Chapter 2-measuring national economic activity for BBA

Chapter 2Chapter 2Chapter 2Chapter 2

Measuring National Measuring National Economic ActivityEconomic Activity

The concept of national accounts

• National income refers to the total income of the nation in a particular period of time.

• National income data reveals the aggregate economic performance of the economy as a whole.

• National income represents a receipts total, an expenditure total, and the total value of production

• Since one man’s income is another man’s expenditure and each commodity is sold at its market price, national income accounting is based on the fundamental three fold identity: the value received equals, the value paid equals, the value of goods and services given in exchange

• Thus, National income=National expenditure =National product

National accounts: What do economists say

“ The labor and capital of a country acting on natural resources, produce annually a certain net aggregate of commodities, material and immaterial including services of all kinds…. This is the true net annual income or revenue of the country or national dividend.” Alfred Marshall

Features:• All outputs whether they come to market or not,

and • Income from abroad should be added in the

national incomeLimitations:• Difficult to have correct estimate • Possibility of double counting


“ National income is that part of objective income of the community, including of course income derived from abroad, which can be measured in money.” A.C. Pigou

Features:• Includes only goods and services measured in money• Income received on investment from abroad included• Precise, convenient and workable Limitations:• Makes an artificial distinction between outputs

measured for money and not measured on that• Difficult to apply in countries dominating barter

system


“ The national dividend/income consists solely of services as received by ultimate consumers, whether from their material or from their human environments. Thus, a piano, or an overcoat made for me this year not a part of this years income, but in addition to the capital. Only the services rendered to me during this year by these things are income.” Irving Fisher

Features:• Emphasizes on welfareLimitations:• Difficult to have an estimate of net consumption than

of net production• Difficult to measure the value of services rendered

by durables

National accounts: Concepts

• The national income accounting refers to the measurement of aggregate economic activity, particularly national income and its components such as Gross Domestic Product (GDP), Net Domestic Product (NDP), Gross National Income (GNI), Net National Income (NNI), Personal Income (PI), and Disposable Income (DI).

• National income accounting was first developed by Simon Kuznet during the great depression of 1930s.

Gross Domestic Product

• GDP is the total value of all final goods and services-bread, rice, wheat, healthcare, concert etc-produced in a country during a period, usually a year.

• Hence, GDP is the total value of goods and services produced within the territorial boundary of the nation irrespective of who owns the factors of production.

Gross Domestic Product: Expenditure

and Income• Two definitions:

– Total expenditure on domestically-produced final goods and services.

– Total income earned by domestically-located factors of production.

Expenditure equals income because every dollar spent by a buyer

becomes income to the seller.

Expenditure equals income because every dollar spent by a buyer

becomes income to the seller.

The Circular Flow

Households Firms

Goods

Labor

Expenditure ($)

Income ($)

Residents/Nonresidents • Residents means: Center or territory of

economic interest. • Nepalese citizens performing economic

activities in Nepal, • Firm, company, and partners registered in

Nepal• Foreign citizens and firms involved in economic

activities for more than one year in Nepal• Nepalese citizens, firm, company, partnership,

and institutions operating for less than one year in foreign land.

Residents/Nonresidents• Non-resident means: • Foreign citizens, firm, company, partnership

firm, and institutions operating in Nepal for less than one year.

• Nepalese citizens, firm, company, partnership, and institutions operating for more than one year in foreign land.

• Diplomatic missions, foreign military offices, and their employees even if they are operating for more than one year in Nepal.

Residents/Nonresidents• This classification of resident and non-

resident is usually helpful in figuring out the net factor income from abroad (NFIA):

• Income earned by residents and domestically owned capital is added to the GDP and income earned by non-residents and capital owned by foreigners is deducted. This gives NFIA.

Sectors of the economy• Households:• Enterprises• Government• External

Sectors of the economy• Households: sell land, labor, and capital on

various factor markets and buy goods and services in the market for products, but they may also work as producers by forming or owning enterprises. Households make decisions about how much to spend on consumer goods and services, how much to save, and how to allocate their savings as holdings of alternative financial and real assets (cash on hand, bank saving deposits, bonds, home ownership, and so forth).

