NATIONAL INCOME ACCOUNTING

1. Introduction

• The economic wealth, or well-being, of a country thus does not necessarily depend on the mere possession of resources; the point is how these resources are used in generating a flow of production and how, as a consequence, income and wealth are generated from that process.
• People combine their energies with natural and manmade environments within a certain social and technological structure to generate a flow of production. In our modern economic setting, this flow of production arises out of the production of commodities – goods and services by millions of enterprises large and small

2. Types of Goods

• Goods produced in an economy are generally classified as final goods and intermediate goods. Final Goods Goods which have crossed the boundary line of production and are readily available for use by their final users are termed final goods.
• Consumers and producers are the two types of final goods. Intermediate Goods Goods which are within the boundary line of production, the value is yet to be added to these goods and are not available for use by their final users are called intermediate goods.
• These goods are consumed by another firm and used as intermediate goods in the production process or for further sale.
• For example, papers purchased by newspaper agencies for printing news are intermediate goods.
• Expenditure on intermediate goods by the producers during an accounting year is called intermediate consumption.

Value of output– Intermediate consumption = Gross Value Addition or Gross Product of the Users

Consumer Goods or Consumption Goods: Final consumer goods are purchased by the consumer for the satisfaction of their wants. They are the final users of foodstuff, dress material and other accessories. Final users of consumption goods are consumer households, general government or government welfare agencies and non-governmental organizations.

3. Classification of Consumption Goods

• Durable consumer goods are those goods which can be used for several years and are of relatively high value. Examples are televisions, washing machines and air conditioners.
• Semi-durable consumer goods are those goods which can be used for one year or slightly more. Examples are clothes, furniture and crockery.
• Non-durable or single-use consumer goods are those goods which are used in a single act of consumption. Examples are bread, ink, petrol and milk. Services are those non-material goods which directly satisfy human wants. Examples are doctors, lawyers and domestic servants.

Producer Goods or Capital Goods: Final producer goods are purchased by the producers in the production process for several years and are of high value. These goods are fixed assets of the producers such as land, buildings and machinery.

All capital goods are producer goods but all producer goods are not capital goods

• Producer goods include goods used as raw materials such as papers for print media to print newspapers, journals, books and magazines and also goods used as fixed assets such as land, buildings and machinery. Capital goods include only the fixed assets of producers.
• These goods are used as durable use producer goods, whereas the goods used as raw materials are single-use producer goods.
• These goods cannot be used again in the production process.
• Therefore, all capital goods are producer goods but all producer goods are not capital goods.
• Expenditure incurred on final consumer goods by the households is called consumption expenditure, whereas expenditure on final goods by the producers is called investment expenditure

4. Fixed Investment and Inventory Investment

• Fixed investment means an increase or addition in the stock of fixed assets of the producers during an accounting year.
• Fixed Investment = Stock of fixed assets with the producers at the end of the accounting year – Stock of fixed assets with the producers at the beginning of the year = Increase in the stock of fixed assets with the producers during an accounting year.
• Inventory investment means the stock of finished goods, semi-finished goods and raw materials. It keeps varying over a period.
• Inventory Investment = Inventory stock at the end of the accounting year – inventory stock at the beginning of the accounting year = Change in inventory stock during an accounting year.

5. Net Investment, Gross Investment and Depreciation

• Expenditure on the purchase of fixed assets or inventory stock during the year is called gross investment.
• It also includes expenditure on the purchase of new assets in place of worn-out assets.
• Replacement of fixed assets owing to their depreciation is a part of gross investment. This will not cause any net increase in the existing stock of capital.
• If expenditure on the replacement of worn-out fixed assets is excluded from gross investment, we get net investment.
• Net investment implies net addition to the stock of capital.
• Net investment = Gross investment – Depreciation
• Gross investment = Net investment + depreciation
  • Depreciation is the loss of value of fixed assets in use because of normal wear and tear, normal rate of accidental damages and expected or foreseen obsolescence. It is also called as consumption of fixed capital. Because of depreciation, fixed assets are to be replaced after a certain period. A provision of funds is required to meet the replacement cost of fixed assets. This is called a depreciation reserve fund

Stocks and Flows: A stock is a quantity measured at a particular period. For example, the amount of money in a bank account at a particular period. A flow is a quantity measured over a specified period. For example, the amount of interest received against the bank deposits. 

6. Circular Flow of Income

Circular flow of income refers to the unending flow of activities such as production, income generation and expenditure involved in all the sectors of the economy.

Three Phases of Circular Flow

• The production of goods and services causes the generation of income. Income causes expenditure. When demand increases, expenditure causes production again.
• This leads to the generation and disposition of income again.
• The flows of production, income and expenditure form circularity with no end and beginning. Thus, it is called circular flow. The production aspect states the flow of goods and services in the economy or the process of value-adding.
• Income or distribution aspect states the distribution of income in terms of wage, rent, interest and profit. 
• Expenditure or disposition aspect states the disposal of income in terms of consumption expenditure or investment expenditure.

