What is national income accounts?It is an accounting frameworkIt 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 incomeThere are three approaches to measure

national income:

1. Product approach2. Income approach and3. Expenditure approach

All these three approaches give identical measurements of the amount of current economic activity.

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The product approachMeasures 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 approachMeasures 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 approachesOrange 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 orange 25000

Juice Co.’s sales value of juice 40000

Total Value added 35000 + 15000 = 50000

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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

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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

Market valueGoods 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 servicesWe 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 approachFour 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 continuedConsumption: 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 continuedNet 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 approachIt 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).

Subtracting Net Factor Payment with GNP we get GDP.20

Income approach continuedA 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)21

Note: GDP vs. GNPGDP = 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)22

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. + NFPPDI =Y – (T – TR – INT) + NFP

Where, Y = GDPNFP = net factor payments from abroadTR = 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 wealthTo 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 taka as 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 nationPrivate Savings = PDI – consumptionPrivate 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 = GNP – C – G

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Use of Private SavingsPrivate 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)

= I + CAPrivate Savings + Govt. savings = I + CA Private savings = I + CA – Govt. savings

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CA = current account balance

Savings and National WealthNational 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 GDPSo 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:

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Product

Year 1 price

Year 1 quantit

y

GDP of year 1

Year 2 price

Year 2 quantit

y

GDP of year 2

Rice 30 100 3000 40 100 4000If 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.

Note: Real GDPTo 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 GDPWe 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 indexAlthough 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.