ree National Income and Related Aggregates INTRODUCTION National income accounting is a branch of macroeconomics of which estimation of national income and related aggregates is a part. National income or any aggregate related to it, is a measure of the value of production activity of a country. There are three methods of estimation of national income— value added or product method, income method and expenditure method. To understand these, we must know how the macroeconomy (it refers to the economy that we study in macroeconomics) works in a circular way? It begins with the question—‘thow does the flow of production arise?” Ina closed economy, without a government or external trade, there are only two sectors, namely firms and households. The production units are called firms, In a firm the entrepreneur (or entrepreneurs) is at the helm of affairs. He hires wage labour from the market, he employs the services of capital and Tand as well. After hiring these inputs he undertakes the task of production. His motive for producing goods and services (referred to as output) is to sell them in the market and earn profits. In the process he undertakes risks and uncertainties. For example, he may not get a high enough price for the goods he is producing; this may lead to fall in the profits that he earns, The households, on the other hand, consist of people who work in firms as workers and earn wages or they are the owners of firms and earn profits. Moreover, they can also earn rent by leasing land or earn interest by lending capital. > Thus, goods and services are produced by firms with the combined efforts of factors of production (labour, land, capital and entrepreneurship). The output produced is sold to the consumers, who may _ be an individual or an enterprise and the good or service purchased by that entity may be for final use (¢.g., bread purchased by households) or for use in further production. When it is used in further production, it loses its characteristics as that specific good and is transformed through a productive process into another good. For example, 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 it | is transformed into cloth; the cloth is, in turn, transformed into an article of clothing which is then ready to be sold to the ultimate consumers for final use. Why do we call this a final good? Because once it has been sold, it will not undergo any further transformation at the hands of any producer. Tt may, however, undergo transformation by the action of the ultimate consumer, e.g, 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 process of cooking. But cooking at home is not an economic activity because home cooked food 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, materialsDUBE Ucn at eTOCs regates What is Macroeconomics? In macroeconomics, we study the economic behaviour of the economy as a whole by focusing our attention on aggregate measures such as total output, employment and aggregate price level. Here, we are interested in finding out how the levels of these aggregate measures are determined and how the levels of these aggregate measures change over time, Some of the important questions that are studied in macroeconomics are as follows: * What is the level of total output in the economy? © How is the total output determined? How does the total output grow over time? Are the resources of the economy (e.g, labout) fully employed? ‘What are the reasons behind the unemployment of resources? + Why do prices tise? Thus, instead of studying the different markets as is done in microeconomics, in macroeconomics, we try to study the behaviour of aggregate or macro measures of the performance of the economy. Some Ba: Final Goods and Intermediate Goods Goods are classified as final goods and intermediate goods on the basis of the end use of the goods. Final Goods If goods are purchased for consumption, i.e., for satisfaction of wants, or for investment, these are called final goods (or final products). Expenditure on them is called final expenditure. Examples: (i) Machine purchased by a firm for installation in factory isa final good because itis purchased for investment. (ii) Milk purchased by households is a final good as itis purchased for consumption. (iii) Furniture purchased by a school is a final product because it is purchased for investment. (iv) Computers installed in an office is a final product because it is purchased for investment. (v) Printer purchased by a lawyer for office use is a final product because it is purchased for investment. (vi) Blackboard used in a school is a final good because it is for investment. It is not used up completely in a year but remains for production of educational services. (vii) Second hand car purchased by a house hold is a final good because it is purchased for consumption. Intermediate Goods Goods and services purchased by a production unit from other production units with the purpose of reselling or with the purpose of using them completely during the same year are called intermediate goods (or intermediate products). Cees EMU eC Le Ciel w ctar i tapsCrae li ratetiteg Top Tips i ‘+ Raw materials or non-factor inputs purchased for producing goods are intermediate + intermediate goods are also called ‘single use producer goods. “= The expenditure on the intermediate goods is called intermediate cost or intermediate consumption. () Steel sheets used for making automobiles and copper used for making since they are purchased with the purpose of using them com, ee of stel gates/utensis. aplenty de fay oti ee porchasd by « mobile desler aretitepediate hee eeeer FT (iii) Chalks, dusters, etc. purchased by a school are intermediate products because these are used up completely during the same year in the production of educational services. (iv). Paper purchased by a publisher is an intermediate product because itis used as raw material for production of books in the same year. (¥) Purchase of rice by a grocery shop is an intermediate product because it is purchased for resale. (vi) Coal used by a manufacturing firm is an intermediate product because it is used as a non-factor input for production of other commodities during the same yeat: (vii) Fertilisers used by the farmers are intermediate products because these are used up completely for producing grains during the same year. (vil) Corton used by a spinning mill is an intermediate product because it is used for further production of clothes during the same year. Top Tip ‘National income includes the value of final goods only. The value of intermediate goods is not included in the national income estimates because its already included in the value of the final goods. Including intermediate goods separately willinflate or overestimate the national income. Consumption Goods and Capital Goods Final goods produced in an economy in a given period of time are cither in the form of consumption goods (both durable and non-durable) ot capital goods. As final goods they do not undergo any further transformation at the hands of any producer. Thus, of the final goods, we can distinguish berween consumption goods and capital goods. Consumption Goods The final goods which are consumed (or used) for satisfaction of wants by the consumers are called consumption goods or consumer goods", e.g., food, clothing, television sets, etc. > Those consumer goods like television sets, automobiles, home computers, etc. which are of durable character are called consumer durables. > Those consumer goods like food, clothing, etc. which are extinguished by immediate or shore period consumption are known as consumer non-durable goods. Capital Goods ‘The final goods of durable character which are used in the production of other goods and services are called capital goods or investment goods, e.g., machines, tools and equipments. Capital goods are also called durable use producer goods having a long span of life, say 5 years or 10 years. {Bass of classification of final goods into consumption goods and capital goods ‘The same good can be consumption good and also capital good. It depends on the economic nature of its use. For example, 2 machine purchased by a household is @ consumption good whereas, if itis purchased by a frm for use in the business, then itis a capital good. Similarly, a car purchased by a household is a consumption good whereas if its purchased by a firm for use in business, then itis a capital ood. Stocks and Flows Stocks Stocks are economic variables measured at a given point of time, ‘ For example, Capital, Wealth, Money supply, Population, Inventories, Foreign deb ina factory, Balance in a bank account, etc. are stock variables since they are measul Buildings and machines red at a particular point ia ; ntcp tanec) onees ‘tis eneraatinn which are consumed but for convenience we may refer to them as consumer goods. wiiUU