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National Income ing

Discipline Courses-I Semester-I Paper I: Principales of Economics(POE) Unit-III Lesson: National Income ing Lesson Developer: Rakhi Arora and Vaishali Kapoor College/Department: Rajdhani College, University of Delhi

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National Income ing Table of Contents: 1. Learning outcomes 2. Introduction 3. What is macroeconomics? 4. Measurement of GDP a. Various concepts of National Income b. The Circular Flow c. Expenditure approach to calculate GDP d. Income approach to calculate GDP 5. Real Vs Nominal GDP 6. Price Indexes 7. Summary 8. Exercises 9. Glossary 10. References

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National Income ing Learning outcomes: After you have read this chapter, you should be able to:a) Understand the various issues in an economy b) Define National Income c) List the various concepts of National Income d) Understand the flow of money in the economy e) Compute National Income through Expenditure and Income approach f) Differentiate between Real and Nominal GDP g) Acquaint with the GDP deflator and Consumer Price Index

INTRODUCTION Newspapers, these days, are full of headlines symptomatic of the worsened conditions of the global economy; which suggest that policy makers and economists have been worried about what form the ongoing global financial crisis will take, how all economies would be affected and whether all economies would emerge as gainers and take the lead? One needs to know, how economists predict these crises & their repercussions;how economists study the symptoms of any disturbance in the economy and provide the cure. Economists & researchers keep studying every economy with the help of various economic variables & economic tools at hand & economic data that is widely released in various newspapers journals & articles –mostly produced by government. These data /statistics are used to study the economy & policy makers use them to monitor the ongoing development processes in the economy &to formulate policies.

This chapter broadly covers the macroeconomic issues and the macroeconomic variablesin Section one. It discusses in Section two the Gross Domestic Product, GDP, – an indicator of the health of an economy and in Section three, it explains the meaning of Consumer Price Index,I, which represents the overall prices.

This chapter largely

focuses on the ing of National Income.

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National Income ing

WHAT IS MACROCONOMICS?

Macro Economics is the study of the structure and performance of national economies and of the policies that government‟s use to try to affect economic performance. The various macroeconomic issues are as follows: (i) Long Run Economic Growth This issue addresses why do some nations economies grow rapidly, providing their citizens with fast improving living standards, while other nation‟s economies remain stagnant. For Instance, in 1870 per capita income was smaller in Norway then in Argentine, but today per capita income is three times as high in Norway as in Argentina. India‟s GDP has been growing since 1950 as represented in figure1 and it has been impressive since 1990s because of the policy reforms adopted by Indian government.

National Income of India*( Rs. Cr) 8000000 7000000 6000000 5000000 4000000 3000000 2000000 1000000 0

1950-51 1960-61 1970-71 1980-81 1990-91 2000-01 2000-02 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12

National income of India Rs. Cr

Figure 1: National income of India from 1950 to 2012 Source: Statistical Outline of India 2012-13, TATA services ltd. *national income is calculated at factor cost with new base year of 2004-05

(i)

Business Cycle

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National Income ing Instead of growing at an ever rate at all times, economies tend to experience short-term ups & downs in their performance technically described as Business cycle. Why do economies experience such business cycles –recession for instance (fall in output) in 1990 and then exhibited recovery (rise in output), the longest period of uninterrupted economic growth in US economic history but economic performance in 2000 was much weaker. A mild recession in 2001 was followed by weak recovery that lasted only with December 2007. The recession that began at the end of 2007 was worsened by financial crisis in 2008, which contributed to a sharp decline in output at the end of 2008 and in early 2009. (ii)

Unemployment The important aspect of recessions is that they are usually accompanied by an increase inunemployment, which is measured by the key indicator of the economy‟s health- the unemployment rate. One needs to figure out the reason for high unemployment rates; sometimes even during relative prosperity times?

(iii)

Inflation

Many efforts have been devoted by the economists to identify the costs & consequences of even the moderate inflation.

