NATIONAL INCOME ACCOUNTING-1.pdf

 INTRODUCTION  National Income (NI) of a country can be obtained as the total market value of all final goods and services produced in the economy in a year.  It measures the market value of annual output. In other words, National Income is a monetary measure.  For ca...

 INTRODUCTION  National Income (NI) of a country can be obtained as the total market value of all final goods and services produced in the economy in a year.  It measures the market value of annual output. In other words, National Income is a monetary measure.  For calculating NI accurately, all goods and services produced in any given year must be counted only once, and not more than once. Hence, NI only includes the market value of all final goods and services, and thus ignores the transactions involving intermediate goods.  The concept of NI has three interpretations : It represents a total value of production, it represents a receipts total, and it also represents an expenditure total. Every expenditure is at the same time a receipt. In other words, amount spent is equal to amount received. But if goods and services are valued at their market prices, we have a three-fold identity, that is the value received equals the value paid equals the value of goods and services produced and sold.  INTRODUCTION  Thus, National Income = National Product = National Expenditure.  So, there are three different measures of NI of a country : (a) The sum of values of all final goods and services produced. (b) The sum of all incomes, in cash and kind, accruing to the factors of production in a year and (c) The sum of consumers' expenditure, net investment expenditure and government expenditure on goods and services.  CIRCULAR FLOW OF INCOME  The modern economy is a monetary economy. In the modern economy, money is used in the process of exchange.  Money has facilitated the process of exchange and has removed the difficulties of the Barter System. Thus, money acts as a medium of exchange.  The households supply the economic resources or factors of production to the productive firms and receive in return the factor payments in terms of money.  Hence, in the monetary economy, there will be flows of money income corresponding to the physical flows of economic resources as well as the goods and services.  But each money flow is in opposite direction to the real flow.  CIRCULAR FLOW OF INCOME IN A 2 - SECTOR ECONOMY The main Assumptions of Circular Income Flow Model in a country are :  The money income earned by one sector is exactly equal to the expenditure incurred by the other mutual sector.  The Household sector is the owner of all the inputs / factors of production in an economy.  There is no fresh injection or leakage of money income within the economic system. CIRCULAR INCOME FLOW IN A 2 - SECTOR ECONOMY  CIRCULAR INCOME FLOW IN A 2 - SECTOR ECONOMY  In a Two - Sectoral model, there exists only two private sectors, namely, the Households (Consumers) and the Business Firms (Producers).  In the upper loop of the above diagram, it is observed that the economic inputs like Land, Labour, Capital and Entrepreneurship flow from the Household sector to the business Firms as indicated by the arrow mark from left to right.  In exactly opposite direction to this, from right to left, money income flows from the firms back to the households, in the form of factor payments such as Rents, Wages, Interests and Profits (upper panel).  In the lower part of the above figure, money income flows from the households to the firms, in the form of Consumption Expenditure made by these households on the purchase of final goods and services produced by the firms, as shown by the arrow mark from left to right direction.  CIRCULAR FLOW OF INCOME IN A 2 - SECTOR ECONOMY  But the flow of final goods and services from the firms back to the households occurs in an exactly opposite direction from right towards left (lower panel).  Thus, we see that, money income in any 2 sector economy flows mutually from the firms to the households and then it again flows back from the household sector to the firm sector in a complete full circular manner. This is called as the concept or model of ‘Circular Flow of Income’.  This Circular Flow of Money Income will not always remain the same in volume, that is, it will not always continue at a constant level.  In years of depression, the circular flow of money income will contract and during years of prosperity, it will expand. This is so, because, the flow of money is a measure of NI of any country.  Also, the households supply and deposit money in the form of Savings in the banks, from which, credit is extended for investment demanded by the producing firms (uni-directional money flow). CIRCULAR INCOME FLOW IN A 3 - SECTOR ECONOMY  CIRCULAR INCOME FLOW IN A 3 - SECTOR ECONOMY  In a Three – Sector economy, there also exists the Government Sector (public) apart from both the private Household Sector (Consumption Unit) and the Firm Sector (Production Unit). This model is called as a closed economy with the Government.  Whereas, the simple two – sector model is known as a closed economy without the Government, which is practically unrealistic and not feasible.  The government sector spends money in many forms including expenditure on capital goods and infrastructure (highways, power, communication etc.), defence goods, education, public health and so on.  Government expenditure may be financed through taxes, out of assets or by borrowing.  Government borrowing from the financial market can be represented as the money flow from the financial sector to the government (To avoid confusion and simplify the diagram, this one – way money flow arrow is not drawn or shown).  CIRCULAR INCOME FLOW IN A 3 - SECTOR ECONOMY  Government borrowing increases the demand for credit which causes the rate of interest to rise. This public borrowing through its effect on the interest rate affects the behavior of the firms and households. The firms consider the interest rate as cost of borrowing and hence lowers private investment when interest rate increases. On the other hand, the households view the rate of interest as return on savings and thus feel encouraged to save more due to a rise in interest rate.  From the above figure, we observe that in addition to the circular income flows between the households and the firms mutually, the government receives Net Direct Taxes (that is, Total Direct Taxes – Total Subsidies) from the household sector and again similarly, it gets Net Indirect Taxes (Total Indirect Taxes – Total Subsidies) from the firms. So, the sum of total direct and indirect taxes form the aggregate tax revenue receipts side of the government.  