cor oer ny er Flows Flows are economic yariables measured over a period of time National income or Gross domestic produet (GDP) or Production or Output, Sales, Savings, Expenditure, Profits, Losses, Exports, Imports, Net capital formation or net investment, Depreciation, Interest, Change in inventories, Change in money supply, Value added, etc. are low variables since they are measured over a period of time, Top Tip ‘An example to understand the difference between stock variables and flow variables Suppose a tanks being filled with water coming from a tap. The amount of water which is flowing into the tank from the f tap per minute isa flow. But how much water there isin the tank ata particular point of time isa stock concept. Gross Investment and Depreciation Investment In economics, the term “investment” is defined as addition to the stock of fixed capital (such as machines) and change in inventories during a year. ‘That part of final output which comprises of capital goods constitutes gross investment of an cconomy. For example, machines, tools and implements, buildings, office spaces, store houses or infrastructure like roads, bridges, airports or jetties, etc, Depreciation A part of the capital goods produced this year goes for maintenance or replacement of existing capital goods because the existing capital stock suffers wear and tear and needs maintenance and replacement. This portion of the capital goods produced is not an addition to the stock of capital goods and its value needs to be subtracted from gross investment to arrive at net investment. This deletion made from the value of gross investment in order to accommodate regular wear and ear of capital, is called depreciation. Depreciation is an annual allowance for normal wear and tear and forescen obsolescence of a fixed capital asset. | New addition co capital stock in an economy is called net investment (or net capital formation). Net Investment = Gross investment — Depreciation ‘Thus, investment is defined as capital formation, a gross or net addition to capital stock. Let us examine the concept of depreciation a little more in detail: Cost of the capital assec — Scrap value [Estimaced life of the capital asset in years) Example: Suppose a new machine is purchased for €20 lakh having useful life of service 10 years, after which it falls into disrepair and needs to be replaced. Suppose, the scrap value of the machine will be nil after 10 years. 220 lakhs—0 10 years Thus, the machine is gradually used up in each year’s production process and each year 1/10th of its original value, i. 22 lakh gets depreciated. So, instead of considering a bulk investment for replacement after 10 years, we consider an annual depreciation cost every year. : Note that depreciation does not take into account unexpected/unforeseen obsolescence or sudden destruction oF disuse of capital as can happen with accidents, natural calamities or other such extraneous circumstances. This is called ‘capital loss’, . ©The tenn investment Contised with the commonplace . . | ‘or fnancial SS ra re eee acca y Seon en sien i er Depreciation on capital Therefore, Depreciation on the machine = 22 lakh per year.ee Nee Top Tip Depreciation is also defined as: 1. Consumption of fied capital ‘Value of capital consumption Current annual replacement cost of fixed capital assets ‘Annual replacement investment to keep the value of fixed capital assets constant ‘Annual allowance for normal wear and tear and foreseen obsolescence ‘Annual maintenance and replacement cost of existing capital goods Regular wear and tear of capital Part of capital stock used up in each year’s production process Industrial classification — Primary, Secondary and Tertiary Sectors Industrial classification means grouping production units into distinct industrial groups,or sectors. This is the first step required to betaken in estimating national income, irrespective of the method of estimation. It is statistically more convenient to estimate national income originating in a group of similar production units rather than for each production unit separately. It is now a matter of general practice to group all the production units of a country into three broad groups — primary sector, secondary sector and tertiary sectors. Each of these sector can be further subdivided into smaller groups depending upon the requirement. Let us now explain each sector. Primary Sector Primary sector includes production units exploiting natural resources like land, water, subsoil assets, etc. Growing crops, catching fish, extracting minerals, animal husbandry, forestry, etc. are some examples. Primary means of first importance. Itis primary because itis a source of basic raw materials for the secondary sector, Secondary Sector Secondary sector includes production units which are engaged in transforming one physical good into another physical good. Such an activity is called manufacturing activity. These units convert raw materials into finished goods. Factories, construction, power generation, water supply, etc. are some examples. Iris called secondary because it is dependent upon the primary sector for raw materials. Tertiary Sector Tertiary sector includes production units engaged in producing services. Transport, trade education, hotels and restaurant, finance, government administration, etc. are some examples. This sector finds third place because its growth is mainly dependent on the primary and secondary sectors. Indirect Tax and Subsidy Indirect Tax Indirect tax is a tax imposed by government on production and sale of goods and services. Ic is a tax where the payer and the bearer of the tax are different people. Examples: Goods and services tax (GST)*, excise t2% ‘customs duties (export duty and import duty), service tax, sales tax ete. Imposition of indirect taxes by the government increases the market prices of goods and services. Subsidy Subsidy isa form of financial/economic assistance given by the government to the firms and households, with @ motive of general welfare. Examples: Cash grants, interest-free loan to the firms, subsidy on price of cooking g35 to the houscholds, etc. Subsidies granted by the government reduce the market prices of goods and services. Goals and Services Tax (GST) has replaced various increct taxes, levied bythe Cental and Staten Governments. Some of te malt taxes that wor ‘Gane wore Contra! Exese Duy, Senco Tax, Central Sales Tax, ot. Tho ts ea eatariort Taxa. Tose ave been eubsurod n GST rar Stat taxes wore VAT/Saes Tx EY r aTea Cee CLC ee cd Market Price and Factor Cost Market Price Marker prices are the prices as paid by the consumers. Market prices also include in Factor Cost Factor cost refer to the prices of products as received by the producers. Jn other words, factor cost is what is actually available to production units for distribution of income among the owners of factors of production. Indirect taxes are deducted from and subsidies are added to market price to calculate what production uw actually receive. Factor cost = Market price ~ Indirect taxes + Subsidies on Factor cost = Market price ~ Net Factor Income and Transfer Income Factor Income ‘The payment for the services rendered to the production units by the owners of factors of production is called factor payment ot factor income. Examples: Wages and salary, rent, interest profit, etc Transfer Income ‘Any payment for which no service is rendered is called a transfer payment or transfer income. It does not involve any production of goods and services. Examples: Gifts, donations, charity, etc. Top Tip National income includes only factor payments which are received in return for the factor services provided in production of goods and services. On the other hand, transfer payment is not included in national income. This is because national income is a measure of. the value of production activity of a country, whereas transfer payment does not involve any production activity. Inventory and Change in Inventories Inventory 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 measured at a given point of time, e.g. value of inventory in the beginning of the year or value of inventory at the end of the year. So, itis a stock variable, Change in Inventories Change in inventories equals closing inventory minus opening inventory. ‘Net change (or increase) in inventories = Closing inventory — Opening inventory Change in inventories (or stock) takes place over a period of time. Therefore, it is a flow variable. Top Tip Inventory is treated as capital. So, itis a stock variable. On the other hand, change in the inventory of a firm is treated as investment, Le., addition to the stock of capital ofa firm. $o, itis flow variable. waeMacroeconomics XIl - by Subha: 4 Net product taxes and Net production taxes import duties, etc. Net product taxes = Product taxes ~ Product subsidies Net production taxes Production taxes and subsidies are paid or received in relation to production and are independent of the volume of production, eg. land revenues, stamp and registration fee. Net production taxes = Production taxes — Production subsidies () Net Product Taxes (+) Net Product Taxes (product taxes ~ product subsidies) (product taxes ~ product subsidies) Net product taxes Product taxes and subsidies are paid or received per unit of product, e.g., excise tax, service tax, export and In In a cat int sal Pr (~) Net Production Taxes (+) Net Production Taxes i (production taxes ~ production subsiies) (production taxes ~ production subsidies) Top Tip ‘+ Market prices include both Net Product taxes and Net Production taxes. ‘+ Basic prices include net production taxes but not net product taxes. + Factor cost includes only the payment to factors of production, it does not include any tax. 7 Final gnods—Goods puchesed fr final consumption, , for satisfaction of wats o irl investment, variables measured at a given point of time, e.g. capital, wealth, etc. Ic variables measured over a period of time, e.g, income, output, et.