Sectors of the economy• Enterprises: employ factors of

production such as land, labor and capital to produce goods and services for the products market. They make production, pricing, hiring, and investment decisions with a view to maximizing their profits.

Sectors of the economy• Government: The government's

economic role involves creating an effective regulatory and legal framework, providing certain public goods such as education, infrastructure, and a social safety net; overseeing the tax system, and managing government expenditures.

Sectors of the economy• Financial Sector: provides financial

intermediation services for the economy. It includes all entities whose main activity involves supplying assets to savers (such as households) while lending at a different maturity to borrowers (such as enterprise). The financial sector includes commercial banks, credit unions, savings and loan associations, investment banks, pension funds, and insurance companies.

Sectors of the economy• External: Nonresidents make up

the external sector of economy, also referred to as the rest of the world.

Circular flow of income

Final goods, value added, and GDP

• GDP = value of final goods produced = sum of value added at all stages

of production.

• The value of the final goods already includes the value of the intermediate goods, so including intermediate and final goods in GDP would be double-counting.

The expenditure components of GDP

• consumption• investment• government spending• net exports

Consumption (C)– durable goods

last a long time ex: cars, home appliances

– nondurable goodslast a short time ex: food, clothing

– serviceswork done for consumers ex: dry cleaning, air travel.

definition: The value of all goods and services bought by households. Includes:

Investment (I)Definition 1: Spending on [the factor of production] capital.Definition 2: Spending on goods bought for future useIncludes:– business fixed investment

Spending on plant and equipment that firms will use to produce other goods & services.

– residential fixed investmentSpending on housing units by consumers and landlords.

– inventory investmentThe change in the value of all firms’ inventories.

Investment vs. CapitalNote: Investment is spending on new capital.

Example (assumes no depreciation): – 1/1/2006:

economy has $500b worth of capital

– during 2006:investment = $60b

– 1/1/2007: economy will have $560b worth of capital

Government spending (G)• G includes all government spending on

goods and services. Includes such items as national defense, expenditures, cost of road-paving by state and local governments, and salaries of government employees.

• G excludes transfer payments (e.g., unemployment insurance payments), because they do not represent spending on goods and services.

Net exports= Exports-Imports• Exports represent foreign spending on

our country’s output, so we include exports.

• Imports represent the portion of domestic spending (C, I, and G) that goes to foreign goods and services, so we subtract off imports.

• NX, therefore, equals net spending by the foreign sector on domestically produced goods & services.

Net exports: NX = EX – IM

def: The value of total exports (EX) minus the value of total imports (IM).

U.S. Net Exports, 1950-2006

-800

-600

-400

-200

0

200

1950 1960 1970 1980 1990 2000

billi

ons

of d

olla

rs

-8%

-6%

-4%

-2%

0%

2%

perc

ent

of G

DP

NX ($ billions) NX (% of GDP)

An important identityY = C + I + G + NX

aggregate expenditurevalue of

total output

A question for you:Suppose a firm

• produces $10 million worth of final goods

• but only sells $9 million worth.

Does this violate the expenditure = output identity?

Why output = expenditure

• Unsold output goes into inventory, and is counted as “inventory investment”……whether or not the inventory buildup was intentional.

• In effect, we are assuming that firms purchase their unsold output.

GDP: An important and versatile concept

We have now seen that GDP measures– total income

– total output

– total expenditure

– the sum of value-added at all stages in the production of final goods

GNP vs. GDP• Gross National Product (GNP):

Total income earned by the nation’s factors of production, regardless of where located.

• Gross Domestic Product (GDP):Total income earned by domestically-located factors of production, regardless of nationality.

