NATIONAL INCOME ACCOUNTING

Economics may be defined as:

The science of how individuals and societies deal with the fact that wants
are greater than the limited resources available to satisfy those wants.

Microeconomics and Macroeconomics

Economics is studied on various levels. Microeconomics is the study of how households and firms make
decisions and how they interact in markets. Macroeconomics is the study of economy-wide phenomena,
including, but not limited to inflation, unemployment, and economic growth.

Microeconomics and macroeconomics are closely intertwined because changes in the overall economy
arise from the decisions of individual households and firms. Because microeconomics and
macroeconomics address different questions, they sometimes take different approaches and are often
taught in separate courses.

As a student of economics therefore, you must also develop competence in using the tools required for the
study of each branch. Interestingly enough, the distinction that we have just made between
microeconomics and macroeconomics does not necessarily extend to the analytical tools for studying
them. In fact, you will eventually find out that there is considerable similarity in the tools used.

Circular Flow Diagram – Closed Economy

Economists use economic models to explain the world around us. Most economic models are composed
of diagrams and equations. The goal of a model is to simplify reality in order to increase our
understanding. This is where the use of assumptions is helpful.

To understand how simple but unrealistic models can be useful, consider a road map. A road map is an
unrealistic representation of the real world. For example, it does not show where all of the stop-signs, gas
stations, or restaurants are located. It assumes that the earth is flat and two-dimensional. But, despite
these simplifications, a map usually helps travellers get from one place to another. Thus, it is a good
model.

Let us take a look at a model used in economics:

The Circular Flow Diagram – Closed Economy

An economy is said to be closed if it does not participate in international trade. Thus if an economy does
not import goods or export goods, the economy is said to be closed. The circular flow diagram we are
about to review represents a closed economy.

Figure 1.1 Model 1: The Circular Flow Diagram

 A Circular-flow diagram is a visual model of the economy that shows how dollars flow through markets
among households and firms. This diagram is a very simple model of the economy. Note that it ignores
the roles of government and international trade.

• There are two decision-makers in the model: households and firms.

• There are two markets: goods market and factor market.
• Firms are sellers in the goods market and buyers in the factor market.
• Households are buyers in the goods market and sellers in the factor market.
• The inner loop represents the flows of inputs and outputs between households and firms.
The outer loop represents the flows of dollars between households and firms. Figure 1.1 - Model 1:

This diagram describes all transactions between households and firms in a simple economy. It simplifies
matters by assuming that all goods and services are bought by households and that households spend all
of their income. In this economy, when households buy goods and services from firms, these
expenditures flow through the markets for goods and services. When the firms use the money they
receive from the sales of goods and services to pay workers’ wages, landowners’ rent, and firm owners’
profit, this income flows through the markets for factors of production. As illustrated in Figure 4.1,
money continuously flows from households to firms and then back to households.

Circular Flow Diagram – Open Economy

The Sectors of the Economy
We can define a sector of an economy as that part of the economy united by common needs and
functions. We have already seen the interactions of two sectors of the economy; the household sector and
the private sector in the simple circular flow diagram illustrated in Figure 1.1.

The simple circular flow diagram can be expanded to include other important features of the real world
such as the government and the foreign sectors. With these features we have added the flow of funds into
and out of the foreign and government sectors. For example, some households sell their labour services
to government rather than the private sector. In addition, some households receive money from
government in the form of welfare payments and social security; and part of the household’s income and
firm’s profits goes to the government in the form of taxes. Finally, some firms receive subsidies from
government and sell goods and services to foreigners (exports) while households import goods and
services from abroad. Figure 4.2 below is an illustration of a circular flow diagram with a government
and a foreign sector added:
Figure 4.2 The Expanded Circular Flow Diagram

Payments for Payment for

Exports Imports
Foreign Sector

Revenue MARKETS Spending

FOR
GOODS AND SERVICES
Goods and • Firms sell Goods and
services • Households buy services
sold bought

FIRMS HOUSEHOLDS
• Produce and sell goods • Buy and consume goods
and services and services
• Hire and use factors of • Own and sell factors of
production production

Factors of MARKETS Labour, land

production FOR FACTORS OF and capital
PRODUCTION
• Households sell Income
Wages, rent,
• Firms buy
and profit

- Flow of inputs and outputs

- Flow of dollars
Taxes Taxes

Subsidies Government
Transfer Payments
 The expanded circular flow diagram shows the interrelations of the four identified sectors of the
economy, that is, the inter-connections among the household, firms (business), government, and foreign
sectors, by illustrating the movement of funds among the sectors.

