Macro Economics Session

3&4

National Income
Determination

Session plan
Need

for National Income

Accounting
The production of Output &
Payments to FOP
Components of Aggregate Demand
Some Important Identities
Problems of GDP Measurement

Need for National Income

Accounting
It

gives regular estimates of GDP.

It provides a conceptual
framework for describing the
relationship among three key
macroeconomic variables: output,
income and spending.
It helps us in understanding key
characteristics of our economy.

GDP at Constant Prices & Current

Prices
If

GDP is estimated on the basis of

the prevailing prices, it is called GDP
at current prices or nominal NY.
If GDP is measured on the basis of
some fixed price, that is price
prevailing at a point of time or in
some base year, it is known as GDP
at Constant price or Real NY.

Real & Nominal GDP

Nominal

GDP measures the value of output in a

given period in the prices of that period
National Income at Current Prices.
Real GDP uses constant base-year prices to
place the value on the economys production of
G & S.
Real GDP measures changes in physical output
in the economy between different time periods
by valuing all goods produced in the two
periods at the same prices. National Income
at Constant Prices

The GDP Deflator

GDP deflator is a measure of the price level

calculated as the ratio of nominal GDP to
real GDP times 100.
GDP deflator = Nominal GDP/ Real GDP *100
GDP deflator at the base year always equals
100.
GDP deflator for subsequent years measures
the changes in nominal GDP from the base
year that cannot be attributable to a change
in real GDP.
It measures the current level of prices
relative to the level of base-year prices.

The inflation rate

The

term inflation is used to describe a

situation in which economys overall price
level is rising.
The inflation rate is the percentage change
in the price level from one period to the
next.
Inflation rate in year 2 = GDP deflator in
year 2 GDP deflator in year 1/ GDP
deflator in year 1
Pt Pt-1/Pt-1

Real & Nominal GDP

Products

Nominal GDP
- 2000

Nominal GDP
- 2004

Wheat

10 Kg at Rs. 10 20 Kg at Rs. 40 20 Kg at Rs. 10

Pens

10 at Rs. 5

30 at Rs. 20

30 at Rs. 5

150

1400

350

GDP Deflator = 1400/350 = 4

Real GDP
2004

Class activity:
Calculate

the Nominal GDP, Real GDP & GDP

Deflator
Year

Price of
Hot Dogs
($)

Qty of
Hot
Dogs

Price of
Hamburger
($)

Qty of
Hamburger
s

2010

$1

100

$2

50

2011

$2

150

$3

100

2012

$3

200

$4

150

Answer
Nominal
GDP

Real GDP

GDP
Deflator

2010

($1 per hot dog *100) + ($2 *50 hamburgers)

= $200

2011

($2 per hot dog *150) + ($3 *100 hamburgers)

= $600

2012

($3 per hot dog *200) + ($4 *150 hamburgers)

= $1,200

2010

($1 per hot dog *100) + ($2 *50 hamburgers)

= $200

2011

($1 per hot dog *150) + ($2 *100 hamburgers)

= $350

2012

($1 per hot dog *200) + ($2 *150 hamburgers)

=$500

2010

($200/$200)*100 = 100

2011

($600/$350)*100 = 171

2012

(&1,200/$500)*100 = 240

Nominal & Real GDP in

India

Some Important Identities

A Simple Economy: without Govt & International trade

Output produced equals output sold. ( which is not sold
is a part of investment) Expenditure method
YC+I
The output is either consumed or invested. Income
method
YS+C
C + I indicates agg demand & C + S indicates allocation
of income. Output produced is equal to output sold or
income received.
C+IYC+S
Relation between Savings & Investments
IYCS
Investment is equal to savings.

Three Sector Economy with

Total Exp or Y = C + I + G
Govt
Total

Inc or Y = C + S + T
C + I + G = C + S + T
= I + G = S + T
= G T = S I
It means if G is greater than T; ie if there is a
deficit budget, the Govt will have to borrow from
financial market. For this purpose Pvt I has to be
less than Pvt S. Thus govt borrowings reduce I in
the economy Crowding out
If G > T; then I < S Govt borrowings reduce
private investments.

Four Sector Open Economy

Y = C + I + G + Xn; where Xn = X M

Y=C+I+G+X=C+S+T+M

Or I + G + X = S + T + M (ignoring C)

This implies that sum of total leakages (withdrawals)

from the circular flow of income (S + T + M) must equal
the sum of total injections into circular flow (I + G + X)

Or I + G + (X-M) = S + T

This implies that in an open economy, the sum of

private investment, government purchases & net
exports must equal sum of savings & taxes.

Saving-Investment & Current Account

In an
Balance
open economy, the difference between total saving &
investment equals the current account balance:

S+T+M=I+G+X

S + (T G) I = X M

It implies that if X < M, the country is saving less than what it is

investing domestically.

If X > M; then the country is saving more than what it is

investing domestically.

Or S I = (G T) + (X M)

This implies that the difference between S & I = budget deficit

+ trade surplus/surplus

Eg. In a country like India, if S <I, it means C is high leading to

higher imports & I is financed by capital inflows from abroad.
Current account deficit & surplus at capital account

In a country like Japan, S > I, it means S will flow out of the

country 7 there will be deficit at capital account & surplus at
current account

Measurement of NY
1.

Production method (Output

method)
GDPMP - Consumption of fixed
capital = NDPMP
NDPMP IT + subsidies = NDPFC
NDPFC + NFIA = NNPFC

Measurement of NY
Income

method:
Net value added by factor cost:
= sum of compensation of
employees + rent and royalties +
Interest + profits (operating
surplus) + mixed incomes
NDPFC + NFIA = NNPFC

Measurement of NY
Final

expenditure method:
GDPMP = Pvt Consumption expen +
Govt final econ exp + Gross domestic
capital expen + Net exports
NDPMP = GDPMP Consumption of
fixed capital
NDPFC = NDPMP + Subsidies Indirect
taxes
NNPFC = NDPFC + NFIA

Calculate GNP fc by Income & Expenditure

method
Rs. crores
Item
Net domestic capital formation

500

Compensation of employees

1850

Depreciation

100

Govt final consumption expenditure

1100

Pvt final consumption expenditure

2600

Rent

400

Dividend

200

Interest

500

Net exports

-100

Undistributed profits

900

Net factor income from abroad

-50

Net

indirect
subsidy)

taxes

(Indirect

taxes

250

Answer
Income

method:
= Compensation to employees + rent + interest
+ Un Profits + Dividend + NFI from abroad +
Depreciation
= 1850 + 400 + 500 + 900 + 200 50 +100 =
3900 crs
Expenditure method:
= Pvt cons expen + Govt expen + Net domestic
capital formation + Net exports + Net Factor
income from abroad net indirect taxes +
depreciation
= 2600 + 1100 + 500 -100 50 250 +100 =
3900 crs

Problems in GDP
Measurement
Value of non-monetary transaction - Value of some

output is not measured as they are not traded in the

market. Eg. Value created by home makers, social
workers, etc.

Problem of double counting difficulty in

distinguishing between final good & intermediate
good

Underground economy many transactions are not

reported legally & hence are not taken in NY
accounting.

It doesnt consider improvement in quality of goods.

Eg. Improvement in technology like computers, etc.

Problems in measurement of NI
Treatment

of Government activities: How to

measure the value of administrative functions of
the government like maintain g law and order,
defense, justice, etc.
Prevalence of non-monetized transactions
subsistence agriculture, barter exchange, etc
Non-reporting of incomes, unreliable reporting of
income, underreporting of incomes high
proportion of unorganized sector
Inadequate data to estimate national income

GDP and Economic WellBeing

Real GDP per capita is the main

indicator of the average
persons standard of living.

But

GDP is not a perfect measure

of
well-being.
Robert

Kennedy issued a very

eloquent
yet harsh criticism of GDP:

Gross Domestic Product

does not allow for the health of our
children, the quality of their education,
or the joy of their play.
It does not include the beauty of our poetry or
the strength of our marriages, the
intelligence of our public debate or
the integrity of our public officials.
It measures neither our courage, nor our wisdom,
nor our devotion to our country.
It measures everything, in short, except that which makes life
worthwhile, and it can tell us everything about America except
why we are proud that we are Americans.
- Senator Robert Kennedy, 1968

GDP Does Not Value:

the

quality of the environment

leisure

time

non-market

activity, such as the

child care
a parent provides his or her child
at home
an

equitable distribution of
income

Then Why Do We Care About

GDP?
Having

a large GDP enables a

country to afford better schools, a
cleaner environment,
health care, etc.

Many

indicators of the quality of

life are positively correlated with
GDP. For example

Life expectancy (years)

GDP and Life Expectancy in 12 countries

Indonesia
China

Japan
Mexico

U.S.
Germany

Brazil
Pakistan
India

Russia

Bangladesh
Nigeria

Real GDP per capita

27

GDP and Literacy in 12 countries

China

Russia

Adult Literacy
(% of population)

Mexico

Germany

Japan

U.S.

Brazil
Indonesia
Nigeria
India
Pakistan
Bangladesh

Real GDP per capita

28

GDP and Internet Usage in 12 countries

Internet Usage
(% of population)

Japan

Pakistan
Nigeria

U.S.

Germany

Indonesia

Brazil
Mexico

Russia
China
India

Bangladesh

Real GDP per capita

29

Limitations of GDP as a Measure of

Economic Well-being
Non-material

aspects such as health, life

expectancy, satisfaction level, leisure time is not
taken into consideration.
It doesnt measure the level of inequality.
It doesnt measure the social cost of negative
externality such as pollution, etc.
It doesnt measure the balance between
consumption & investment. Sustainability of
growth is not considered.
It doesnt analyse how the growth is taking place
social indicators such as life expectance, child
mortality rates, gender equity give more
information about how the growth is taking place.

Class activity
GDP

does not measure value of goods that are

resold. How do you think this reflects on GDP
as a measurement of welfare?
Which contributes more to the economy?
production of Nano car or production of
Mercedes car why?
Give an example of something that would raise
GDP and yet be undesirable.
Why Transfer payments are not included in
GDP?

Class activity
One

day Suresh earns Rs 400 for haircut. Over

this day, his equipment depreciates in value
by Rs. 50. Of the remaining Rs. 350, Suresh
spends Rs. 30 to the government in sales tax,
takes home Rs. 220 as his salary and retains
Rs. 100 in his business to add new equipment.
From Rs. 220, he pays Rs. 70 as income tax.
Find out
A. GDP
B. NDP mp
C. NDP fc
D. Disposable personal income

Concepts learnt
Components

of GDP
Measurement of NY
National income identities
Problems in measurement of NY
Limitations of GDP as a
measurement of welfare