Circular Flow Model in a Two-Sector Economy

• In a simple economy, there are firms and household sectors’ economic activity. People from households render factor services to firms and firms hire factor services from households. Households spend their earned income completely on consumption. Products which are produced by firms are sold to consumers.
• Assume that there is no external trade and government in an economy, then:
• Total production of goods and services by firms is equal to the consumption of goods and services by firms.
• Factor payments by firms are equal to the factor incomes of the household sector Consumption expenditure of the household sector is equal to the income of the household sector.
• Money flows are opposite to real flows because factor services flows from households to firms are real flows and the factor payments made by firms to households are money flows.

Leakages and Injections in a Circular Flow

• Injections are those flow variables which cause an expansion in the process of production or the income generation in the economy.
• Investments, exports and consumption expenditure on goods and services by the household or the government are the expenditure variables on goods and services produced in the economy.
• It affects the economy as it increases the volume of production and generation of demand for the production of goods and services.
• Leakages are those flow variables which hurt the process of production in the economy.
• Savings, imports and taxes by the government are the variables which reduce the flow of income in the economy.

7. National Income and methods of calculation

• The three phases of the circular flow of income are the different methods of explaining the concept of national income or national product.
• Phase I is the value addition or production of final goods and services which is converted into factor incomes in Phase II and factor incomes are converted into expenditure on final goods and services in Phase III.
• Hence, these three phases of the circular flow of income are measured through three methods - product or value added method, expenditure method and income method.

Note-Some Basic Concepts

Gross and Net Income: Gross income is inclusive of depreciation and/or consumption of fixed capital. Net national income does not include depreciation.

Market Price and Factor Cost

• National income may be explained in terms of market price or factor cost such as national income at market price or national income at factor cost.
• Market price includes the impact of subsidies which tend to lower it and indirect taxes which tend to raise it.
• Factor cost is free from the impact of subsidies and indirect taxes.
• National income at market price – Indirect taxes + Subsidies = National income at factor cost. (Or) National income at market price – Net indirect taxes = National income at factor cost.

Factor income/payment and transfer income/payment

• Factor incomes are incomes received by the owners of factors of production i.e. households for rendering their factor services to the producers.
• Because of these real factor services, there is a money flow from producers to the households in the form of rent, interest, profit and wages.
• Hence, there is production of goods and services in an economy
• Transfer payments are charity or grant from one sector to the other sector which do not cause the production of goods and services in the economy.
• It only transfers income from one sector to the other sector without any return.

• National income in terms of production of goods and services: National income is the market value of final goods and services produced in an economy during the period of an accounting year.
• National income in terms of factor incomes: National income is the total factor income earned by normal residents of a country during an accounting year as rewards for rendering their factor services.
• National income in terms of expenditure of income: National income is the total of the final consumption expenditure and investment expenditure in an economy during an accounting year.
• Gross Domestic Product at market price: GDPMP is the market value of the final goods and services produced within the domestic territory of a country.
• Gross National Product at market price: GNPMP is the market value of the final goods and services produced by normal residents of a country during an accounting year. Net factor income from abroad = Factor income earned by our residents from abroad – Factor income earned by non-residents within our country. Components of net factor income from abroad are net compensation of employees, net income from property and entrepreneurship and net retained earnings of resident companies abroad. Gross Domestic Product at market price + Net factor income from abroad = Gross National Product at market price
•  Net National Product at Market Price: NNPMP is the market value of the final goods and services produced by normal residents of a country during an accounting year, exclusive of depreciation. NNPMP = GNPMP – Depreciation
•  Net Domestic Product at factor cost: NDPFC is the sum total of factor incomes, profit, wages, interest and rent generated within the domestic territory of a country during a year. NDPFC = NDPMP – Indirect taxes + Subsidies (Or) NDPFC = NDPMP – Net indirect taxes
• Gross Domestic Product at factor cost: GDPFC is the sum total of factor incomes, profit, wages, interest and rent generated within the domestic territory of a country, along with the consumption of fixed capital during a year.