(GNP – GDP) = (factor payments from abroad)

– (factor payments to abroad)

GNP vs. GDP• Emphasize that the difference b/w GDP and GNP

boils down to two things:• location of the economic activity, and ownership

(domestic vs. foreign) of the factors of production. • If you take the example of the US• From the perspective of the U.S., factor

payments from abroad includes things like: wages earned by U.S. citizens working abroad

profits earned by U.S.-owned businesses located abroadincome (interest, dividends, rent, etc) generated from the foreign assets owned by U.S. citizens

GNP vs. GDP• If you take the example of the US• Factor payments to abroad includes

things like:wages earned by foreign workers in the U.S.profits earned by foreign-owned businesses located in the U.S.income (interest, dividends, rent, etc) that foreigners earn on U.S. assets

• Remember, factor payments are simply payments to the factors of production, for example, the wages earned by labor.

Discussion question:

Which would you want to be bigger, GDP, or GNP?

Why?

(GNP – GDP) as a percentage of GDP

selected countries, 2002U.S.A. 1.0% Angola -13.6 Brazil -4.0 Canada -1.9 Hong Kong 2.2 Kazakhstan -4.2 Kuwait 9.5 Mexico -1.9 Philippines 6.7 U.K. 1.6

U.S.A. 1.0% Angola -13.6 Brazil -4.0 Canada -1.9 Hong Kong 2.2 Kazakhstan -4.2 Kuwait 9.5 Mexico -1.9 Philippines 6.7 U.K. 1.6

Real vs. nominal GDP• GDP is the value of all final goods

and services produced. • nominal GDP measures these

values using current prices. • real GDP measure these values

using the prices of a base year.

Practice problem, part 1

• Compute nominal GDP in each year.

• Compute real GDP in each year using 2006 as the base year.

2006 2007 2008

P Q P Q P Q

good A

$30 900 $311,00

0$36

1,050

good B

$100 192 $102 200 $100 205

Answers to practice problem, part 1

nominal GDP multiply Ps & Qs from same year

2006: $46,200 = $30 900 + $100 192

2007: $51,400

2008: $58,300

real GDP multiply each year’s Qs by 2006 Ps

2006: $46,200

2007: $50,000

2008: $52,000 = $30 1050 + $100 205

Real GDP controls for inflation

Changes in nominal GDP can be due to:– changes in prices. – changes in quantities of output produced.

Changes in real GDP can only be due to changes in quantities, because real GDP is constructed using constant base-year prices.

Real GDP controls for inflation

•Suppose from 2006 to 2007, nominal GDP rises by 10%. Some of this growth could be due to price increases, because an increase in the price of output causes an increase in the value of output, even if the real quantity remains the same. •Hence, to control for inflation, we use real GDP. Remember, real GDP is the value of output using constant base-year prices. If real GDP grows by 6% from 2006 to 2007, we can be sure that all of this growth is due to an increase in the economy’s actual production of goods and services, because the same prices are used to construct real GDP in 2006 and 2007.

GDP Deflator• The inflation rate is the percentage

increase in the overall level of prices.• One measure of the price level is

the GDP deflator, defined as

Nominal GDP

GDP deflator = 100Real GDP

GDP Deflator• the GDP deflator. • The GDP deflator is so named because it is

used to “deflate” (remove the effects of inflation from) GDP and other economic variables.

• Nominal = Pt * Qt• Real = Pb*Qt• Nominal/Real = Pt/Pb in base year = 100.

Practice problem, part 2

• Use your previous answers to compute the GDP deflator in each year.

• Use GDP deflator to compute the inflation rate from 2006 to 2007, and from 2007 to 2008.

Nom. GDP Real GDPGDP

deflatorInflation

rate

2006 $46,200 $46,200 n.a.

2007 51,400 50,000

2008 58,300 52,000

Answers to practice problem, part 2

Nominal GDP

Real GDPGDP

deflatorInflation

rate

2006 $46,200 $46,200 100.0 n.a.

2007 51,400 50,000 102.8 2.8%

2008 58,300 52,000 112.1 9.1%

Some frequently used terminologies

National income concepts at market price• GDP at market price: Value of all final goods and

services produced within the domestic territory of a country in one fiscal year.

