National Income Accounting.ppt

National Income AccountingNational Income Accounting

GDP – Gross Domestic Product

A measure of the total flow of goods and services produced by the economy over a specified time period. It is obtained by valuing outputs of goods and services at market prices and then aggregating. Note that all intermediate goods are excluded and only goods used for final consumption or investment goods (capital) or changes in stock are included. This is because the values of intermediate goods are implicitly included in the prices of final goods.

GDP – Gross Domestic Product

The word ‘gross’ means that no deduction for the value of expenditure on capital goods for replacement purposes is made. The word ‘domestic’ is used to highlight the fact that income arising from investments and possessions owned abroad is not included.

GNP – Gross National Product

GNP is GDP plus the income accruing to domestic residents arising from investment abroad less income earned in the domestic market accruing to foreigners abroad.

GNP = GDP + Exports - Imports

National Income

A measure of the money value of goods and services becoming available to a nation from economic activity during a prescribed period. It can be calculated by three different methods:

1. By adding all the incomes generated in the country by economic activity – wages, interest, profit and rent. The money value or price of a commodity is exactly equal to the sum of the various incomes generated in its production.

National Income

2. By adding together the values of all goods and services produced in a country ie. Prices minus indirect taxes, while avoiding double counting.

3. By adding the values of what has been consumed (deducting indirect taxes plus subsidies) and what has been invested in the country to give total expenditure.

Whichever method is adopted, the final gross amount should be the same. Allowance may be made for the depreciation of assets to give a ‘net’ figure.

GDP

The GDP is the most comprehensive measure of a nation’s total output of goods and services. It is the sum of the monetary values of consumption (C), gross investment (I), government purchase of goods and services (G), and net exports (X) produced within a nation during a given year.

GDP = C + I + G + X

Measurement of GDP – Goods flow and Earnings flow

Flow of Product Approach Each year the public consumes a wide

variety of goods and services. We include only final goods – goods ultimately bought and used by consumers.

Market prices are used as weights in valuing different commodities because market prices reflect the relative economic value of diverse goods and services.

Measurement of GDP – Goods flow and Earnings flow

Earnings or Cost Approach There are various costs of doing business –

wages to be paid to labor, rent to be paid to land, profits to be paid to capital and so on. But these business costs are also the earnings that households receive from firms. By measuring the annual flow of these earnings or incomes we can arrive at the GDP.

The Problem of Double Counting

A final product is one that is produced and sold for consumption or investment. GDP excludes intermediate goods – goods that are used up to produce other goods. GDP therefore includes bread but not wheat and home computers and not computer chips.

To avoid double counting of intermediate goods, we calculate value added at each stage of production.

Real Vs. Nominal GDP

We can measure the GDP for a particular year using the actual market prices of that year. This gives us the nominal GDP, or GDP at current prices. But we are usually more interested in determining what has happened to the real GDP, which is an index of the volume or quantity of goods and services produced. Real GDP is calculated by tracking the volume or quantity of production after removing the influence of changing prices or inflation.

Real Vs. Nominal GDP

The difference between the growth of nominal GDP and real GDP is the growth in the price of GDP, sometimes called the GDP deflator.

Consumption

Consumption is by far the largest component of GDP, equaling about 2/3rd of the total. Consumption expenditures are divided into three categories: durable goods such as automobiles, nondurable goods such as food, and services such as medical care. The most rapidly growing sector is services.

Investment and Capital Formation

Investment consists of the additions to the nation’s capital stock of buildings, equipment, software etc. during a year. The national accounts include tangible capital (buildings, computers etc.) but omit most intangible capital (R&D, Education etc.)

Composition of U.S. GDP in 2001

Consumption as a Share of GDP:U.S. and Japan, 1955-2001

Circular flow of macroeconomic activity

Purchasers(households,

governments…)

Producers(businesses)

(b)Productive services

(labor, land, etc.)

(a)Final goods and services

(bread, computers, haircuts, etc.)

$Consumption purchases

$Wages, rents, profit, etc.

Value added accounting

To avoid double counting of intermediate products, we calculate value added at each stage of production. This involves subtracting all the costs of materials and intermediate products bought from other businesses from total sales.

