National Income Accounting | CBSE Class 12 Economics Notes

This note covers what macroeconomics is and how it emerged; the four sectors of an economy; final, intermediate, consumption and capital goods; stocks and flows; investment and depreciation; the circular flow of income; the value added, expenditure and income methods; factor cost, basic prices and market prices; GDP, GNP, NDP and NNP; real and nominal GDP and the GDP deflator; and GDP as an index of welfare.

What is macroeconomics, and how does it differ from microeconomics?

Macroeconomics studies the economy of a country as a whole. It asks questions that concern all citizens. Will prices as a whole rise or come down? Is employment getting better or worse? What steps can the State take to improve the economy?

Output, prices and employment of different goods tend to move together. A growth in food grain output is generally accompanied by a rise in the output of industrial goods. So macroeconomics can study a single representative good whose output, price and employment reflect the general level of the economy.

For some purposes it uses a few kinds of goods instead, such as agricultural goods, industrial goods and services, or studies sectors such as agriculture and industry.

Who are economic agents?

Economic agents are individuals or institutions that take economic decisions: consumers, producers, and entities such as the government, corporations and banks. In microeconomics they are individual buyers and sellers maximising their own profit or satisfaction. Even a large company is 'micro', since it acts for its own shareholders.

Macroeconomic policies are pursued by the State or by statutory bodies such as the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI). Their goals are public ones defined by law or the Constitution. In a developing country like India, such choices include reducing unemployment, improving access to education and primary health care, good administration and defence.

Why was a separate macroeconomics needed?

Adam Smith suggested that if everyone followed their own self-interest, the welfare of the country would need no separate thought. Economists found three problems: some markets did not or could not exist; some markets failed to reach equilibrium; and society often chose social goals that required the aggregate effects of individual decisions to be modified.

How did macroeconomics emerge, and what are the sectors of an economy?

Macroeconomics emerged as a separate branch after the British economist John Maynard Keynes published The General Theory of Employment, Interest and Money in 1936. Before him, the classical tradition held that all labourers ready to work would find employment and all factories would work at full capacity.

The Great Depression of 1929 made economists think in a new way. Output and employment in Europe and North America fell by huge amounts. In the USA, from 1929 to 1933, the unemployment rate rose from 3 per cent to 25 per cent, and aggregate output fell by about 33 per cent.

Unemployment rate = People not working and looking for jobs ÷ People working or looking for jobs

Keynes examined the economy in its entirety and the interdependence of its sectors. The analysis mainly concerns a capitalist economy, in which most economic activities show private ownership of the means of production, production for sale in the market, and labour bought and sold at a price called the wage rate.

What are the four sectors of an economy?

A household is a single individual, or a group of individuals whose consumption decisions are jointly made. Trade with the rest of the world takes the form of exports, goods sold abroad, and imports, goods bought from abroad.

What are final, intermediate, consumption and capital goods?

A country's wealth does not depend merely on possessing resources; resource-rich Africa and Latin America have some of the poorest countries. What matters is how resources generate a flow of production.

A farmer sells cotton to a spinning mill, which makes yarn. A textile mill turns the yarn into cloth, which becomes clothing for consumers. An item meant for final use that will not pass through any more stages of production is a final good.

Tea leaves bought for home are final goods; home cooking is not an economic activity, as the food is not sold. Tea leaves bought by a restaurant that sells tea are inputs. So a good becomes final not by its nature but by the economic nature of its use.

How are final goods classified?

Consumption goods, such as food, clothing and recreation, are consumed when bought by ultimate consumers. Durable ones, such as television sets, automobiles and home computers, are consumer durables. Capital goods, such as tools, implements and machines, are durable goods that enable production without being transformed; they undergo wear and tear.

Why are intermediate goods left out?

Intermediate goods are material inputs for other producers, such as steel sheets for automobiles and copper for utensils. Money is the common measuring rod. The value of final goods already includes the intermediate goods used, so counting both causes double counting.

What is the difference between stocks and flows?

'The average salary of someone is Rs 10,000' is incomplete: is it yearly, monthly or daily? Income, output and profits make sense only for a stated period. They are flows, defined over a period of time, and are often expressed per year.

The buildings and machines of a factory exist irrespective of any period. They are stocks, defined at a particular point of time. A change in a stock over a period, such as machines added this year, is a flow.

When a tank is filled from a tap, the water flowing in per minute is a flow and the water in the tank at a moment is a stock. Likewise capital is a stock and net investment, the addition to capital, is a flow.

What are gross investment, net investment and depreciation?

The part of final output made up of capital goods is gross investment. It includes machines, tools, buildings, storehouses, and infrastructure such as roads, bridges, airports and jetties.

Part of it only replaces capital worn out through wear and tear. The deduction from gross investment for regular wear and tear is depreciation, and the new addition to capital is net investment.

Net investment = Gross investment − Depreciation

Note: For economists, investment is always capital formation. Buying shares or property, or an insurance policy, is not investment in this sense.

