Chapter Two –National Income Accounting

2.1. Introduction
In this unit we will discuss about the national income and accounting. The purpose of this topic is to
study how the gross national product is measuring the economic activity of a nation. The concept is
defined and explained. The components are analysed in the expenditure and the income approach, and
the two are reconciled. Adjustments for inflation are presented. The concept is compared to other
measures of economic welfare.

Casual observation is one source of information about what’s happening in the economy. When you
go shopping, you see how fast prices are rising. When you look for a job, you learn whether firms are
hiring. Because we are all participants in the economy, we get some sense of economic conditions as
we go about our lives. However, the most important source of information for economic analysis is
economic data or statistic.

Today, economic data offer a systematic and objective source of information, and almost every day
the newspaper has a story about some newly released statistic. Most of these statistics are produced by
the government. Various government agencies survey households and firms to learn about their
economic activity—how much they are earning, what they are buying, what prices they are charging,
whether they have a job or are looking for work, and so on. From these surveys, various statistics are
computed that summarize the state of the economy. Economists use these statistics to study the
economy; policy makers use them to monitor developments and formulate policies.

2.1.1. National income accounting

A term used in economics to refer to the bookkeeping system that a national government uses to
measure the level of the country's economic activity in a given time period.

In national income accounting, we are concerned with statistical classification of the economic activity
so that we are able to understand easily and clearly the operation of the economy as a whole. In
national income accounting the following distinctions are drawn between:
(a) forms of economic activity, namely, production, consumption, and accumulation of wealth;
(b) sectors or institutional division of the economy; and
(c) types of transactions, such as sales and purchases of goods and services, gifts, taxes, and other
current transfers.

Macro Economics Ch-2. National Income Accounting

2.1.2. Meaning of National Income

National Income is one of the basic concepts in macroeconomics. National Income means the total
income of the nation, the aggregate economic performance of the whole economy is measured by the
national income data.

National Income refers to the money value of all final goods and services produced by the normal
residents of a country while working both within and outside the domestic territory of a country in an
accounting year. National Income also includes net factor income from abroad.

2.2. Importance of National Income Accounting:

National income accounting is an important discovery of the twentieth century. The credit for
presenting this system in a systematic and scientific manner goes to Simon Ku/nets.

National income accounts present the picture of the entire economy in a very short form reflecting the
significance of all economic activities. The significance of national income accounting becomes
evident from the following points:

(i) Information about the economy: National income accounting provides detailed information
relating (of the contribution of different sectors of an economy in the production process. This
indicates the relative significance of all the sectors of economy, such as agriculture, industry, services
etc.,

(ii) Sharing of national income: National income accounts show as to how national income is shared
among various factor of production.

(iii) Information about structural changes: National income accounting helps in finding out
structural changes that take place in an economy.

(iv) International Comparisons: National income accounting can be helpful in making international
comparison about volume of output.

(v) Adequate & reliable information about economic life: Adequate and reliable information about
various aspects of economic life is very essential, these days. National income accounting is very
useful in providing information about various aspects of economic life in a country.

(vi) Information about economic development: Every country tries its level best to increase its lie of
economic development. National income accounting enables us to know as to whether the rate of
economic development is more or less at par with in comparison to that of last year

Macro Economics Ch-2. National Income Accounting

2.3. MEASUREMENT OF NATIONAL INCOME

Let us now discuss how the national income is measured. There are four methods of measurement of
national income. These are:

(i) Product method or Output Method

(ii) Value added method
(iii) Income method and
(iv) Expenditure method
2.3.1. Product Method:
Product method measures national income at the phase of production. In this method, the total value of
final goods and services produced in a country (economy) during a year is calculated at market prices
to find out the GNP, the data of all productive activities., such as agricultural products, wood received
from forest s, mineral received from mines , commodities produced by industries, the contributions to
production made by transport , communications insurance companies ,lawyers ,doctors ,teachers ,etc.
are collected and accessed at market prices. Only final goods and services are included and
intermediate goods and services are left out.