CIRCULAR INCOME FLOW IN A 3 – SECTOR ECONOMY  Subsidies paid by the government, are treated as Transfer Payments, and are hence equivalent to negative tax receipts.  The government pays Wages and Salaries to the public sector employees of the household sector, which is shown by the flow of money income from the government to the households. This is opposite in direction to the income flow from the households to the government, in the form of Net Direct Taxes.  Lastly, the government sector like the households, also purchases final goods and services from the producing firms, in return of which, it pays money to the firms for consumption of final output. This is in exactly opposite direction to the income flow from the firms to the government, in the form of Net Indirect Taxes.  Wages and Salaries of individuals as well as Spendings on the purchase of final goods and services, both are a part of Aggregate Government Expenditure. CIRCULAR INCOME FLOW IN A 4 – SECTOR ECONOMY  CIRCULAR INCOME FLOW IN A 4 – SECTOR ECONOMY  In a 4 – Sector Open Economy, apart from the three domestic sectors, that is, the Households, the Firms and the Government, there also exists another fourth sector known as the External Trade Sector.  An open economy is such an economy which has trade relations with other foreign countries. Thus, the inclusion of the foreign sector reveals the interaction of the domestic economy with the rest of the world. Foreigners interact with the domestic firms and households through exports and imports of final goods and services, as well as through borrowing and lending operations via the financial market.  Goods and services produced within the domestic territory of the nation, which are sold to the foreigners are called as Exports. While, purchases of foreign – made goods and services by domestic households are called as Imports.  CIRCULAR INCOME FLOW IN A 4 – SECTOR ECONOMY  In our analysis, we assume that, it is only the business firms of the domestic economy that interact through mutual trade relations with the foreign countries, and therefore export and import final goods and services.  The flow of money income spent on real imports occurs from the domestic firms to the foreign countries in the above Circular Flow diagram. This is called as monetary outflow of Import Payments.  On the contrary, the flow of money receipts on physical exports of a domestic economy takes place from the foreign countries to the domestic firms, in an exactly opposite direction. This is called as monetary inflow of Export Earnings.  If Export Earnings (denoted by ‘X’) are equal to the Import Payments (denoted by ‘M’) then there exists a Balance of Trade.  But, generally, export receipts and import bill are not equal to each other. If the value of Exports exceeds the value of Imports of a country then Trade Surplus occurs. On the other hand, if M > X then Trade Deficit occurs. CIRCULAR INCOME FLOW IN A 4 – SECTOR ECONOMY  In an open economy, the private household sector interacts with the rest of the world though lending and borrowing funds. When there is a trade surplus in the economy, that is, when X > M then Net Capital Outflow will occur. This means that the foreigners will borrow money from the domestic savers to finance their purchases of our exports. As a result, domestic savers will lend to foreigners and hence acquire foreign financial assets.  On the contrary, when M > X then trade deficit occurs and as a result, there will be Net Capital Inflow. Hence, the domestic consumer households and business firms will borrow money from Abroad to finance their excess of imports over exports. As a result, the foreigners will acquire domestic financial assets.  CIRCULAR INCOME FLOW IN A 4 – SECTOR ECONOMY  Thus, graphically, money as foreign Aid, Grants and Remittances will flow in from the foreign countries to the domestic households and similarly money in the form of domestic Aid, Grants and Remittances will flow out, oppositely, from the domestic households to the rest of the external / foreign world.  Only in case of a developing country like India, the domestic households will export excess unemployed manpower to Abroad, which is a physical flow alone, in an open economy. SAVINGS - INVESTMENT IDENTITY IN NATIONAL INCOME ACCOUNTS IN A 2 – SECTOR ECONOMY  In a simple economy which has neither government, nor foreign trade, from the demand side, the value of output produced, which we denote by ‘Y’, is equal to the value of output sold. Since, the value of total output (Y) sold in a simple two sector economy, is equal to the sum of aggregate Consumption Expenditure (C) and aggregate Investment Expenditure (I), we have - Y = C + I [Aggregate Demand (AD)]  National Income in the simple economy from the viewpoint of its allocation or distribution between consumption and saving, implies that NI can either be consumed or saved from the supply side. So, we get - Y = C + S [Aggregate Supply (AS)]  At equilibrium, we know that - AD = AS SAVINGS - INVESTMENT IDENTITY IN NATIONAL INCOME ACCOUNTS IN A 2 – SECTOR ECONOMY  Hence, substituting the above two equations in the equilibrium condition, we get – Y = C + I = C + S => I = S ; where, ‘I’ is a component of AD and ‘S’ is a component of AS  Therefore, in a simple two – sector closed economy without the government, Aggregate Investment (I) and Aggregate Savings (S) are identically equal. SAVINGS - INVESTMENT IDENTITY IN NATIONAL INCOME ACCOUNTS IN A 3 – SECTOR ECONOMY  In a 3 – sector closed economy with the Government, we know that, the total expenditure flow is now equal to the sum of Aggregate Consumption Expenditure (C), Aggregate Investment Expenditure (I) and Aggregate Government Expenditure (denoted by ‘G’). Thus, from the Aggregate Demand side of such an economy, we have – Y = C + I + G (AD)  In the presence of the public sector (Government), the private Households will have to pay Direct Taxes and the private Firms will have to pay Indirect Taxes to the Government. Hence, the Total Income (Y) earned or received, is now allocated to Consumption (C), Savings (S) and Aggregate Taxes (denoted by ‘T’) [Direct + Indirect Taxes]. Thus, from the Aggregate Supply side of the market, we have – Y = C + S + T (AS) SAVINGS - INVESTMENT IDENTITY IN NATIONAL INCOME ACCOUNTS IN A 3 – SECTOR ECONOMY  Since total expenditure incurred must be equal to the total income (Y) received, so at equilibrium, we have – AD = AS  Hence, putting the above two equations in the equilibrium condition, we get the following identity – Y = C + I + G = C + S + T => I + G = S + T [cancelling out ‘C’ from both sides] => G - T = S - I [by re-arranging the terms]  From the above equation, we observe that, if the Aggregate Government Expenditure (G) exceeds the Aggregate Tax Revenue (T) then, the government will have a budget deficit, and hence, S > I. But, if G < T then, the fiscal budget of the government will be in surplus, and hence, we will obtain, S < I. SAVINGS – INVESTMENT IDENTITY IN NATIONAL INCOME ACCOUNTS IN A 3 – SECTOR ECONOMY  Whereas, if G = T then, the fiscal budget of the government is balanced, and hence, from the above equation, we get, S = I.  