC
INVESTMENT EXPENDITURE (IG):
• Thus investment refers to all
spending by businesses and it
includes:
• All final purchases of machinery, equipment
and plants.
• All new constructions including residential
constructions.
• Changes in inventories
All final purchases of Machinery, Equipment and Plants.

• The first group simply fits

our definition of what
investment is.
All new constructions including
residential constructions
• The second – all new constructions – such as
building a new factory, warehouse or office
building is also form of investment.
• Residential construction is also considered
investment because apartment buildings like
office buildings are income-earning assets.
Owner-occupied houses are investment goods
because they could be rented out to yield money
income return, even though the owner may not
do so.
Changes in Inventories

• Finally, changes in inventories are counted

as investment because an increase in
inventories is, in effect, “unconsumed
output”.
• Because GDP measures total current
output, we must include in GDP any
products produced this year though not
sold this year.
 CHANGES IN INVENTORIES

• To be an accurate measure of total output,

GDP must include the market value of any
additions to inventories accruing during the
year.
• A lipstick produced in 2017 must be
counted as GDP in 2017, even though it
remains unsold as of February of 2018.
•If we exclude an increase
in inventories, GDP would
understate current year’s
production.
• A decline in inventories must rather
be subtracted in figuring out GDP.
The economy can sell a total output
which exceeds its production by
dipping into, and thus reducing its
inventories.
• Some of the GDP purchased this year
reflect not current production but,
rather, a drawing down of inventories
on hand at the start of the year. And
inventories on hand at the start of
any year’s production represent the
production of previous years.
• Thus, the lipstick produced in
2017 but sold in 2018,
cannot be counted as 2018
GDP.
GOVERNMENT PURCHASES (G):

• Generally includes such expenditure

on security, general infrastructure
that households want and salaries of
government employees. Therefore, it
is expenditure on the provision of
goods and services for consumption
of the economy.
• That is from rural or local councils to the
state.
• This expenditure does not include
transfer payments such as welfare
payments to the aged and any such
payments because such outlays do not
reflect any current production.
• The sum-total of consumption (C),
investment (I) and government (G)
expenditures gives the national income
in a closed economy, where the
country does not trade with any
country or does not deal with the
international community.
 NET EXPORTS (XN):
• Exports are goods manufactured
in this country and purchased by
foreigners. We obviously will
need to include exports in our
GDP as a measure of goods and
services produced in a year.
• Imports are goods and services
produced in foreign countries and
consumed in Ghana. Thus, imports
are deducted in figuring out our GDP.
The difference between exports and
imports is called net exports (Xn = X –
M).
• These four categories of expenditures –
personal consumption expenditures (C),
gross private domestic investment (Ig),
government purchases (G) and net exports
(Xn) – are comprehensive. They include all
types of spending.
• Added together, they measure the
market value of the year’s output or
in other words, the GDP. That is,
GDP = C + I + G + Xn
 ILLUSTRATION
Personal Consumption (C) 410
Gross Fixed Capital Formation (Ig) 64.5
Government Purchases (G) 81
Add Exports (X) 82
Less Imports (M) 128
Net Exports -46
Gross Domestic Product (GDP) 509.5
Add Factor Receipt from Abroad 50.0
Less Factor Payment to rest of the
world 59.5
Net Factor Income -9.5
Gross National Product (GNP) 500
 QUESTION
ITEM AMOUNT (GHC)

Net Investment 264

Depreciation 70

Exports 300

Imports 400

Government purchases 414

Consumption 1552

Net taxes on production 150

Employee Compensation 1513

Corporate profit 204

Rental income 232

Net interest 120

Proprietor’s income 166

Factor income from abroad 255

 QUESTION

• Find:
i. GDP at market price with the expenditure approach
•
i. GDP at market price with the income approach
•
i. GNP and NNP
•
i. Given statistical discrepancy of 10 billion, find the
national income
 PROBLEMS OF THE
EXPENDITURE APPROACH
• The high illiteracy in developing countries
including Ghana makes record keeping on
expenditures very difficult to permit a
reasonable assessment of expenditures.
•A large proportion of the national
expenditure consists of private expenditures
from the small-scale earners who are
unwilling to give correct information on their
expenditures for fear of high taxes.
 PROBLEMS OF THE
EXPENDITURE APPROACH
• Population figures, which are often based
on projections for obtaining the final
aggregates may not be, quiet accurate.
• Subsistence production may also pose a
problem due to the fact that only a little of
what they produce is sold for money and
therefore not easy to compute subsistence
consumption.
 PROBLEMS OF THE
EXPENDITURE APPROACH