Value added accounting

Bread Receipts, Costs, and Value Added (cents per loaf) Stage of production

(1) Sales receipts

(2) Less: Cost of intermediate

products

(3) Value added

(wages, profit, etc.) (3) = (1) – (2)

Wheat 23 0 = 23 Flour 53 23 = 30 Baked Dough 110 53 = 57 Final product : bread

190 110 = 80

Total 376 186 190

(sum of value added)

National income calculation

Product approach Earnings approach Components of gross domestic product

Consumption (C) + Gross private domestic investment (I) + Government purchases (G) + Net exports (X)

Equals: Gross domestic product

Earnings or costs as sources of gross domestic product Compensation of labor(wages, salaries and supplements) + Corporate profits + Other property income (rent, interest, proprietors’ income) + Depreciation + Production taxes

Equals: Gross domestic product

National income calculation

The previous table presents the major components of the two sides of the national accounts. The left side shows the components of the product approach. The symbols C, I, G and X are the four items of GDP. The right side shows the components of earnings or cost approach. Each approach will ultimately add up to exactly the same GDP.

GDP Deflator

Nominal GDP (PQ) represents the total money value of final goods and services produced in a given year where the values are expressed in terms of the market prices of each year. Real GDP (Q) removes price changes from nominal GDP and calculated GDP in terms of goods and services. The GDP price index (P) is the “price of GDP” and is approximately determined as follows:

Q = real GDP = nominal GDP / GDP price index

GDP Deflator

Date (1) Nominal GDP

(current $, billion)

(2) Index number of

prices (GDP deflator,

1929 = 1)

(3) Real GDP

($, billion, 1929 prices)

3 = (1) / (2)

1929 104 1.00 104 / 1.00 = 104 1933 56 0.75 56 / 0.75 = 76

GDP to National income to Disposable income

Net exports

Government

Investment

Consumption

National Income

Depreciation

Taxes

Transfer payments Net business saving

GDP

DI

Gross domestic product (GDP)

National Income (NI)

Disposable Income (DI)

GDP to National income to Disposable income

Important income concepts are 1. GDP, which is total gross income to all

factors2. National income, which is the sum of factor

incomes and is obtained by subtracting depreciation from GDP

3. Disposable personal income, which measures the total incomes, including transfer payments but minus taxes, of the household sector.

Price Indexes and Inflation

A price index is a level of the average level of prices.

Inflation denotes a rise in the general level of prices.

The rate of inflation is the rate of change of the general price level.

Deflation is a fall in the general level of prices.

Price indexes

When news papers report “inflation is rising”, they are really reporting movement of a price index.

A price index is a weighted average of the prices of a number of goods and services. In constructing price indexes, economists weight individual prices by the economic importance of each good. The most important price indexes are the consumer price index, the GDP price index (GDP deflator) and the producer price index.

Monetarism Vs Fiscalism

Monetary Policy

“The management of the expansion and contraction of the volume of the money in circulation for the explicit purpose of attaining a specific objective such as full employment” – Raymond P Kent

Monetary Policy

The objectives of monetary policy are

a. Stability of price

b. Stability of exchange rate

c. Full employment

d. Economic growth

Monetary Policy - Objectives

a. Stability of priceFluctuations in price level are always accompanied by fluctuations in the level of business activity. However, price instability creates difficult problems of production and distribution affecting different sections of the people in the country differently. During periods of falling prices, there is widespread collapse of businesses resulting in tremendous increase in unemployment and decrease in production and income.


Periods of rising prices, on the other hand, witness shifts in the distribution of wealth and income from the poor to the rich. Only periods of relatively stable prices have been able to combine an active and stable prosperity with a largely neutral effect on wealth distribution. Moreover, periods of price and business fluctuations have also witnessed economic and political turmoil. Therefore, stabilisation of internal prices is a major objective of the monetary policy.


b. Stability of exchange rateStable exchange rate is an essential condition for promotion of healthy foreign trade. Fluctuations in exchange rates result in flight of capital and lack of investor confidence. It also results in speculative activity in the foreign exchange market. Hence, monetary policy lays great emphasis on exchange rate stability which is deemed to be the best guarantee for maximum economic and social welfare. In recent times, however, the formation of economic unions like European Union and ASEAN as also the emergence of international bodies like IMF and IBRD have taken this objective out of the sole ambit of monetary policy.


c. Full employmentIn cases of economies suffering from unemployment because of deficiency of investment, monetary policy could try to: (a) create additional bank deposits, (b) create additional money, and (c) increase velocity of circulation of money through activating of idle cash balances. All these necessitate reduction in rate of interest to stimulate borrowings from banks for investment. Hence, monetary policy designed to promote investment and ultimately achieve full employment is commonly known as cheap money policy.


d. Economic growthThe monetary authorities strive to establish an efficient currency and banking system to facilitate and foster economic growth. Horizontal penetration of the banking system into rural and semi-urban areas and vertical penetration into sophisticated and specialised money markets in the urban areas is a vital task of the monetary authorities.The Central Bank must ensure money supply that is adequate to the growth process and is sufficiently elastic. Paper money must replace coins and banking instruments must gradually takeover paper money.