In case of budget deficit, to finance this deficit, the government will borrow from the financial market. In that case, then private Investment (I) by the business firms must be definitely less than the private Savings (S) of the households. Thus, government borrowing reduces private investment in the economy. In other words, government borrowing crowds out private investment.  For the equilibrium condition in the financial market, we have – Y = C + I + G => Y - C - G = I ; where, (Y - C - G) represents National Savings (denoted by NS). SAVINGS – INVESTMENT IDENTITY IN NATIONAL INCOME ACCOUNTS IN A 3 – SECTOR ECONOMY  This National Savings (NS) is decomposed into two parts : 1. Private Savings [denoted by (Y - T - C)] , and 2. Public / Government’s Savings [denoted by (T - G)].  So, NS = (Y - T - C) + (T - G) = (Y - C - G) ; where, (Y - T) denotes Disposable Income.  If the economy is to remain in a steady state, then monetary flows into the financial market (that is, private saving and public saving) must balance the money flows out of the financial market. Thus, for the economy to remain in a Steady – State Equilibrium, we have – NS = (Y - T - C) + (T - G) = I  Therefore, at the steady state position, the sum total of private savings and public savings equal aggregate investment in a three – sector closed economy. SAVINGS - INVESTMENT IDENTITY IN NATIONAL INCOME ACCOUNTS IN A 4 – SECTOR ECONOMY  In a 4 – sector open economy, NI must be measured by Aggregate Expenditure, that also includes the value of Net Exports (that is, X - M), apart from the three types of domestic expenditures such as C, I and G.  Here, ‘X’ denotes Export Earnings and ‘M’ denotes Import Payments. Value of Imports must be subtracted from the total expenditure made by foreigners on our domestically produced goods and services exported to them, to calculate the value of Net Exports (denoted by NX) in an open economy. Thus, from the Aggregate Demand side, we have – Y = C + I + G + (X - M) [AD] => Y = C + I + G + NX ; where, NX = (X - M).  Since, NI can either be consumed, saved or paid as taxes to the government, based on its allocation, so from the Aggregate Supply side, we have - SAVINGS - INVESTMENT IDENTITY IN NATIONAL INCOME ACCOUNTS IN A 4 – SECTOR ECONOMY Y = C + S + T [AS]  At equilibrium, we know that – AD = AS  Hence, substituting the above two equations in the equilibrium condition, we get – Y = C + I + G + NX = C + S + T => (I + G) + (X - M) = S + T  Thus, in an open economy, the sum of Private Investment (I) and Government Expenditure (G) and Net Exports (NX = X - M) is equal to the sum of Private Household Savings and Tax Revenue (T).  SAVINGS- INVESTMENT IDENTITY IN NATIONAL INCOME ACCOUNTS IN A 4 – SECTOR ECONOMY  The NI Accounting Identity of the open economy can be further used to show the relationship between Aggregate Domestic Output (Y), Aggregate Domestic Expenditure (C + I + G) and Net Exports or Trade Balance (X - M).  From the above AD equation, by re-arranging the terms, we get – NX = Y - (C + I + G)  Hence, Net Exports = National Domestic Product - Aggregate Domestic Expenditure.  From the above analysis, it follows that in an open economy, Aggregate Domestic Expenditure may not be equal to the Aggregate Domestic Output. If Y > C + I + G then, we export the excess of domestic output that is, NX > O. On other hand, if domestic output is less than domestic expenditure then we import this shortfall that is, NX < O. SAVINGS – INVESTMENT IDENTITY IN NATIONAL INCOME ACCOUNTS IN A 4 – SECTOR ECONOMY  As in the case of a closed economy, the commodity markets are very closely related to the financial market in the open economy. From the above NI Accounts Identity of an open economy, by re-arranging the terms, we get – Y - C - I - G = NX => Y - C - G = I + NX => NS = I + NX [since, NS = Y - C - G] => (NS - I) = (X - M)  The above identity shows that an economy’s Net Exports (NX) must always be equal to the difference between National Savings (NS) and Private Investment (I).  Net Exports are also called as the Trade Balance of a country, because it gives us the difference between the value of exports and value of imports of an economy.  SAVINGS - INVESTMENT IDENTITY IN NATIONAL INCOME ACCOUNTS IN A 4 – SECTOR ECONOMY  Hence, if X > M , then, Trade Balance (NX) is positive and hence, from the above equation, we get that, NS > I. Whereas, if X < M , then, Trade Balance (NX) is negative and hence, we obtain that, NS < I.  In the context of the relation between international capital flows and the goods market in an open economy, we find that, if (NS - I) is positive, that is, NS > I , then, the nation will be lending the excess funds to the foreigners, hence there will occur Net Capital Outflow from the economy.  On the contrary, if (NS - I) is negative, that is, NS < I , then, economy will be borrowing from Abroad to finance their excess investment, and hence, there will be Net Capital Inflow into the country in order to finance higher capital formation in the economy.  Thus, it follows from above that, Net Capital Flows (NS - I) is always equal to the Balance of Trade (BOT) or the Current Account Balance (including Invisibles also apart from the Visible trade) in an open economy.  DIFFERENT CONCEPTS / MEASURES OF NATIONAL INCOME There are four different measures of estimating National Income in a country : ❑ GROSS NATIONAL PRODUCT (GNP) ❑ GROSS DOMESTIC PRODUCT (GDP) ❑ NET NATIONAL PRODUCT (NNP) ❑ NET DOMESTIC PRODUCT (NDP)  DEFINITIONS AND IMPORTANT CONCEPTS OF NATIONAL INCOME  National Product = Money Value of all Final Goods and Services produced = Total Rent of Land + Total Wages of Labour + Total Interests on Capital + Total Profits of Organization = National Income.  National Income (NI) is defined as the aggregate market value of all final goods and services produced by the residents of a country during a specific period of time (usually a financial year). It is a flow concept. NI of an economy is equivalent to the value of NNPfc.  Gross National Product (GNP) is defined as the aggregate market value of all final goods and services produced by the residents of an economy during a particular financial year. GNP includes the values of Net Factor Income earned from Abroad as well as Depreciation of physical capital.  