• There is the problem of estimating the

expenditures of numerous farmers and
other small scale operators and
households residing in the remote areas
because of the inaccessible roads to
these areas.
 THE INCOME APPROACH

• This is the method whereby the

National Income is arrived at by
adding up all the money values of
incomes earned by the factors of
production employed in producing the
output in an economy within a
specified period of time like one year.
 COMPONENTS OF INCOME
APPROACH

• Compensation of Employees: this

accounting category includes not only
wages and salaries paid to
employees, but also the monetary
values of fringe benefits, tips,
bonuses, paid vacations and the
employers’ contribution to Social
Security.
 COMPONENTS OF INCOME
APPROACH

• Rental Income: rent consists of

income received by the households
and business that supply property
resources. They include the monthly
payments tenants make to landlords
and the lease payments businesses
pay for the use of office space.
 COMPONENTS OF INCOME
APPROACH
• Interest: interest consists of the
money paid by private businesses to
the suppliers of money capital. It also
includes such items as the interest
households receive on savings
deposits, certificates of deposits, and
corporate bonds.
 COMPONENTS OF INCOME
APPROACH

• Profits: what we have loosely

termed “profits” is broken down
by the national income
accountants into two accounts:
 1. PROPRIETORS’ INCOME

• proprietors’ income which consists of net

income sole proprietorships, partnerships
and other non-incorporated businesses; and
corporate profits. Proprietors’ income flows
to proprietors. Included in proprietors’
income is an estimate of the value of food
grown and consumed on farms although not
sold on the market.
 2. CORPORATE PROFITS
• Corporate Profits: corporate profits are earnings of
owners of corporations. Corporations use their profits in
three different ways; one mandatory and the other two
optional. National income accountants therefore
subdivide corporate profits into three categories:
• Corporate income taxes: these taxes are levied on
corporations’ net earnings and flow to the government.
• Dividends: these are the part of corporate profits that are paid to
the corporate stockholders and thus flow to households – ultimate
owners of all corporations.
• Undistributed Corporate Profits: these are part of the
corporation’s profit saved to be reinvested later in new plants and
machinery. They are also called retained earnings.
• The national income accountants add
together employee compensation, rents,
interest, proprietors’ income and corporate
profits to arrive at what we called National
Income – all the income that flows to
Ghanaian supplied resources, whether
here or abroad over a period of time.
• NB: the expenditure
approach leads us to GDP
whereas the income
approach leads us to
national income (NI).
 FROM NI TO GDP
Expenditures Approach ¢ Income Approach ¢

Personal Consumption (C) 7304 Compensation of Employees 5977

Gross Fixed Capital Rents 142
Formation (Ig) 1593
Government Purchases (G) 1973 Interest 684
Exports (X) 576 Proprietors' Income 757

Imports (M) -1000 Corporate Income taxes 213

Dividends 434
Undistributed Corporate
Profits 141

National Income 8348

Indirect Business Taxes 695

Consumption of fixed Capital 1393

Net Foreign Factor Income 10

Gross Domestic Product 10446 Gross Domestic Product 10446

 FROM GDP TO NI
Expenditures Approach ¢ Income Approach ¢

Compensation of
Personal Consumption (C) 7304 Employees 5977
Gross Fixed Capital Formation
(Ig) 1593 Rents 142
Government Purchases (G) 1973 Interest 684
Exports (X) 576 Proprietors' Income 757
Imports (M) -1000 Corporate Income taxes 213
Gross Domestic Product (GDP) 10446 Dividends 434
Undistributed Corporate
Net Factor Income -10 Profits 141
Gross National Product (GNP) 10436
Consumption of fixed Capital -1393
Net National Product (NNP) 9043
Indirect Business Taxes -695
National Income 8348 National Income 8348
 RECONCILING GDP TO ARRIVE
AT NI
• Despite the assertion that the total income
of a nation is represented by the payments
to all factors of production, it is desirable to
make some few adjustments to make the
total expenditure exactly equal to the total
remunerations to the factors.
• There are three different adjustments to be
made to GDP to arrive at NI.
 NFI