Example: Suppose a firm sells flour of $50 to a bakery, which uses the flour to make bread of worth
$100. If we include the output of both firms in national income, we should get $150 altogether. In this
case, we would be counting the output of the flour industry twice. However, in order to avoid the
double counting error, economists have suggested the value added method where only the value
added at each stage is being counted.

Problems in production method

The following problems arise in the computation of national income by product method:
 Services of housewives  Consumer services
 Intermediate and final goods  Capital gain
 Second hand goods and assets  Price changes.
 Illegal activities

Macro Economics Ch-2. National Income Accounting

2.3.2. The Value-Added Approach

Another method of measuring national income is the value added by industries. The difference
between the value of material outputs and inputs and each stage of production is the value added.

Firm Cost of intermediate goods Revenue ( in birr) Value added(in birr)

Farmer 1000 1000

Cloth industry 1000 2000 1000
Whole seller 2000 3000 1000
Retailer 3000 5000 2000
GDP 5000 birr
A firm’s value added is the revenue it receives for its output, minus the cost of all the intermediate
goods that it buys.

2.3.3. Income Method

According to this method, net income payment received by all citizens of a country in a particular
year are added up, i.e.net income that accrue to all factors of production by way of net rents net
wages , net interest, and net profits (The incomes earned by the factors of production– land, labour,
capital and organisation- are totalled up)all are added together but incomes received in the form of
transfer payments are not included in it.

For example, X pays Rs. 1,00,000 to Y. Y's income will increase but at the national level or macro
level, there is no change in income because what Y has gained is exactly what X has lost. Donations,
pensions etc. are not considered in calculating national income. Again, income earned by smuggler is
also not considered in calculating national income as the smugglers' income is earned through illegal
mean
Problems in income method
The following problems arise in the computation of national income by income method
 Owner occupied houses
 Self-employed persons
 Goods meant for self-consumption
 Wages and salary paid in kind

Macroeconomics Chapter 2 -National income accounting

 2.3.4. Expenditure Method:
In measuring national income, the expenditure method take into account the aggregate of all the final
expenditure on gross domestic product in an economy during a year is added together and includes
personal consumption expenditure, net domestic investment, government expenditure on goods and
services, and net foreign investment.

This method is also known as 'consumption and investment method' or 'income disposal method'.
This concept is based on the assumption that national income equals to national expenditure.

Gross Domestic Product Expenditure method includes

1. Consumer expenditure on durable and nondurable goods and services(C).

2. Investment fixed Capital residential non-residential building, machinery and inventories (I)
3. Goods and services produced by the government (G).
4. Export of goods and services produced by the people of country (X)
5. Less imports (M)

Thus GDP by expenditure method at market prices =C + I + G +(X-M)

Where, (X-M) is net export which can be positive or negative.
Example: The GDP using expenditure approach from the following table, every number is in birr.
Consumption Investment Govt.purchase Net export

Service 3656 Equipment 1166 consumption 1333 Export 996

Non-durable goods 1841 New home 411 investment 296 import 1253
Durable goods 758 Change in inventory 44
C 6255 I 1621 G 1629 NX -257

GDP=C+I+G+NX
6255+1621+1629+ (-257) = 9248birr
Expenditure Approach: GDP = C +I+ G+ NX
Value-Added Approach: GDP = Sum of value added by all firms
Income Approach: GDP =Sum of factor payments made by all firms
= Wages and salaries + interest + rent+ profit +Total household income
Problems in Expenditure method
The following problems arise in the computation of national income by Expenditure method
 Government services
 Transfer payment
 Durable use consumer goods
Since our economic well-being (welfare) depends, in part, on the goods and services we can buy, it is important to
translate nominal values which are measured in current dollars to real values which are measured in purchasing power.

Macroeconomics Chapter 2 -National income accounting

 2.4. Concepts of National Income
There are a number of concepts pertaining to national income and methods of measurement relating
to them.