Gross Domestic Product (GDP) is defined as the aggregate money value of all final goods and services produced by the residents and non-residents of a particular economy, within the domestic territory of that country, during a specific time period. GDP includes Depreciation cost but excludes Net Factor Income earned from Abroad.  DEFINITIONS AND IMPORTANT CONCEPTS OF NATIONAL INCOME  Net National Product (NNP) is defined as the aggregate market value of all final goods and services produced by the residents of an economy during a specific period of time, after providing for Depreciation. NNP includes Net Factor Income earned from Abroad but excludes Depreciation of physical capital.  Net Domestic Product (NDP) is defined as the aggregate money value of all final goods and services produced by the residents and non-residents of a country, within its geographical boundary, during a particular time period, after providing for Depreciation. NDP excludes both Depreciation cost as well as Net Factor Income earned from Abroad.  Per-Capita Income (PCI) refers to the per-head income of an economy. It is also called as the “Average” income of all the individuals of a country. It is defined as follows : PCI = (National Income / Population)  DEFINITIONS AND IMPORTANT CONCEPTS OF NATIONAL INCOME  The value of PCI gets affected over time, depending upon the relative rates of change in NI and Population. If the growth rate of NI exceeds that of population then PCI rises. If the growth rate of population exceeds that of NI then PCI decreases. Similarly, if both NI and population of a country grow at the same rate then PCI remains constant.  Transfer Income / Payment is a part of Personal Income of an individual but it is not included within the value of NI of the economy. It is a type of received income, which is also known as “Unearned” income. This is so because no fruitful economic activity is being generated in the economy in return of Transfer Income receipts. It does not lead to current production of any new final good or service in the economy. It only changes the levels of personal assets or wealth. For Eg. Beggar’s Income, Old-age Pension, Unemployment Allowance, Cash Prize, Gift Cheque, Relief Donation, Interest Payment on Public Debt etc.  DISTINCTION BETWEEN NATIONAL PRODUCT AND DOMESTIC PRODUCT  The adjusting factor between any National and any Domestic Product is the value of Net Factor Income earned from Abroad (NFIA).  NFIA is defined as follows : NFIA = Total Factor Income earned from Abroad - Total Factor Income paid to Abroad.  NFIA mainly contains the following three components : 1. Net Compensation of Employees. 2. Net Income from Property, that is, Rent, Interests, Profits and Dividends. 3. Net Retained Earnings of the resident companies working in foreign countries.  The value of NFIA is included within National Product but it is excluded from Domestic Product of a country. So, National Product is comparatively higher in value than Domestic Product.  DISTINCTION BETWEEN NATIONAL PRODUCT AND DOMESTIC PRODUCT  Thus, when the value of NFIA is deducted from National Product then we get Domestic Product. So, we have - National Product - Domestic Product = NFIA => National Product = Domestic Product + NFIA => Domestic Product = National Product - NFIA  Hence, we get the following set of equations : GNP = GDP + NFIA => GDP = GNP - NFIA Also, NNP = NDP + NFIA => NDP = NNP - NFIA  DISTINCTION BETWEEN GROSS PRODUCT AND NET PRODUCT  The adjusting factor between any Gross Product and any Net Product is the value of Depreciation of physical capital.  The physical capital goods, like machinery, wear out or fall in value as a result of continuous consumption or use in the production process. This Consumption of Fixed Capital or reduction in the value of fixed capital due to its physical wear - and – tear is called as Depreciation. Thus, alternatively, Depreciation is defined as a type of additional cost or expenses being borne by the producing firms for either repairing or replacing the damaged parts of physical capital equipments (wear-and-tear), when these are continuously used in the production process for a long period of time.  The value of Depreciation is included within Gross Product but it is excluded from Net Product of a country. So, Gross Product is always higher in value as compared to Net Product.  DISTINCTION BETWEEN GROSS PRODUCT AND NET PRODUCT  Thus, when we deduct the value of Depreciation from Gross Product then we obtain Net Product. So, we have – Gross Product - Net Product = Depreciation => Gross Product = Net Product + Depreciation => Net Product = Gross Product - Depreciation  Hence, we get the following set of equations : GNP = NNP + Depreciation => NNP = GNP - Depreciation Also, GDP = NDP + Depreciation => NDP = GDP - Depreciation  DISTINCTION BETWEEN MARKET PRICE AND FACTOR COST  The adjusting term between Market Price valuation and the corresponding Factor Cost valuation of any measure of NI is Net Indirect Taxes (NIT). Alternatively, NIT is also called as Net Indirect Business Taxes (NIBT).  NIT is defined as follows : NIT = Total Indirect Taxes - Total Subsidies  The value of NIT is included within Market Price measure but it is excluded from Factor Cost measure of any of the concepts (i.e, GNP, GDP, NNP or NDP) for estimating NI in a country. So, the Market Price value is always greater than the Factor Cost value in comparison.  Thus, when the value of NIT is deducted from Market Price measure then we get the Factor Cost measure.  DISTINCTION BETWEEN MARKET PRICE AND FACTOR COST  So, we have – Market Price - Factor Cost = NIT => Market Price (MP) = Factor Cost (FC) + NIT => Factor Cost (FC) = Market Price (MP) - NIT  Hence, we get the following set of equations : GNPMP = GNPFC + NIT or, GNPFC = GNPMP - NIT Also, GDPMP = GDPFC + NIT or, GDPFC = GDPMP - NIT Again, NNPMP = NNPFC + NIT => NNPFC = NNPMP - NIT NDPMP = NDPFC + NIT or, NDP = NDP - NIT  RELATION BETWEEN NATIONAL INCOME (NI) AND PERSONAL INCOME (PI)  Personal Income (PI) is actually the sum of all incomes received by an individual or a household during a given year. Thus, Transfer Incomes are included within PI, although these are not a part of NI.  NI, which is total incomes earned and PI, which is total incomes received must be different because some incomes which are only earned such as, Social Security Contributions, Undistributed Corporate Profits and Corporate Income Taxes are not actually received by the households; and conversely, some incomes which are only received like Transfer Incomes are not currently earned by the individuals. The value of PI is thus much less than that of NI relatively.  So, in moving from NI as an indicator of income earned, to PI as an indicator of income actually received, we must subtract from NI those three types of incomes, which are earned but not received; and hence, add those incomes which are received but currently not earned.  