> al = ieee we study the economic behaviour ofthe economy as a whol, e 2Bpreate demand, aggregate supply, rae employment and price in the economy. Eee and intermediate Goods Goods ar clasified as final goods and intermediate goods on the bas ofthe end se Final goods are the goods which are usd for final consumption ie, for saisaclonof wants) or oF investment. ples: () Machine purchased by a frm for installation in factory, i) Mik or bread purchased by households, i) Printer Purchased by a lawyer for office use, ete. Intermediate goods (or single use producer goods) are the goods which are purchased during the year by a frm from another for the purpose of further production or resale. Examples: ()) Raw materials such a stee! sheets used for making automobiles and copper used for making utensil i) Mobile sets purchased by a mobile dealer, (ii) Chalks, dusters, ete. purchased by a school, (iv) Paper purchased by 2 publisher, (v) Purchase of rice by a grocery shop, (vi) Fertilisers used by the farmers, etc. Consumption Goods and Capital Goods ‘Consumption goods (or consumer goods) are that part of the final goods which are consumed (ot used) for sa wants by the consumers, e., food, clothing, TV sets, refrigerators, etc. Capital goods (or investment goods or durable use producer goods) are that part ofthe fi meeting immediate needs of the consumers but are for producing other goods, eg. mad durable character. Stocks and Flows Stocks are economic variables which can be measured at a given point of time, eg. Capital, Wealth, Money supply, Buildings and machines in a factory Balance in a bank account, etc. Flows are economic variables which can be measured over a period of time, e.g, National income or GDP or Production or Output, Sales, Savings, Expenditure, Profits, Losses, Exports, Imports, Gross/Net capital formation or Gross/Net Investment, Depreciation, Interest, Change in inventories, Change in money supply or money creation, Value addition, ete. Gross Investment and Depreciation Gross investment (or gross capital formation) refers to the addition to capital stock of an economy during an accounting year Depreciation is an annual allowance for normal wear and tear and foreseen obsolescence ofa fixed capital asset, Depreciation is also defined as value of consumption of fixed capital or annual maintenance and replacement cost of fixed capital assets. Costof fixed capital asset — Scrap value after its useful life Estimated useful life ofthe fixed capital asset (in years) Note: Unexpected/unforeseen obsolescence or sudden destruction of capital assets is not depreciation. Its called capita oss, Net investment (or net capital formation) isthe new addition to capital stock nan economy. Apartof the capital goods produced ‘goes for maintenance or replacement of existing capital goods. Thus, Net Investment = Gross investment ~ Depreciation. Indirect Tax and Subsidy Indirect tax isa tax imposed by government on production and sale of goods and services, Examples: Goods and services tax (GST), excise tax, etc. Indirect taxes increase market prices of goods and services. Subsidy is a form of financial/economic assistance given by the government to the firms and households, with a motive of ‘general welfare. Examples: Cash grants, interest-free loan to the firms, subsidy on price of cooking gas to the households, etc. Subsidies reduce the market prices of goods and services Net indirect tax = Indirect taxes ~ Subsidies ‘Market Price and Factor Cost Market price is what the buyers pay. It includes indirect taxes but excludes subsidies, Factor cost is what is actually available to production units, Factor cost = Market price - Indirect taxes + Subsidies Factor Income and Transfer Income ‘The payment for the services rendered tothe production unis by the owners of factors of production i called factor payment ‘or factor income, e.¢. wages and salary, rent, interest profit, etc. ‘pny payment for which no service i rendered scalleda transfer payment or transfer Income, It doesnot involve any production ‘of goods and services. Examples: Gifts, donations, charity, etc. Inventory and Change in Inventories ‘The stock of unsold finished goods, or semi-finished goods, or raw materials which a firm carries from one year to the next Is tisfaction of inal goods which are bought not for shines and equipments. They are of Inventories, Depreciation on fixed capital asset = ‘called inventory. [Net change (or Increase) in inventories = Closing inventory ~ Opening inventoryCOL CUUB cD nce rite cad 1.2 | Domestic Territory and Resident: Implications Domestic territory (or Economic territory) ‘The first thing to note is that economic territory of a country is not simply political frontiers of that country. ‘The wo may have common elements, but still they are conceptually different. Let us first see how it is defined, According to the United Nations: Economic territory (or Domestic territory) is the geographical territory administered by a government within which persons, goods and capital citculate freely. ‘The above definition is based on the criterion "freedom of circulation of persons, goods and capital." Clearly, those parts of the political frontiers of a country where the government of that country does not enjoy the above ‘freedom’ are not to be included in economic territory of that country. One example is embassies. Government of India does not enjoy the above freedom in the foreign embassies located within India. So, these are not treated as a part of economic territory of India. They are treated as part of the economic territories of their respective countries. For example, the U.S. embassy in India is a part of economic territory of the U.S.A. Similarly, the Indian embassy in Washington is a part of economic territory of India. Based on the criterion ‘freedom of circulation of persons, goods and capital’, the scope of domestic territory is defined to covert 1, Political frontiers or geographical boundaries including territorial waters and air space. For example: (3) Branch of an American Bank in India is included in the domestic territory of India because it is located within the geographical boundaries of India i) Office of Tata Industries in America is not the geographical boundaries of India. 2. Embassies, consulates, military bases, etc. located abroad. For example: () Indian embassy in Japan is a part of the domestic territory of India. i) Russian embassy in India is nota part of the domestic territory of India. Iisa part of domestic territory of Russia. luded in the domestic territory of India because it is outside 3. Ships, aircrafts etc. operated by the residents between two or more countries. For example, aixcrafis operated by Air India between Russia and Japan are treated as a part of the domestic territory of India. 