With the inclusion of the government and foreign sectors in the above diagram we have added the
following features or flows:

• Payments for imports by households to the foreign sector.

• Payments for exports by the foreign sector to the firms.

• Payment of taxes to government by both firms and households.

• Payment of subsidies by the government to firms.

• Welfare payments by government to households.

The Economy’s Income and Expenditure

To judge how well a person is doing economically, you might first look at his or her income. Persons
with high incomes can more easily afford life’s necessities and luxuries. Such people generally enjoy
higher standards of living—better housing, better health care, fancier cars, expensive vacations, etc.

A similar logic holds for a nation’s economy. It is also natural to look at the total income of a country to
determine whether it is performing well or poorly. The gross domestic product (GDP) of a country is the
statistic which allows us to make this determination.

GDP measures two things simultaneously: the total income of everyone in the economy; and the total
expenditure on the economy’s output of goods and services. The reason why GDP can measure total
income and total expenditure at the same time is that these two things are really the same. For an
economy as a whole, income must equal expenditure.

GDP measures this flow of money. We can compute it for this economy in one of two ways: (1) by
adding total expenditure by households or (2) by adding up the total income (wages, rent, and profit) paid
by firms. Because all expenditure in the economy ends up as someone’s income, GDP is the same
regardless of how we compute it.

Naturally, the actual economy is more complicated than the one illustrated in Figure 1.1. Households do
not spend all their income; they pay taxes, and they save some for the future. In addition, households do
not buy all the goods and services produced in the economy; some goods and services are bought by
governments, and some are bought by firms that plan to use them to help them produce their output. Yet,
regardless of who buys the good or service, the transaction has a buyer and a seller. Thus, for the
economy as a whole, expenditure and income are always the same.

The Measurement of Gross Domestic Product (GDP)

Gross Domestic Product (GDP) is the market value of all final goods and services produced within a
country in a given period of time. Let us consider each part of this definition more carefully.

“GDP is the market value...”: GDP adds together many different products into a single measure of the
value of economic activity. To do this, it uses market prices. Because market prices reflect the amount
people are willing to pay for different goods, they reflect the value of those goods.

“...Of all...”: GDP tries to be comprehensive. It includes all items produced in the economy and sold
legally in markets.

GDP includes the market value of the housing services provided in the economy’s housing stock. For
rental housing, the rent equals the tenant’s expenditure and the landlord’s income. Of course, many
people own the house they live in. The government includes this owner-occupied housing in GDP by
estimating its rental value. In essence, the owner is renting the house to himself. The imputed rent is
included in the homeowner’s expenditure and in his income, so it adds to GDP.
GDP excludes some products because measuring them is difficult. It excludes items produced and sold
illicitly, such as illegal drugs. It also excludes items produced and consumed that never reach the market
place, such as vegetables which you grow and consume at home (vegetables bought at the market are part
of GDP).

These exclusions can cause strange results. For example, John owns a landscaping business. If June pays
John to mow her lawn, that transaction is part of GDP. If June marries John, even though John continues
to mow June’s lawn, the value of mowing is now out of GDP because John’s service is no longer sold in
the market. Thus, when June marries John, GDP falls.

“...Final...”: When a good is produced and used in the production of another good or service, it is called
an intermediate good. For example, if PreConco makes concrete blocks which Hal’s Contracting uses to
build houses, then the concrete blocks are an intermediate good, and the houses are final goods. The
reason is that the value of the intermediate good is already included in the price of the value of the final
good. Adding the market value of the blocks to the market value of the houses would be double counting.
That is, it would incorrectly count the value of the blocks twice.

An important exception to this principle arises when an intermediate good is produced and rather than
being used, it is added to a firm’s inventory of goods for sale at a later date. In this case, the intermediate
good is taken to be “final” and its value as inventory investment is added to GDP. When the inventory is
later used or sold, the firm’s inventory investment is negative, and GDP for the latter period is reduced
accordingly.