RELATION BETWEEN NATIONAL INCOME (NI) AND PERSONAL INCOME (PI)  Therefore, we get the following relationship between NI and PI : NI = PI - Transfer Incomes + Social Security Contributions + Undistributed Corporate Profits + Corporate Income Taxes => PI = NI + Transfer Incomes - Social Security Contributions - Undistributed Corporate Profits - Corporate Income Taxes  Social Security Contributions refer to the contributions towards employees’ social welfare schemes. It is a part of NI but not a part of PI.  Undistributed Corporate Profits are a part of the total profit income of corporate organizations which are retained back as surplus earnings. It is a part of NI but not a part of PI.  Corporate Income Taxes refer to the direct tax imposed by the government on the level of total profit Income of the corporate companies. It is a part of NI but not a part of PI. RELATION BETWEEN PERSONAL INCOME (PI) AND PERSONAL DISPOSABLE INCOME (PDI)  The entire incomes which are actually received by the people are not available to them for their consumption. This is because the government levies some types of Personal Taxes such as, Income Tax, Personal Property Tax, Wealth Tax etc.  Therefore, after a portion of the PI is paid to the government in the form of Personal Taxes, whatever remains back with the individual is called as Personal Disposable Income (PDI). Hence, PDI is that part of PI, which can be used / spent (asset) by the individual anytime, after paying off the compulsory income taxes (liabilities) to the government. Thus, we have – PDI = PI - Personal Taxes => PI = PDI + Personal Taxes => PI = Y = (C + S) + T ; where, ‘T’ denotes Personal Taxes (Direct)  RELATION BETWEEN PERSONAL INCOME (PI) AND PERSONAL DISPOSABLE INCOME (PDI)  So, PDI can either be Consumed (that is, spent for Consumption of final output) or Saved as deposits in the Banks by the individuals. Hence, we get – PDI = Personal Consumption + Personal Saving = C + S  Thus, PI is always greater than PDI exactly by the amount of Personal Direct Taxes.  MEASUREMENT OF NATIONAL INCOME Since factor incomes arise from the production of final goods and services, and also since incomes are spent on final goods and services produced, so there are three alternative methods of estimating National Income in an economy, mentioned as follows : ❖ VALUE - ADDED METHOD ❖ INCOME METHOD ❖ EXPENDITURE METHOD  VALUE – ADDED METHOD  This method is also called as the Output Method or Production Method.  In this method, the contribution of each enterprise to the generation of flow of goods and services is measured.  Under this method, the entire economy is divided into different sectors like Agriculture, Fishing, Mining, Construction, Manufacturing, Trade and Commerce, Transport, Communication and other such services.  Then the Net Value Added at Factor Cost (NVAFC) by each productive enterprise as well as by each industry or sector is estimated. Measuring by each sector requires first to find out the Value of Output (VO).  Thus, we need to estimate the value of various goods and services produced by different enterprises within the domestic territory of a country. The quantity of all final goods and services produced by a particular enterprise multiplied by their market prices is called as the Value of Output (VO).  By summing up the Value of Output of all producing enterprises in a given sector, we can obtain the Value of Output of that entire sector.  VALUE – ADDED METHOD  A major part of output of a firm or enterprise is sold in the market and termed as Sales. The remaining part of output which is not sold in the accounting year is added to the stock of goods in the form of Inventories. Thus, we have, Value of Output of an enterprise (VO) = Sales + Change in Stocks  Gross Value Added measures the contribution to the Value of Output of a product produced during a year. So, Gross Value Added at Market Prices by a production unit is obtained by deducting the value of Intermediate Consumption (that is, the value of intermediate goods such as raw materials used in production) from the Value of Output produced at Market Prices. Hence, we get, Gross Value Added at Market Prices (GVAMP) = VO - Intermediate Consumption  VALUE – ADDED METHOD  A firm disposes of its Gross Value Added at Market Prices (GVAMP) among the following three items : a. Making Depreciation provision for Consumption of Fixed Capital during the year b. Making payments of Indirect Taxes such as Excise Duties, Sales Tax, Import Duty, Customs Duty etc. to the government, and c. Making Factor Payments such as Wages, Interests and Profits to the factors of production whose services have been used for the production of a final good.  When we deduct Depreciation on account of Consumption of Fixed Capital during the production process of a final good during the year, from GVAMP , then we get Net Value Added at Market Prices (NVAMP). Thus, NVAMP = GVAMP - Depreciation  So, Net Value Added is always net of Depreciation of physical capital.  VALUE – ADDED METHOD  When adjustment is made in NVAMP for the payment of Net Indirect Taxes (NIT) [that is, the difference between total Indirect Taxes received and total Subsidies paid by the government], we obtain Net Value Added at Factor Cost (NVAFC). This is because after the subtraction of Depreciation amount and NIT, whatever remains is used for making payments to factors of production like Wages, Rents, Interests and Profits. In other words, NVAFC measures the Value of Factor Cost a firm has to incur.  Summing up the Net Values Added at Factor Cost by all productive enterprises of a particular sector, gives us the Net Value Added at Factor Cost of each sector.  We then add up the NVAFC by all such sectors to calculate the Net Domestic Product at Factor Cost (NDPFC).  VALUE – ADDED METHOD  Finally, to NDPFC we add Net Factor Income from Abroad to (NFIA) to get Net National Product at Factor Cost (NNPFC), which is also known as the NI of the nation. Hence, we have - NI or NNPFC = NDPFC + NFIA ; where, NFIA = Total Factor Income earned from Abroad - Total Factor Income paid to Abroad  This method of estimating NI can be used only where there exists a Census of production for the financial year. In many countries, the data of production of only a few important industries are known. Apart from the above mentioned drawback, one great advantage of this method is that it reveals the relative importance of the different sectors of the economy by showing their respective contributions to the NI annually.  