4, Fishing vessels, oil and natural gas rigs, etc. operated by the residents in the international waters or other areas over which the country enjoys the exclusive rights or jurisdiction. For example, fishing, vessels operated by Indian fishermen in international waters of Indian Ocean are treated as a part of the domestic territory of India. Resident ‘A resident is defined as follows: A resident, whether a person or an institution, is one whose centre of economic interest lies in the domestic territory of the country in which he lives. The ‘centre of economic interest’ implies two things: (i). the resident lives or is located within the domestic territory, and (ii) the residene carries our the basic economic activities of earnings, spending and accumulation from that location. Examples: . i) (i) Indians working in the office of the United Nations Organisation (UNO) in India are normal residents of India since they live in India and their centre of economic interest also lies in India. alby Subhash Dey fa eeerrcnnne bad sic for medical treatmene }) Indians going abroad for medical treatment are residents of India. Normally, ; riod visit. (i) eae who visit India for recreation, holidays, medical treaument, eae SP: cones exc. are not residents of India, e.g. forcign tourists visiting India to see the Taj Mahal. Normally, visit ro ‘ee historical monuments like Taj Mahal is a short period visit. : Indian officials working in the Indian Embassy in USA are not residents of India because although they are living within the domestic territory of India but they do not carry out the basic economic activities of ings, Sf and accumulation in India, a2 ao. in Indian embassy in America are not residents of India, but residents of Americg because they live in America. (iv) @) Top Tip Resident versus Citizen Note that citizen and resident are two different terms. This does not mean thata citizen is not a resident, and a resident not a citizen. A person can be a citizen as well asa resident, but ts not necessary that a citizen of a country is necessarily the resident ofthat country. A person can bea citizen of one country and at the same time a resident of another country, For eample a NRI, Non-resident Indian. A NRIs citizen of India but a resident ofthe country in which he lives. Ctizenshipis basicaly a legal concept based on the place of birth ofthe person or some legal provisions allowing a person to become a citizen. On the other hand, residentship is basically an economic concept based on the basic economic activities performed by a person. | Implications of the Concepts of Economic Territory and Resident ‘National income and related aggregates are basically measures of production activity, There are two categories of national income aggregates: domestic income and national income, or domestic product and national product. Domestic product Domestic product includes production activity of the production units located in the economic territory irrespective of whether carried out by the residents or non-residents. Gross Domestic Product (GDP), Net Domestic Product (NDP) are some examples. Illustrative example: How will you treat the following while estimating domestic product (or domestic factor income) of India? Rent received by an Indian resident from his property in Singapore (ii) Salaries received by Indian residents working in Russian embassy in India ii) Profits carned by a foreign company or a foreign bank in India (iv) Salaries paid to Koreans working in Indian embassy in Korea (%) Compensation of employees to the resident of Japan working in Indian embassy in Japan (vi) Profits earned by a branch of State Bank of India in Japan Answer: | (No, it will not be included in domestic factor income of India because this income is earned outside the domestic territory (economic territory) of India. It is factor income from abroad, @)_No, ic will not be included in domestic factor income of India because Russian embassy in India is nota part of domestic territory of India. So, this income is not earned within the domestic territory of India. It is factor income from abroad. (iii) Yes, it will be included in domestic factor income of India becauise the forei; i Bae dee oad os ee (iv) ey ee luded in dor factor i : iv) Yes, it will be included in domestic factor income of India because this income is earned the domestic territory of India. Indian embassy in Korea is «par of the MEE Eerieen | 2 | (W). Yes, ie will be included as itis part of Factor Income earned in domestic territory of India, though earned by non-resident. (vi) No, as profits are not earned within the domestic territory of India, It is factor income from abroad, National product National product includes production activities of residents isrespective of whether performed within the economic territory or outside it. Gross National Product (GNP), Net National Product (NNP) are some examples. Illustrative example: Will the following be included in Gross National Product (GNP)? Give reasons. (Profits earned by a foreign company or a foreign bank in India (ii). Salary paid to Americans working in Indian Embassy in America (iii) Salaries received by Indian residents working in Russian Embassy in India (iv) Dividend received by an Indian from his investment in shares of a foreign company Answers: (No, because itis a factor income earned by a non-resident (a foreign company or a foreign bank) from its contribution to production inside the domestic territory of India, ic, factor income paid to abroad. (Gi) No, because this factor income is paid to non-residents, ic. factor income to abroad. ii) Yes, because it is a factor income earned by Indian residents outside the domestic territory of India i.e., factor income from abroad. (iv) Yes, because itis a factor income earned by a resident from outside the domestic territory of India, i.e, factor income from abroad. Top Tip It can be realised that a factor income which is included in domestic factor income of India may not be included in national income. For example, profits earned by a branch of a foreign bank in India will be included in the domestic factor income of India because these profits are earned within the domestic territory of India. However, it will nt be included in national income of india as its a factor income paid to abroad. (Foreign Bank is not a resident of India.) Similarly, an income which is included in national income may not be included in the domestic factor income. For example, salaries received by Indian residents working in Russian Embassy in India will be included in the national income as it is residents’ contribution to production, though outside the domestic territory of India. However, it will not be included in domestic Income since this income is earned outside the domestic territory ofthe country ie. factor income from abroad. Relation between national product and domestic product i ‘The concept of domestic product is based on the production units located within economic tertitory, operated both by residents and non-residents. The concept of national product is based on residents, and includes their contribution to production both within and outside the economic territory. Normally, in practical estimates, domestic product is estimated first. National product is then derived from the domestic product by making certain adjustments, Let us sce how? National product is derived in the following way: National product = Domestic product + Residents’ contribution to production outside the — Non-residents’ contribution luction In practical estimates, the residents’ contribution. a ee from abroad” and the non-residents’ contribution inside the economic territor to residents”, Therefore: es : National product = Domestic product + Factor income received fron Shey se — Factor income paid to abroadis in addition to their contribution to domestic product. Noel ae > ‘Factor income paid to abroad! is subtracted because this part of domestic product, does not belong yo the residents. By subtracting "factor income paid to abroad” from "factor income reccived from abroad”, we get @ net figure "Net factor income from abroad" popularly abbreviated as NFIA. National product = Domestic product + Net factor income from abroad (NFIA) Net factor income from abroad Ik is the excess of factor incomes (rent, wages, interest, profit) earned from abroad over factor incomes (rent, wages, interest, profit) paid to abroad. NFIA can be positive, negative or zero, 1. Positive NFIA: NFIA is positive when factor income from abroad is more than factor income paid to abroad. Note that if NFIA is positive, national product (or national income) will be greater than domestic product (or domestic income), 2. Negative NFIA: NFIA is negative when factor income from abroad is less than factor income paid to abroad, If NFIA is negative, national income will be less than domestic income. 