National Income Accounting- NCERT Notes UPSC

Circular Flow of Income

It states that income in a simple economy flows in a circular loop, as follows:

• There is no government or the external sector (Foreign Firms) in this simple economic model.

• The households receive their income from the firms, for the services that they perform for the firms. 
• Households dispose of their entire earnings only in one way by spending it entirely on goods and services produced by the domestic firms (that is, households do not save anything).
• In other words, factors of production use their remunerations to buy the goods and services which they assisted in producing.
• Thus, the entire income of the economy, comes back to the producers in the form of sales revenue. 
• The firms again use this revenue to pay for factor services and thus the loop continues again.

Circular flow of income

Based on this concept, the aggregate value of goods and services can be calculated through various ways. 

Methods to Calculate Aggregate Value of Production

There are three methods to calculate the said value, that is: Product or Value-Added Method, Expenditure Method and Income Method. 

The Product Method

• It is also known as value-added method. 
• This method is used to calculate the aggregate value of goods and services produced by all the firms in an economy during a financial year.
• To calculate aggregate value of production, the value of intermediate goods is subtracted from the value of production of the firm.

Value Added by a firm = Value of production of the firm – Value of intermediate goods 

• Value of aggregate amount of goods and services produced by the economy can be measured by summing the gross value added of all the firms in an economy during a year and the value so obtained is the Gross Value Added (GVA)
• If Depreciation is reduced from GVA to account for the normal wear and tear of the Capital Factors of Production, it is said as Net Value Added (NVA).

 Expenditure Method

• It is an alternative method to calculate the GDP. 
• Under this method, the aggregate value of all goods and services produced in a year, are calculated by looking on the expenditure made by different sectors.
• In this method, following expenditures are added: 

• The final consumption expenditure made by the firms on the goods and services produced by other firms. 
• The households which undertake consumption expenditure on various goods and services. 
• The final investment expenditure incurred by other firms on the capital goods produced by a firm. 
• The expenditure (both consumption and investment) incurred by the government on the final goods and services produced by firm. 
• The export revenues that the firms earn by selling their goods and services abroad.

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Income Method

• The sum of final expenditures in the economy must be equal to the incomes received by all the factors of production taken together (final expenditure is the spending on final goods, it does not include spending on intermediate goods). 
• Revenues earned by the firms put together must be distributed among the factors of production (land, labour, capital and entrepreneurship) as salaries, wages, profits, interest earnings and rents. Let there be M number of households in the economy.
• Therefore, GDP under this method is obtained by adding up salaries, wages, profits, interest earnings and rents.  

Factor Cost, Basic Prices and Market Prices

• Net Production Taxes: Production taxes and subsidies that are paid or received in relation to production and are independent of the volume of production such as land revenues, stamp, and registration fee.

Net Production Taxes = Production Taxes – Production Subsidies.

• Net Product Taxes: Product taxes and subsidies, are paid or received per unit or product, e.g., excise tax, service tax, export and import duties etc. 

Net Product Taxes = Product Taxes – Product Subsidies.

• Factor cost: It includes only the payment to factors of production; it does not include any tax or subsidy.  
• Basic prices: In addition to the factor cost, they include the net production taxes but not net product taxes. 
• Market prices: Net Product taxes are added to the basic prices. (Market prices include both the Indirect Taxes.)

Some other Macro-Economic Identities

Gross Domestic Product

• It measures the aggregate production of final goods and services taking place within the domestic economy during a year. 

• Any citizen of India working abroad and earning wages will be included in the GDP of that particular country but not in the GDP of India. 
• However, citizens of India even work abroad and contribute to the Indian Economy from their earnings outside the Domestic Territory of India. 

Gross National Product (GNP)

• It measures the monetary value of all the finished goods and services produced by the country’s factors of production irrespective of their location. 

GNP ≡ GDP + Net factor income from abroad

• GNP = GDP + Factor income earned by the domestic factors of production employed in the rest of the world – Factor income earned by the factors of production of the rest of the world employed in the domestic economy. 
• Factor income earned by the domestic factors of production employed in the rest of the world – Factor income earned by the factors of production of the rest of the world employed in the domestic economy, is also called the Net Factor Income from Abroad (NFIA).

Net National Product (NNP)

• It is the net value of national output after subtracting depreciation.
• Depreciation is the certain amount of capital which is consumed due to wear and tear. It does not form the part of any one’s income and hence should be deducted to get a more accurate measure.

Net National Product (NNP) = Gross National Product (GNP) – Depreciation 

Personal Income

It is that part of the National Income, which is received by the households. Following amounts are to be adjusted for in the NI to obtain personal income: 

• Undistributed Profits (UP): The part of profit earned by the firms and government enterprises, which is not distributed to the factors of production. 
• Corporate Tax: Which is imposed on the earnings made by the firms and does not accrue to the households. 
• Net interest payments made by households: The interest paid by the households to the firms or the government for any past loan/borrowing of any kind taken by them, adjusted by any interest payment that the households may receive from the firms or the government. 
• Transfer payments to the households from the government and firms: Transfer payments that the households receive from government and firms (for example pensions, scholarship, prizes etc.)