• Gross National Product (GNP) at market price: GDP at mkt price+ Net factor income from abroad

• Net National Product (NNP) at market price: GNP at mkt. price- Depreciation• National income/Net National Product at factor

cost: NNP-Indirect taxes +subsidies


What is indirect tax?• The incidence and burden of taxes shifted are called

indirect taxes. These are levied on the sellers but shifted on the buyers by the sellers. Sales taxes/VAT, customs, excises are indirect taxes. It is to be subtracted to avoid a discrepancy between market prices and prices received by producers. If not deducted, market price becomes higher than producers’ price.

• Subsidies: These are the financial help given by the govt. to encourage the production in some sectors of the economy. These understate the value of national income. So, these should be added to get NI.


National income concepts at factor cost (FC)

• Net Domestic Product (NDP) at factor cost: Wages + Interest + Profits+ Rents

• Gross Domestic Product (GDP) at factor cost: NDP at factor cost + Depreciation

• GNP at factor cost: GDP at FC +Net factor income from abroad

• National Income/Net National Product at factor cost: GNP at FC-Depreciation


Personal Income and Disposable Income• Personal Income: is the money income received by

households before they pay their personal taxes. PI= NI-pre tax corporate profits-social security taxes+ transfer payments + Net interest (including dividend)

• Disposable personal income: is the income that households can choose to consume or save after subtracting income taxes from personal income. Personal income- direct personal taxes

• Disposable personal income is the sum of consumption and saving i.e. DPI=C+S

Three approaches to measure GDP

• The expenditure approach to GDP• The Value added approach to GDP• The income approach to GDP

The Expenditure Approach to GDP• Expenditure approach divides output into

four categories according to which group in the economy purchases it as final users– Consumption goods and services (C)—

purchased by households– Private investment goods and services (I)

—purchased by businesses– Government goods and services (G)—

purchased by government agencies– Net exports (NX)—purchased by

foreigners

The Expenditure Approach to GDP

• Consumer spending, C, is the sum of expenditures by households on durable goods, nondurable goods, and services. Examples include clothing, food, and health care.

• Investment, I, is the sum of expenditures on capital equipment, inventories, and structures. Examples include machinery, unsold products, and housing.

• Government spending, G, is the sum of expenditures by all government bodies on goods and services. Examples include naval ships and salaries to government employees.

• Net exports, NX, equals the difference between spending on domestic goods by foreigners and spending on foreign goods by domestic residents. In other words, net exports describes the difference between exports and imports.

The Expenditure Approach to GDP• Everyone who purchases a good or service

included in the GDP of a country must be either a – Household of that country– business entity/firm – government agency (including state and local

government)– Or else is part of the foreign sector

• When we add up the purchases of all four groups we get GDP

• GDP = C + I + G + NX

Consumption Spending• Consumption is the part of GDP purchased by

households as final users– Almost everything households buy during the year

is included as part of consumption spending when we calculate GDP

– One exception is construction of new homes• Counted as private investment

– Some quirky exceptions to the definition of consumption• Total value of all food products that farm families

produce and consume themselves• Total value of the housing services provided by

owner-occupied homes

Private Investment• Private investment has three components

– Business Purchases of Plant, Equipment, and Software• A firm’s plant, equipment, and software are

intended to last for many years—only a small part of them is used up to make the current year’s output

• Are regarded as final goods, and firms that buy them as final users of those goods

– New Home Construction• Residential housing is an important part of

nation’s capital stock• House will continue to provide services into

the future

Private Investment– Changes in Inventories

• We count the charge in firms’ inventories as part of investment in measuring GDP

• Why?– When goods are produced but not sold

during the year, they end up in some firm’s inventory stocks

– Part of the nation’s capital stock– Will provide services in the future, when

they are finally sold and used

Government Purchases• Purchases by state, local governments and

federal government are included• Government purchases include

– Goods• Fighter jets, police cars, school buildings, spy

satellites, etc.– Services

• Such as those performed by police, legislators, and military personnel

• Government is considered to be a purchaser even if it actually produces the goods or services itself

Government Purchases• Important to distinguish between – Government purchases

• Which are counted in GDP– Government outlays

• As measured by local, state, and federal budgets and reported in the media (include transfer payments.