3. Zero NFIA: NFIA is zero when factor income from abroad is equal ro factor income paid to abroad. IFINFIA is zero, national product (or national income) will be equal to domestic product (or domestic income). I is important to note that ‘Net factor income paid to abroad’ is opposite/negative of NFIA. If Net factor income to abroad = 100 crore, then NFIA = (-) £100 crore. Top Tip Calculation of NFIA in different cases: 1. If factor income from abroad INFIA = 1000 - 800 = %200 crore 2, If factor income from abroad = £700 crore and factor income to abroad =%1100 crore, then NFIA = 700-1100 = (-)400 crore 3. If factor income to abroad = %200 crore and factor income from abroad is not given, then we assume that factor income from abroad is zero. Therefore, NFIA = 0 - 200 = (-) %200 crore 4, If factor income to abroad = (-) 7300 crore and factor income from abroad is not given, then we assume that factor income from abroad is zero, Therefore, NFIA = 0 — (—)300 = 7300 crore 5. If factor income from abroad = (-) ®50 crore and factor income to abroad is not given, then we assume that factor income to abroad is zero. Therefore, NFIA '1000 crore and factor income to abroad = €800 crore, then ~ Domestic territory (oF economic territory}—The geographical teritory administered by a government within which "persons, goods and capital circulate freely. __ Resident A person or an institution whose centre of economic interest les inthe domestic territory ofthe country a= UNIT 1: National Income and Related Aggregates cM Circular Flow of Income (Two- Sector Model) Circular flow of income refers to flow of income across different sectors of an economy in a circular way. In a closed economy* without a government, external trade or any savings, there are only two sectors, namely, households and firms. Households are owners of factors of production. They provide factor services (in the form of labour, capital, Jand and entrepreneurship) to the firms (producing, units). Income is generated in production units in the form of value of total final goods and services produced MBAS! Lorca in the economy. Firms distribute the entire income generated to make factor payments (in the form of wages and salaries, from firms to households. Circular flow of income in a two sector economy Aggregate value of final goods and services produced = Aggregate factor payments In this simplified economy, there is only one way in which the households may dispose off their earnings ~ by spending their entire income to buy the goods and scrvices produced by the firms. 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. So, households buy goods and services from firms for which they make payment to the firms. Thus, consumption expenditure (ie., spending on goods and services) flows from houscholds to the firms, making the circular flow of income complete. Hence, circular flow of income in a two sector economy is based on the axiom that one’s expenditure is other's income, ‘The entire income of the economy, therefore, comes back to the producers in the form of sales revenue. There is no Ieakage** from the circular flow of income. Aggregate factor payments = Aggregate final expenditure on purchase of goods and services Note that the same amount of money is moving in a circular way. Thus, national income can be calculated by three methods, which give us the same value. 1. Production method: Product method measures aggregate value of final goods and services produced by all the firms in the economy during a year (Annual flow at A). 2. Income method: Income distribution method measures aggregate factor payments made in the economy 4 during a year (Annual flow at B). 3, Expenditure method: Expenditure method measures the aggregate final expenditure on goods and services in the economy during a year (Annual flow at C). Top Tip. Nominal Flow and Real Flow = + Nominal Flow/Money Flow isthe flow of factor payments and payments for goods a and firms. ‘ ‘ ‘+ Real Flow is the flow of factor services and the flow of goods and services between ose eco one tat das no trade ith oer nations in goods and *Leakages refer fo withdrawal of money fram the circular low of income. itis that | Ferexample, savings, tx0s and imports are leakages from tho cular Row ofPUERCO Puce once tet Production Method of Calculating National Income In product method or value added method, we calculate the aggregate annual value of goods and services produced during a year. 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 — 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 ina year the cotal value of wheat that the farmers have produced is 2100. Our of this they have sold %50 worth of wheat to the bakers. The bakers have used this amount of wheat completely during the year and have produced 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 €200 (value of production of the bakers) v0 2100 (value of production of farmers). The result will be 300. A litde reflection will tell us that the value of aggregate production is not €300. The farmers had produced €100 worth of wheat for which it did not need assistance of any inputs. Therefore, the entire €100 is rightfully the contribution of the farmers. But the same is not true for the bakers. The bakers had to buy %50 worth of wheat to produce their bread. The £200 worth of bread that they have produced is not entirely their own contributiori. 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 750 | 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, £200 - 50 = 2150. Hence, aggregate value of goods produced by this simple economy is €100 (net contribution by the farmers) + %150 (net contribution by the bakers) = €250. ‘The term that is used to denote the net contribution made by a firm is called its 'value added’, We know 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: | ‘Value added ofa firm = Value of output produced by the firm — Cost of intermediate goods used The value added of a firm is distributed among its four factors of production, namely, labour, capital, entreprencurship 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 a flow variable. We can represent the example given above in terms of the following Table. Value of output 100 200 Intermediate consumption 0 50. ‘Value added 100 200 - 50 =150 Problem of Double Counting The problem of double counting arises when the value of same goods and services are counted more than once while estimating national income. ‘There are two approaches/methods to avoid the problem of double counting: (i). Take the value of final goods and services only ignoring all intermediate products. (ii) Take value added at different stages in production process instead of toral output.Steps for calculation of national income by product method Step 1: Estimation of value of output produced by each firm in all the sectors of the economy during the year. Value of ourput is the market value of goods and services produced by a firm during an accounting year, ‘Value of output = Output produced (in units) x Market price (@) Ifa firm had no initial unsold stock in the beginning of the year: Value of output produced = Sales + Value of unsold stock Note: Sales = Output sold (in units) x Market price Sales = Sale of goods and services to domestic buyers + Exports of goods and services. (b) Ifa firm had some unsold stock in the beginning of the year: ‘Value of ourput = Sales + Net change in stock or, _ Value of output = Sales + Closing stock ~ Opening stock Example: Suppose that a firm had an unsold stock worth €100 at the beginning of the year. During: the year it produced 71000 worth of goods by using raw materials and other inputs worth %400 and managed to sell 7800 worth of goods. (i) Value of closing stock = Opening stock + Value of output produced ~ Sales = 100 + 1000 — 800 = 7300 i) Change in stock = Closing stock ~ Opening stock = 300 — 100 = 200 of, Change in stock = Value of output produced ~ Sales = 1000 ~ 800 = ®200 (ii) Value of output produced = Sales + Change in stock = 800 + 200 = 1000 Step 2: Calculation of Value Added/Value Addition (VA) and Gross Domestic Product at market price (GDPmp) Value added/value addition is the difference between value of output and intermediate consumption. ‘Value added = Value of ouput ~ Intermediate consumption Top Tip Intermediate consumption = Purchase of rw materials etc. + Imports of raw materials etc. In our example of farmers and bakers, the Value Added by farmers and bakers are their Gross Value Added at market price (GVAmp).. GVAmp of firm = Value of ouput — Intermediate consumption’ Now, if we sum the GVAmp of all che firms in all the sectors of the economy, we get Gross Domestic Productry ‘Why is GDPmp called gross? GDPmp is final products valued at market price. This is what buyers pay. But this is not what production units seeually receive, Out of what buyers pay, the production units have to make provision for deprecitton and tax like excise, sales tax, etc. This explains why GDPmp is called ‘gross’ It is called gross 1 has been made for depreciation. However, if depreciation is deducted from the GDR it ion does not become part of anybody's income. payment of indirect because no provision becomes Net Domestic Product (NDP). Naturally, depre ‘Why is GDPmp called ‘at market price’ ? Out of what buyers pay, the production units have to m: accrue to the government, and not to the production uni transfer payment as no good or service is provided in return. Hence, to calculate what production units actually receive. Sometimes production units receive subsidy on pi production units receive from the buyers. Therefore, price’ but "market price — indirect tax + subsidies". Step 3: Calculation of Net Domestic Product at factor