The key questions that need to be

addressed are: who are Gainers & losers from inflation? What costs does inflation impose on society and their severity? What are the causes of inflation? What are the best ways to curb it? Figure 2 shows the behavior of consumer goods prices over time in India. They have been rising since 1950 and have doubled in the last decade owing to droughts, US crisis and recession.

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National Income ing

Consumer Price Index(2001 =100) I 250 200 150 100

Consumer Price Index(2001 =100) I

50

1950-51 1960-61 1970-71 1980-81 1990-91 2000-01 2000-02 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12

0

Figure 2: Consumer Price Index of India from 1950 to 2012 Source: Statistical Outline of India 2012-13, TATA services ltd.

(iv)

International Economy

This issue focuses on the economic links among nations – international trade & borrowings etc. that affect the performance of individual economies & world economy as a whole. The recent crisis affected the entire globe even when it originated in US as Sub Prime crisis. This shows that countries are linked by international trade and more so by financial flows.

(v)

Macroeconomic Policy How should economic policy be conducted so as to keep the economy‟s output, inflation, unemployment rate & other variables as stable as possible to avoid the major fluctuations which could risk the smooth functioning of the economy? The bailout package given to banks in US to lessen the impact or spread of crisis is one such example. The ongoing inflation in India is a matter of concern for RBI and they have been framing policies to keep the inflation low.

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National Income ing

MEASUREMENT OF GDP

The national income s are an ing framework used in measuring current economic activity. National Income s are set up in a way that mirrors the structure of the economy. Working through these s is a first important step towards understanding how the macro economy works.

The economic activity that occurs during a period of time can be measured in the following 3 ways: 1. The total output produced in the economy. 2. Income received by the producer of the output. 3. Total expenditure incurred by final consumers. All three approaches portray the identical picture of the economy.

The money value

computed from either of the above ways is technically known as National income of the economy. VARIANTS OF GDP Several variants of measuring economic activity are as follows:1. Gross Domestic Product (GDP) GDP is the market value of all final goods and services produced by normal residents as well as non-residents in the domestic territory of a country in a year. It includes the market value of only final goods and ignores intermediate goods to avoid the problem of double counting (i.e.) to count all goods and services produced in any given year only once. GDP= C+I+G+NX Where,

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National Income ing C= Value of final consumer goods and services produced in a year and consumed by households. I= Purchase of capital goods by Producing sector (Addition to physical stock of capital or stock) G= Net expenditure made by Government (Government purchase of goods and services) X-M= Net Exports i.e. the difference between foreign spending on domestic goods and domestic spending on foreign goods (i.e.) NX=Exports-Imports 2. Gross National Product (GNP) It is defined as the total market value of all final goods and services produced in a year by normal residents of a country. These residents may be national or nonnational companies having their set up plants in India. It is calculated by adding net factor income from abroad in GDP. GNP=GDP+NFIA Where, NFIA is the difference between factor income received from abroad by normal residents of India for rendering factor services in other countries and the factor incomes paid to the foreign residents for factor services rendered by them in the domestic territory of India. 3. Net Domestic Product (NDP) The capital goods wear out or fall in value as a result of its consumption or use in the production process. This consumption of fixed capital or fall in the value of fixed capital due to wear and tear is called depreciation. So this depreciation is to be deducted from GDP to get NDP. Therefore,NDP is the net market value i.e. after providing for depreciation, all final goods and services produced by normal residents as well as non-residents in the domestic territory of a country in a year. Therefore,

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National Income ing NDP= GDP-Depreciation

Exhibit 1: Relation between various measures of economic activity 4. Net National Product (NNP) It refers to the market value of goods and services produced by normal residents of a country in a year after providing for depreciation. It is also known as National income at market price. NNP= GNP-Depreciation Or NNP= GDP-Depreciation+ NFIA