2.4.1. Gross Domestic Product (GDP)

Gross domestic product, or GDP, is often considered the best measure of how well the economy is
performing. In Ethiopia this statistic is computed every year by the Central Statistics Agency, from a
large number of primary data source. The primary sources include both administrative data, which are
by products of government functions such as tax collection, education programs, defence, and
regulation, and statistical data, which come from government surveys of, for example, retail
establishments, manufacturing firms, and farm activity.

The purpose of GDP is to summarize all these data with a single number representing the dollar value
of economic activity in a given period of time.

There are two ways to view this statistic. One way to view GDP is as the total income of everyone in
the economy. Another way to view GDP is as the total expenditure on the economy’s output of goods
and services. From either viewpoint, it is clear why GDP is a gauge (measure) of economic
performance. GDP measures something people care about—their incomes. Similarly, an economy
with a large output of goods and services can better satisfy the demands of households, firms, and the
government.

How can GDP measure both the economy’s income and its expenditure on output? The reason is that
these two quantities are really the same: for the economy as a whole, income must equal expenditure.
That fact, in turn, follows from an even more fundamental one: because every transaction has a buyer
and a seller, every dollar of expenditure by a buyer must become a dollar of income to a seller. When
Joe paints Jane’s house for $1,000, that $1,000 is income to Joe and expenditure by Jane. The
transaction contributes $1,000 to GDP, regardless of whether we are adding up all income or all
expenditure. To understand the meaning of GDP more fully, we turn to national income accounting,
the accounting system used to measure GDP and many related statistics.

Macroeconomics Chapter 2 -National income accounting

 2.4.2. Approaches to measuring GDP
GDP can be measured in three alternative but equivalent approaches, namely income, value-added &
expenditure approaches.

2.4.2.1. Income approach

The income approach measures national income from the side of payments made to the primary
factors of production in the form of rent, wages, interest, and profit for their productive services in an
accounting year. Since the income of factors of production is cost to their employers, so factor
income and factor costs are the same. Thus, if the factor incomes of all the producing units generated
within the domestic economy are added up, the resulting total will be the domestic income at factor
cost. Mathematically;

If we add the value of depreciation and indirect business tax to this list, we get GDP.

Depreciation means loss of the value of fixed capital assets during production and is considered as
cost of production. In other words, depreciation is the value of existing capital stock that has been
consumed or used up in the process of producing output. Fall in the value of fixed assets due to
normal wear and tear and to expected obsolescence is called consumption of fixed capital or
depreciation.

Taxes which are levied by the government on production and sale of commodities, such taxes as
excise tax, sales tax, custom duty, etc., are called indirect taxes. The buyer of a taxed commodity
pays taxes indirectly because the tax is included in the price which the buyer pays.

Depreciation represents consumption of fixed capital which can be considered as cost of production.
Indirect business tax represents the difference between what buyers pay for final product and what
sellers receive as an income. Since it is an income generated through production process but not
earned by factor owners, indirect business taxes are considered as income generated in the
accounting period. This implies indirect business tax and depreciation enter the income side in the
process of GDP computation.

Macroeconomics Chapter 2 -National income accounting

 The following table illustrates how GDP is computed using the income approach hypothetical
economy.
Table 2.1: GDP of hypothetical economy in billions of dollars
Component of GDP Values in million dollars
Wages and salaries $450
Rental income $100
Interest income $90
Profit $210
National Income $850.0
Plus depreciation $20
Plus Indirect business tax $30
GDP $900
Plus net foreign factor income $-20
Plus Statistical discrepancy $0
GNP $880.00

2.4.2.2. Expenditure approach

The value of total output in the economy can be measured by aggregating expenditure made on final
goods and services in the product market. Such approach of measuring GDP is known as expenditure
approach. The expenditure approach represents the demand for final goods and services. This
demand (expenditure) for domestically produced goods comprise of four main components; namely,
consumption expenditure (C), Business investment (I), Government expenditure (G), and net export
(NX).

GDP is the sum of consumption, investment, government purchases, and net exports. Each dollar of
GDP falls into one of these categories. This equation is an identity— an equation that must hold
because of the way the variables are defined. It is called the national income accounts identity.