cost (NDPfc) If we make adjustment of depreciation, indirect taxes and subsidies in GDPmp, we get Net Domestic Product at Factor Cost (NDPf.). ake payments of indirect taxes, if any. Indirect taxes ts, Payment of indirect taxes to the government is a indirect taxes are deducted from GDPmp roduction. This is in addition to the market price which whaé production units actually receive is not the 'market- NDPfc = GDPmp — Depreciation — Indirect taxes + Subsidies on, NDPfe = GDPmp - Depreciation — Net indirect taxes or, NDPfe = GDPmp — Depreciation — Net product taxes ~ Net production taxes NDPfe is the income earned by the factors of production in the forin of wages, profits, reif, interest, etc., the domestic territory of a country. This is also called domestic income because this is the income generated in the production process within the domestic territory of the count Step 4: Calculation of Net National Product at factor cost (NNPfc) or National Income (NI) “Net National Product at factor cost (NNPfe) is the net domestic factor income added with the net factor income from abroad. In other words: ‘National income (NNPfe) = NDPfe + NEIA or, NNPfe = GDPmp — Depreciation — Net indirect taxes + NFIA- ot, NNPfc = GDPmp — Depreciation — Net product taxes ~ Net production taxes + NFIA. NNP at factor cost is the sum of income carned by all factors in the production in the form of wages, profits, rent and interest, etc., belonging to a country during a year. It is the National Product and is not bound by production in the national boundaries. Top Tip RES Domestic Product (DP) _ oO oxen | | 2st : cornu | { (aan __ National Product (NP) (©) Indirect taxes haee (#) Subsidies pavectsta or (©) Net betrect taxes (+) net incre axesOther Basic National Income Aggregates 1, Net Domestic Product at Market Price (NDPmp) NDPmp = GDPmp = Depreciation y is o spend just to maintain their 7 pe en See ee ee ec rash depecetin, ea GDP Wil Cl 2. Gross National Product at Market Price (GNPmp) GNPmp = GDPmp + Net factor income from abroad (NFIA) GNPmp is the value ofall the final goods and services that are produced by the normal residents of India and Nel at che market prices, in a yea. GNP refers to all the economic ousput produced by nations nom residents, whether they are located within the national boundary or abroad. Everything is valued at the market pri 3, Net National Product at Market Price (NNPmp) NNPmp = GDPmp — Depreciation + NFIA ‘his is a measure of how much a country can consume in a given period of time. NNP measures ourpg regardless of where that production has taken place (in domestic territory or abroad). 4, Gross Domestic Product at Factor Cost (GDPfe) GDP at factor cost is gross domestic product at market prices less net indirect taxes. GDPfe = GDPmp — Net indirect taxes or GDPfe = GDPmp = Net Product Taxes ~ Net Production Taxes GDP at factor cost measures money value of ourput produced within the domestic boundaries of a country ina year as received by the factors of production. 5. Gross National Product at Factor Cost (GNPfc) GNP at factor cost is gross domestic product at market prices less net indirect taxes plus NFIA. GNPfe = GDPmp ~ Net Indirect taxes + NFIA or GNPfe = GDPmp ~ Net Product Taxes ~ Net Production Taxes + NFIA GNP at factor cost measures value of output received by the factors of production belonging to a country in ayeat Precautions in calculating national income by value added method 1, Avoid double counting. ‘Value of intermediate goods is not i goods is reflected in the value of final goods. So, avoid double counting of goods and services as these tend (0 inflate national income estimates. 2, Do not include sale of second hand goods, 4 Value of second hand goods (or used goods) being sold should not be included in national i heir value was accounted for at the time of first production, Sale of the second hand goods is Be enone vy Te second hand good should not be treated as fresh production, and therefore is not included in national income However, any brokerage or commission paid to facilitate the sale of second hand goods is a fresh production activity, It should be included in production but to the extent of brokerage or commission only. 2 3. Self-consumed output must be included, ‘Output produced but retained for selFconsumption, rather chan selling in market, i In estimates. Services of owner-occupied buildings, farmer consuming its awn prod EER ip output and muse be ineladed own. produce, etc. are some examplesSolution: Particulars Gin crore) Value of output of all sectors (note I) aay C) Cost of intermediate inputs purchased by all sectors (nate 2) 390 (@) Gross Domestic Product at Market Price (GDPmp) Ge Adjustment: (©) Consumption of fixed capital of all sectors (oy (©) Indirect taxes paid by al sectors 0 (4) Subsidies received by al sectors a (4) Net factor income fiom abroad (NFIA) (note 3) can (B) National Income (NNPf) ae Nore: 1. Value of output of all sectors = Value of output of primary, secondary and tertiary sectors = 800 +200 + 300 = €1300 crore 2, Cost of intermediate inputs purchased by all sectors = 400 +100 + 50 = 8550 crore 3. NBIA = Factor income received by the residents from rest of the world — Factor income paid to non-residents = 10-20 =) 210 crore Do it yourself 8 From the following data calculate the (a) Gross National Product at Market Price (b) National Income, 3 marks Value of output in primary sector [Net factor income fiom abroad Value of ouspus in tertiary sector Intermediate consumption in secondary sector ‘Value of ourput in secondary sector ww, © c) (ai) Intermediate consumption in primary sector Intermediate consumption in tertiary sector Net Indirect Taxes Consumption of fixed Capital we) [Ans. (a) 21,380 crore (b) 2980 crore] Income Method of Calculating National Income Steps for calculating national income by income method Step 1: Estimate the factor payments by each firm in all the sectors of the economy during the year. : ’ ‘The sum of factor payments equals Net Value Added at Factor Cost (NVAfc) of a firm. Step 2: Take the sum total of NVAfe by all firms in all the sectors of the economy to arrive at NDPfc. The components of NDPfe are compensation of employees, operating surplus and mixed income. 1. Compensation of employees: It is defined as the total remuneration in cash or in kind, payable by the employers to employees in return for work done by them during, an accounting year.een ‘The main components of compensation of employees are: (a) Wages and salaries in cash and in kind. For example + Payment of bonus by a firm to its employees + Free medical facilities, free meals and rent-free house given by the employer * House rent allowance or leave travel allowance paid by the employer * Medical treatment of employce’s family (b). Social security contributions by the employers. For example, * Contribution to provident fund by the employer + Insurance premium paid by the employer Top Tip Contribution to provident fund or insurance premium paid by employees is not included in national income because itis paid out of compensation of employees, which is already included, Similarly, compensation given by insurance company to an injured worker is not included as compensation is given by insurance company to the employee, and not by employer. Also, gifts received from employer, e.g. festival gift, gifts on independence day, etc. is not included in national income as itis a transfer payment. 2. Operating surplus: Operating surplus is defined as the sum of rent, royalty, interest and profits, Operating surplus can also be termed as ‘Income from property and entrepreneurship’, i.e: \comes earned by property owners. It includes rent and royalty, profit and interest. (a) Rentis defined as the amount receivable by a landlord from a tenant for the use of land. (b) Royalty is defined as the amount receivable by the owner for granting the leasing rights of sub-soil assets, eg., royalty income received by an author of a book from the publisher. (©) Interest is defined as the amount payable to the owners of financial assets in the production unit. The production unit uses these assets for production and in turn makes interest payment, imputed or actual. Top Tip Payment of interest by banks to its depositors or Payment of interest by a firm (government firm or a private firm) to households or Payment of interest by a firm to a bank is included in national income because itis factor payment. The borrowed money is used for carrying out production of goods and services However, payment of interest on aloan taken by an employee from the employer or payment of interest by an individual toa bank ona loan to buy a car or interest received on loans ‘given to a friend for purchasing a car will not be included in national Income because the individual isa consumer, and the loan is taken to meet