What is national income accounts?

It is an accounting framework

It is used to measure current economic
activity of a country

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Why do we need to measure
national income?
Because, we can compare sizes of different
economies. This helps to compare the level of
economic development of different economies.
Because, it gives us idea about the productive
capacity of the economy.
Because, it helps the policy makers to set policy
targets aiming at attaining certain level of
economic growth.

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Methods to measure national income
There are three approaches to measure national
income:

1. Product approach
2. Income approach and
3. Expenditure approach

All these three approaches give identical

measurements of the amount of
current economic activity.
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The product approach
Measures the economic activity by adding the market
values of goods and service produced, excluding any
goods and services used up in intermediate stages of
production.
This is also called the “value added” approach.
The value added of any producer is the value of its
output minus the value of the inputs it purchases
from other producers.
The product approach computes economic activity by
summing the value added by all producers.
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The income approach
Measures economic activity by adding all
income received by producers of output.
Income received includes wages and
profits.

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The expenditure approach
Measures the economic activity by adding
the amount spent by all ultimate users of
output.
How do we define the ultimate user?
Ultimate users are those who finally
consume a finished product. Usually the
household.

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Equivalence of the three approaches
Orange Co.
Wages paid to workers 15000
Taxes paid to govt. 5000
Revenue received from the sales of oranges 35000
Oranges sold to public 10000
Oranges sold to Juice Co. 25000
Juice Co.
Wages paid to workers 10000
Taxes paid to govt. 2000
Oranges purchased from Orange Co. 25000
Revenue received from sales of orange juice 40000
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The product approach
Value added by the Orange Co. 35000

Value added by the Juice Co. 15000

Juice Co.’s purchase value of

25000
orange

Juice Co.’s sales value of juice 40000

Total Value added 35000 + 15000 = 500009

The income approach
After tax income of Orange Co. 15000

After tax income of Juice Co. 3000

Wages of Orange Co. workers 15000

Wages of Juice Co. workers 10000

Govt.’s tax earnings from Orange Co. 5000

Govt.’s tax earnings from Juice Co. 2000

Total income 50000

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The expenditure approach
Oranges purchased by households from Orange Co. 10000

Juice purchased by households from Juice Co. 40000

Total expenditure by the households 50000

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Fundamental Identity
Total production = Total income = Total expenditure

Now, we have methods to measure economic activity of a

country. However, we need to determine what we shall
measure using these methods.

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Gross Domestic Product (GDP):
the most popular aggregate
 Gross domestic product (GDP) is a measure of the
income and expenditures of an economy.
 It is the total market value of all final goods and services
newly produced within a country in a given period of
time.
 Please notice the three important words-
 Market value
 Final goods and services and
 Newly produced
 Within a country

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Market value
 Goods and services are counted in GDP at their market values.
 Some goods are not marketed. What do we do with them?
 In Bangladesh officially we do not try to estimate them. We just
ignore them. If it were possible to incorporate those items in
the official estimates, our GDP would rise to a higher level.
 Example: Homemaking, child rearing.
 What about services like defense, education etc. provided by
the govt.?
 As there is no market value for these services, we do not
have any idea about the value addition. Therefore, we
calculate those at their cost of production.
 What about the underground economy?
 Underground economy arising out of hiding legal activities, and
 Underground economy arising out of hiding illegal activity

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Newly produced goods and services
We measure only current economic activity. Not
activities of the past periods.
If anything is sold and bought that is not produced in
the current period, we do not include them in the
calculation of GDP.
Suppose, a car sales agent sells a used car today. The
car was produced in the previous period. Do we
include the sales into GDP? Do we include the service
of the sales agent into GDP?

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Final goods and services
 Goods can be of two types: intermediate or final.
 Intermediate goods and services are those used up in the production of other
goods and services in the same period that they themselves were produced.
 If potato produced and then stored in a cold storage during the previous year is
used to produce potato chips in the current year, we shall not consider these
potatoes as intermediate goods.
 How shall we classify capital goods? Capital goods are used to produce other
goods. But these are not natural resources. Capital goods are considered final
goods.
 How shall we classify inventories? Unsold finished or unused intermediate
items. Inventory investment is treated as final goods.
 How shall we count natural gas that we explore and use in Bangladesh? Shall we
treat natural resources as inventories? No, we do not treat natural resources as
inventories. When we procure natural resources we just add the value of the
resource with GDP.
 How shall we adjust the cost of pollution with GDP? We should have deducted
the cost. However, in practice we cannot determine the cost and therefore do
nothing.