Government Purchases• Transfer payments represent money redistributed from one group of citizens (taxpayers) to another (poor, unemployed, elderly). While transfers are included in government budgets as outlays they are not purchases of currently produced goods and services and therefore

• Not included in government purchases or in GDP

• Example? – Social Security payments by Fed, unemployment insurance and welfare payments by state gov, money disbursed to homeless shelters by city gov etc

Net Exports• Once we recognize dealings with the rest of

the world, we must correct an inaccuracy in our measure of GDP – Deduct all imports – Include domestic production that is purchased by

foreigners: total exports

• To properly account for output sold to, and bought from, foreigners– Must include net exports—difference between

exports and imports—as part of expenditure in GDP

Precautions on Exp. method

• Exp on second hand goods be excluded since that is not on currently produced goods.

• Exp on purchase of shares and bonds be excluded since they are not for goods and services.

• Gov. exp on transfer payments be excluded since they are not in exchange of goods and services.

• Exp on intermediate goods and services be excluded. Otherwise it creates the problem of double counting.

Product Approach• Product approach can be classified into:

-Final Product Approach-Value added approach

• Final product approach: Market value of final goods and services produced in the economy in a given period. However, there is the risk of double counting.

The Value-Added Approach

• Value added – Firm’s contribution to a product as

it is produced or– Revenue it receives for its output

minus cost of all the intermediate goods that it buys

– Example: Production of bread, as discussed in chapter 1

The Value-Added Approach

• GDP is sum of values added by all firms in economy. For example, (Rs. million)Sectors

Value of output

Cost of intermed.

Value Added

Agricult.

50 15 35

Mafg. 80 40 40

Service 20 10 10

Total 150 65 85=GDP

The Factor Payments Approach• In any year, value added by a firm is

equal to total factor payments made by that firm

• Factor payments: payments to the owners of resources that are used in production.

• GDP equals sum of all firms’ value added– Each firm’s value added is equal to its

factor payments

The Factor Payments Approach• Each firm’s value added is equal to its factor

payments• Thus, GDP must equal total factor payments

made by all firms in the economy• Since all of these factor payments are received

by households in the form of wages and salaries, rent, interest or profit– GDP is measured by adding up all of the

income—wages and salaries, rent, interest, and profit—earned by all households in the economy (Third Method of measuring GDP)

• Gives us an important insight into the macroeconomy– Total output of economy (GDP) is equal to total

income earned in the economy

The Factor Payments Approach• Factor Payments are generally classified

into: 1. Rent, including imputed rent2. Compensation of employees i.e. wages and

salaries3. Interest4. Profits, which include (dividends, Retained

earnings, Corporate taxes, direct taxes, indirect taxes)

5. Mixed income of the self-employedTotal of these gives NDP at factor cost. Think, how do you get GDP at factor cost,

GNP at factor cost, NNP at factor cost

Precautions in the Factor Payments Approach

• Transfer payments should not be included because there is no corresponding production of goods and services.

• Value of production for self consumption should be included.• Imputed rent is to be included.• Illegal incomes should not be included• Windfall gains should not be included• Corporate tax is a part of profit and therefore be included• Gift tax, wealth tax, and tax on windfall gains are to be

excluded because they are not paid from current income.• Money received from selling second hand goods are not to

be included because there is no corresponding production of goods and services.

• Interest on public debt is transfer payments and therefore should be excluded while calculating GDP.