consumption expenditure. There is ‘No contribution to production of goods and services. Therefore, itis not a factor payment, (d)_ Profits a residual factor payment by the production unit to the owners of the production unit, The production unit uses profi for (i) payment of corporation tax to the government, (i dividend payments to the owners of the production unis, and (ii) undistributed profits retained earnings for investment in new projects and ventures, Profits = Corporation tax + Dividend + Undistributed profits/Retained earnings/savings of private corporate sector + on Profits = Corporate profit tax + After-tax profit (Note: After-tax profit = Dividend + Retained earnings) Top Tip - i Payment of corporate tax by a firm is also not included in national income as it is a ‘transfer payment. Corporate tax [.aleady included in profits. Corporate tax accrues to the government. tis not received by the ‘owners of factors of Production, Hence, itis not a factor income.Ren Pune nO Cerro 43 Mixed income of self-employed: The income of self employed people like doctors, chartered accountants, consultants, etc. has two or more factor incomes. For example, a doctor's income may consist of salary from a hospital, fees earned by him from the patients in his own clinic, rental income from his property, and profits of a business owned by him, In such cases, total income is estimable, but not its different components. So, mixed income of self-employed is another factor payment, which is added to the national income. NDP£e = Compensation of employees + Operating surplus + Mixed income Top Tip The main source of factor payments are the accounts of production units. Since accounts of most production units are not ‘available to the estimators, and also since the accounting practices differ, itis not possible for the estimators to clearly identify the components. Therefore, in cases where total factors payment is estimable but not is different components, an additional factor payment item called ‘mixed income’ is added. Since this problem arises mainly in case of self employed people like doctors, chartered accountants, consultants, ete, this factor payments popularly called "mixed income of the self-employed”. Step 3: Once we estimate NDPfc, we can find NNPfc (national income) by adding NFIA to it. ‘National income (NNPfc) = NDPfc + NFIA Top Tip Components of National Income by Income Method are: (i) Compensation of employees (i) Operating surplus (i) Mixed income of self-employed (i) Net factor income from abroad (NFA) "National income (NNPfc) = Compensation of employees + Operating surplus + Mixed income + NFIA Precautions in making estimates of national income by income method 1. Avoid transfers. National income includes only factor payments, ie. payment for the services rendered to the production units by the owners of factors of production, ‘Any payment for which no service is rendered is called a transfer (cg. gifts, donations, charity, etc.), and not a production activity. Hence, transfer payment is not included in national income, 2. Avoid capital gain. Capital gain refers to the income from the sale of second hand goods and financial assets. Income from the sale of old cars, old house, bonds, debentures, etc are some examples, ‘These transactions are not production transactions. So, any income arising to the owners of such things is not a factor income. 3. Include income from self-consumed output. ‘When a house owner lives in that house, he does not pay any rent. But in fact he pays rent to himself. Since rent is a payment for services rendered,even though rendered to the owner itselfit must be counted as a factor payment. 4, Include free services provided by the owners of the production units. Owners work in their own unit but do not charge salary. Owners provide finance but do not charge any interest. Owners do production in their own buildings but do not charge rent. : ‘Although they do not charge, yer the services have been performed. The imputed value of these must be included in national income.Per srieeees Calculate the value of “Mixed Income of Self-Employed” from the following data: (CBSE 2019) (4 marks) ‘Compensation of Employees Interest ‘Consumption of Fixed Capital Mixed Income of Self Employed Subsidies Gross Domestic Product at Market price Indirect Taxes Profits Rent [Ans. €2,750crore] ional Income Expenditure Method of Calculating Nat In this method, we take the sum of final expenditures on consumption and investment. This sum equals GDPmp. These final expenditures are on the final goods and services (both consumption goods and capital goods) produced within the domestic territory of the country. \ Top Tip Expenditure method includes only final expenditure, i.e. expenditure on consumption and investment. Intermediate ‘expenditure like that on raw materials, etc. is not included in national income. Final Expenditure refers to the expenditure on final goods and services produced within the domestic territory of the country, which are meant for final consumption and investment, Examples: “ (i) Expenditure on purchase of car/furniture/sewing machine/refrigerator by a household isa final expenditure on consumption, and thus included in national income. {i)_ Expenditure on purchase ofa car/furniture/machine/refrigerator for use by a firm s afinal investment expenditure, and thus included in national income. Intermediate Expenditure/Intermediate Consumption/Intermediate Cost refers to the expenditure incurred by @ production unit on purchasing those goods and services from other production units, which are meant for resale or for Using up completely during the same year. Examples: ) Expenditure on fertilisers by a farmer (i) Payment of electricity bill by 3 schoo! (ii) Purchase of uniforms for nurses by a hospital {iv) Expenditure on engine oil by a car service station (W)_ Expenditure by a frm on payment of fees toa chartered accountant ora lawyer (Note that a chartered accountant or a lawyers on outsider to the [Link], payment of festo them wil nat be a factor income, but an intermediate expenditure) (v)_ Expenditure on maintenance of factory building by a firm (ui) Fees toa mechanic pald by a firm (vill, Transport expenses by a firm (0x). Expenditure on advertisement and scientific research by a firm Main components of GDPmp or final expenditures in the economy . 1. Private final consumption expenditure (PFCE) ong yeti Tosi Mok ala slisslaed | Ir is the consumption expenditure of houscholds on the final goods and services produced in the economy. For cxample, purchase of car by a household, expenditure on education of children by a family (school fee or purchase of books), etc. want apap bis ablntye yall! 262. Government final consumption expenditure ee) r n expenditure that the government makes on . Le aa acmnpe govemment expendvreon fee services provided such at education service, defense services, etc. 3. Gross domestic capital formation (GDCF) Tc is the final investment expenditure incurted by firms and the government. For a farmer, purchase of taxi by a taxi driver, purchase of a truck to carry goods by reftigerator installed in a production unit by a firm. ‘Note that GDCF is composed of the following: GDCF = Gross domestic fixed capital formation + Net change in stocks GDCE « (Net fixed capital formation + Depreciation) + (Closing Stock ~ Opening Stock) he final goods and services produced in health, police 1 example, purchase of tractor by or 4, Net exports (= Exports — Imports) (X-M) Net export refers to the excess of the value of exports over the value of imports of a country in an accounting year Exports, though purchased by non-residents, are produced within our domestic territory, and therefore, a part of domestic product and thus, included in GDPmp and hence national income. Imports, however, are deducted because goods and services imported are not produced within the domestic territory of the country. ‘GDPmp = Private final consumption expenditure + Government final consumption expendicure + Gross domestic capital formation + Net exports Top Tip Net imports is negative of net exports. For example, if net imports = 30 crore, it means net exports = (-) €30 cro GOPmp = PFCE + GFCE + GDCF — Net Imports By making the usual adjustments we can artive at national income. ‘National Income (NNPf) = GDPmp ~ Depreciation ~ Indirect taxes + Subsidies + NFIA Precautions in making estimates of national income by expenditure method 1. Avoid intermediate expenditure. By definition, che expenditure method includes only final expenditures, ic. expenditure on consumption and investment. Like in the value added method, inclusion of intermediate expenditure like that on raw materials, etc. will mean double counting. 