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The expenditure approach
Four major categories of expenditures are added
to get GDP:
Y = C + I + G + (X – M)
Where, Y is GDP, C is consumption, I is
investment, G is government spending, X is
export and M is import. The part- (X – M) is
called net export (NX).
This equation is referred as Income-Expenditure
identity.

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Expenditure approach continued
Consumption: Spending of domestic households on final
goods and services, including those produced abroad.
Investment: Includes both spending for new capital
goods (fixed investments) and inventory investment. Like
consumption, I includes spending on foreign produced
goods.
 Shall we include investment in the stock market in I?
Government Spending: Includes government’s spending
on currently produced goods and services. Like C and I, G
includes spending on foreign goods.
 Shall we include transfer payments (such as social security
schemes for the poor) made by the government into
government spending?

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Expenditure approach continued
Net Export = Export – import = X – M
Why do we add export in the measurement of GDP?
Because- export means foreigners spend on goods that are
produced in our country.
If foreigners purchase intermediate goods from our
country and use those to produce a final product in their
country, shall we include this sales in our GDP?
Why do we subtract import in the measurement of GDP?
Because, it ensures that total spending reflects spending only
on output produced in the country. Imports are produced
abroad and are already included in C, I and G. If we do not
subtract it, then it means we are including products in the
calculation of GDP that are not produced in the country.

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Income approach
 It calculates GDP by adding the incomes received by producers,
including profits, and taxes paid to the government.
 Key part of the income approach is a concept known as “National
Income.”
 National Income is the sum of five broad category of income. These are-
 compensation of employees,
 proprietor’s income,
 rental income of persons,
 corporate profits and
 net interest.
 From national income taxes are paid to the government, which is
income for the government. If we add this income to the national
income we get Net National Product.
 If we add depreciation to net national product we get Gross National
Product(GNP).
 GNP= NNP + Depreciation.
 Subtracting Net Factor Payment with GNP we get GDP.
 GDP = GNP-NFP.
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Income approach continued
A Compensation of employees
B Proprietor’s income
C Rental income
D Corporate profits
E Net interest
F National income (A+B+C+D+E)
G Indirect business taxes and other small items
H Net National Product (F+G)
I Consumption of fixed capital (depreciation)
J Gross National Product (H+I)
K Net factor income (income paid to domestic factors of production by
the rest of the world – income paid to foreign factors of production by
the domestic economy)

L Gross Domestic Product (J-K)

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 Note: GDP vs. GNP
GDP = goods and services produced by nationals within the country
+ Goods and services produced by foreigners within the country

GNP= goods and services produced by nationals within the country

+ goods and services produced by nationals abroad

GDP = goods and services produced by nationals within the

country
+ goods and services produced by foreigners within the country
+ goods and services produced by nationals abroad
- goods and services produced by nationals abroad

GDP = GNP + (goods and services produced by foreigners within the

country - goods and services produced by nationals abroad)

GDP = GNP – Net Factor Payments from abroad (NFP)

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Note: Private Disposable Income (PDI)
So far, we have measured economic activity as the sum of all
incomes received in an economy.
However, information about private sector income is important.
Why? Because, when we have information about the private
sector we can determine the extent of the government’s role in
the economic activity.
PDI = GDP – net income of the govt. + NFP
PDI =Y – (T – TR – INT) + NFP
PDI= Y –T+TR+INT + NFP
PDI = Y+TR+INT+NFP-T
 Where, Y = GDP
 NFP = net factor payments from abroad
 TR = transfers from the govt.
 INT = interest received by the private sector from the govt.
 T = taxes and fees paid to the govt.