“...Goods and Services...”: GDP includes both tangible goods (food, clothing, cars) and intangible
services (housecleaning, doctor visits, auditing).
“...Produced...”: GDP includes goods and services that are currently produced. It does not include
transactions that happened in the past. When a new car is bought, the value of the car is included in GDP.
When it is sold in the second hand market, its value is not included in GDP.

“...Within a Country...”: GDP measures the value of production within the geographic confines of a
country. When a Barbadian works temporarily in Antigua, his production is part of Antiguan GDP.
When a Trinidadian citizen owns a factory in Jamaica, the production of the factory is part of Jamaican
GDP. Thus, items are included in a nation’s GDP regardless of the nationality of the producer.

“...In a Given Period of Time.” GDP measures the value of production that takes place within a specific
interval of time. Usually, the interval is one year, or a quarter (three months). GDP measures the
economy’s flow of income and expenditure during that interval.

When the government reports GDP for a quarter, it usually represents GDP at an annual rate. This means
that the figure reported for quarterly GDP is the amount of income and expenditure during the quarter
multiplied by 4.

The definition outlined above focuses on expenditure. However, recall that we said that GDP measures
total income in the economy as well. The government also adds up the incomes of every factor of
production as well. The two methods give almost exactly the same answer. Although the two measures
should be precisely the same, data sources are not 100% accurate. The difference between the two
calculations of GDP is called the statistical discrepancy.

Components of GDP
Economists are interested in the composition of GDP among various types of spending. To do this, GDP
(Y) is divided into four components: consumption (C), investment (I), government expenditure or
spending (G), and net exports (NX):

Y = C + I + G + NX

This equation is called an identity—an equation that must be true because of how the variables are
defined. Because each dollar of expenditure included in GDP is placed into one of the four components
of GDP, the total of the four components must always be equal to GDP.

Consumption
Consumption is spending by households on goods and services. Goods include household spending on
durable goods, such as cars and appliances, and nondurable goods, such as food and clothing. Services
include intangible items such as haircuts, and medical care. Spending on education is also considered
consumption spending (some people argue that it would fit better into the next component).
Investment
Investment is the purchase of goods that will be used in the future to produce more goods and services. It
is the sum of purchases of capital equipment (such as machinery and computers), inventories, and
structures (such as housing).

Critically note, that GDP accounting uses the word investment differently from how the term is used in
everyday conversation. When you hear the word investment, you might think of financial investments,
such as stocks, bonds, and mutual funds (discussed in detail in Unit 5). By contrast, in a macroeconomic
context, investment means purchases of investment goods, including capital equipment, inventories, and
structures.

Government Expenditure
Government expenditure includes spending on goods and services by government. It includes the
salaries of government workers, and spending on public works.

Government spending on social security benefits, (for example, pensions and welfare) are called transfer
payments. Since such payments do not represent spending by government on a currently produced good
or service, they are not counted as part of the economy’s production and hence are excluded from the
measurement of GDP. Transfer payments include payments for non-productive uses and, as such, are not
included in GDP.

Net Exports
Net exports are calculated as the purchases of domestically produced goods by foreigners (exports; X)
minus the domestic purchases of foreign goods (imports; M):

NX = X - M

When X > M (exports exceed imports), NX is positive (Trade Surplus); and when X < M ( exports are
less than imports), NX is negative (Trade Deficit ).

Real vs. Nominal GDP

GDP measures total spending on all goods and services produced in an economy. If total spending rises
from one year to the next, one of two things must be true: (1) the economy is producing a large output of
all goods and services; or (2) the prices of goods and services are higher than before. Economists want a
measure of the total quantity of goods and services that is not affected by changes in the prices of those
goods and services.
To do this, economists use a measure called real GDP. Real GDP answers the hypothetical question:
What would be the value of the goods and services produced this year if we valued these goods and
services at the prices that existed at some specific year in the past? By evaluating current production
using prices that are fixed at past levels, real GDP shows how the economy’s overall production of goods
and services changes over time. To see this more clearly, let us consider the economy illustrated in Table
4.1, which produced only footballs and basketballs.

