Measurement of National Income

MacroeconomicsSession 2 & 3

Learning Objectives

• Understand circular flow of income and output• Define gross domestic product (GDP)

– Various approaches to estimate GDP• Savings-Investment Identity• Distinguish between nominal GDP and real GDP• Understand the limitations of GDP

National Income Accounting

• Gross Domestic Product (GDP)– The total market value of all final goods and

services produced by factors of production located within a nation’s borders

– Then what about income ??

The Simple Circular Flow

• Two observations– In every economic exchange, the seller receives

exactly the same amount that the buyer spends.– Goods and services flow in one direction and

money payments flow in the other.

The Simple Circular Flow

• Profits explained– Question

• Why is profit a cost of production?– Answer

• Profits are the return entrepreneurs receive for the risk they incur when organizing productive activities

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Circular Flow - SimpleAssumptions:

• Only two sectors• Consumers (Households) and Producers (Firms)

No government and no international trade (Closed economy)

• Consumers spend all their Income on goods an services

• Consumers are the owners of productive resource - land, labour, capital and enterprise

Total Output = Total Income = Total Expenditure

O = Y = E

National Income Accounting

• Gross Domestic Product (GDP)– The total market value of all final goods and

services produced by factors of production located within a nation’s borders

What is the value of final output

• Farmer produces 50kg wheat. Sells it @ Rs 10/kg to baker (all 50 kg)

• Baker produces 60 kg of bread and sells it @ Rs 20/kg (all 60 kg)

• Total value of output• Contribution of different sectors in output

• Avoid double counting…..

Final and Intermediate Goods

• What is a final good?– Wheat?– Steel?– Oil?– Bread?

• Intermediate Goods– Goods used up entirely in the production of final

goods

What is the value of Final Output

• Wheat produced by farmer: 50kg• Sold to baker: 30Kg @ Rs10/kg. 20 kg was

retained by farmer for consumption in family• Baker hired some additional workers and

Produced 40 Kg of bread. • Sold 40 kg of bread @ Rs 20 per kg.• Sold 30 kg of bread @ Rs 20 per kg.

Three Approaches of Measuring GDP

• Expenditure Approach– Computing national income by adding up the value at current

market prices of all final goods and services• C + I + G+ X –M

• Income Approach– Measuring national income by adding up income received by all

factors of production

• Production approach– Computing value added at each stage of production by deducting

value of intermediate products from the output produced.

Deriving GDP by the expenditure approach

• Consumption Expenditure (C)– Durables, Nondurables, Services

– Food & Non-food items

– Construction of residential buildings is a part of investment rather than consumption. Imputed rent is part of consumption.

Deriving GDP by the expenditure approach

• Gross Domestic Investment (I)– The creation of capital goods, such as factories and

machines, that can yield production and hence consumption in the future

– In India, I includes investment by government as well. In US, only private investment is taken as part of I.

– A car bought by Reliance would be investment. Same car bought by Mukesh Ambani would be private final consumption expenditure.

Deriving GDP by the expenditure approach

• Deriving GDP by the expenditure approach– Government Expenditures (G)

• State, local, and federal• Valued at cost: for producing services such as

governance, education, health, etc.

• In India, G includes only final consumption expenditure by government. In US, G include both final consumption expenditure and investments by government.

Deriving GDP by the expenditure approach

• Deriving GDP by the expenditure approach– Net Exports (Foreign Expenditures)

Net exports (X) = total exports - total imports

Mathematical representation of expenditure approach

GDP = C + I + G + NX

Deriving GDP by the Income Approach

• Gross Domestic Income (GDI)– The sum of all income—wages, interest, rent, and

profits—paid to the four factors of production