Consumption consists of the goods and services bought by households. It is divided into three
subcategories: nondurable goods, durable goods, and services. Nondurable goods are goods that last
only a short time, such as food and clothing. Durable goods are goods that last a long time, such as
cars and TVs. Services include the work done for consumers by individuals and firms, such as
haircuts and doctor visits.

Investment consists of goods bought for future use. Investment is also divided into three
subcategories: business fixed investment, residential fixed investment, and inventory investment.
Business fixed investment is the purchase of new plant and equipment by firms. Residential
investment is the purchase of new housing by households and landlords. Inventory investment is the
increase in firms‟ inventories of goods (if inventories are falling, inventory investment is negative).

Macroeconomics Chapter 2 -National income accounting

Government purchases are the goods and services bought by federal, state, and local governments.
This category includes such items as military equipment, highways, and the services provided by
government workers. It does not include transfer payments to individuals, such as Social Security and
welfare. Because transfer payments reallocate existing income and are not made in exchange for
goods and services, they are not part of GDP.

Net exports accounts for trade with other countries. Net exports are the value of goods and services
sold to other countries (exports) minus the value of goods and services that foreigners sell us
(imports). Net exports are positive when the value of our exports is greater than the value of our
imports and negative when the value of our imports is greater than the value of our exports. Net
exports represent the net expenditure from abroad on our goods and services, which provides income
for domestic producers.

Table 2-2 GDP and it components, in $ millions for the same hypothetical economy

Component of GDP Amount of spending(in millions)

 Personal consumption expenditure ................................................$500.00
o Durable goods… .................................................... $300.00
o Nondurable goods .................................................. $120.00
o Services goods… ....................................................$80.00
 Business investment ...................................................................... $170.00
o Business fixed investment ..................................... $130.00
o Residential Investment........................................... $20.00
o Inventory Investment ............................................. $20.00
 Net export…………………………………………………………………$-20.00
o Exports… ................................................................. $60.00
o Import ..................................................................... $80.00
 Government spending ...................................................................... $250.00
o Federal Gov‟t spending .......................................... $200.00
 State and local .......................................................... $50.00
GDP...................................................................................................................................$900.00

2.4.2.3. Product or value added approach

Production of goods and services typically involves different stages of production. Each stage
involves separate market transaction and flow of income. As an example consider the stages involved
in the production of bread. Suppose that bread production involves 4 stages from the wheat farmer to
the final bread consumer. The farmer first grows up the wheat and then sells the wheat to Mill
owners. Then, the miller converts the wheat into flour and sells it to bread beaker. The bread baker
sells the bread store owners and, store owners sell the bread to final consumers. This process is
shown in table 2.3 below. So, how should the production of bread affect our GDP‟s calculation?
What is the value of bread production that should appear in our GDP calculation?

Macroeconomics Chapter 2 -National income accounting

 Table 2.3: Production of bread involving four different stages
Stage of Transactio Value of Value
production n transaction in added
birr in birr
Stage 1 Farmer grows wheat & sells it to mill owner 0.12 0.12
Stage 2 Miller converts wheat to flour & sells it to 0.28 0.16
baker
Stage 3 Baker bakes bread & sells it to store owner 0.60 0.32
Stage 4 Store owner sells bread to final consumer 0.75 0.15
Total 1.75 0.75

If we add the separate values of each transaction from each stage, we would come to the conclusion
that the value of output produced in production process equals 1.75 birr. But, the value of final output
produced is equal to $0.75. Thus, in order to avoid double counting, we either can take the value of
the final product or we can take the sum of values added by each separate stage of production. As a
result, we can conclude that the production of bread has created a value of 0.75 birr and it is this
value that appears in our GDP calculation.