How is depreciation calculated?

If a machine serves for twenty years, one-twentieth of its original value is treated as used up each year. Depreciation is thus an annual allowance for wear and tear.

Depreciation = Cost of the capital good ÷ Years of useful life

It is an accounting concept: no real expenditure may occur in a given year. It excludes unexpected destruction by accidents or natural calamities.

Is there a trade-off between consumer and capital goods?

With output given, more capital goods mean fewer consumer goods. But capital raises productivity: a weaver takes months to weave a sari, while modern machinery produces thousands of pieces of clothing in a day. So more capital goods today allow more consumer goods in future. The key is the element of time.

How does income flow in a circular way in a two-sector economy?

Consider an economy of firms and households only, with no government, external trade or savings. Households supply four factors of production and receive a remuneration for each.

Households spend their entire income on goods produced by domestic firms. So the whole income returns to firms as sales revenue, and there is no leakage. Year after year, income moves round the two sectors. This is the circular flow of income.

Firms (left) and Households (right) are joined by four curved arrows. At the top, the outer arrow, Spending, runs from households to firms and is marked A; the inner arrow, Goods and Services, runs from firms to households and is marked B. Below, Factor Payments runs from firms to households, marked C, and the outermost arrow, Factor Services, runs from households to firms.

See Fig. 2.1 in your NCERT textbook

The upper arrows form the goods and services market; the lower arrows form the factors of production market. The same money moves round the circle, so the annual value can be measured at any point.

1. At A, measure aggregate spending on final goods: the expenditure method.
2. At B, measure the value of final goods produced: the product method.
3. At C, measure the sum of factor payments: the income method.

If households spend more, firms produce more and pay factors more, so income rises to match. A single worker cannot raise her income this way. Such a simplified story is a macroeconomic model. Even with savings added, the three methods give the same value.

How is national income measured by the value added method?

Farmers grow Rs 100 of wheat using only labour and sell Rs 50 of it to bakers, who use it up to bake Rs 200 of bread. Adding the outputs gives Rs 300, but the Rs 50 of wheat is then counted twice. This is double counting.

Worked example 1: value added. Using the table, find the value of aggregate production.

Working: farmers add 100 − 0 = Rs 100; bakers add 200 − 50 = Rs 150.

Answer: aggregate production is Rs 100 + Rs 150 = Rs 250, not Rs 300.

A firm's net contribution is its value added. It is distributed among the four factors as wages, interest, profits and rents, and it is a flow variable.

Value added = Value of production − Value of intermediate goods used

What is the difference between gross and net value added?

Depreciation is also called consumption of fixed capital. Value added including depreciation is gross value added (GVA); deducting it gives net value added (NVA).

NVA = GVA − Depreciation

Worked example 2: GVA and NVA. A firm produces Rs 100 of goods a year, uses Rs 20 of intermediate goods and has Rs 10 of capital consumption.

Answer: GVA = 100 − 20 = Rs 80 per year; NVA = 100 − 20 − 10 = Rs 70 per year.

How is GDP obtained from value added?

The sum of the gross value added of all firms in a year is Gross Domestic Product (GDP). Here Σ denotes summation over all N firms.

GDP = ΣGVAᵢ

How are inventories treated in national income?

The stock of unsold finished goods, semi-finished goods or raw materials a firm carries from one year to the next is its inventory, a stock variable. The change in inventories over a year is a flow.

Change in inventories = Production − Sales

Since production is value added plus intermediate goods used, the change in inventories also equals value added plus intermediate goods minus sales. The sign ≡ marks such an identity, which always holds: 2 + 2 ≡ 4, but 2 × x = 4 is true only when x = 2.

Worked example 3: inventories. A firm starts the year with stock worth Rs 100, produces Rs 1,000 of goods and sells Rs 800.

Answer: inventories rise by Rs 200, so the closing inventory is Rs 100 + Rs 200 = Rs 300.

Why is a change in inventories treated as investment?

Inventories are treated as capital, and an addition to capital is investment. There are three major categories of investment: a rise in the value of inventories; fixed business investment in machinery, factory buildings and equipment; and residential investment in housing.

What are planned and unplanned changes in inventories?

An unexpected fall in sales causes unplanned accumulation; an unexpected rise causes unplanned decumulation. A shirt firm starts with 100 shirts and expects to sell 1,000.

Allowing for inventories, the gross value added of a firm equals its sales, Vᵢ, plus the change in inventories, Aᵢ, minus intermediate goods used, Zᵢ. Sales include exports.

GVA of firm i = Vᵢ + Aᵢ − Zᵢ

How is GDP measured by the expenditure method?

The expenditure method adds up final expenditure, spending not made for intermediate purposes. In the farmer and baker economy, bakers receive Rs 200 and farmers Rs 50 of final expenditure, giving Rs 250 again.

A firm can receive final expenditure on four accounts:

1. consumption expenditure, Cᵢ, mostly by households;
2. investment expenditure, Iᵢ, by other firms on its capital goods, which remain with the buyer, unlike intermediate goods;
3. government expenditure, Gᵢ, covering both consumption and investment;
4. export revenue, Xᵢ, from sales abroad.

