National Income Accounting:

Macroeconomic Analysis

- Looks at the working of the whole economy.

- The aggregate is considered e.g. measurement of inflation, unemployment,

economic growth.

- The total value of final output produced in an economy domestically within a

given period of time e.g. one year id GDP (gross domestic product).

- National output(Y) is also called gross domestic product (GDP). Gross domestic
product is the total expenditures on all final goods and services produced
domestically in a given year.

- National income(Y) is the total value of income earned over the same period.

- Economic growth can be calculated using nominal GDP or Real GDP figures.

- Nominal GDP is calculated using current prices and current quantities. The
economic growth shown by nominal GDP may or may not show the increase in
output produced in the economy.

- RDGP is calculated using base year prices and current quantities. RGDP actually
shows how much output has been produced in the economy.

- Economic growth = RDGPyr2 –RGDPyr1 x 100

RGDPyr1
- GDP per capita: RGDP/population: it shows on average how much income
each person is earning in a country in a given year.

- Inflation is the general rise in price level. Inflation can be calculated using GDP
deflator or consumer price index (CPI). CPI is the cost of a basket of selected
goods and services purchased by an urban household.

GDP deflator = Nominal GDP (NGDP)/ Real GDP (RGDP) * 100

Inflation rate = GDP deflator yr2 –GDP deflator yr1 x 100

GDP deflator yr1

Consumer Price Index (CPI) = ∑current year prices x base year quantities
∑base year prices x base year quantities

Inflation rate = CPI yr2 – CPI yr1 x 100

CPI yr1

- The aim of national income accounting is to place a money value on the year's output.
- The relationships explained in the circular flow of income form the basis of national
income accounting. Looks at how different sectors of the economy are interrelated
and how the economy operates. These relationships can be explained by the circular
flow model.
The circular flow model can be for 2 sector, 3 sector or 4 sector economies.

Two sector model: consists of households and firms only. Households supply factors of
production to the firms and the firms supply goods and services to the households.
Households receive income for their services while firms receive payments for their
goods and services. Two sector circular flow diagram on pg 9 of coursebook2.

A household can either spend or save their income. Therefore Y=C+S; where Y is
national income, C is consumption and S is savings. Savings is a leakage in the circular
flow. From the firms’ side, when they invest, Investment is known as an injection in the
circular flow. Output is Y = C+I

In a three sector model, government sector is introduced and in the four sector model,
foreign sector is introduced. Therefore the national output or GDP equation becomes:
Y = C +I +G+NX in a four sector model.
Where Y = output or equilibrium level of income; C =consumption; I = investment; G =
government spending; and NX is net exports or (exports – imports).
The value of output (Y) is equal to the total expenditures on all sectors of the economy.
This is also same as the AD equation .AD = total expenditures in the economy. This is
one of the approaches to measuring GDP known as expenditure approach.

In equilibrium, all income =all expenditures=the value of output.

Leakages from circular model are equal to injections to the circular flow.
Net equation is S + T+ M = I + G + X
Where S = savings; T = taxes; M = imports; I = investment; G = government spending
and X = exports.

In detail, the components of expenditure approach or AD.

Components of expenditure approach can be autonomous or induced. Autonomous
expenditures are independent of the level of income whereas induced expenditures are
dependent on the level of income.

First Consumption (C). Consumption is the total expenditure by households on all final
goods and services. Consumption can be both autonomous and induced. Autonomous
consumption is that proportion that is not dependent on the level of household income.
This is given as a constant in the consumption function. Induced expenditure is dependent
on the level of household income.

C = a + cYD (DY or DI sometimes are used for disposable income).

C = 500 + 0.8 YD; 500 is automous consumption and 0.8 is the induced consumption.
0.8YD is also known as marginal propensity to consume meaning the additional
consumption resulting from an additional dollar of income earned. For e.g., for each
additional dollar of income earned, the households will spend $0.80 on consumption.
YD or disposable income is after tax income. After taxes are deducted, the net income
received by households.
YD = Y –T; where Y is Real GDP and T is taxes.

Taxes can also be autonomous or induced.

T = 100 + 0.2Y; where 100 is autonomous taxes and 0.2Y is induced taxes (marginal tax
rate).

Therefore based on this example; the consumption function is:

C = 500 + 0.8(Y – (100 + 0.2Y)
C = 500 + 0.8(Y – 100 – 0.2 Y)
C = 500 + 0.8Y – 80 – 0.16Y
C = 420 + 0.64Y; this is our final consumption function

Investment and government expenditures are autonomous expenditures.

Net Exports = X – M; X is autonomous whereas M is autonomous as well as induced.

M = 200 + 0.1Y
200 is autonomous imports whereas 0.1Y is induced imports (marginal propensity to
import).

Multiplier effect: any injection into the economy will have an impact on the GDP which
is greater than the initial injection. An initial expenditure in the economy causes a chain
reaction in other components of AD through national income which is termed as a
multiplier effect.
For example, an increase in government spending will cause an increase in RGDP (Y)
which will increase induced consumption and therefore the final effect on the RGDP is
more than the amount of government spending.

The formula for multiplier is 1/ 1-c (1-t) +m

Where c = induced consumption; t = induced taxes and m is induced imports.

The change in RGDP = a change in autonomous expenditure X multiplier.

E.g. c = 0.4YD; t = 0.2Y and m = 0.1Y

The value of multiplier = 1/ (1-0.4(1-0.2) +0.1
= 1.28
If government spending increases by $40m in the economy; $40m x 1.28 = $51.2m;
Therefore the RGDP increases by $51.2m which is more than initial government
spending of $40m.

Measuring GDP: There are three methods used in national income accounting to measure GDP:

There are 3 approaches to measuring GDP.

- Expenditure approach (AD = C +I+G+NX)
- Income approach
- Production approach/value added approach
- Expenditure approach adds up all the expenditures on final goods and services produced
in the economy. It adds up all the expenditure components of the circular flow diagram.
Therefore Y= C+I+G+NX

- Income approach measures GDP as the sum of all the incomes created in the production
of national output. These include salaries/wages, profits, dividends, rents and interest
payments. It also takes into account indirect taxes and subsidies.

- Production approach measures GDP as the sum of all values added by all production
groups in the economy.

When measuring GDP, only the value of final g/s are taken to avoid the problem of double
counting which can result if the value of intermediate goods are also taken for measurement and
the value of GDP would be overstated.

Interpreting GDP: some drawbacks or limitations of GDP as a measure of economic growth.

To get a clear picture of how an economy is operating, RGDP instead of NGDP can be used.
However even when using RGDP to calculate economic growth, some drawbacks arise.

Exclusions from GDP:

- Informal transactions: performed for cash or in exchange for g/s but for which no
records are kept. E.g. black market; illegal activities, drugs etc.

- Non-market activities: production of g/s that are not priced because they do not pass
through the market e.g. households growing their own vegetables.

- Non-productive activities e.g. proceeds from a garage sale (second hand items)

- Improvement in the quality of g/s due to technological change or other factors are not
taken into account.

- Intangible things such as lack of open space, traffic congestion, tension and stress of
everyday living are not valued therefore not included in GDP.

GDP per capita is again not a good measure of standard of living because it just shows
average income of each person.
For e.g. if GDP per capita is $10000 per year, it means on average each person is earning that
much. In reality many people would be earning much more and others very less than the
stated amount.

Distinction between GDP and GNP (GNI). GDP is the total value of final g/s produced
domestically in a given year whereas GNP is GDP plus (income from abroad less income
going out of the country).