As economic growth reaches maturity, monetary system becomes less important. In the later stages of development, the monetary system becomes part of the entire financial mechanism which controls the flow of funds as well as securities. But in the meantime, the monetary authorities must help the continuous expansion of the banking and financial systems. Monetary authorities have another important responsibility as regards growth viz. creation of new financial institutions for mobilising savings for productive use. Presently, the credit system is more prone to providing credit to large estates, plantations, export industries and so on. Credit facilities are not readily available to peasants, small industries and small traders.


Finally, the monetary authorities must solve the BOP problem that every developing country faces. To counter adverse BOP, Central Bank must resort to direct control over foreign exchange and bank rates. “Central banking in a planned economy can hardly be confined to the regulation of the overall supply of credit or to a somewhat negative regulation of the flow of bank credit. It would have to take a direct and active role. Firstly, in creating or helping to create the machinery needed for financing development activities all over the country, and secondly, in ensuring that the finance available flows in the direction intended.” – Planning Commission.

Monetary Policy – an evaluation

Firstly, monetary policy is not given any major importance in the expansion and development of the economy. It is well realized that GOI would play the pivotal role in stimulating the economy and sustain economic growth. The role of RBI is minor and is one of overseeing steady finance for developmental needs.

Secondly, the powers and weapons available to RBI aid in exercising control only on commercial and scheduled banks. To the extent of controlling inflation, RBIs selective controls are effective. But in India, inflation has been more on accord of deficit financing and real physical shortages over which RBI has no control.

Thirdly, extensive use of black money in the country for hoarding and speculating limits the efectiveness of monetary policy.

Fiscal Policy - Objectives

Fiscal policy means the policy of the Finance Ministry of the GOI and is also called the budgetary policy (Fisc means Treasury). Many economists including Keynes advocated use of fiscal policy to:

a. achieve optimum allocation of economic resources,b. bring about equal distribution of income and wealth,c. maintain price stability,d. promote and achieve full employment, ande. attain rapid economic growth.

Fiscal Policy - Objectives

Fiscal policy has three tools: taxation, public expenditure and public debt management.

Taxation is meant to bring revenue to the government but can also be used to encourage or restrict private expenditure on consumption and investment.

Public expenditure is usually in the form of normal govt. expenditure and expenditure on relief works and subsidies. While taxation reduces the income of the general public, public expenditure increases the income of the general public.

Govt. borrowing and public debt influence the volume of liquid assets with the public. Subscription to public debt transfers funds from the public to the Govt.while repayment of debt will have the opposite effect.

Fiscal Policy and Stabilization of business

Keynes opines that depression and unemployment are due to deficiency of aggregate demand and recommends active usage of fiscal policy to overcome this situation. Fiscal policy increases aggregate demand either by increasing GOI expenditure or by inducing general public to increase consumption or investment.

Tax Policy during Depression – Fiscal policy during depression aims to stimulate purchasing power, consumption and investment. Such a policy aims at reducing (a) personal income tax, corporate tax and direct taxes to promote saving and investments; and (b) excise and sales taxes which will promote consumption.


Public Expenditure during depression: Public expenditure may be undertaken with the express purpose of compensating the decline in private investment proportionately. This is also called compensatory public spending. Public expenditure may also be undertaken to help revive economic activity. Such expenditure is called pump priming.

Public expenditure creates capital assets like railways, canals, airports etc. which help in direct employment and also stimulate secondary and tertiary sector employment. They constitute social and economic infrastructure that promotes real output and income of the economy.


However, corrective public expenditure has the following limitations: (a) it is difficult to forecast business depressions and the required corrective expenditure, (b) there are delays in starting public works programs, (c) public expenditure financed out of borrowings entails huge burden on future generations, and (d) public works programs have to be completed even after the period of business depression expires. To eliminate these shortcomings economists often suggest alternative patterns like transfer payments, unemployment insurance, social security schemes and others.