VALUE – ADDED METHOD : PRECAUTIONS The following precautions should be taken while measuring NI of a country through Value – Added Method : ▪ Imputed Rent values of Self-occupied Houses should be always included in the value of NI. ▪ Sale and Purchase of Second-hand Goods should not be included in the value of final output of the current year. Only the Commission or Brokerage Fee earned in their sale and purchase, has to be included within the NI value in the current financial year. ▪ Value of Production for Self-consumption should be included while measuring NI. ▪ Value of Services of Housewives are not included in the calculation of NI. ▪ Value of Intermediate Goods must not be included while measuring value – added (Problem of Double Counting).  INCOME METHOD  This method approaches NI from the distribution side. In other words, this method measures NI at the phase of distribution and appears as income paid or income received by different individuals of the country. Thus, under this method, NI is obtained by summing up of the incomes of all individuals of a country during a particular year.  Individuals earn incomes by contributing their own services and also the services of their property such as land and capital to the national production. Hence, NI is calculated by adding up the total rent value of land, wages and salaries of employees, interest on capital, profits of entrepreneurs (including undistributed corporate profits) and incomes of self-employed people.  This method of estimating NI has the great advantage of indicating the distribution of NI among different income groups such as landlords, owners of capital, workers, entrepreneurs etc. Measurement of NI through Income Method involves the following main steps :  INCOME METHOD 1. Like the Value – Added Method, the first step in Income Method is also to identify all the productive enterprises and then classify them into various sectors such as Agriculture, Fishing, Forestry, Manufacturing, Transport, Trade and Commerce, Banking etc. 2. The second step is to classify the different factor payments. The factor payments are classified into the following groups – a) Compensation of Employees, which includes wages and salaries, employers’ contribution to social security schemes. b) Rent and Royalty c) Interest d) Profits : The total Profits of an organisation are divided into the following three sub-groups – i) Dividends / Distributed Profits ii) Undistributed Profits, and iii) Corporate Income Tax e) Mixed Income of the Self-Employed : In India, as in other developing countries, there is another fifth category of factor income which is termed as the Mixed Income of Self-employed.  INCOME METHOD e) In India, a good number of people are engaged in household industries, family farms and other such unorganized enterprises. Because of self- employment nature of the business, it is very difficult to separate the wages for the work done by these self-employed from the surplus or profits made by them. Therefore, the incomes earned by them are a kind of mixture of wages, rent, interest and profit; and are thus called as Mixed Income of the Self-employed. 3. The third step is to measure the factor payments. Income paid out by each enterprise can be estimated by gathering information about the number of units of each factor employed and the income paid out to each unit of every factor / input. Price paid out to each factor multiplied by the total number of units of each factor employed would give us the factor’s income. 4. The next step is the adding-up of all such factor payments by all the enterprises belonging to an industrial sector, which would give us the total incomes paid out to various factors by a particular sector.  INCOME METHOD  By summing up the incomes paid out by all the different sectors in an economy, we will obtain the value of domestic factor income, which is also called as Net Domestic Product at Factor Cost (NDPFC).  Finally, by adding up Net Factor Income earned from Abroad (NFIA) to the Net Domestic Factor Income or NDPFC we get the value of Net National Product at Factor Cost (NNPFC), which is also called as NI of the country. Remarks : ▪ Compensation of Employees by the producers is the sum of wages and salaries, paid both in cash and kind, and also contribution to social security schemes of the employees made by the employers. ▪ Wages and salaries payable in cash include the following – 1. Wages and salaries received in cash by the employees from their employers.  INCOME METHOD 2. Payments received by the employees for overtime work done by them. 3. Travelling allowance received by the employees for going to and coming home from their work places. 4. Bonuses, if any, receivable by the workers. 5. Dearness allowance paid to the employees to neutralise the rise in cost of living, 6. Leave Travelling Allowance (LTC). 7. Vacation allowance and sick leave allowance. 8. Medical allowances or re-imbursements. 9. Commission provided, if any, to the sales staff on the targeted sales. 10. Housing Rent Allowance (HRA). ▪ Wages and salaries payable in kind include the following – 1. Housing accommodation provided free of cost. 2. Free meals and drinks (such as tea, coffee, cold drinks) provided free to the employees when they are on duty.  INCOME METHOD 3. Uniforms and special clothing, if any, received free of cost from the employer. 4. The free services of vehicles (like cars, scooters, buses etc.) provided by the employers to their employees. 5. Free provision of goods and services which are produced by the enterprises themselves. Free travelling by the staff of railways or airlines, free coal to the workers working in coal mines fall under this category. 6. Creches provided by the employers for the children of theiremployees. 7. Value of interest on the free-interest loans given by the employers to their employees or the value of concessions in interest on loans given on concessional rates of interest. 8. Value of recreation and sport facilities provided by the employers to their employees and the members of their households.  INCOME METHOD ▪ Employers’ contributions relating to the various social security schemes of their employees such as life insurance, casualty insurance, Contributory Providend Fund (CPF), pension schemes etc. are also a part of the compensation of employees. ▪ In addition to all the above, in India’s NI accounting, salaries and allowances paid to the Members of Parliament and State Legislatures, pay and allowances to the President of India, State Governors, Ministers of Central and State Cabinets are also included and treated as compensation of employees.  