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Note: Savings and wealth
To assess economic condition, current income would be a good
indicator. However, current income might not always give the
right information about the real economic condition. Why? See
examples below.
For example, a retired person may not have any current income
but might have millions of dollars as an assets. On the other
hand, a fresh graduate may have taka 40,000 per month income
as well as heavy debt left over from his student life.
Therefore, to assess the economic condition of an individual or
a household we need to know current income as well as total
assets and liabilities owned by that person or household.
Similarly, the economic condition of the entire nation depends
not only current income but also its total wealth (assets –
liabilities). This is what we call “national wealth.”
An important determinant of national wealth is the rate of
SAVINGS
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Savings of the nation
Private Savings = PDI – consumption
Private savings = Y – (T – TR – INT) + NFP – C

Govt. Savings = net govt. income – govt. purchases

Govt. savings = (T – TR – INT) – G

National savings (S) = Private savings + Govt. saving

= Y – (T – TR – INT) + NFP – C + (T – TR – INT) – G
= Y + NFP – C – G we know that GNP = GDP+NFP
= GNP – C – G
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Use of Private Savings
Private savings may be used to
 fund new capital investment,
 provide resources for government to finance deficit, and
 acquire assets from or lend to foreigners.
We know that S = Y + NFP – C – G
= C + I + G + NX + NFP – C – G
= I + (NX + NFP)
CA = current account balance
= I + CA
Private Savings + Govt. savings = I + CA
Private savings = I + CA – Govt. savings
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Savings and National Wealth
 National wealth is the total wealth of the residents of a country.
 National wealth = country’s domestic physical assets + foreign assets
held by domestic residents – domestic assets held by foreigners
 Foreign assets held by domestic residents – domestic assets held by
foreigners = Net Foreign Asset (NFS)
 National wealth may change in two ways-
 Value of existing stock of wealth change and
 Through a change in national savings (S). How? See below.
 Recall that S = I + CA. This means that when savings is invested it
increases national wealth. Also, when we lend our savings to
foreigners CA increases and as a result our national wealth
increases.

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Note: Nominal GDP
So far, we have calculated GDP by determining values of goods
and services using current market price. When we use current
market price to determine the value of GDP, we call it nominal
GDP.
But looking at nominal GDP may give us wrong picture about
economic condition of a country.
Consider the following example:
Product Year 1 Year 1 GDP of Year 2 Year 2 GDP of
price quantity year 1 price quantity year 2
Rice 30 100 3000 40 100 4000
If we look at the nominal value of the GDP we may have the idea that
GDP has increased by 1000 Taka. However, this is not right. Why?
Because our real production did not increase.

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Note: Real GDP
To overcome the problem of nominal GDP, we use fixed
prices for the goods and services produced in every period.
These fixed prices are selected from a year in which price
were relatively stable and everything else about the
economy was normal.
This year is called the “base year” and these prices are
called “ base year prices.
In the previous table if we use year 1 price as base year
price the we can see that GDP does not change in year 2.
GDP, thus calculated using a base year price, is called real
GDP.
Real GDP gives us actual changes in the production of
physical goods and services.
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Use of nominal and real GDP
We use nominal and real GDP to construct price indexes
that reflect changes in the price level.
This gives us idea about INFLATION.
GDP Deflator and Consumer Price Index (CPI) are two of
such indexes.
GDP deflator is used to measure change in the prices of all
goods and services of the country.
On the other hand, CPI is used to measure changes in
price only for the goods and services that are important
for the consumers. Therefore, in calculation of CPI only a
limited number of goods and services are considered.
GDP deflator = (nominal GDP / real GDP) X 100

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Note: CPI may overstate cost of living
index
 Although CPI is widely used to measure inflation and cost of
living, it may overstate the cost of living on two grounds.
 Example 1: if a new model of air cooler arrives in the market but
with a 10% higher price, the CPI will record the price increase.
However, if that 10% price increase is for 10% more efficient use of
energy then cost of living will not change. Yet, CPI will note
inflation. This called quality adjustment bias.
 Example 2: If consumers like bread and rice equally and if both
these items are included in CPI, then increase of price of any one
of these items will increase CPI. However, the consumers will
switch to the product having the same price and therefore their
living standard will not change. This is called substitution bias.

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