5. Net National Product at Factor Cost (NNP fc) Conceptually NNP at MP and NNP at FC are supposed to be identical - as the value of final goods and services at market price is nothing but the sum total of factor cost involved in their production as production process is the combined efforts of various factors of production namely land, labour, capital and enterprise. NNPfc is also called National Income, as it is the sum of all incomes earned by factors of production for their contribution of land, labour, capital and entrepreneurial ability in the year‟s net

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National Income ing production. It is calculated by deducting indirect taxes and adding subsidies to the national income at market price as indirect taxes lead to increase the market price as compared to factor cost and subsidies lead to decrease the market price as compared to the factor cost. NNP fc= NNPmp- Net Indirect Taxes Net Indirect Taxes= Indirect taxes-Subsidies

THE CIRCULAR FLOW DIAGRAM A useful way to study the economic interactions among the four sectors in the economy is through a circular flow diagram, which shows the income received and payments made by each sector. The phenomenon of three methods of measurement of national income giving identical results can be shown diagrammatically through the circular flow of money in the economy.

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National Income ing

Exhibit 2: Circular Flow Diagram Let‟s analyze the circular flow step by step. Households provide their services to the firms and government and in return they get wages. The circular flow diagram above shows the flow of wages in the household sector as a compensation for their services. Interest on corporate and government bonds and dividends from firms is another receipt of the households. Social security benefits, veterans‟ benefits, and welfare payments are also received by some of the households from the government. These kinds of payments from the government for which the recipient does not supply any good/service/labor are called as Transfer Payments. All these receipts constitute the total income received by the households. Households pay out by purchasing goods/services from the firms and by giving taxes to the government. These components constitute the total payments by the households. The

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National Income ing gap between the total receipts and total payments of the households is whatthey save/dissave. Savings are categorized as a „leakage‟ from the circular flow as they withdraw the current income/purchasing power from the system. Goods/services are sold to the households and the government by the firms. Revenues are generated by these sales which are shown as a flow into the firm sector in the diagram above. Wages, interest and dividends are paid by the firms to the households and taxes are paid by the firms to the government. These expenses are shown as flows out of the firm sector. Taxes are collected by the government from the households and the firms. Government makes payments also by purchasing goods /services from the firms, paying wages and interest to the households, and by making transfer payments to the households. Households expend part of their income on imports and rest on domestically produced goods/services.

THE EXPENDITURE APPROACH TO MEASURING GDP

GDP can be obtained by adding up the four major categories of expenditures of national income s- Consumption, Investment, Government purchases of goods/services, net exports of goods/services. According to the expenditure approach, GDP is measured as the total spending on the final goods/services produced in the nation during a specified period of time of the national income. Symbolically, GDP can also be obtained by Y= GDP=total production (or output) = total income =total expenditure; C=

consumption;

I=

investment;

G=

Government purchases of goods and services;

NX = net exports of goods and services.

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National Income ing With these symbols, we express the expenditure approach to measuring GDP as Y=C+1+G+NX.

1. Consumption. The expenditure on the final goods/services by the domestic households including on those produced abroad is called as Consumption. It happens to be the principal component of expenditure and it ed for 56% of the Indian GDP in 2010. The expenditures on consumption can be broadly categorized as follows: a) Consumer durables, which are long-lived consumer items such as cars, televisions, furniture, and major appliances (but not houses, which are classified under investment) b) Non-Durable goods, which are shorter lived items such as food, clothing, and fuel; and c)

Services, such

as

education, health

care, financial

services, and

transportation etc.

2. Investment Investment includes both spending for new capital goods, called fixed investment, and increases in firms, inventory holding, called inventory investment. Investment, in India, ed for 37% of GDP in 2010. Fixed investment in turn has two major components. a) The expenditure by the businesses on equipments such as vehicles, computers, machines and furniture, structuressuch as office building, warehouses and factories and software by the businesses is called as Business fixed investment. b) The expenditure on the construction of new houses and apartment building is usually called as the Residential investment. These apartment buildings and houses are considered as the capital goods as they provide shelter (service) over a long period of time.