INCOME METHOD – PRECAUTIONS While estimating NI of a country through Income Method, the following precautions should be taken : ▪ Transfer Payments are not included in estimating NI. ▪ Imputed Rent of Self-occupied Houses should be included in NI. ▪ Illegal Money such as Hawala money; money earned through Smuggling, Gambling etc. are not included within NI. ▪ Windfall Gains such as Prizes won, Lotteries are also not included in NI. ▪ Corporate Profit Tax that is, taxes levied on income of corporate companies, should not be separately included while calculating NI. ▪ Death Duties, Gift Tax, Wealth Tax, Tax on Lotteries etc. should not be included in the current period’s NI. ▪ The Receipts from the Sale of Second-hand Goods should not be included in NI. ▪ Income equal to the Value of Production used for Self-consumption at home by poor farmers should be estimated and included in NI measure.  EXPENDITURE METHOD  Expenditure Method arrives at National Income by adding up all expenditures made on goods and services during a financial year.  Income can be spent either on consumer goods or capital goods. Again, expenditure can be made by private individuals and households or by the government and business enterprises.  Further, people of foreign countries spend on the final goods and services which the domestic country exports to them. Similarly, people of a domestic (home) country spend on imports of final goods and services from other foreign countries.  Thus, we add up the following types of expenditures incurred by the households, government and different productive enterprises to obtain the value of NI in an open economy : 1) Expenditure on final consumer goods and services by private individuals and households. This is called as Final Private Consumption Expenditure and is denoted by ‘C’.  EXPENDITURE METHOD 2) Government’s expenditure on final goods and services to satisfy collective wants. This is called as Government’s Final Consumption Expenditure and is denoted by ‘G’. 3) The expenditure by productive enterprises on capital goods and inventories or stocks. This is called as Gross Domestic Capital Formation (GDCF) or Gross Domestic Investment (GDI) and is denoted by ‘I’. GDCF is divided into two parts : a. Gross Fixed Capital Formation b. Addition to the stocks or inventories of final goods 4) The expenditure made by foreigners on domestic goods and services of a country exported to other countries, which are called Exports, and are denoted by ‘X’. We deduct from Exports (X), the expenditure made by people, enterprises and the government of the domestic country on Imports (M) of final goods and services from other foreign countries. That is, we have to estimate the value of Net Exports [Export Earnings - Import Payments], denoted by (X – M) or NX.  EXPENDITURE METHOD  Thus, we add up the above four types of expenditure to get the final expenditure on Gross Domestic Product at Market Prices (GDPMP). Hence, GDPMP = C + I + G + (X – M) = C + I + G + NX  On deducting Consumption of Fixed Capital (Depreciation) from GDPMP we get Net Domestic Product at Market Prices (NDPMP).  In this method, we then subtract the value of Net Indirect Taxes (NIT) [Total Indirect Taxes – Total Subsidies] to calculate Net Domestic Product at Factor Cost (NDPFC).  Finally, we sum up the value of Net Factor Income earned from Abroad (NFIA) to obtain Net National Product at Factor Cost (NNPFC); which is called National Income. Hence, NNPFC = GDPMP – Depreciation – NIT + NFIA  EXPENDITURE METHOD  In this method, the Government’s Final Consumption Expenditure on goods and services includes the following items : a. Compensation of Employees, including Wages, Salaries, Social Security Contributions etc. b. Intermediate Consumption Expenditure by the general Government, which refers to purchases of final goods and services by the government less sales of some goods by it c. Consumption of Fixed Capital or Depreciation  EXPENDITURE METHOD - PRECAUTIONS While estimating GDP in an economy through Expenditure Method, the following precautions should be taken : ▪ Expenditure on Transfer Payments by Government such as unemployment benefits, old-age pension etc. should not be included within NI. ▪ Expenditure on Intermediate Goods like raw materials, should also be excluded from the value of NI (Multiple Counting Problem). ▪ The expenditure made on Second-hand Goods (resale value) should not be included in the current year’s NI. ▪ Expenditure on the Purchase and Sale of Old Shares, Bonds and Equities should not be included while estimating GDP / NNP.  PROBLEMS / DIFFICULTIES IN MEASUREMENT OF NATIONAL INCOME The difficulties involved in the measurement of NI of an economy accurately, are both conceptual and statistical in nature. Some of these main problems faced, specifically in developing countries like India, are enumerated below - ▪ Treatment of Non-monetary Transactions : This relates to the treatment of services of housewives to the members of their families and farm output consumed at home by poor farmers. On this point, the general agreement is to exclude the value of services rendered by housewives, while to include the value of farm output consumed at home by agricultural farmers in the estimate of NI. ▪ Treatment of Government Activities in NI Accounts : In this case, the general viewpoint is that as regards to the administrative functions of the government like justice, administration and defence are concerned, these should be treated as giving rise to final consumption of such services by the community as a whole, so that contribution of general government activities will be equal to the amount of wages and salaries paid by the government. Moreover, capital formation by the government is treated at par with that by the private enterprises.  PROBLEMS / DIFFICULTIES IN MEASUREMENT OF NATIONAL INCOME ▪ Treatment of Income Generated by Foreign Firms : In this regard, the IMF viewpoint which is generally accepted is that production and income arising from a foreign enterprise should be ascribed to the NI of the country in which the production takes place. However, the profits earned by these foreign companies are usually credited to their parent country’s NI. ▪ Illiteracy : Because of the presence of illiteracy in the developing countries like India, most producers do not have any clear idea about the exact quantity and value of their total output produced, and thus do not follow the practice of keeping regular accounts. This makes the task of getting reliable data and information from a large number of petty producers all the more difficult. ▪ Incomplete Occupational Specialization : Due to underdevelopment, occupational specialization in developing nations is still incomplete, so that there is a lack of differentiation in economic functioning. An individual may receive income partly from farm ownership, partly from manual work in an industry in the slack season etc. This also makes the task of estimating NI very difficult.  