Measuring GDP: A Summary• Different ways to calculate GDP

– Expenditure Approach• GDP = C + I + G + NX

– Value-Added Approach• GDP = Sum of value added by all firms

– Factor Payments Approach• GDP = Sum of factor payments made by

all firms• GDP = Wages and Salaries + interest +

rent + profit• GDP = Total household income

Actual and potential or full employment GDP

• The output gap measures the gap between actual output and the output the economy could produce at the full employment level, given the existing resources. Output gap= Potential output- Actual output

• This provides the framework for the analysis of output (GDP) gap. This leads to the discussion of trade cycle.

• Remember the graph drawn while making discussion on business cycle. The output below and above the trend line reflects the output gap in an economy.


• Suppose: potential/full employment GDP=y*, Actual GDP=y

• GDP Gap =y*-y• When y‹y*, A recessionary gap/deflationary

gap. Output falls. Unemployment rises.• When y›y*, An inflationary gap, upward

pressure on prices. The economy is overheating.

• Both of these situations call for policy actions in terms of monetary policy and fiscal policy to stabilize actual output growth around potential GDP growth.


Time

Output Potential GDP/trend line

Output gap Output gap

Actual GDP line

Importance of the study of National Income

• Indicator of economic structure• Indicator of welfare• Helpful in devising economic policy• Shows the inflationary or deflationary gap• Important in international comparison• Economic analysis• Basis of measuring standard of living• Basis of growth accounting

Problems in National Income Computation

• Unreported activities (underground economy)

• Non market activities• Economic bads-environmentnal damages• Double counting• Transfers• Non-availability of data• Non-monetized sector• Mixed incomes: arises due to lack of

specialization• Capital gains


• Unreported activities (underground economy): NI does not record activities such as gambling, prostitution, black marketing, drug dealing etc. Because of this, NI underestimates the value of output.

• Non market activities: Activities that take place within household but do not come in the market are not included in GDP. A house-wife’s contribution in cleaning, washing, cooking etc. But if the home maid is hired for this, his/her wages is included in GDP. In economies where there are more activities of non-marketable nature, accurate measurement of national income is difficult.


• Economic bads-environmentnal damages: Ni counts goods produced but ignores the bads. No nation is making an account related to the depletion of natural resources in terms of mining minerals (oil, gas etc.), soil erosion, and pollution of water and air. NI neither measures the possible degradation of human capital as a result of environmental pollution (ill health) nor provides any account of resource depletion.


• Double counting: Basic thrust in NIA to follow value added approach is to avoid double counting. But again it is difficult to draw a clear line between final goods and intermediate goods. The same goods can be counted as intermediate goods and final goods. Rice produced by farmer is final good if consumed and is intermediate if sold to the miller.


• Transfers: May lead to miscalculation of NI. For example, social security payments like pension, unemployment allowances, prize, gifts, charity payments, awards, scholarships do not reflect the flow of goods and services. In other words, these are not in exchange of goods and services. But if these are not considered properly, there will be overestimation of NI. For example, if a retired person gets pension for his past service and salary for the present job, a clear distinction between his transfer income and income that he earned in exchange of his services.


• Non-availability of data: Lack of data on various economic activities has made the NIA a difficult task in developing countries.

• Non-monetized sector: Imputation is done for owner occupied housing, wages paid in kinds, services provided free of cost and government services. Exclusion of these activities understates the actual economic activities. To include these, some type of imputations are needed, which may lead to subjective valuation.

• Mixed incomes: arises due to lack of specialization


• Capital gains: Sometimes there are capital gains just because of the price rise. For example, increase in the value of land and building because of the inflation. Gains arising from inflationary reasons should not be included in NI since these are not against productive services. However, any gain due to improvements such as planting, digging the well, leveling represent current flow of goods and services and should be included in NI.

Assignment for your own knowledge

• Find which method of NIA is used in Nepal.

• What are the classification of sectors of economy in Nepal?

• What is the annual GDP growth in Nepal over the last five years?

• For necessary information, visit the website of the Central Bureau of Statistics, and Ministry of Finance/ Nepal.

Chapter 2-measuring national economic activity for BBA

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