3. Government purchases of goods and services

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National Income ing

The third major component of expenditure is the government‟s spending on currently produced goods/services- Foreign as well as domestic. It ed for 11% of Indian GDP in 2010. Government also makes payments in the form of transfers, which are not made in exchange for current goods/services. Transfers can take the forms of social security and Medicare benefits, unemployment insurance welfare payments, and so on. Transfers are not counted in GDP according to the expenditure method as they are excluded from the government purchases category. In the similar way, interest payments on national debt are also expelled from the government purchases category. Much like the distinction between private-sector consumption and investment some part of government purchases s for current needs (such as employee salaries) as some is devoted to acquiring capital goods (such as office buildings).

Exhibit 3: Components of Total Spending

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National Income ing

4. Net Exports Net exports are exports minus imports. Exports are the goods and services produced within a country that are purchased by foreigners. . It is about 22% of GDP in 2010 in India. Imports are the goods and service produced abroad that are purchased by a country‟s residents, which was about 26% of GDP in 2010 in India. Net exports are positive if exports are greater than imports and negative if imports exceed exports. Exports are added to total spending because they represent spending (by foreigners) on final goods and services produced in a country. Imports are subtracted from total spending because consumption, investment, and government purchases are defined to include imported goods and service. Subtracting imports ensures that total spending C+I+G+NX, reflects spending only on output produced in the country.

THE INCOME APPROACH TO MEASURING GDP

According to the Income Approach, National Income is the summation of eight types of income. It totals the income received by the producers inclusive of the profits and the taxes payment to the government. The eight components are as follows: 1. Compensation of employees-The income of the workers excluding the self employed and including the wages, salaries, employee benefits (inclusive of the contributions by employers to pension plans) and employer contributions to social security constitute the Compensation of Employees. Compensation of employees happens to be the principal component of national income, which ed for 55.7% of GDP in 2008. 2. Proprietors’ income- Proprietors‟ income is the income of the unincorporated selfemployed. Because many self-employed people own some capital (for example, a farmer‟s tractor or a dentist‟s X-ray machine), proprietor‟s income includes both labor income and capital income. Proprietor‟s income was 7.7% of GDP in 2008.

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National Income ing 3. Rental income of persons-It is basically the income earned by the individuals owning land/ structures that they rent to others. It is an insignificant component of income and broadly covers various miscellaneous incomes such as royalty income paid to authors, recording artists and others. Rental income of persons was about 1.5% of GDP in 2008.

4. Corporate profits-The earnings of the corporations are called as the corporate profits. It represents the residue of the corporate revenue after the payments of wages, interests, rents and other costs. These corporate profits are used to pay corporate income tax and dividends to the shareholders. The remaining corporate profits after these two payments are called as the retained earnings and are kept by the corporations. 5. Net interest-Net interest is interest earned by individuals from businesses and foreign sources minus interest paid by individuals. Net interest has varied from 4% to 8% of GDP each year over the past 25 years.

6. Taxes on production and imports-It includes indirect business taxes such as sales tax and excise taxes that are paid by businesses central to state, and local governments, as well as customs duties and taxes on residential real estate and motor vehicle licenses paid by households. These taxes have averaged about 7% of GDP for the past 25 years. 7. Business current transfer payments (net)- Business current transfer payments are payments made by businesses to individuals or governments or foreigners, but not for wages or taxes or as payment for services. Instead such transactions as charitable donations insurance payments are covered by this category of income. Business current transfer payments have been between 0.5% and 0.9% of GDP each year for the past 25 years.

8. Current surplus of government enterprises- Current surplus of government enterprises is essentially the profit of businesses that are owned by governments.

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National Income ing

In addition to the eight components of national income just described, three other items need to be ed for to obtain GDP:  Statistical discrepancy;  Depreciation; and  Net factor payments.