PROBLEMS / DIFFICULTIES IN MEASUREMENT OF NATIONAL INCOME ▪ Unorganized Production Sector : Another difficulty in measuring NI in the developing countries arises because of the fact that production, both agricultural and industrial, is unorganized and scattered vastly. This does not admit of easy calculation of NI. In India, agriculture, cottage industries and indigenous banking are some of the production sectors which are unorganized and scattered. An assessment of output produced by self- employed agriculturists, small producers and owners of household enterprises in the unorganized sectors requires an element of guess work, which makes the figure for NI inaccurate and unreliable.  PROBLEMS / DIFFICULTIES IN MEASUREMENT OF NATIONAL INCOME ▪ Lack of Adequate Statistical Data : The greatest difficulty in the measurement of NI in the developing countries is the general lack of adequate statistical data. Inadequacy, non-availability and unreliability of statistics is a great handicap in measuring NI in such nations. In India, statistical information regarding agriculture and its allied occupations, and also household enterprises is not available. Even the statistical information regarding the enterprises in the organized sector is sketchy and unreliable. There is no accurate information available regarding consumption, investment expenditure and savings of either the rural or urban population. NOMINAL INCOME AND REAL INCOME (GNP)  Nominal Income or Nominal GNP is defined as the money value of all final goods and services produced in an economy in an accounting year. This money value is obtained using Current Year’s Market Prices of final goods and services produced. So, Nominal Income is measured at Current Prices. However, Nominal GNP does not truly indicate the real performance or economic growth of a country over time if prices are changing. While Nominal GNP may be increasing due to rise in price level, the quantity of final output produced may remain constant.  Therefore, in order to estimate, to what extent the amount of final goods and services produced has increased, we have to eliminate the effect of change in prices on the Nominal value of GNP in the Current Year. To do so, the economists evaluate the quantity of final goods and services produced in a financial year using the market prices that prevailed in a certain chosen previous / past year, called as the Base Year. NOMINAL INCOME AND REAL INCOME (GNP)  Estimates of India’s Real GNP which were made using 1993 - 94 as the Base Year has now been changed to the year 1999 - 2000. Thus, in India, now market prices of the year 1999 - 2000 are used to estimate the value of Real GNP, which is also called as NI at Constant Prices.  The calculation of Real GNP helps us to know whether the availability of real goods and services in the economy has increased over time. Besides, by calculating the percentage change in Real GNP during a year, enables us to measure the rate of economic growth of the country in that particular year.  Further, it is Real GNP that is often used for making comparisons of international standards of living and rates of economic growth of various countries.  CONCEPT OF GNP DEFLATOR ▪ With the help of Nominal GNP and Real GNP, we can measure the Rate of Inflation that has occurred over time in an economy. ▪ This measure of Rate of Inflation in a country is known as the ‘GNP Deflator’. So, the GNP Deflator, also called as Implicit Price Deflator GNP, is the ratio of Nominal GNP of a country in a particular year to its Real GNP during the same year. Thus, we have - GNP Deflator = Nominal GNP of a year / Real GNP in the same year => Nominal GNP = Real GNP × GNP Deflator => Real GNP = Nominal GNP / GNP Deflator  NUMERICAL EXAMPLES / PROBLEMS 1. Calculate : (i) GDPMP and (ii) NI from the following information – Items Amount (Rs.) Personal Consumption Expenditure 6500 Indirect Taxes less Subsidies 150 State Government Consumption & Investment Expenditure 500 Central Government Consumption & Investment Expenditure 2000 Change in Business Inventories 100 Gross Private Domestic Fixed Investment 1200 Exports 900 Net Factor Payments to the Rest of the World 100 Imports 1200 Depreciation 200  NUMERICAL EXAMPLES / PROBLEMS  (i) We know that, Y = C + I + G + (X - M) So, GDPMP = Personal Consumption Expenditure + (Gross Private Domestic Fixed Investment + Change in Business Inventories) + (Central Government Consumption and Investment Expenditure + State Government Consumption Expenditure) + (Exports - Imports) Thus, GDPMP = 6500 + 1300 + 2500 - 300 = Rs. 10,000 /-.  (ii) Hence, NI or NNPFC = GDPMP + NFIA - Depreciation - NIT So, NI = 10000 - 100 - 200 - 150 = Rs. 9550 /-. [Since, NFIA (Net Factor Income earned from Abroad) = - Net Factor Income paid to Abroad]  NUMERICAL EXAMPLES / PROBLEMS 2. Calculate : (a) NI and (b) PDI from the following given information – Category Amount (Rs.) GDPMP 6000 Receipts of Factor Income from the Rest of the World 150 Payments of Factor Income to the Rest of the World 225 Depreciation 800 Indirect Taxes minus Subsidies 700 Corporate Profits 1200 Dividend 600 Transfer Payments to persons 1300 Personal Taxes 1500  NUMERICAL EXAMPLES / PROBLEMS  NI of a country is equal to the value of NNPFC.  (a) So, NI or NNPFC = GDPMP - Depreciation + NFIA - NIT = 6000 - 800 + (150 - 225) - 700 = Rs. 4,425 /-.  (b) Thus, PDI = NI - Undistributed Corporate Profit + Transfer Payments to Persons - Personal Taxes = 4425 - (1200 - 600) + 1300 - 1500 = Rs. 3,625 /-. [Since, Undistributed Corporate Profits = Corporate Total Profits - Dividends]  NUMERICAL EXAMPLES / PROBLEMS 3. Calculate : (i) NDPMP and (ii) NI from the following given data – Items Amount (Rs. Crore) Subsidies 10 Sales 1000 Closing Stock 100 Indirect Taxes 50 Intermediate Consumption 300 Opening Stock 200 Consumption of Fixed Capital 150 Net Factor Income earned from Abroad 10  NUMERICAL EXAMPLES / PROBLEMS  (i) VO = Sales + Change in Stock = Sales + (Closing Stock - Opening Stock) = 1000 + (100 - 200) = Rs. 900 Crore.  Thus, NVA or NDPMP = VO - Intermediate Consumption - Consumption of Fixed Capital (Dep.) = 900 - 300 - 150 = Rs. 450 Crore  (ii) Hence, NI (NNPFC) = NDPMP - NIT + NFIA = 450 - (50 - 10) + 10 = Rs. 420 Crore [Since, NIT = Total Indirect Taxes - Total Subsidies]  TEXTS AND REFERENCES : ❖ Dornbusch, Fischer and Startz, Macroeconomics, McGraw Hill, 11th Edition, 2010 ❖ N. Gregory Mankiw, Principles of Macroeconomics, Indian Imprint of South Western by Cengage, India, 6th Edition, 2015 ❖ N. Gregory Mankiw, Macroeconomics, Worth Publishers, 7th Edition, 2010 ❖ Ghosh Chandana and Ghosh Ambar, Macroeconomics, PHI Learning Pvt. Ltd., 2014 ❖ Sikdar Soumyen, Principles of Macroeconomics, Oxford University Press, 2nd Edition, 2012