2. Do not include expenditure on second hand goods and financial assets. Buying second hand goods is nota fresh production activity: Buying financial assets is not a production activity because financial assets are neither goods nor services. Therefore, they should not be included in estimates of national income. 3. Avoid transfer expenditures. AA transfer payment is a payment against which no services are rendered. Therefore, no production takes place. Since no production takes place it has no place in national income. Charities, donations, gifts, scholarships, et are some examples, i 4. Include the self use of own produced final products. ‘example, a house owner using the house for self, Although explicitly he does not is i Implicily he eras . if ly not incur any expenditure, making payment of rent to himself Since the house is producing a service, the impy housing service must be included in national income, Lume eed Se toad a firm, purchase of a machine or ated value of : | iNominal GDP, Real GDP and GDP Deflator Nominal GDP It is the value of the final goods and services produced within domestic territory of a country duri an accounting year, as estimated at the current year’s prices. Jn other words, Nominal GDP (or GDP at cut prices) is measured as the product of current year's output (Q)) of final goods and services and their year’s price (P,). Change in nominal GDP may include both change in prices and change in flow of goods and services, nominal GDP may increase even if there is no increase in the output of goods and services produced in economy, due to rise in general price level during the current year. Real GDP Iris the market value of the final goods and services produced within the domestic territory of a country durin an accounting year, as estimated at the base year's* prices/constant prices. Jn ather words, Real GDP (or GDP constant prices) is measured as product of current year output (Q)) and their base year’s price (P9). Since base years prices remaining constant, real GDP will increase only if the output of goods and service produced in the economy is increasing, 7 Top Tip Real GDP is a better indicator of economic growth and welfare of people of the country than Nominal GDP as itis not_| affected by changes in general price level. Secondly, because increase in real GDP means more goods and services are available to the society during the year. Thus, welfare increases. ‘Numerical Example: Current Year| Price of Base Year | Quantity of Current | Nominal GDP (Rtas (GOs Year (Qs) (in units) (2:Q A 20 10 100 2,000 1,000 B 10 5 200 2,000 1,000 | Cc 30. 20 50 1,500 1,000 | P,Q; = 5,500_|EP,Q, = 3,000 In the above example, Nominal GDP = 2P,Q, = 25,500 and Real GDP = 2P,Q, = 23,000. The difference between Nominal GDP and Real GDP is 5,500 — 3,000 = %2,500. This is only the monetary difference as the quantity sold in the market remains unchanged and the variation in the value of nominal and real GDP is merely due to the change in the prices in the economy between the base year and current year GDP Deflator The ratio of Nominal GDP to Real GDP of current year is a well known price index, called GDP Deflator. GDP Deflator Nominal GDP nor Real GDP ‘Sometimes GDP deflator is also denoted in percentage terms. In such a case, Nonna GDI = change in price level between the c 5 in the ca on of real @ 700" ie year whose picos are used ocala tho rorg In our numerical example, Nominal GDP = P,Q, = 5,500 and Real GDP = 2P,Qy = 83,000 Nominal GDP 4, 00 Real GDP. 3,000 “This implies that the prices have risen by 83.33% between the base year and the current year. 100 = 183.33% Therefore, GDP Deflator Given the Nominal GDP, how to find out Real GDP? Given the Nominal GDR we can find out Real GDP by eliminating the effect of change in prices between the base year and the current year i “The effect of change in prices on the nominal GDP can be eliminated in the following way: Nominal GDP SDP =————x 100 RelGhS 7 supengae Example: Suppose Nominal GDP = €288 and Price index = 120, then Real GDP can be calculated as: Real pp = Nominal GDP 99 = 288 19 = 240 Price Index 120 Top Tip ‘Nominal GNP, Real GNP and GNP Deflator + Nominal GNP is the value of GNP at the current year’s prices. + Real GNP is the value of GNP at the base year’s prices. ‘+ The ratio of nominal GNP to real GNP of the current year is called GNP Deflator. GNP Detlator = NOTUNALGNE Real GNP 100 Nominal and Real Income Nominal National Income (or National Income at current prices) ‘When national income (product) of the current year is estimated on the basis of prices prevailing in the current year, it is called nominal national income (or national income at current prices). ‘In other words, nominal national income is measured as the product of current year’s ousput (Q4) of final goods and services and their current year’s price (P,). Change in nominal national income may include both change in prices and change in flow of goods and services. ‘Thus, nominal national income may increase due to increase in prices of goods and services during the current year without increase in the flow of goods and services in the economy, due ro rise in general price level’ during the current year. Real National Income (or National Income at constant prices) ‘When national income (product) of the current year is estimated on the basis of prices prevailing in the base year, iv is called real national income (or national income at constant prices). ‘mn other words, real national income is measured as product of current year ousput (C,) and their base yea’ price (P,). Since base year’s prices remaining constant, real national income will increase only if the output of goods and services produced in the economy is increasing. Thus, real national income reflects the real growth of an economy because it increases only when there is an increase in real national output over a period of time. ol neti/ Derr Numerical Example: A 20 10 100 2,000 B 10. 5 200 2,000 c 30, 20 50. 1,500. SPQ, = 5,500 Nominal National Income = EP,Q, = 85,500; Real National Income = PQ, = 3,000 “The difference between Nominal National Income and Real National Income is 5,500 — 3,000 = %2,500. ‘This is only the monetary difference as the quantity sold in the market remains unchanged and the variation jy the value of nominal and real national income is merely due to the change in the prices in the economy between the base year and current year, Given the Nominal National Income, how to find out Real National Income? Given the Nominal national income, we can find out Real national income by eliminating the effect of change in prices between the base year and the current year. ‘The effect of change in prices on the nominal national income can be eliminated in the following way: Real national income = Nominal national income | 4, Index Example: Suppose Nominal national income = %288 and Price index = 120, then Real national income can be calculated as: { Nominal national ir Real national income =o 3100 = 100 =240 Price Index a Nominal GDP Nominal GDP is messured asthe product of current years output (Q) of final goods and services and their current years price (P3). Nominal GOP may increase even if there is no increase inthe output of goods and services produced in the economy, due {0 rise in genera price level during the current year Real GDP Real GDP is measured as product of current year output (Q,) and the base year's price (Pa). Real GDP wil Increase only ifthe sutput of goods and services produced in the economy is increasing, Thus, Real GDP is a better indicator of economic growth nd welfare of people ofthe country than Nominal GDP as it's not affected by changes in general price level. Given Nominal GDP, we can find Real GDP by eliminating the effect of change in prices between the base year and the current ‘year in the following way: Real GOP Romina Soe 100 GDP Deflator oe inc of Nominal GD? to Real GOP of current years a well known price index, called GDP Deflator. It elves the change price level between the base year and current yea. GDP Deflator/Prce Inde Nominal? 100 ‘Nominal and Real National Income na ao aoral Income (produ) ofthe current years estimated on the basi of pices prevaling in the current year, itis cle pomina national income (or national income at current prices) whereas when national produc of the current year is estimated Grin bist of prices realign the bes yea tis calle el national nome or national income at constant pices) se conal income may increase due to increase in prices of goods and services during the current year without sacri of goods and services in the economy, Real national income reflects the real growth of an econort i inereases only when there Is an increase in real national output over a period of time. cminal income, we can find Real Income by eliminating the effet of change in pices between the base year and t! nthe following way’ : rium Nominal National Income : ce Price index Real National income =: