Macroeconomics: National Income Accounting

What is Macroeconomics? It is concerned with behavior of economy as a whole: growth, price levels,
unemployment, balance of payment, exchange rate. Long run and short run fluctuations that constitute the
business cycles. It also constitute policies that affect consumption, investment, trade balance, wages, prices,
interest rate, money supply, fiscal and monetary policy. Essentially, macroeconomics tries to bring equilibrium
in three markets: goods & services market, labour market and the money market.
Macroeconomics is all about getting facts and theories together to understand and then plan for the future:
improve Economic Growth, stabilize Price levels and reduce Rate of unemployment while maintaining external
sector balance.
Business cycle and output gap: Inflation, growth and unemployment are related through business cycle. It is
the more or less regular pattern of expansion and contraction of economic activity around the path of trend
growth. Trend path - is the growth in GDP if all the factors of production are fully employed. Full employment-
is an economic concept when all those factors that want to be employed are employed. Output is fluctuates
around the trend level, it can at times rise above the trend or fall below.
The output gap measures gap between actual output and the output the economy could produce at full
employment with the given resources. Output gap = actual output – potential output
Positive gap signifies over employment and negative means underutilization of resources.
Inflation and Business cycle: Positively related to output gap. Expansionary aggregate demand policies tend to
produce inflation, unless they occur at high levels of unemployment.

The Production Possibilities Frontier (PPF)

The production possibilities frontier is used to illustrate the economic circumstances of scarcity, choice, and
opportunity cost.
To describe the concept of the production possibilities frontier, assume that we live on an island that has only
two cities and two industries (automobiles and airplanes). Given the resources available on our island
economy, the table below shows how labor and capital can be allocated to the production of autos and
airplanes.

The Production Possibilities for a Single Country

Option Automobiles Airplanes

A 150 0
 B 125 4

C 80 9

D 30 16

E 0 25

The table presented here can be used to describe the economic problems of scarcity, choice and opportunity
cost. Scarcity is present because finite amounts of each good can be produced. We may want a combination of
150 autos and 25 airplanes, but given the limited labor and capital inputs available, this is not a feasible
combination. To produce 150 autos requires that all labor and capital available be used in the assembly of
automobiles, leaving nothing for the production of airplanes.
Only by giving up some autos (moving from Option A to Option B) do we gain airplanes. In a practical sense,
labor and capital is switched from producing automobiles to airplanes. This presents opportunity cost – the
best alternative that we give up (autos) to increase airplane output.
Finally, choice is demonstrated by the five options of the table. How are choices made? Perhaps the firm or
the market will determine the combination of autos and airplanes that are produced. There can be a central
planning agency that makes this determination or the democratic process will let citizens vote for their
preferences.

Two characteristics of the production possibilities frontier are:

1. It slopes downward to the right. This represents the tradeoff present in production. By producing more
automobiles, workers and capital must migrate. An increase in auto production necessitates a
reduction in the output of airplanes.
2. The production possibilities frontier is "bowed outward." The curvature of the production possibilities
frontier reflects the increasing opportunity cost when substituting one type of production for another.
This situation is caused by the specialization of workers. If society initially favors auto production over
airplanes so that we are located in the southeast portion of the frontier, workers become skilled in
auto production. But as we move to the left along the curve, increasing airplane output and decreasing
auto production, some workers switch to building airplanes. For many workers, the skills used in
producing autos are not perfectly transferable. In addition, the machinery used for auto production
may not be well suited to making airplanes. As a result, the output per worker falls as they are
relocated to making goods in which they are less skilled.
Assumptions of the Production Possibilities Frontier
There are 3 assumptions that must be satisfied if our country is to achieve a point along the production
possibilities frontier.
1. Finite resources - at any given time, the total amounts of labor, land and capital are fixed.
2. Full and efficient use of the resources - at any point along the PPF we have productive efficiency. We
cannot increase the output of one good without decreasing the output of another.
3. A given state of technology - the production possibilities frontier represents the technology available to
producers.

Characteristics of the Production Possibilities Frontier

1. Points along the frontier show the tradeoff between two different goods for society; to get more of
one, we must give up some of the other.
2. Points outside the curve are unobtainable with given resources and technology.
3. Points inside the frontier are attainable, but do not utilize society's resources efficiently.
4. The production possibilities frontier illustrates concepts of
a. Scarcity - resources are limited.
b. Choice - choices in the production of different goods need to be made.
c. Opportunity cost - to gain more of a good something else must be given up.
Application
1) Inefficient Use of Resources
Economists use the term full employment to indicate the lowest desirable unemployment rate that the
economy can comfortably sustain without causing significant inflationary pressures. Unemployment rates
greater than at full employment are undesirable because there are more individuals actively seeking
employment than there are jobs available.
2) Expansion of the Economy's Productive Capacity
There are two factors that will allow our production possibilities frontier to shift outward over time. The first is
an increase in our resources. The second is due to improvements in technology.
Assuming that the immigrants are effectively assimilated, our resource base grows and so does our ability to
produce goods and services. As long as our three assumptions are satisfied, including full employment, our
nation's production possibilities frontier shifts outward (to the right). An alternative scenario would keep
population constant but allow technology to improve (or even a combination of the two). Allowing for
technological improvement, such as the development of the computer and robotics industries, improves
worker productivity and thus our economic capacity to create goods and services.
3) A Contraction of the Production Possibilities Frontier
A country's production possibilities frontier may shift inward due to a depletion of resources. The death and
destruction caused by war is one way resources used in production may be reduced, leading to a contraction
of the production possibilities frontier.
A historical example of a dramatic contraction of the production possibilities frontier was caused by the
bubonic plague in Europe between 1347 and 1350, rats infested with plague-ridden fleas spread the disease,
reducing the population of various European countries by 33% to 65%. One consequence of the plague was a
reduction of the labor pool, so that producers required labor saving devices. This led to a rapid escalation of
capital innovation, investment, and the substitution of capital for labor in production. New uses for water-
power, agricultural implements, and other labor-saving developments occurred.

Circular flow of Income

The circular flow of income shows connections between different sectors of our economic system. It revolves
around flows of goods and services and factors of production between firms and households.
Businesses produce goods and services and in the process of doing so, incomes are generated for factors of
production (land, labour, capital and enterprise) – for example wages and salaries going to people in work.
Leakages (withdrawals) from the circular flow: Not all income will flow from households to businesses
directly. The circular flow shows that some part of household income will be:
(1) Put aside for future spending, i.e. savings (S) in banks accounts and other types of deposit
(2) Paid to the government in taxation (T) e.g. income tax
(3) Spent on foreign-made goods and services, i.e. imports (M) which flow into the economy
Withdrawals are increases in savings, taxes or imports so reducing the circular flow of income and leading to a
multiplied contraction of production (output).
Injections into the circular flow: Additions to investment, government spending or exports so boosting the
circular flow of income leading to a multiplied expansion of output.
(1) Capital spending by firms, i.e. investment expenditure (I) e.g. on new technology
(2) The government, i.e. government expenditure (G) e.g. on infrastructure or defence
(3) Overseas consumers buying domestic goods and service
An economy is in equilibrium when the rate of injections = the rate of withdrawals from the circular flow

National Income Accounting

GDP is the market value of final goods & services produced and consumed within a country in a period. GDP is
the equilibrium between the goods produced and the goods demanded.
The production of goods generates income for those who produce, major allocation being to the labour and
owners of capital.
Output is demanded for private consumption and investment, for government expenditure and for
international trade.
The rupee value of GDP depends on both physical production and price level. Inflation is the change over time
in the price level.

National Output is measured by three methods

The Product or Value Added Method
In product method we calculate the aggregate annual value of goods and services produced (if a year is the
unit of time). In case, there are only two kinds of producers in an economy, wheat producers (or the farmers)
and bread makers (the bakers) and in a year the total value of wheat that the farmers have produced is Rs 100
of which they sell Rs 50 worth of wheat to the bakers. The bakers use this amount of wheat completely during
the year and to produce Rs. 200 worth of bread. What is the value of total production in the economy?
The farmers had produced Rs 100 worth of wheat for which it did not need assistance of any inputs. Therefore
the entire Rs 100 is value added by the farmers. The bakers had to buy Rs 50 worth of wheat to produce their
bread. The Rs 200 worth of bread that they have produced is not entirely their own contribution. To calculate
the net contribution of the bakers, we need to subtract the value of the wheat that they have bought from the
farmers.
Therefore, the net contribution made by the bakers is, Rs 200 – Rs 50 = Rs 150. Hence, aggregate value of
goods produced by this simple economy is Rs 100 (net contribution by the farmers) + Rs 150 (net contribution
by the bakers) = Rs 250.

Factor Income Method

On the production side, wages, salaries, interest, dividends: study of growth and aggregate supply.
The production side of the economy changes inputs, factors of production and giving them factor income to
produce output, GDP.
So we can have a production function: No. of cakes = f (ovens, bakers) but with macro we need a more general
production function where we say GDP (Y) = f (N, K) labour & Capital.
So can we say that all factor payments should equal the output or that Y = wL +rK+profit.
Hence the income approach formula to GDP as follows: Total national income is equal to the sum of all wages
plus rents plus interest and profits.

Expenditure Method
On the demand side, consumption or inventories for future consumption: study of aggregate demand.
C + I + G + NX: National Income accounting identity
Consumption (C): Durables + non durables + services.
The consumption of goods and services falls under one of the following categories:
Durable goods - The consumption of durable goods is considered similar to a consumer investment. Durable
goods are purchased with the intention of keeping them for a sustained duration of time. Examples of durable
consumer purchases include washing machines, refrigerators, automobiles, and toaster ovens.
Nondurable goods - In contrast to durable goods, nondurable items have a shorter life span. An example of a
nondurable consumer purchase is groceries. The life span of the typical food is short, especially compared
with the refrigerator (durable item) in which perishable foods are kept. Other examples of purchases that are
considered nondurables include newspapers, magazines, clothing, and hats (which are always flying off with
the wind).
Services - The fastest growing component of consumer purchases has been the area of services. Services
include medical treatment, lawyers, and dry cleaners.
Investment (I)
Gross private domestic investment: addition to physical capital stock. Education as investment in human
capital is considered in GDP as consumption. Businesses and corporations undertake investment activity that
involves the purchase of goods which themselves assist in the production process.
The categories of investment are:
Business Investment - This includes the actual purchases of goods used in the production process. Business
investment includes the construction of new offices and factories, and the purchase of machinery, computers,
and any other equipment used to assist labor in the production of goods and services.
Business investment counts as gross investment, which includes purchases of machinery to replace worn-out
equipment.
Residential Construction - This part of overall investment tracks the actual construction of housing, not the
sale of homes. A new home that is built during a given year is counted in that year's GDP, while the purchase
of a previously owned house has already been counted in the GDP of the year it was constructed.
Changes in inventories - Firms invest in inventories, which are produced goods held in storage in anticipation
of later sales. Firms also stockpile raw materials and intermediate goods used in the production process.
Goods held in inventories are counted for the year produced, not the year sold.
Government Spending (G)
The government sector tracks what the government actually spends money on. Government purchases of
goods and services include stealth bombers, government-funded research, space shuttles, salaries, and
toasters. Many of these items are seldom sold in markets; as a result, they are valued at the price the
government pays for them. The calculation of government spending for GDP purposes excludes several
tremendous categories of actual spending: transfer payments, which redistribute income primarily to
individuals who are potential consumers, and interest payments on the debt. We need to understand words
such as Transfer payments, payments made to people for service not rendered in the current period. Hence
they are not part of GDP.
Net Exports (NX)
This component is important as it makes clear whether we are consuming more foreign goods or the other
way round. May be C rose by 10%, then we assume GDP also will rise by 10% but if consumption of imports
has gone up then GDP will not change.
Measures of National Income Accounting

Gross National Product

Gross Domestic Product measures the aggregate production of final goods and services taking place within the
domestic economy during a year. However when factors of production of an economy render services in the
external sector, their earnings are considered to compute Gross National Product (GNP).

Therefore 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

Hence, GNP = GDP + Net factor income from abroad.

Net National Product

A part of the capital gets consumed during the year due to wear and tear called depreciation. Depreciation
does not become part of anybody’s income. Deduction of depreciation from GNP the measure of aggregate
income that we obtain is called Net National Product (NNP).

Therefore NNP = GNP – Depreciation.

Market Price to Factor Cost

When indirect taxes are imposed on goods and services, their prices go up. When indirect taxes are deducted
from NNP evaluated at market prices, we get NNP which actually accrues to the factors of production.
Similarly, there may be subsidies granted by the government on the prices of some commodities (in India
petrol is heavily taxed by the government, whereas cooking gas is subsidised). So we need to add subsidies to
the NNP evaluated at market prices. The measure that we obtain by doing so is called Net National Product at
factor cost or National Income.

Therefore, NNP at factor cost = National Income (NI) = NNP at market prices – (Indirect taxes – Subsidies) =
NNP at market prices – Net indirect taxes (Net indirect taxes = Indirect taxes – Subsidies).

In order to calculate the part of National Income which is received by households, we compute Personal
Income (PI). We deduct UP and Corporate Profit from NI to arrive at PI, since UP does not accrue to the
households. Similarly, Corporate Tax, which is imposed on the earnings made by the firms, will also have to be
deducted from the NI, since it does not accrue to the households. On the other hand, the households receive
interest payments from private firms or the government on past loans advanced by them.

And households may have to pay interests to the firms and the government as well, in case they had borrowed
money from either. So we have to deduct the net interests paid by the households to the firms and
government. The households receive transfer payments from government and firms (pensions, scholarship,
prizes, for example) which have to be added to calculate the Personal Income of the households.

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

Households have to pay taxes from PI. If we deduct the Personal Tax Payments (income tax, for example) and
Non-tax Payments (such as fines) from PI, we obtain what is known as the Personal Disposable Income. Thus
Personal Disposable Income (PDI) = PI – Personal tax payments – Non-tax payments.

Personal Disposable Income is the part of the aggregate income which belongs to the households. They may
decide to consume a part of it, and save the rest.

Investment and Savings Identity

Simple economy: No G & NX. Y = C + I Output can either be consumed or added to inventories so investment
spending.
How is income allocated? Y = C + S so C + I = Y = C + I, investment is identical to saving in a simple economy.
If we bring in G & NX, then we have Y = C + I + G + NX as the output produced and sold.
YD = Y + TR – TA, further this YD is spent on C + S
YD - TR + TA = C + I + G + NX
C + S - TR + TA = C + I + G + NX
S = I + (G + TR – TA) + NX
Savings go towards financing Investment, Government deficit or Trade surplus (-NX: trade deficit). If S = I then
government deficit needs to be finance by a trade deficit. Any sector that spends more than its income has to
borrow.
A part of GDP is consumed and a part is saved (from the recipient side of the incomes). On the other hand,
from the side of the firms, the aggregate final expenditure received by them (GDP) must be equal to
consumption expenditure and investment expenditure. The aggregate of incomes received by the households
is equal to the expenditure received by the firms because the income method and expenditure method would
give us the same figure of GDP. Since consumption expenditure cancels out from both sides, we are left with
aggregate savings equal to the aggregate gross investment expenditure.
There are many limitations to using GDP as a way to measure current income and production:

 Changes in quality and the inclusion of new goods - higher quality and/or new products often replace
older products. Many products, such as cars and medical devices, are of higher quality and offer better
features than what was available previously. Many consumer electronics, such as cell phones and DVD
players, did not exist until recently.
 Leisure/human costs - GDP does not take into account leisure time, nor is consideration given to how
hard people work to produce output. Also, jobs are now safer and less physically strenuous than they
were in the past. Because GDP does not take these factors into account, changes in real income could
be understated.
 Underground economy - Barter and cash transactions that take place outside of recorded marketplaces
are referred to as the underground economy and are not included in GDP statistics. These activities are
sometimes legal ones that are undertaken so as to avoid taxes and sometimes they are outright illegal
acts, such as trafficking in illegal drugs.
 Harmful Side Effects - Economic "bads", such as pollution, are not included in GDP statistics. While no
subtractions to GDP are made for their harmful effects, market transactions made in an effort to
correct the bad effects are added to GDP.
 Non-Market Production - Goods and services produced but not exchanged for money, known as
"nonmarket production", are not measured, even though they have value. For instance, if you grow
your own food, the value of that food will not be included in GDP. If you decide to watch TV instead of
growing your own food and now have to purchase it, then the value of your food will be included in
GDP
Inflation and Price indices
Nominal GDP is GDP calculated at current market prices. Therefore, nominal GDP will include all of the
changes in market prices that have occurred during the current year due to inflation or deflation. Inflation is
defined as a rise in the overall price level, and deflation is defined as a fall in the overall price level.
In order to remove the changes in the overall price level, we calculate the Real GDP. Real GDP is GDP
computed at the market prices of some base year. For example, if 2011-12 is chosen as the base year, then
real GDP for 2017-18 is calculated by taking the quantities of all goods and services purchased in 2017-18 and
multiplying them by their 2011-12 prices.

Inflation and Prices: Inflation is the rate of change in prices.

The price index is an indicator of the average price movement over time of a fixed basket of goods and
services. The constitution of the basket of goods and services is done keeping in to consideration whether the
changes are to be measured in retail, wholesale, or producer prices etc. The basket will also vary for economy-
wide, regional, or sector specific series. At present, separate series of index numbers are compiled to capture
the price movements at retail and wholesale level in India. Currently, in India, the Consumer Price Index
(composite) and Wholesale Price Index are calculated on a monthly basis.
The Consumer Price Index is a comprehensive measure used for estimation of price changes in a basket of goods
and services representative of consumption expenditure in an economy. Various categories and sub-
categories have been made for classifying consumption items and on the basis of consumer categories like
urban or rural. It is one of the most important statistics for an economy and is generally based on the
weighted average of the prices of commodities. It gives an idea of the cost of living.

The Wholesale Price Index or WPI is "the price of a representative basket of wholesale goods". The WPI is
published by the Economic Adviser in the Ministry of Commerce and Industry. The Wholesale Price Index
focuses on the price of goods traded between corporations, rather than goods bought by consumers. The
purpose of the WPI is to monitor price movements that reflect supply and demand in industry, manufacturing
and construction.

The Gross Domestic Product (GDP) deflator is a measure of general price inflation. It is calculated by dividing
nominal GDP by real GDP and then multiplying by 100. Nominal GDP is the market value of goods and services
produced in an economy, unadjusted for inflation (It is the GDP measured at current prices). Real GDP is
nominal GDP, adjusted for inflation to reflect changes in real output (It is the GDP measured at constant
prices).
GDP Deflator = Nominal GDP x 100
Real GDP

The GDP deflator is a much broader and comprehensive measure. Since Gross Domestic Product is an
aggregate measure of production, being the sum of all final uses of goods and services (less imports), GDP
deflator reflects the prices of all domestically produced goods and services in the economy whereas, other
measures like CPI and WPI are based on a limited basket of goods and services, thereby not representing the
entire economy (the basket of goods is changed to accommodate changes in consumption patterns, but after
a considerable period of time).

Another important distinction is that the basket of WPI (at present) has no representation of services sector.
The GDP deflator also includes the prices of investment goods, government services and exports, and excludes
the price of imports. Changes in consumption patterns or the introduction of new goods and services or
structural transformation are automatically reflected in the deflator which is not the case with other inflation
measures.
However WPI and CPI are available on monthly basis whereas deflator comes with a lag (yearly or quarterly,
after quarterly GDP data is released). Hence, monthly change in inflation cannot be tracked using GDP
deflator, limiting its usefulness.

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