REAL VS NOMINAL GDP GDP, measured in rupee , is sum of value of the output produced in the economy, i.e. sum of product of prices of different commodities produced and their respective quantities. Nominal GDP = ∑piqi Where, pi= price of the ithcommodity qi= quantity of the ithcommodity The value of goods/services measured at current prices is usually called as nominal GDP by the economists. Nominal GDP is not capable of reflecting accurately as to how well an economy is able to satisfy the demands of households, firms and the government. If only all the prices double and the quantities remain unchanged, then accordingly GDP would double. But it would be misleading to state that the ability of the economy to satisfy the demands has doubled as the quantities of every good-produced remains unchanged. A better and more reliable measure to monitor the economy‟s well-being would be one that would not be influenced by the changes in prices. Henceforth, real GDP is used by the economists. Real GDP is the measurement of the value of goods/services using a constant set of prices, i.e., it would tell us the affect on expenditure on output when only quantities change and prices don‟t. A real variable is an economic variable that is measured by the base year prices. The physical quantity of the economic activity is measured by the real economic variables. Real GDP measures the physical volume of an economy‟s final production, using the base year prices. Nominal GDP measures the value of an economy‟s final output, using the current market prices.

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National Income ing

PRICE INDEXES

A measure of the average level of prices for some specified set of goods/services relative to the prices in a specified base year is called as the Price Index. For instance, a GDP deflator is a price index, which measures the overall level of goods/services included in GDP. It is defined as follows: Real GDP= nominal GDP/ (GDP deflator/100) The GDP deflator (divided by 100) is the amount by which nominal GDP must be divided, or” deflated” to obtain real GDP. In our example, we have already computed nominal GDP and real GDP, so we can now calculate the GDP deflator by rewriting the preceding formula as: GDP deflator = 100X nominal GDP/real GDP.

The Consumer price Index

GDP deflator deals with the average level of prices of goods/services that are included in GDP. The I, Consumer Price Index, is available monthly. The Bureau of labor Statistics constructs the I by sending people out each month to find the current prices of a fixed list, or “basket” of consumer goods and services, including many specific items of food, clothing, housing, and fuel. The I for the month is then computed as: 100*(Current cost of a basket of consumer items)/ (cost of the same basket of items in reference base period).

SUMMARY



Macroeconomics deals with understanding and providing solutions to inflation, high unemployment, long run economic growth, business cycles and dynamics of international economy.

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National Income ing 

National income of the economy can be computed by either adding the expenditure incurred by the residents in a year or by adding everybody‟s income. Either of the two sums will yield same result as income of one person is expenditure of the other and vice a versa.



Computations could be made easy by ing following equations: 1. Net + CFC = Gross 2. EC+ NIT = MKT Price 3. Domestic + NFIA = National



In expenditure method, national income is computed by adding consumption (C), government expenditure (G), investment (I) and net exports (NX) in a given ing year.



While calculating national income by income method, following components are added:Compensation of employees, Proprietors‟ income, Rental income of persons, corporate profits, Net interest, Taxes on production and imports, Current surplus of government enterprises, and Business current transfer payments (net).



Real economic variables deal with the physical quantity of the economic activity using base year prices. For example, real GDP is at constant prices i.e. it measures physical production of this year at base year prices. In contrast, nominal GDP is current rupee- GDP i.e. rupee value of an economy‟s final output, measured at current market prices.



A price indexmeasures theaverage level of prices of a basket of goods/services relative to the prices of the same basket in a specified base year.

EXERCISES

SHORT ANSWER QUESTIONS

Q1. Which of the following items will be included while calculating GDP of India? Why and why not? a. Mohan purchased a computer worth Rs.30, 000. b. Shyam bought a second hand scooter worth Rs. 25,000. c. Sunita bought furniture manufactured in Hongkong worth Rs. 1, 00,000.

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National Income ing Q2. Fill in the blanks: a. NNPfc+ …………....= NNPmp b. NNPmp - ……...........= NDPmp c. GNPfc + NIT – CFC = ………

LONG ANSWER QUESTIONS

Q1. What are major macroeconomic issues that each economy has to deal with? Explain it with reference to Indian scenario. Q2. What are the approaches to measuring economic activity? Why do they give same answer? Q3. List all the components of total spending. Why imports are subtracted when GDP is computed in the expenditure method? Q4. “For assessing growth performance of an economy real GDP is a better measure”. Comment.