Public debt policy to check a depression: The following points determine the efficacy of public debt policy – (1) This policy has positive benefits only if idle funds are mopped up and not if these funds are transferred from private investments. (2) Funds borrowed from the Central Bank must contribute to increase in money supply. (3) The GOI must prevail on RBI to follow a policy of cheap money.

Keynes opines that while monetary policy impacts effective demand indirectly, fiscal policy impacts effective demand directly.

Fiscal Policy and Inflation

Fiscal policy is effective in controlling demand-push, cost-pull and sectoral inflations. Taxation helps in rationalization of liquidity in the economy. Taxes are of two types – direct and indirect. Direct taxes are immediately effective as the impact and incidence of taxation is on a specific target income group. Indirect taxes are essentially used to mop excess purchasing power of the public. Taxation also aids in equitable distribution of wealth and reallocates purchasing power in order to curb sectoral inflation.


Since inflation is caused by increased public expenditure, a reduction in Govt. expenditure has a dampening effect on inflation. Control of aggregate demand is of vital importance. Often, a part of Govt. expenditure is non-essential and can be easily curtailed. During times of inflation, it is prudent to have a surplus budget wherein the revenue is more than expenditure. Deficit budgets have the effect of increasing the incomes of the public. Developing countries also face the problem of balancing their defense and developmental expenditure.


Government borrowing during inflation results in transfer of money from the public to the government. This borrowing must basically be from non-banking institutions and individuals which will curtail money supply in the economy. On the other hand, government borrowing from RBI and the banking system expands money supply. The proper debt policy would, therefore, be to redeem that portion of public debt which is held by the RBI and banking system and increase borrowing from individuals and non-banking institutions.

Fiscal policy – an evaluation

Firstly, fiscal policy invariably has an inflationary impact on the economy because creation of money income is always preceding the availability of goods and services.

Secondly, increasing taxation and public borrowing have their own limitations. While high taxation adversely impacts production, loans from the general public may not be adequate for govt. spending. Private expenditure cannot be kept down through fiscal action. Hence fiscal policy only moderates inflationary pressures and does not eliminate them completely.

Lastly, fiscal devises are more efficient as supports or supplements to other policies than as independent policies during inflation.

Monetary policy and Fiscal policy :A comparison

There is no intrinsic contradiction between monetary and fiscal policies as their objectives are mostly identical in nature. For instance, to control inflation, monetary policy aims at high interest rates and tight money conditions with the object of reducing investment and expenditure; with the same end in view, fiscal policy aims at higher levels of taxation and surplus budgeting. To support the fiscal policy of compensatory spending monetary policy should maintain a low bank rate and thus bring about cheap money conditions in the country.

Monetary policy and Fiscal policy :A comparison

Both fiscal policy and monetary policy are formulated and implemented by the government, but through two different institutions – monetary policy through the central bank and fiscal policy through the finance ministry. Hence, the two policies are complementary and supplementary to each other.

Inflation & Unemployment

INFLATION - definitions

Too much currency in relation to the physical volume of business being done

Too much money chasing too few goods Prices rise due to an increase in the

volume of money as compared to the supply of goods

Abnormal increase in the quantity of money

Inflation

Keynes relates inflation to a rise in price level which comes into existence after the stage of full employment. Keynes states that the rise in prices up to the stage of full employment is a good thing for the country since there is an increase in output and also in employment. He differentiates two types of rises in price:

A. rise in prices accompanied by increase in production

B. rise in prices not accompanied by increase in production

Kinds of Inflation

DEMAND – PULL INFLATION This is caused by increased demand for

goods that are not accompanied by relative increase in supply of goods. Bottlenecks may prevent supply to increase commensurate with increase in demand. Increase in demand is essentially rapid economic development, rising private investment or high government expenditure.

Kinds of Inflation

COST – PUSH INFLATION Costs of production are essentially on

account of increase in wage rates (through trade union activities) or increased profit margins for the manufacturers. Higher taxation, profiteering, hoarding and speculating are the other causes for this type of inflation.

Kinds of Inflation

Sectoral Demand Shift Theory Inflation is confined to one sector of the

economy but because of the importance of this sector, the inflationary impulses percolate to other sectors also. Increase in agricultural prices, petroleum prices or tertiary sector prices will have a overbearing and overarching effect on all the other sectors of the economy. This concept also explains the simultaneous existence of inflation in one sector and deflation in another sector called “Stagflation”.