• The first is to account for Net Foreign

Factor Income (NFI). As noted earlier
before we arrive at GNP we need to adjust
GDP with the value of the NFI. Thus to
know how much Ghanaian resources have
been able to produce anywhere in the
world we need to account for the NFI.
 DEPRECIATION
• Secondly, Gross Private Domestic Investment (Ig)
overstates the amount of growth in the nation’s
stock of capital. The decline in value of capital
because of wear and tear or obsolescence must
also be considered.
• Accountants refer to these declines in value as
depreciation. NI accountants called this charge
Consumption of Fixed Capital or Capital
Consumption Allowance because it is the
allowance for capital that has been “consumed”
in producing the year’s GDP.
• The money allocated to consumption of fixed
capital is a cost of production and thus included in
the gross value of output (because we use Ig for
GDP calculations).
• But this money is not available for other purposes
and unlike rent or interest, it does not add to
anyone’s income. To arrive at national income
(income that goes to households) we must subtract
depreciation from total expenditures (GNP) to
achieve a balance with the economy’s income.
• Subtracting capital consumption allowances from
GNP yields Net National Product (NNP).
• NNP therefore is an estimate of how much we can
consume in a given year and still have some amount of
capital stock available for production at the beginning
of the next year. This means that NNP is the net value
of goods and services produced in an economy after
we have adjusted for the fact that we used up some of
our productive capacity during the year.
• [NB: subtracting capital consumption allowance
from Gross Private Domestic Consumption gives
Net Private Domestic Consumption].
• The final adjustment to be made to GDP to
arrive at NI is Indirect Business Taxes (IBT).
The amounts you pay for products and the
amounts received by business are not equal.
There are sales taxes, VAT, excise taxes,
property taxes, etc to consider. These are
indirect taxes and serve as wedges between
what customers or investors spend and the
amount received by sellers.
• For instance, if a firm produces a product
that sells for GH¢ 10, the production and
sale of that product create GH¢ 10 of
wage, rent, interest and profit. But if the
government imposes a GH¢ 2 unit sales
tax, the retailer adds the tax to the price of
the product and shifts it to the consumer
and this is part of consumption
expenditures. But the GH¢ 2 is not part of
production because the government
contributes nothing to the production of
the product in return for it.
• To make the final adjustment between
GDP and NI we need to subtract from
GDP that part of expenditure that is not
received by the factors of production.
• Deducting IBT from NNP yields NI.
• [NB: the opposite holds for the case
of subsidies]
 PROBLEMS OF THE INCOME
APPROACH

• Transfer payments must be identified and excluded

to avoid double counting. Sometimes it becomes
difficult to know whether a payment made constitute
a transfer or not. For example whether money given
to a “regular customer” (prostitute) or girlfriend
constitute a transfer payment since one may argue
that you are consuming her services.
• Subsistence production which when sold would have
form part of the producer’s income must be
estimated and included in the computation.
• Poor records especially from the
informal sector and the self
employed.
• Inaccurate and unavailable records
for fear of high taxation.
 THE PRODUCT OR OUTPUT
APPROACH

• This is the value of final goods and services

produced by countries own factors of
production within a given period. That is
adding up the monetary value of the
physical goods and services in an economy
within a given period, usually within a year.
The final total output is called National
Product/or output.
 THE PRODUCT OR OUTPUT
APPROACH
• The output approach involves adding up the
market value of the total output (goods and
services) of all firms in the various sectors of the
economy (agriculture, Mining, manufacturing,
services etc.) in a year.
• This yields the GDP at market price. It is called
GDP at market prices because the market
prices are used in the computation of the GDP.
The market prices differ from factor cost because
of indirect taxes and subsidies.
 THE PRODUCT OR OUTPUT
APPROACH
• When GDP at market prices is added to the net factor
income (the difference between income earned by
foreigners in the domestic country and income earned
by the citizens residing abroad) we get GNP at market
prices.
• GDP at market prices + Net Factor Income = GNP at
market prices.
• GNP at market prices -Indirect taxes+ subsidies= GNP at
factor cost.
• Gross National Product at factor cost – Depreciation=Net
National Product at factor cost
 THE PRODUCT OR OUTPUT
APPROACH
• It must be emphasised that only value added by
productive units in a country are summed up to obtain
GDP at market price without any double or multiple
counting.
• Value added is the increase in the value of goods as a
result of the production process.
• It is calculated by deducting from the value of the firm’s
output the cost of the inputs used for producing the
goods. Thus all intermediary cost must not be added to
the value of the final product so as to avoid the problem
of double counting.
 THE PRODUCT OR OUTPUT
APPROACH
Stage of Value of Cost of Value added
production output intermediate (cedis)
(cedis) goods (cedis)
Farmer sells
cassava 8 000 0 8 000

