CHAPTER 1

INTRO

National income means the value of goods and services produced by

a country during a financial year. Thus, it is the net result of all
economic activities of any country during a period of one year and is
valued in terms of money. National income is an uncertain term and
is often used interchangeably with the national dividend, national
output, and national expenditure.
Importance of Calculating National Income

Setting Economic Policy

National Income indicates the status of the economy and can give a clear
picture of the country’s economic growth. National Income statistics can
help economists in formulating economic policies for economic
development.

Inflation and Deflationary Gaps

For timely anti-inflationary and deflationary policies, we need aggregate

data of national income. If expenditure increases from the total output, it
shows inflammatory gaps and vice versa.

Budget Preparation
The budget of the country is highly dependent on the net national income
and its concepts. The Government formulates the yearly budget with the
help of national income statistics in order to avoid any cynical policies.

Standard of Living
National income data assists the government in comparing the standard
of living amongst countries and people living in the same country at
different times.

Defense and Development

National income estimates help us to bifurcate the national product

between defense and development purposes of the country. From such
figures, we can easily know, how much can be set aside for the defense
budget.

CONCLUSION

The usefulness of estimating National Income is as follows: It depicts the

change in the production to output and also the effects of the Government
policies on the economy.

1. Explain the product method of calculating national income

Product method is also known as output method or value added method.
In this method, we calculate the national income in terms of final goods
and services produced in an economy during a particular period of time.
The final goods are those which are either available to the consumers for
consumption or become a part of national wealth in the form of
investment.

Definition
Product method is that which estimates the national income by measuring
the contribution of final output and services by each producing enterprise
in the domestic territory of a country during a given accounting period.

Classification of Productive Enterprises

The first step in this method of measuring national income is the
classification of enterprises. All the productive enterprises in the
economy are classified into three main categories, viz. (i) Primary Sector,
(ii) Secondary Sector and (iii) Tertiary Sector. Let us briefly explain these
sectors.

(i) Primary Sector – Primary sector refers to that sector of the economy
which exploits natural resources to produce goods. Agriculture and allied
activities like mining, quarrying, fishing, forestry etc. are included in this
sector.

(ii) Secondary Sector – The manufacturing sector of the economy which

transforms one physical good into another is included in the secondary
sector.

(iii) Tertiary Sector – Primary sector refers to that sector of the economy
is known as the tertiary sector. This includes banking, insurance,
education, trade, commerce etc.

Step II.

Classification of Output
National output is classified into the following types:

(i) Consumer Goods – Consumer goods are those goods which help in the
further production of consumer gods. These are also called are also called
capital goods.

(ii) Producer Goods– Producer gods are those goods which help in the
further production of consumer gods. These are also called capital gods.

(iii) Govt. Produced Goods– These include defence, police, education,

health care, roads, railways, ports, dams etc.

(iv) Net Exports– Net exports refer to the value of goods and services
exported to the rest of the world minus the value of goods & services
imported during an accounting year.

Step III.
 Measurement of Value of Output
There are two methods of measuring the value of output. They are (i)
Final output method, (ii) Value added method. Below we discuss these
two approaches of product method of measuring national income.

(i) Final Output Method

In final method, we have to estimate the following element involved to
arrive at the correct figure of the final output.

(a) Value of output

Here output means final goods as well as intermediate goods. The value
of all these goods can be estimated by multiplying the quantity of output
of each producing unit with the market price.

(b) Value of intermediate consumption

The goods and services used by the firms as inputs are known as
intermediate consumption. To calculate the value of intermediate
consumption, we have to multiply the intermediate goods with the prices
paid by the enterprises to purchase these goods.

(C) Consumption of fixed capital

Consumption of fixed capital means depreciation. When goods are
produced, there is wear and tear of machines leading to the loss of value
of the capital assets.

According to final output method, the value of intermediate goods is

deducted from the value of output. The quantity produced by each
producing enterprise is multiplied by the market price. This gives us the
value of output. From this, we deduct the value of intermediate
consumption to arrive at the value of the output.

Measurement of National Income – Production Method

Estimated by adding the value added by all the firms.
Value-added = Value of Output – Value of (non-factor) inputs

1. This gives GDP at Market Price (MP) – because it includes depreciation (therefore ‘gross’) and
taxes (therefore ‘market price’)
2. To reach National Income (that is, NNP at FC)
  Add Net Factor Income from Abroad: GNP at MP = GDP at MP + NFIA
 Subtract Depreciation: NNP at MP = GNP at MP – Dep
 Subtract Net Indirect Taxes: NNP at FC = NNP at MP – NIT

3. Explain the income method of calculating national income

Income method calculates national income based on the flow of factor
revenues. There are four factors associated with every production activity;
these are land, labor, capital, and entrepreneurship. Laborers receive their
wages, the land gets rent, capital accrues interest, and entrepreneurship
gets profit, each earning through the individual means.
Apart from that, self-employed individuals like doctors, CAs, advocates,
etc. employ their own capital and labor. Thus, their income is regarded as
mixed income.
Therefore, in the income method, the national income is measured in
terms of these factor payments. Thus, it is also known as the ‘factor
payment method.’
To arrive at national income using this method, you must sum up all the
individual income that occurred in a country within a specific period. It
includes wages and salaries, rent of land, interest gained on capital and
income of self-employed individuals. This method conclusively indicates
the distribution of national income among every income group of a
country.

Income Method Formula

National Income (NNPFC) = Net Domestic Product at Factor Cost (NDPFC) +
Net Factor

Income from Abroad

Here NDPFC = Compensation of Employees + Operating Surplus + Mixed-
Income
Here Operating Surplus = Rent + Interest + Profit

Steps of Income Method Formula

1. Identification and Classification of Production Units

The first step in calculating national income by income method is to
identify and segregate the units of production. They are classified into
three categories, primary, secondary, and tertiary.

2. Classify and Estimate the Factor Income

The next step of the income method of national income is to classify factor
payments in different categories like wages, rent, interest, profit, and
mixed income.

2. Calculating Domestic Income

Summing up all factor incomes of every sector will present the domestic
income figure (NDPFC).
NDPFC = Compensation of Employees + Operating Surplus + Mixed-
Income

4. Estimate NFIA to arrive at National Income

The last step to reach the final National Income figure is to estimate Net
Factor Income from Abroad (NFIA) with NDPFC.
National Income (NNPFC) = Net Domestic Product at Factor Cost (NDPFC) +
Net Factor Income from Abroad (NFIA)

Components of Factor Income

Factor income is an essential part of the income method. Summing up all
the factor incomes within a country for a period resulted in Domestic
Income or NDPFC. There are three components of factor income
compensation to employees, operating surplus, and mixed income.

Compensation to Employees (COE)

Compensation to employees refers to the remuneration paid by an
employer to his/her employees for their productive services. It includes all
monetary and non-monetary benefits that employees receive, directly or
indirectly. Moreover, COE comprises of 3 elements, these are –

 Wages in Cash
It consists of every monetary benefit, such as wages, bonuses,
commissions, dearness allowance, etc.

Wages in Kind

This includes every non-monetary benefit that employees receive from

their employers, like home, car, medical and educational facilities.
Employer’s Contribution to Social Security Schemes
It includes the contribution employers make in social security plans such
as employees provident fund, gratuity, pension plans, etc.

Operating Surplus
Operating surplus is also divided into 3 categories, these are –

 Rent
Rent arises from the ownership of properties. Income under this head
comprises both actual rent and imputed rent. Actual rent is calculated on
properties to let out on rent

Interest

It refers to the interest amount received for loaning funds to a

manufacturing unit. This interest comprises both actual and imputed
interest. Additionally, it also includes interest paid on loans taken for
production units.

Profit
An entrepreneur earns profits for his/her contribution to the company. It
is a residual income, which the entrepreneur earns after paying other
factors of production.

Mixed-Income
Self-employed individuals and unincorporated businesses generate this
form of income. The mixed income arises when elements of factor
incomes cannot be separated from each other. For example, a doctor
running his/her clinic.

4. Explain the expenditure method of calculating

national income
INTRO
The Expenditure method is a system used for determining the Gross
Domestic Product (GDP) of a country. This method considers
consumption, investments, net export, and government Expenditure to
calculate a nation’s annual GDP.
Expenditure method of National Income can be considered as the most
common way to calculate GDP as it includes both public and private sector
expenses incurred within a nation’s borders. However, this system can
only be used to calculate nominal GDP, which is not adjusted for inflation.

How is GDP Determined?

The process of calculating GDP with the Expenditure process is similar to
that of determining demand as the total spending of an economy is
considered as aggregate demand. For which reason, both Expenditure and
aggregate demand shifts in tandem with each other.

However, aggregate demand usually considers the average price of all

goods and services produced and utilized in an economy. That makes it
similar to GDP only in the long run, after adjusting for inflation.

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Expenditure Formula
There are primarily four different types of aggregated expenses that are
utilized to determine GDP. These are –

1. Investments made by businesses.

2. Government expenses on goods and services.

3. Household consumption.

4. Net export (total exports minus the value of imported goods and
services).

The Expenditure Method Formula is as Following –

GDP=C+I+G+(X–M)GDP=C+I+G+(X–M)

Here, C is consumer spending on different goods and services, I

represents investments made by businesses, and on capital goods, G
represents government’s spending on goods and services provided to the
public, X is exports, and M is imports.
Primary Components Used in Expenditure Method of Calculating
National Income
The above mentioned types of aggregated expenses can be further
broken down depending on the parameters these include. Let’s take a
look –

1. Consumer Spending – Consumer spending usually accounts for a

large part of a nation’s GDP. It can be divided into two categories –
purchases of durable and non-durable goods, and procurement of
services.

2. Government Expenditure – It represents expenses undertaken by

both State and Central authorities for providing infrastructure,
essential commodities, and other requirements to the general
populace.

3. Business Investment – Business investments include capital

Expenditures on assets by different organizations.

Business investment can be divided into two categories –

 Gross Fixed Capital – It indicates expenses incurred during

purchase of fixed assets. Gross fixed capital can be further
categorised into two types.

o Gross Business Fixed Investments – It includes expenses

made towards long-term assets, such as machinery, real-
estate, production facility, infrastructure, etc.

o Gross Residential Construction Investments – Expenses

incurred by businesses for purchasing or constructing
residential units upon receiving tenders.

 Net Exports – The difference in valuation between the exports and

imports undertaken by a country within one financial year is
considered as net exports.