Table 4.1 Prices and Quantities of Footballs and Basketballs

Price of Quantity of Price of Quantity of

Year Basketballs
Footballs Footballs Basketballs
2005 $10 120 $12 200
2006 12 200 15 300
2007 14 180 18 275
To compute total spending in this economy each year, we would multiply the quantities of footballs and
basketballs by their corresponding prices. The production of goods and services valued at current prices
is called nominal GDP:

Nominal GDP in 2005 = ($10 × 120) + ($12 × 200) = $3,600

Nominal GDP in 2006 = ($12 × 200) + ($15 × 300) = $6,900
Nominal GDP in 2007 = ($14 × 180) + ($18 × 275) = $7,470

Total spending rises from $3,600 in 2005 to $6,900 in 2006 to $7,470 in 2007. Part of the increase each
year is due to increases in production and part is attributable to increases in the prices of footballs and
basketballs.

To obtain a measure that is not affected by the changes in prices, we use real GDP, which is the
production of goods and services valued at constant prices. We calculate real GDP by first choosing a
base year. We then use the prices of footballs and basketballs in the base year to compute the value of
goods and services in all the years.

Suppose we choose 2005 as the base year in our example. We then use the prices of footballs and
basketballs in 2005 and the quantities of footballs and basketballs in each year to calculate real GDP:

Using 2005 as the base year:

Real GDP in 2005 = ($10 × 120) + ($12 × 200) = $3,600
Real GDP in 2006 = ($10 × 200) + ($12 × 300) = $5,600
Real GDP in 2007 = ($10 × 180) + ($12 × 275) = $5,100

Table 4.2 Nominal vs. Real GDP

Price of Quantity of Price of Quantity of Nominal

Year Real GDP
Footballs Footballs Basketballs Basketballs GDP
2005 $10 120 $12 200 3,600 3,600
2006 12 200 15 300 6,900 5,600
2007 14 180 18 275 7,470 5,100
Note in Table 4.2 that nominal GDP and real GDP will be the same in the base year. In this example, you
see that it is possible for nominal GDP to increase (compare 2007 nominal GDP to 2006 nominal GDP)
while real GDP declines.

In summary, nominal GDP is measured using current prices while real GDP is measured using constant
base year prices. Because real GDP reflects only changes in the amounts of goods being produced, real
GDP is a better gauge of the economic well-being of an economy than nominal GDP.

The GDP Deflator

Using the statistics of nominal GDP and real GDP, we can compute a measure called the GDP deflator,
which reflects the prices of goods and services but not the quantities produced.

The GDP deflator is calculated as follows:

GDP Deflator = Nominal GDP *100

Real GDP
Because nominal and real GDP must be the same in the base year, the GDP deflator for the base year
must equal 100. The GDP deflator for subsequent years measures the change in nominal GDP from the
base year that cannot be attributable to change in real GDP; it measures the current level of prices relative
to the level of prices in the base year. Let us return to our examples in Tables 4.1 and 4.2 and compute
the GDP deflator as illustrated in Table 4.3 below.

GDP deflator for 2005 = ($3,600/$3,600) × 100 = 1 × 100 = 100

GDP deflator for 2006 = ($6,900/$5,600) × 100 = 1.2321 × 100 = 123.21
GDP deflator for 2007 = ($7,470/$5,100) × 100 = 1.4647 × 100 = 146.47

Table 4.3 Nominal GDP, Real GDP and the GDP Deflator

Price of Quantity of Price of Quantity of Nominal Real GDP

Year Footballs Footballs Basketballs Basketballs GDP GDP Deflator

2005 $10 120 $12 200 3,600 3,600 100

2006 12 200 15 300 6,900 5,600 123.21
2007 14 180 18 275 7,470 5,100 146.47

As illustrated in Table 4.3 above, we can say that the price level in 2006 increased by 23.21% compared
to the price level in 2005 and by 46.47% in 2007, also compared to the base year of 2005.

The GDP deflator is one measure that economists use to monitor the average level of prices in the
economy and thus the rate of inflation. The GDP deflator gets its name because it can be used to take the
inflation out of nominal GDP—that is, to deflate nominal GDP for the rise that is due to increases in
prices.
 Is GDP a Good Measure of Economic Well-being?
Earlier, it was said that GDP is the single best measure of the economic well-being of a nation. Let us try
to evaluate that claim.
GDP measures the economy’s total income and the economy’s total expenditure on goods and services.
Thus, GDP per person (capita) tells us the income and expenditure of the average person in the economy.
Because most people would prefer to receive higher income and enjoy higher expenditure, GDP per
capita seems a reasonable measure of the economic well-being of the average individual.

