National Income Accounting PDF

National Income Accounting In an economy, the production process yields various goods and services. These goods and services are then sold to consumers, who can be either individuals or enterprises. The purchased goods may be used for final consumption or for further processing....

National Income Accounting In an economy, the production process yields various goods and services. These goods and services are then sold to consumers, who can be either individuals or enterprises. The purchased goods may be used for final consumption or for further processing. For producing Purchased by enterprises Good and Sold to the Final services produces consumer consumption Purchased by individual Goods and services can be classified based on their use and the purchaser. Final goods Intermediate goods Final Goods : Final goods are those that are ready for consumption by consumers. They do not require any further production or transformation to be used. For example a car at a showroom is a final good, ready to be driven out on the roads. Intermediate Goods : Intermediate goods are not ready for final consumption by consumers. They are used as inputs or raw materials in the production process and undergo further transformation. For example : Steel used in the manufacturing of cars. Flour used in baking bread. Wood used in making furniture. Stock Variables and Flow Variables A variable is a quantity that can change over time, assuming different values at different points. In economics, variables can be divided into two categories: stock variables and flow variables. Stock Variable: A stock variable measures a quantity at a specific point in time. It represents a snapshot of a certain value, such as the amount of money in a bank account, the number of houses in a city, or the inventory of goods in a warehouse. Flow Variable: A flow variable measures a quantity over a specific period of time. It represents the rate of change or the amount of something that occurs within a certain timeframe, such as income earned in a month, the number of cars produced in a year, or the amount of water flowing through a river per day. Comparison between stock and Flow Variables : Basis of Comparison Stock Variable Flow Variables Definitions A stock variable measures a A flow variable measures a quantity at a specific point in quantity over (during) a period time. of time. Nature Static Dynamic Time Particular time Over time like 1 year ,6 month etc. Example Water in a tank ,Bank deposit Water flow in a river, Interest on loan Type of circular flow : We can classified the circular flow into two part i.e. Real flow or product flow Money flow or income flow Real flow Household sector provides factor services i.e. land, labour and capital to the firms and the firms in turn provide them with the produced goods and services. This flow of factor services from the household sector to the firms and the corresponding flow of goods and services from the firms to the households is called the real flow. Money flow: In every modern economy, money is the medium of exchange. When the households provide factor services to the firms, in return they receive factor payments. Land receives rent, labour receives wages and capital receives interest. In other words, the households receive money income in return of their factor services. The factor payments received by the household is then spent on goods and services produced by the firms. This expenditure on goods and services forms the money income of the firms.  Circular flow model in Two sector Economy : The circular flow model is a diagram that illustrates how money and resources move through an economy. It shows the interaction between different sectors, such as households and businesses, where households provide labour and other resources to businesses, and in return, they receive wages and other incomes. Businesses use these resources to produce goods and services, which are then purchased by households. This model highlights the continuous and interconnected nature of economic activity. Assumption of the model:  There is only two sector in the economy ; Household and Firm  There is no government sector  Closed economy  The households spend the entire income received on the goods and services. In other words, it is assumed that there is no saving in the economy. Diagrammatic Representation: The above diagram depicts a two-sector circular flow model. The inner arrow in the upper part of the diagram shows that the household sector provides factors services in the form of land, labour and capital to the firms. In return of the factor services provided, they receive factor payments from the firms in the form of rent, wages and interest (as shown by the upper most arrow). With the income received, households incur consumption expenditure on the goods and services provided to them by the firms (as shown by the lower most arrow). With the help of this circular flow model, we can estimate the national income for the economy. National income can either be measured by aggregating the income of all the factors of production (inner arrow of the lower part) or by aggregating the expenditure incurred by all the sectors (upper most arrow). In this simple two-sector model, we observe that the aggregate spending of the economy (consumption expenditure) equals the aggregate income earned by the factors of production (factor payments). Now let us consider what will happen if at any point of time the aggregate spending exceeds the aggregate income in the economy (either through borrowings or any other source). As the aggregate spending exceeds the aggregate income, this implies that the firms face a greater demand for the goods and services. To meet this extra demand, the firms will produce more goods and services. Thus, to expand