National Income A ccounts

1. National Income Accounts

2. What is national income accounts? • It is an accounting framework • It is used to measure current economic activity of a country

3. 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.

4. Methods to measure national income • There are three approaches to measure national income: • Product approach • Income approach and • Expenditure approach All these three approaches give identical measurements of the amount of current economic activity.

5. The product approach • Measures 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.

6. The income approach • Measures economic activity by adding all income received by producers of output. • Income received includes wages and profits.

7. The expenditure approach • Measures 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.

8. Equivalence of the three approaches

9. The product approach

10. The income approach

11. The expenditure approach

12. 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.

13. Gross Domestic Product (GDP): the most popular aggregate • 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

14. Market value • Goods 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

15. Newly produced goods and services • We 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?

16. 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 servicesin 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.

17. The expenditure approach • Four 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.

18. Expenditure approach continued • Consumption: 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?

19. Expenditure approach continued • Net 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.

20. Income approach • It 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.

21. Income approach continued

22. Note: GDP vs. GNP GDP = 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)

23. 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. + NFP • PDI =Y – (T – TR – INT) + NFP • Where, Y = GDP • NFP = net factor payments from abroad • TR = transfers from the govt. • INT = interest received by the private sector from the govt. • T = taxes and fees paid to the govt.

24. Note: Savings and wealth • To 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

25. Savings of the nation Private Savings = PDI – consumption Private 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

26. Use of Private Savings • Private 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 + CA Private Savings + Govt. savings = I + CA Private savings = I + CA – Govt. savings CA = current account balance

27. Savings and National Wealth • National 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.

28. Note: Nominal GDP • So 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: If 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.

29. Note: Real GDP • To 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.

30. Use of nominal and real GDP • We 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

31. Note: CPI may overstate cost of living index • Although 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.