Points to note in Measuring GDP

In all the three approaches used to measure GDP, there are basic ideas that should be considered:

-GDP accounting involves measuring the expenditure and income stream that comes from current
production of goods and services. A transaction that involves transfer of ownership of existing assets
would not be considered as component of GDP. This is because they are not a result of current
production. Transfer payments such as social security benefits, and unemployment benefit,
scholarships and grants given to state and local government should excluded because the recipients in
return provide no productive services for the current accounting period. Sales from inventories also
do not add to economy’s total income.

2.5. Nominal GDP and Real GDP

Nominal GDP is the market value (money-value) of all final goods and services produced in a
geographical region, usually a country. Also known as: GDP

Nominal GDP is the sum of this year's output valued at this year's prices. The problem is that nominal
GDP changes when prices change and when the quantity of output changes. We want to separate the
desirable increase in the quantity of output from the undesirable increase in prices.

Macroeconomics Chapter 2 -National income accounting

Real GDP is a macroeconomic measure of the value of output economy, adjusted for price
changes. The adjustment transforms the nominal GDP into an index for quantity of total output. Also
known Constant GDP

= ×

Real GDP is the sum of this year's output valued at base year prices. Prices from the base year are
used to calculate real GDP for all years.

Real GDP (Adjusted for inflation): Refers to a GDP that has been adjusted for inflation or deflation
to accurately show the increase or decrease in production for comparison of economic growth from
year to year. Measured in relation to the price index of a given year.

For example:

2000 nominal GDP 2001 nominal GDP

100 coats x $60 = $6000 150 coats x $80 = $12,000

100 radios x 40 = 4000 120 radios x 20 = 2400

--------- ---------

$10,000 $14,400

Suppose we select 2000 as the base year. Then, whenever we calculate real GDP we use the prices
from2000. So, to determine real GDP for 2001, we would use the quantities produced in 2001 and the
prices from2000, the base year.

2000 real GDP

150 coats x $60 = $9000

120 radios x 40 = 4800

2000 real GDP = $13,800

What is real GDP for2000? In the base year, real and nominal GDP are the same.

GDP price index:

A Price Index is a measure, or ratio, of the price of a specified collection of goods and services
(market basket) in a certain year as compared to the price of the same or extremely similar "market
basket" in a reference year (base year/ base period).(Market Basket: specified collection of goods and
services.)

Macroeconomics Chapter 2 -National income accounting

 = × (= )

2.6. Gross Domestic Product at Factor Cost (GDP at FC)

Gross Domestic Product at Factor Cost is sum of net value added by all producers with in the
country. Since the net value added gets distributed as the income to the owners of factor of
production. GDP is the sum of domestic factor incomes and fixed capital consumption or
depreciation. Symbolically,
 GDP at FC = Net value added+ Depreciation.
 GDP at FC = Net Value added –indirect taxes + Subsidies
GDP factor cost included
 Compensation of employees i.e. wages, salaries etc.
 Mixed income of self employed
 Operating surplus (business profit)
2.7. Net Domestic Product at Market Price (NDP at MP)
Net Domestic Product at Market Price is the difference between Net National Product at Market Price
and net factor income from abroad.

Symbolically,
 NDP at MP = NNP at MP – Net Factor Income from Abroad.
 NDP at MP = GDP factor cost – Depreciation
2.8. Net Domestic Product at Factor Cost (NDP at FC)

Net Domestic Product at Factor cost or Domestic Income is the income earned by the factors of
production in the form of wages, profits, rent, interest, etc. within the territorial limits of the country

Net Domestic Product at Factor Cost (NNP at FC) or

Domestic Income = Rent, including imputed rent
+ Compensation of Employees or Wages and Salaries
+ Interest
+ Dividend
+ Reserve Fund of the Firms or Corporate Saving
+ Corporate or Other Direct Taxes
+ Mixed Income of the Self Employed
+ Profits of Government Enterprises

Macroeconomics Chapter 2 -National income accounting

+ Property Income of the Government
+ Savings of Non-Departmental Undertakings.
2.9. Gross National Product at Market Price (GNP at MP)

Gross National Product at Market Price is the money value of all final goods and services produced
annually in a country plus net factor income from abroad. GNP is a broader concept than GDP. GNP
is GDP plus net factor income from abroad.

Symbolically,

GNP at MP = GDP at MP + Net Factor Income from abroad.

Net factor income from abroad is the difference between the factor income earned by our residents
from foreign countries and the factor income earned by the foreigners from our country.

2.10. Gross National Product at Factor Cost (GNP at FC)

Gross National Product at Factor cost is obtained by adding net factor income from abroad to the
Gross Domestic product at Factor Cost.
GNP at FC = GDP at FC + Net Factor Income from Abroad.
2.11. Net National Product at Market Price (NNP at MP)

Net National Product at Market Price is Gross National Product at Market Price less depreciations of
fixed capital or consumption of fixed capital. By deducting the value of depreciation of fixed capital
from the value of Gross National Product in a year, we get the value of Net National Product.

 NNP at MP = GNP at Mp – Depreciation.

 NNP at MP = NDP at MP +Net factor income from abroad

2.12. Net National Product at Factor Cost or National Income (NNP at FC or NI)

Net National Product at Factor Cost or National Income is the total earnings of all factors of
production in the form of wages, profits, rent, interest, etc. plus net factor income from abroad. In
other words, if net factor income from abroad is added to the Net Domestic Product at Factor Cost,
we get Net National Product at Factor Cost.

Symbolically,

NNP at FC or NI = NDP at FC + Net Income from Abroad.

Macroeconomics Chapter 2 -National income accounting

(Net National Product at Factor Cost or National Income can also be calculated by deducting
depreciation from Gross National Product at Factor Cost.

Symbolically,

NNP at FC or NI = GNP at FC – Depreciation

2.13. Per Capita Income:

Per capita income means income per head. Per capita income refers to the average income of the
normal residents of a country during any particular year. It is equal to national income divided by
total population.

Symbolically, Per capita income =

2.14. Personal Income:

The income earned by the personal sector, i.e., households and unincorporated business is personal
income. Personal income includes transfer payments like welfare payments, pensions, unemployment
etc.

2.15. Disposable Personal Income:

That part of the personal income, which the households can spend the way they like, is called
disposable personal income. It refers to the purchasing power of the households.

 Disposable Income = Personal Income – Direct Taxes.

The entire amount of disposable income is not spent on consumption. A part of it is saved. Thus,

 Disposable Income = Consumption Expenditure + Saving.

KEYNESIAN APPROACH TO NATIONAL INCOME

Keynes has suggested three approaches to national income:

(1) Income - expenditure approach: According to this approach, national income is equal to total
expenditure on consumption and investment goods.

(2) Factor - income approach: According to this approach, national income is measured as the
aggregate of incomes received by all the factors of production.

(3) Sales proceeds minus cost approach: According to this approach, national income is defined
as the aggregate sales proceeds minus cost
Macroeconomics Chapter 2 -National income accounting
 MODERN APPROACH TO NATIONAL INCOME

Modern economists consider three aspects of national income and emphasise the fundamental identity
between these three aspects. These three aspects are : (a) product aspect (b) income aspect, and (c)
expenditure aspect. In one of the publications of the United Nations, national income has been
defined in three ways:

(a) 'Net National Product' as the aggregate of the net value added is all branches of economic
activity during a specified period, together with the net income from abroad.

(b) 'Sum of the distributive shares' as the aggregate of national income accrued to the factors of
production (in the form of wages, profits, interest, rent, etc) in a specified period.

(c) 'Net National Expenditure' as the sum of expenditure on final consumption of goods and
services, plus domestic and foreign investments.

Modern economists consider national income as a flow of output, income and expenditure, When
goods are produced by the firms, the factors of production are paid incomes in the form of wages,
profits, interest, rent, etc. These income receipts are spent by the household sector on consumption
goods and their savings are mobilised by the producers for investment spending. Thus, there is a
circular flow of production, income and expenditure, obviously, income, output and expenditure
flows are always equal per unit of time. Thus, there is a triple identity: Output = Income =
Expenditure.

Macroeconomics Chapter 2 -National income accounting