Consequences of inflation

On Production and Employment: Firms find it profitable to hoard rather than

produce and sell Agriculturists find it profitable to hold surplus

stocks in the hope of getting better prices Labour unions resort to strikes to enhance

wages which adversely affects production Beyond a certain stage, surplus stocks

accumulate, profits decline, investment, production, income and employment will fall.

Consequences of inflation

Distribution of income:a. Producing classes – producers, traders and

speculators gain during inflation because of windfall profits. Prices of goods rise much faster than costs of production as there is a time lag involved.

b. Fixed income groups – adversely affected as their income can buy less because of rising prices. The middle class and pensioners fall in this category

c. Working classes – as wages do not rise in proportion to rise in prices, the working classes suffer during an inflation. Though trade unions demand higher wages, there is a time lag between price hike and wage hike.

Control of inflation

Anti-inflationary measures are of four kinds:

1. Monetary policy

2. Fiscal policy

3. Price control and rationing

4. Other methods


1. Monetary policy – during inflationary times, money supply is reduced, interest rates are hiked, reserve ratios of banking system are increased and foreign exchange restrictions are placed on importers

2. Fiscal policy – inflation is sought to be curbed by lessening government expenditure, increasing tax rates, public debt management and mopping up operations of excess liquidity.


3. Price control and rationing – prices of critical, essential and inflation-sensitive commodities are controlled by the government. Further, to ensure equitable distribution of scarce commodities, the availability of goods are rationed to people.

4. Other methods – government may increase supply of goods through increased production and increased imports.

Deflation and Stagflation

Deflation is a situation where prices fall and adversely impact on income and employment. This is the opposite of inflation.

Stagflation is the simultaneous existence of inflation and deflation. It is typical of a mixed economy where certain sectors are stagnating while certain other sectors suffer inflationary trends.

Philips curve analysis

A W Philips identified an inverse relationship between the rate of unemployment and rate of increase in money wages through an empirical study of the UK economy. He found that :

a. When unemployment was high, the rate of increase in money wage rates was low.

b. When unemployment was low, the rate of increase in money wage rates was high.This trade-off is depicted in the succeeding graph

Philips curve

Umemployment %

Gro

wth

of

Mo

ney

Wag

es %

U1 U2 U3 PC

W3

W2

W1


Paul Samuelson and Robert Solow extended the Philips curve analysis to the relationship between the rate of change in prices and the rate of unemployment and concluded that there is a trade-off between the level of unemployment in a country and the rate of inflation. This is illustrated by the following graph:


Umemployment %

Rat

e o

f In

flat

ion

U1 U2 U3PC

P3

P2

P1

Trade Cycles

WC Mitchell – Business cycles are a species of fluctuations in the economic activities of organised communities. The word “Business” implies that these fluctuations are purely commercial and “Cycle” implies that these fluctuations occur regularly.

Keynes – A trade cycle is composed of periods of good trade characterised by rising prices and low unemployment percentage, alternating with periods of bad trade characterised by falling prices and high unemployment percentage.

Phases or stages of a trade cycle

In monetary jargon, the five phases of a trade cycle are identified as depression, reflation, full employment, disinflation and deflation.

a. Depression – Level of economic activity and price levels are very low. Profits cease to exist with mounting losses and unemployment. Interest, wages and profits are low. A period of great suffering, low income, heavy unemployment and utter pessimism.

b. Reflation – Depression gives place to recovery and revival of business activity. Demand for goods and services start rising as also the wages, interest and profits. Pessimism gives way to optimism. Employment and national income increase


c. Full employment – The recovery process culminates in the economy reaching full employment with optimum level of economic activity. There is all round economic stability in output, wages, prices and income.

d. Boom or inflation – Beyond full employment, investments will put pressure on men and material. Speculative investments create overcapacity for production and results in over employment of resources. Bank credit increases significantly. However, bottlenecks start showing up.

e. Recession – Over investment and over optimism during the boom period do not yield desired results because of full employment. Generally, a company or a bank will burst and puncture over optimism. During this phase, business expansion and credit are sharply curtailed. Unemployment and hoarding are on the incline. Stock markets crash and there is general economic gloom.


Number of Years

Lev

el o

f B

usi

nes

s A

ctiv

ity

Full Employment

Recession

Recession

Rec

over

y Rec

over

yBoo

mProsperity

National Income Accounting.ppt

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