the production they will employ additional factors of production. This implies that they will make extra factor payments. The amount of this extra payment by the firms (equal to the income of the households) will be equal to the value of extra goods and services produced. Thus, the extra income generated in the subsequent round will be equal to the extra expenditure incurred in the first phase. Hence, we see that a rise in the expenditure in the economy leads to a rise in the income. Role of Financial system in Circular flow of income: In the basic two-sector economy model, households are assumed to spend all their income on goods and services, implying no savings. However, in reality, households save a portion of their income for future needs, emergencies, and other purposes. Similarly, firms not only produce goods and services but also make investments in new plants, machinery, equipment, and other capital goods. To reflect this reality, we expand the simple two-sector model to include a financial system. This addition acknowledges the role of savings and investments in the economy. Two sector circular flow including Financial system  The above diagram depicts the circular flow in a two-sector model with financial system. The household sector provides the firms with the factor services in return of which they receive factor payments. On the other hand, the firms provide the households with the produced goods and services and in return; the firms get money as prices of goods and services. Now with the inclusion of the financial sector, the factor payments are no longer equal to the consumption expenditure. Rather, a part of the factor payments received by the household is kept as saving (in bank accounts) with the financial system, which in turn is then used as investment when the banks lend to the firms. Algebraic representations: We know that the factor payments received by the households are either used as consumption expenditure or kept as savings. Y= C+S Where , Y= Household Income C= Household consumption S= Household saving For an economy to remain in a stable state (equilibrium), the volume of injections must be equal to the volume of leakages. That is, Injections = Leakages Thus in a two sector model, saving must be equal to the investment, so that the economy is in equilibrium. Leakages and injection : Leakages Leakages refer to those variables that cause a withdrawal of money from the circular flow of income. In this regard, saving is treated as leakage as it takes money out from the circular flow system. Leakages reduce the level of economic activity and thus, reduce the size of the circular flow. Injections Injections refer to those variables that cause addition to the circular flow of income. Investment can be treated as injection in the sense that it puts money back into the circular flow. As opposed to leakages, injections raise the level of economic activity and the size of the circular flow.  Circular Flow Model in a Three-Sector Economy: In the three-sector model, we expand the simple two-sector model by adding the government sector. Now, our model includes the following three sectors in the economy: 1. Household 2. Firm 3. Government The Government sector interacts with the household sector, the firms and the financial system in the following manner. Households and Government The government collects taxes from households and provides services that enhance societal welfare. Additionally, the government offers transfer payments, such as pensions, to households that need financial support.  Government and firm : The Government also receives taxes from the firms and in turn offers those subsidies. The Government also provides the market to firms by purchasing the goods and services produced by the firms. Government and financial sector : The Government borrows from the financial sector as well as invests funds in the financial sector. Injection and leakages in 3 sector model: In a three sector circular flow model beside saving govt. taxes are part of leakages while beside investment govt. expenditures on good and services considered as an injection to the economy. Therefore, the national income in the three-sector model becomes a sum of Consumption, Saving and Taxes. So, Y=C+S+T For equilibrium in an economy, considering three sector model leakages must be equal to injection. That is S+T= I+G  Circular Flow Model in a Four-Sector Economy In the four sector model, apart from the three sectors, households, firms and the government, we introduce another sector, called the 'external sector' or ‘foreign sector’. Household and External sector : Households provide services to the external sector and receive payments in return. They also receive transfer payments from abroad, such as gifts and remittances. Firm and external sector: Firms deal with the external sector through exports and imports.  Thus, the inclusion of the foreign sector will reveal to us the interaction of the domestic economy with foreign countries. Foreigners interact with the domestic firms and households through exports and imports of goods and services as well as through borrowing and lending operations through financial market. If an economy in a four-sector model is at equilibrium, then it implies that the volume of leakages must be equal to the volume of injections. That is S+T+M=I+G+X Here import consider as a leakages and export is the injection fore the economy.  Significance of circular flow : Helps in the Estimation of National Income. Highlights the Interdependence between Different Sectors.  