NUMERICALS

Q1. Calculate national income from expenditure method and gross domestic product at factor cost by income method: a. Government final consumption expenditure

100

b. Gross fixed capital formation

310

c. Operation surplus

800

d. Change in stock

50

e. Exports

40

f. Net factor income from abroad

-10

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National Income ing g. Subsidies

20

h. Consumption of fixed capital

20

i. Imports

50

j. Compensation of employee‟s

300

k. Mixed income of self employed

30

l. Indirect taxes

120

m. Private final consumption expenditure

800

Q2. Calculate Gross National Product at market prices from the following data? a. Consumption of fixed capital

10

b. Value of output in primary sector

100

c. Value of output in secondary sector

150

d. Gross value added at market prices in the tertiary sector

150

e. Net exports

10

f. Net indirect taxes

10

g. Value of intermediate consumption in (i) Primary sector

40

(ii) Secondary sector

50

(iii) Tertiary sector

60

h. Net factor income from abroad

-5

Q3. Calculate national income and GDPmp from given data? a. Mixed income

64,448

b. Gross profit

12,000

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National Income ing c. Consumption of fixed capital

8,868

d. Compensation of employees

53,452

e. Indirect taxes

15,456

f. Interest

4,000

g. Rent

4,176

h. Net factor income from abroad

-1,136

i. Subsidies

1,348

Q4. From the following data, calculate national income and gross domestic product: a.

Compensation of employees

680

b. Depreciation

136

c.

120

Employer‟s contribution to social security

d.

Profit

100

e. Interest

80

f. Rent

40

g. Royalty

20

h.

152

Net indirect taxes

i. Net factor income from abroad

-12

Q5. Consider a three good economy and for this economy then, calculate nominal GDP for year 1 and year 2 and real GDP for year 2 from the following given information: PRODUCTION YEAR1 (Q1)

PRICE PER UNIT YEAR 2

YEAR 1

YEAR 2(P2)

(Q2)

(Rs)

(Rs)

GOOD A

6

11

5

4

GOOD B

7

4

3

10

GOOD C

10

12

7

9

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National Income ing Also calculate, GDP deflator.

GLOSSARY 

Macroeconomics: Macro Economics is the study of the structure and performance of national economies and of the policies that government‟s use to try to affect economic performance.



National Income: National Income is the sum of all incomes earned by factors of production for their contribution of land, labour, capital and entrepreneurial ability in the year‟s net production.



Consumption of Fixed capital: The capital goods wear out or fall in value as a result of its consumption or use in the production process is known as Consumption of Fixed Capital.



Net Factor Income from Abroad:NFIAis the difference between factor income received from abroad by normal residents of India for rendering factor services in other countries and the factor incomes paid to the foreign residents for factor services rendered by them in the domestic territory of India.



Real GDP:Real GDP is the physical quantity produced in an economy in a given ing year measured as (production of current year) x (prices of a base year).



Nominal GDP:Nominal GDP is the value of production in an economy in a given ing year measured as (production of current year) x (prices of current year).



GDP Deflator:The GDP deflator (divided by 100) is the amount by which nominal GDP must be divided, or” deflated” to obtain real GDP.



I:I measuresthe current cost of the basket of consumer items divided by the cost of the same basket of items in the reference base period.

Refernces 1. N. Gregory Mankiw, Economics: Principles and Applications, India edition by South Western, a part of Cengage Learning, Cengage Learning India Private Limited, 4th edition, 2007. 2. Andrew B. Abel and Ben S. Bernanke, Macroeconomics, Pearson Education, Inc.7th edition, 2011. 3. http://data.worldbank.org/indicator/NE.CON.PETC.ZS

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National Income ing 4. Statistical Outline of India 2012-13, TATA services ltd.

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