Miller turning
cassava to
cassava dough 11 000 8 000 3 000

Woman turning
dough to gari 20 000 11 000 9 000

Gari delivered to
retailer 30 000 20 000 10 000

Total 69 000 39 000 30 000

 THE PRODUCT OR OUTPUT
APPROACH
• The value of the gari includes what the farmer receives from
the sale of cassava, what the miller receives for turning the
cassava to the cassava dough, what the gari producer
receives for turning the cassava dough to gari and what the
gari seller (retailer) receives for selling the gari.
• It will be double counting to add all these services to the
selling price of the gari. The total of the value added at each
stage is the same as the total value of the final product.
• The value of intermediate product is in column 2, the value
added is in column 3 and the value of the final product is the
last figure in column 3.
 PROBLEMS OF OUTPUT
METHOD
• The problem of double or multiple counting
• Poor statistics
• The valuation of public services
• The problem of estimating subsistence
production or output
• The problem of depreciation
 CONCLUSION:
• Since the three identified methods measure the same
thing, namely the flow of new wealth or output
produced, national income, national product and
national expenditure must be identical.
• Mathematically, we say that national income =
national product = national expenditure or Y = Q = E.
• This identity is always ex post, measuring a flow of
wealth or output as it is produced or after it has been
produced.
 OTHER SOCIAL ACCOUNTS

• Several other national accounts

provide additional useful information
about the economy’s performance.
We can derive these accounts by
making various adjustments to GDP.
 NET DOMESTIC PRODUCT (NDP):

• GDP as a measure of total output has a defect: it gives

an exaggerated sense of output available for
consumption and new capital. It fails to make allowance
for that part of this year’s output needed to replace the
capital goods used up in the year’s production.
• Net output is a better measure of the production
available for consumption and additions to the capital
stock than gross output. We derive NDP by subtracting
from GDP the consumption of fixed capital.
• Thus NDP is GDP adjusted for depreciation.
NDP = GDP – Capital Consumption Allowance.
 PERSONAL INCOME (PI):
• PI includes all income received whether earned or
unearned. It is likely to differ from national income
(income earned) because some income earned – social
security taxes, corporate income taxes and undistributed
corporate profits –is not received by the households.
• Conversely, some income received – transfer payments –
is not earned. These transfer payments must be added to
obtain PI. In moving from NI to PI we must subtract the
income that is earned but not received and add the
income that is received but not earned.
PI = NI – [SSC + Corporate Income Taxes +
Undistr. Corp. Profits] + Transfer Payments
 DISPOSABLE INCOME (DI):
• DI is personal income less personal taxes.
Personal taxes include personal income taxes,
personal property taxes and inheritance taxes. DI
is the amount of income that households have left
over after paying their personal taxes.
Households DI is either consumed (C) or saved (S).
DI = PI – Personal Taxes
DI = C + S
 THE USES OF NATIONAL
INCOME ACCOUNTING

1. The National income account makes it possible to

see off hand the economic structure of a given
country.
It gives useful information with regard to the
sectoral performance of the economy
throws light on the past earnings that went into
consumption, capital formation or depreciation
and
how far the country depends on foreign
economies for goods and services.
2. The national income accounting also enables
economic planners to evaluate the effectiveness
of a particular economic plan after a planned
period. In other words, the actual performance
of the economy can be ascertained by
comparing the size of the national income “ex-
ante” (i.e. before the) and “ex-post” (i.e. after
the plan). The national income therefore affords
what is known as inter-temporal comparison.
3. Additionally, it makes it possible to
calculate the economic growth (i.e. how
the national income is growing in real
terms) of an economy and this helps to
find out whether an economy is
improving or deteriorating after a
development programme has been
implemented.
4. The national income account makes it
possible to see at a glance the income
distribution of a given economy. It
therefore furnishes one with the information
as to whether the national income in a
given economy is evenly distributed or
unevenly distributed, or whether a few rich
people in the country earn a larger portion
of the national income.
5. The national income account also aids
international organizations like the United Nations
organisation, IMF, NATO etc. in assessing the
monetary contributions of member countries
toward the budgets of these agencies. The larger
a country’s national income the greater will be its
contribution to the budgets of these international
agencies. Also, it makes it possible to identify
poor countries in the world, which may need
international assistance.
6. Given the GNP in real terms and the total
population of a country, real per capital income can
be computed (i.e by dividing GNP in real terms by
the total population) which may reflect the
standard of living of a country. The real per
capital income can also indicate whether the
standard of living of a country over time is
improving or deteriorating. Moreover, it makes it
possible to compare the standard of living of two or
more countries to determine which countries are
relatively poor.
 WEAKNESSES OF NATIONAL INCOME
ACCOUNTS AS AN INDICATOR OF WELL-
BEING AND TOTAL OUTPUT
• There are certain pitfalls that are associated with NI
accounts as a yardstick of the economic performance of a
country or a measuring rod of the economic well-being
(standard of living) of the people of a country.
• Non-Market Transactions
• Leisure
• Improved Product Quality
• Underground Economy
• Environmental Factors
• Non-economic Sources of Well-being
 WEAKNESSES OF NATIONAL
INCOME DATA FOR INTERNATIONAL
COMPARISON