National Income Accounting National income : National Income can be defined as the total market value of all the final goods and services (in terms of money) produced within the domestic territory during an accounting year. Gross Income and Net Income: Gross income- Depreciations = Net income National Income at Market Price and National Income at Factor Cost: When National Income is expressed in terms of market prices, indirect taxes and subsidies are taken into account. While, subsidies tend to lower the market price on the other hand, indirect taxes increases the market prices. When National income is expressed in terms of Factor cost indirect tax and subsidies are excluded. National Income at Market Prices (NNP MP ) = National Income at Factor Costs (NNP FC) + (Indirect Taxes – Subsidies)  Different aggregates of national income: Different aggregates of national incomes are GDP MP , GNP FC , NDP FC , NNP MP , NDP MP , NNP MP , National Disposable Income, Gross Disposable Income, Personal Income, Private Income and Personal Disposable Income. GDP at market price : GDP MP refers to the market value of all the final goods and services produced within the domestic country during an accounting year inclusive of depreciation. Uses current prices during the measurement period. Reflects the nominal value without adjusting for inflation GDP is limited to the domestic territory, thus, excludes NFIA. NFIA = Factor Income Earned from Foreign – Factor Income Paid to the Foreigners  GNP at market price : GNP takes into account all the goods and services produced by the normal residents of a country both within the domestic territory as well as outside the country. GNP includes NFIA , so that GNP MP = GDP MP + NFIA Net National Product at Market Prices: Net National Product at the market prices ( NNP MP ) refers to the total market value of all the final goods and services produced by the normal residents of a country both within the domestic territory as well as outside the country. It includes NFIA but excludes Depreciation. NNP MP = GNP MP – Depreciation  Net Domestic Product at Market Prices Net Domestic Product at the market prices refers to the total market value of all the final goods and services produced within the domestic territory by normal residents as well as non-residents , during an accounting year excluding depreciation. NDP MP = GDP MP – Depreciation Net Domestic Product at Factor Cost or Domestic Income NDP FC refers to the aggregate factor income earned by all the factors of production, in the form of rent, wages, interest and profits. NDP FC = NDP MP – Net Indirect Taxes Gross Domestic Product at Factor Cost ( GDP FC ) GDP FC refers to the aggregate factor income earned by all the factors of production, in the form of rent, wages, interest and profit and including depreciation. GDP FC = NDP FC + Depreciation  NNP FC or NI NNP FC refers to the aggregate of all factor incomes earned by those factors of production that are normal residents of a country both within the domestic territory as well as abroad. NNP FC = NDP FC + NFIA Gross National Product at Factor Cost GNP FC refers to the aggregate of all factor incomes earned by the normal residents of country during an accounting period including depreciation. GNP FC = NNP FC + Depreciation.  Important formula : Gross = Net + Depreciation Net = Gross – Depreciation National = Domestic + Net Factor Income from Abroad Domestic = National – Net Factor Income from Abroad Market price = Factor cost + Net Indirect Taxes Factor cost = Market price – Net Indirect Taxes Net Indirect Taxes = Indirect Taxes – Subsidies  Estimation of National Income : The national income of a country can be measure through three methods : 1) Product method 2) Income method 3) Expenditure method Product method or value-added method: The value-added approach measures a country's national income by calculating how much each production unit contributes to the total output within the country during a given year.  Value added on a good refers to the increase in the value of good at each successive stage of production.  Value Added = Total Value of Output – Total Value of Intermediate Consumption  National Income =Gross Value Added at Market Prices (GDP MP ) – Depreciation – Net Indirect Taxes + NFIA Precautions Regarding Calculation of National Income by Value - Added Method: 1. Value of the sale and purchase of second hand goods are not included. 2. Value of intermediate goods is not included 3. Portion of production that is retained for self consumption should also be included 4. Services of the housewives, a father teaching his own child are not included in the national income.  Income method: According to the Income Method, national income is estimated by aggregating all the factor incomes (in the form of wages, rent, interest and profits) paid to the owners of factors of production (land, labour, capital and enterprise) within the domestic territory in an accounting year. NNP FC or National Income =NDP FC + Net Factor Income from Abroad (NFIA) Precautions: 1. Transfer Earnings are excluded 2. Income from illegal activities excluded 3. Income from sale and purchase of second hand goods excluded 4. Windfall gains such as lotteries and capital gains are unearned income and thus, are not included Expenditure method : According to the Expenditure method, National Income is measured in terms total expenditure on final goods and services produced in an economy. The expenditure on final goods and services can be broadly classified into the following four categories' during an accounting year. 1. Private Final Consumption Expenditure 2. Government Final Consumption Expenditure 3. Investment Expenditure 4. Net Exports NNP FC= GDP MP – Depreciation – Net Indirect Taxes + NFIA Precautions : 1. Expenditure on only final goods and services should be included 2. Expenditure on shares and bonds is not included 3. Imputed value of the goods and services produced for self consumption are included 4. Expenditure on transfer payments by the government should not be included Thank You