• NDPFC + Depreciation = GDPFC
• GDPFC - Depreciation = NDPFC

• Net National Product at factor cost: NNPFC is the sum total of factor incomes earned by normal residents of a country during the period of an accounting year. NNPFC = NDPFC + Net factor income from abroad
• Gross National Product at factor cost: GNPFC is the sum total of factor incomes earned by normal residents of a country, including the depreciation during an accounting year. GNPFC = NNPFC + Depreciation
• National Disposal Income: National disposal income is the income from all sources which is the earned income as well as transfer payments from abroad available to residents of a country for consumption expenditure or for saving during a year. National disposal income = National income + Net indirect taxes + Net current transfers from the rest of the world.
• Factor income from net domestic product accruing to the private sector: Factor income from net domestic product accruing to the private sector includes that part of the net domestic product which accrues to the private sector. It excludes property and entrepreneur
• Private income: Private income is the total factor income from all sources and current transfers from the government and the rest of the world accruing to the private sector. Private income from net domestic product accruing to private sector + Net factor income from abroad + Interest on national debt + Current transfers from government + Current transfers from the rest of the world.
• Personal income: Personal income is the income received by individuals and households from all sources in the form of factor income and current transfers. Personal income = Private income – Undistributed profits (Corporate saving) – Corporation tax

9. Methods of Measuring National Income

Based on the circular flow of income and the aggregate value of goods and services produced in an economy national income can be calculated by the following 3 methods:

• • Product or value-added method
  • Expenditure method
  • Income method

Measurement of National Income using Product or Value-Added Method

• Product method is a method which measures domestic income by estimating the contribution of each producing enterprise to production in the domestic territory of the country during an accounting year.
• Value added means the difference between the value of the output of an enterprise and the value of its intermediate consumption.
• Intermediate consumption refers to the value of non-factor inputs which includes the value of raw material used in the process of production.
• Gross value added by all the producing enterprises within the domestic territory of a country during an accounting year is called Gross Domestic Product at market price (GDPMP).
• Gross Domestic Product at market price (GDPMP) = Gross value added by all producing enterprises within the domestic territory of a country during an accounting year
• Net Domestic Product at market price (NDPMP) = Gross value added by all producing enterprises within the domestic territory of a country during an accounting year – Depreciation Net Domestic Product at factor cost (NDPFC) = NDPMP – Indirect taxes Net
• National Product (NNPFC) or National income = NDPFC + Net factor income from abroad

Measurement of National Income using Expenditure Method

• Expenditure method is a method which measures national income in terms of expenditure on the purchase of final goods and services produced in the country during an accounting year.
• Final expenditure during an accounting year is equal to GDPMP.
• It is broadly classified into four categories: Private final consumption expenditure (c) refers to expenditure on final goods and services by the individuals, households and non-profit private institutions serving society. 
• Government final consumption expenditure (G) refers to expenditure on final goods and services by the government.
• Investment expenditure (I) refers to expenditure on final goods by the producers. Further, these goods are used in the production process.
• Investment is classified into fixed investment and inventory investment.
• Fixed investment refers to expenditure on the purchase of fixed assets and inventory investment refers to change in stock during the year. 
• Net exports (X – M) refer to the difference between exports and imports during an accounting year.
  • Sum total of expenditure on domestically produced goods and services during an accounting year is called GDPMP.
  • GDPMP = Final consumption expenditure + Gross domestic capital formation + Net export.
  • Where Private final consumption expenditure + Government final consumption expenditure is the Final consumption expenditure,
  • Gross domestic fixed capital formation + Change in stock in the government is the Gross domestic capital formation and exports – imports are the net exports.
    • NDPMP = GDPMP – Depreciation
    • NDPFC = NDPMP – Indirect taxes
    • NNPFC = NDPFC + Net factor income from abroad

Measurement of National Income using Income Method

• Income method is a method to measure national income in terms of factor payments to the owners of factors of production during an accounting year.
• Domestic income is estimated as the sum total of factor incomes generated within the domestic territory of a country during an accounting year.
• A factor income refers to income earned as a reward for rendering his or her factor services. Factor incomes are classified as compensation of employees, operating surplus and mixed income.
• Compensation of employees includes wages, salaries in cash or kind, employer’s contribution to social security schemes and pension on retirement.
• Operating surplus refers to income from property and entrepreneurship. It includes rent, interest and profit.
• Further, profit is classified into dividends, corporate profit tax and undistributed profit.
• Mixed income is the income of the self-employed persons using their own land, labour capital and entrepreneurship to produce goods and services.
• These incomes are a mixture of wages, rent, interest and profit.
  • NDPFC is the sum total of factor incomes generated within the domestic territory of a country during an accounting year. It is also known as domestic income.
  • NDPFC = Compensation of employees + Operating surplus + Mixed income
  • NNPFC = NDPFC + Net factor income from abroad.

10. Nominal GDP and Real GDP 

• Hence, it is called GDP at constant price. Real GDP = Nominal GDP / Current Price index * 100 Consumer Price Index measures changes in the price level of a
• market basket of consumer goods and services purchased by households. The Wholesale Price Index is the representative basket of wholesale goods. It is also known as the producer price index.
• GNP deflator measures the average level of the prices of all goods and services produced in a country during an accounting year.
• GNP deflator = Nominal GNP / Real GNP * 100