Personal Income (PI) ≡ NI – Undistributed profits – Net interest payments made by households – Corporate tax + Transfer payments to the households from the government and firms.

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Personal Disposable Income

• It refers to personal income minus taxes at a personal level. 
• It measures the amount of net income that remains after households pay all their tax levies.
• The Personal Tax Payments (income tax etc.) and Non-tax Payments (such as fines etc.) are deducted from PI, and then we obtain what is known as the Personal Disposable Income. 

Personal Disposable Income = PI – Personal tax payments – Non-tax payments

National Disposable Income

• It is to give an estimate about the total amount of goods and services, that the domestic economy has at its disposal.

National Disposable Income = Net National Product at market prices + Other current transfers from the rest of the world. 

Other current transfers from rest of the world, include amounts received on account of gifts, aids, etc. 

Private Income

Private Income = Factor income from net domestic product accruing to the private sector + National debt interest + Net factor income from abroad + Current transfers from government + Other net transfers from the rest of the world.

Nominal and Real GDP

Real GDP 

• It is calculated in a way such that the goods and services are evaluated at some constant set of prices.
• As these prices remain fixed, the changes in Real GDP over different years are thus only when the real volume of production undergoes change. 
• It provides a more precise picture of a nation’s actual rate of economic growth. When calculating real GDP, a base year is selected to control for inflation; the real GDP figures capture the quantities of goods produced in different years using the prices from the same base year. 

Nominal GDP

• It is simply, the GDP which is calculated at the current prevailing prices in the market.
• It includes all of the changes in market prices that have occurred during the current year due to inflation or deflation. 
• The market price of GDP  

GDP Deflator

• It is the ratio of nominal GDP to real GDP. 
• This ratio gives us an idea that how prices in an economy have moved during the subsequent years (Nominal GDP), in relation to the prices of a base year, which are used to determine the Real GDP. 

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Consumer Price Index (CPI)

• It is another way to measure the change of prices in an economy. 
• Generally expressed in percentage terms, this is the index of prices of a given basket of commodities which are bought by the representative consumer.
• The price for the said basket of commodities is calculated for a pre-determined base year and compared to the price for the same basket of commodities in the current year. 
• The increase/decrease of prices in the current year over the base year is represented in percentage terms. 
• Like CPI, the index for wholesale prices is called Wholesale Price Index (WPI).

GDP and People’s Welfare

Generally, higher levels of GDP are understood as better prosperity and well-being for the people, residing in that economy. 

However, there are certain other factors to consider apart from just GDP growth: 

• Uniformity in Distribution of GDP: It is to be understood, that if the GDP rise is only concentrated in the hands of a few individuals/ firms, it may not mean increased prosperity for all the residents of a nation. 
• Non-monetary exchanges: Many productive activities, like the domestic services by the women at home, barter exchanges happening in the informal sectors etc. are not translated into monetary terms, and hence often not counted in GDP estimations of a country. This may lead to underestimation of GDP, not giving a clear idea about the productive activities and the well being of an country. 
• Externalities: Externalities refer to the benefits (or harms) a firm or an individual causes to another for which they are not paid (or penalised). 
• For example: During the course of manufacturing, an industry may pollute a local river or lake, impacting the fish in the waterbody and in turn hampering the catch that the fishermen may be able to obtain. GDP being an estimation of people’s welfare may be overestimated by not accounting for such negative externalities like pollution, environmental degradation etc. 

However, there may also be positive externalities. 

Interesting Points

• Final Goods:  Products which will not go through any further stages of production and are meant for final consumption.
• Intermediate Goods: Goods used as inputs in the manufacturing of other goods. (example: Steel sheets used in making automobiles). To estimate the value of output, the value of Final Goods in monetary terms is considered, as the value of Final Goods already include the value of all the inputs that have been consumed/used in their production. 
• Consumption Goods: Goods that are consumed as and when they are purchased by the ultimate consumer. Examples include:  Food, clothing, services like recreation etc.
• Capital Goods: Goods of durable character, used to facilitate the production process and to transform other goods but not get transformed themselves. (example: Machinery, Implements etc.)
• Consumer Durables: Goods meant for consumption, but do not get used up in a short term instead they have a long life and undergo normal wear and tear. (example: Television, Radio etc.)
• Flow Variables: Concepts that are defined over a period of time. (example: salary, profit etc. as they are defined for a particular period of time.)
• Stock Variables: Concepts that are defined at a particular point of time. (example: Buildings or Machines in a factory etc.)
• Gross Investment: That part of the final output that comprises of capital goods.
• Net Investment: New addition to capital stock in an economy. [Net Investment = Gross investment – Depreciation].
• Inventory (a Stock Variable): The stock of unsold finished goods, or semi-finished goods, or raw materials which a firm carries from one year to the next.

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