However, there are some very serious limitations to its use as a measure of economic well-being. GDP
says nothing about the household distribution of income. The manner in which income is distributed is
important in gauging poverty levels in an economy. Further, welfare relates to the quality of life rather
than simply the quantity of goods produced. Other limitations of using GDP as a measure of welfare are:

• It fails to indicate real improvements in welfare, which can occur through quality changes in goods and
services available for consumption.

• It ignores important elements of welfare such as illegal activity, crime, unemployment levels, leisure,
level of self-employment, and pollution.

• It is extremely difficult to have an accurate measurement of the level of subsistence activity in an

economy.

• There may be an inverse relationship between the growth in goods and services and the decline in
environmental quality. For instance, striving for improved GDP might result in significant negative
externalities (air and water pollution).

Despite these many shortcomings, a large GDP does in fact reflect economic well-being. This is because
most measures of well-being are highly correlated with large GDP. In the end, we can say that GDP is a
good measure of economic well-being, for many, but not all purposes. It is therefore important for you to
keep in mind what GDP includes and what it omits when you use GDP to measure national income/a
nation’s economic wellbeing.

National Income
In addition to GDP which was defined in Session 1, the following are other commonly used measures of
national income.

Gross National Product (GNP) is the total monetary value of all the goods and services produced by the
nationally owned factors of production. To move from GDP to GNP we subtract any income payments to
foreigners and add income payments from overseas operations. So, in contrast to GDP, which simply
measures the value of goods and services produced within the economy, GNP pays attention to the
ownership of factors of production—whether they are locally or foreign owned:

GNP = GDP - Income payments to foreigners + income payments from overseas operations

Per Capita Gross Domestic Product (per capita GDP) is GDP divided by the number of people in the
country/economy (population size). Thus

Per capita GDP = GDP / population

Per capita GDP is especially useful when comparing one country to another because it shows the relative
performance of the countries.

Net Domestic Product (NDP) is equal to GDP minus capital consumption or depreciation allowance.
That is:

NDP = GDP - Capital consumption allowance

Depreciation, another name for capital consumption allowance, is the reduction in the value of machines
and buildings because of wear and tear. As machines and buildings are used to produce output, they
become worn out and this represents an added cost of production that should be balanced against total
output. However, since machines and other capital goods lose value because of wear and tear at different
rates, accounting for how much machines in the economy has depreciated is an extremely difficult task.
Consequently, GDP or GNP is used as a measure of a nation’s output rather than NDP, which must
exclude depreciation.
Gross Domestic Capital Information (or Gross Investment) is the spending on fixed assets (vehicles,
machinery, buildings, etc.) either to replace worn out assets or to add to the stock of existing fixed assets.

Net Investment is the addition to a nation’s stock of existing fixed assets. To derive net investment we
subtract depreciation from gross investment. Hence:

Net Investment = Gross investment - Depreciation

GDP at Factor Cost (GDPFC). Factor cost is the cost at the point of production. GDP at factor cost
measures domestic output exclusive of indirect taxes (such as sales tax), since indirect taxes are levied on
transactions. However, producers could receive subsidies; hence subsidies could be included in the
GDPFC.

GDP at Market Prices (GDPMP). Market price valuation of output can include indirect taxes since
transactions would have taken place. GDPMP measures domestic output inclusive of indirect taxes on
goods and services.

It should be clear that to move from GDPMP to GDPFC, you should subtract indirect taxes and add
subsidies. To move from GDPFC to GDPMP, you add indirect taxes and subtract subsidies.
Net National Product at Factor Cost (NNPFC) is equal to GNPFC less depreciation. NNPFC measures the
amount of money the economy has available for spending on goods and services after setting aside
enough money to maintain its capital stock by offsetting depreciation.

Personal and Disposable Income

Two other important concepts in national income accounting are personal income and disposable income.

Personal income is the portion of national income that is received by the household sector. To arrive at
this we use the following formula:

Personal Income = National Income - Retained Business Earnings - Income received by Government

Hence, personal income shows the amount of national income that is received by individuals.

Disposable income refers to the income of individuals that is available for spending or saving. To arrive
at this we use the following formula:

Disposable Income = Personal Income - personal income taxes + transfer payments

Note that transfer payments are payments for services which do not stimulate economic activity (e.g., old
age pensions).