• Differences in composition of output

• Income inequalities
• Non-market transactions
• Problem of exchange rate
• Underground economy
• Environmental factors
 REAL AND NOMINAL GDP

• Nominal GDP measures the value of output

in a given period in the prices of that
period. Thus 2017 nominal GDP measures
the value of the goods produced in 2017 at
the market prices prevailing in 2017.
• Nominal GDP changes from year to year for
the following two reasons. First, physical
outputs of goods and services change.
Secondly, market prices change.
• Real GDP measures changes in physical output in the
economy between different time periods by valuing
all goods produced in the two periods at the same
price (i.e. At constant prices).
• That is, in calculating real GDP, today’s physical
output is multiplied by the prices that prevailed in
2017 to obtain a measure of what today’s output
would have been worth had it been sold at the prices
of 2017.
 PRICE INDICES

•A price index measures the

combined price of a particular
collection of goods and services,
called “market basket”, in a specific
period relative to the combined price
of an identical or similar group of
goods and services in a
reference/base period.
 THE GDP DEFLATOR

• The calculation of real GDP gives us a

useful measure of inflation known as the
GDP deflator. The GDP deflator is the
ratio of nominal GDP in a given year to
real GDP of that year.
• The deflator measures the change in
prices that has occurred between the
base year and the current year.
 COMPUTING THE
GDP DEFLATOR
• The table below gives an example of how the GDP
deflator can be computed in a particular year for a
hypothetical economy.
• We assume for this economy that only four goods
are produced [computers, shirts, cement and
calculators]. The economy produces 20, 200, 50
and 40 units of computers, shirts, cement and
calculators respectively in the year 2017.
 CALCULATING GDP DEFLATOR
WITH 2005 AS BASE YEAR
Type of Current Curren Prices Current Base Yr
goods Yr (2017) t Yr. of Yr expendi
output Price base expendit ture
per Yr. per ure 2005
unit unit (2017)
¢ (2005)
Computers 20 units 1500 1200 30,000 24,000

Shirts 200 units 500 300 100,000 60,000

Cement 50 bags 800 550 40,000 27,500

Calculators 40 units 700 630 28,000 25,200

Total 198,000 136,700

• Now let’s select 2005 as our reference or base year
to establish a price index for 2017. The 2005 prices
for the components of the 2017 output are listed in
column 4. To determine the year 2017 price index,
we divide the 2017 price of the market basket
(198,000) by the 2005 price of that same collection
of goods (136,700). The quotient is then multiplied
by 100 to express the price index in its conventional
form.
FORMULA FOR GDP DEFLATOR
• The price index for 2017 is 145. This index value
may be thought of as the price level for 2017.
[NB: the index for the base year, 2005 is 100].
• Once the GDP index is constructed for each year,
comparisons of price levels between years is
possible. From our calculations above, the price
indices for 2017 and 2005 are 145 and 100
respectively.
• We can calculate that the price level increase as
45% [145-100] between the two years. If the GDP
deflator for the current year is less than the base
year index [100], prices would have fallen.
• The GDP deflator compares the price of each
year’s output to the price of that same output
in the base year or reference year. A series of
prices indexes for various years enables us to
compare price levels among years. An increase
in the GDP deflator from one year to the next
constitutes inflation; a decrease in the price
index constitutes disinflation.
 ILLUSTRATION
COST OF BASKET OF THE CURRENT
YEAR 2017

Good Quantity Current per- Cost in

Basket unit price current
year

Shirts
10 units 5,000 50,000
Cement
4 bags 12,000 48,000
Maize
3 bags 7,000 21,000
Rice
4 bags 9,000 36,000
Total
155,000
 COST OF BASKET IN THE
BASE YEAR (2005)
Goods Quantity Price of Cost in
basket base year base Year
Shirt 10 bags
3,500 35,000
Cement 4 bags
9,200 36,800
Maize 3 bags
6,000 18,000
Rice 4 bags
7,800 31,200
Total
121,000