Part of C, I and G is spent on imports, Cₘ, Iₘ and Gₘ, which do not reach domestic firms. Total imports are:

M = Cₘ + Iₘ + Gₘ

Subtracting imports gives the expenditure identity. Of its five variables, investment, I, is the most unstable.

GDP = C + I + G + X − M

How is GDP measured by the income method, and why do the methods agree?

The revenues of all firms are distributed among the factors as wages, profits, interest and rents. So final expenditure must equal factor incomes. If W, P, In and R are the wages, gross profits, interest and rents received by all households:

GDP = W + P + In + R

Rent, interest and profits together are called operating surplus. Combining the three methods gives GDP ≡ ΣGVAᵢ ≡ C + I + G + X − M ≡ W + P + In + R, where I includes planned and unplanned investment.

Three columns of equal height stand side by side, enclosed by braces with the label GDP at the right. The Expenditure Method column is divided, from bottom to top, into C, I, G and X − M; the Income Method column into W, R, In and P; the Product Method column is one block, ΣGVAᵢ.

See Fig. 2.2 in your NCERT textbook

Worked example 4: GDP by three methods. Firm A uses no raw material and produces cotton worth Rs 50 and sells it to B, which sells cloth to consumers for Rs 200. Wages and profits are as in the table.

Working: value added is 50 + 150 = 200. The only final expenditure is on cloth, 200. Factor incomes are wages 80 plus profits 120.

Answer: GDP is Rs 200 by every method.

What are factor cost, basic prices and market prices?

In January 2015 the Central Statistics Office (CSO) replaced GDP at factor cost with GVA at basic prices, and GDP at market prices, now called just GDP, became the most highlighted measure.

The valuations differ by two kinds of tax. Production taxes, such as land revenues and stamp and registration fees, are independent of the volume of production. Product taxes, such as excise tax, service tax and export and import duties, are paid per unit. Net taxes are taxes less subsidies.

GVA at basic prices = GVA at factor cost + Net production taxes

GVA at market prices = GVA at basic prices + Net product taxes

From factor cost to market prices, we add all net indirect taxes, that is, indirect taxes less subsidies.

Worked example 5: India's GDP. Provisional estimates for 2024-25, at constant prices, put India's GVA at basic prices at ₹1,71,87,446 crore and net product taxes at ₹16,09,509 crore.

Answer: GDP = 1,71,87,446 + 16,09,509 = ₹1,87,96,955 crore.

How are GDP, GNP, NDP and NNP related?

An Indian working in Saudi Arabia earns a wage counted in Saudi Arabian GDP, though she is Indian. Likewise, the profits of the Korean-owned Hyundai car factory have to be subtracted from India's GDP. Gross National Product (GNP) adjusts for such incomes.

GNP = GDP + NFIA

Net factor income from abroad (NFIA) is factor income earned by domestic factors employed abroad minus factor income earned by foreign factors employed in the domestic economy.

How are net measures and national income found?

Depreciation is not part of anybody's income. Deducting it gives Net National Product (NNP) and Net Domestic Product (NDP).

NNP = GNP − Depreciation

NDP at MP = GDP at MP − Depreciation

Market prices include indirect taxes, which go to the government, and are lowered by subsidies. In India petrol is heavily taxed, whereas cooking gas is subsidised. Removing net indirect taxes gives NNP at factor cost, or National Income (NI).

NI = NNP at MP − Net indirect taxes

Columns stand on a common base. GDP with an NFIA box on top equals the GNP column. NNP at market price with a D box on top equals GNP. NI (NNP at FC) with an ID − Sub box on top equals NNP. Further steps lead down to PI and PDI.

See Fig. 2.3 in your NCERT textbook

What do the eight aggregates measure?

Worked example 6: Raju the barber. Raju collects Rs 500 from haircuts in a day; his equipment depreciates by Rs 50 and he pays Rs 30 sales tax. Find his contribution to GDP, NNP at MP and NNP at FC.

Answer: GDP is Rs 500, as he uses no intermediate goods. NNP at MP = 500 − 50 = Rs 450. NNP at FC = 450 − 30 = Rs 420.

What is the difference between nominal and real GDP?

If GDP doubles, production may have doubled, or only prices. Nominal GDP values output at current prices. Real GDP values it at the constant prices of a base year, so its changes show changes in the volume of production.

Worked example 7: nominal and real GDP. A country produces only bread: 100 units at Rs 10 in 2000, and 110 units at Rs 15 in 2001. Take 2000 as the base year.

Working: nominal GDP in 2001 = 110 × 15 = Rs 1,650. Real GDP in 2001 = 110 × 10 = Rs 1,100. Deflator = 1,650 ÷ 1,100.

Answer: the GDP deflator is 1.50, or 150 per cent, as bread rose from Rs 10 to Rs 15.

Draw bars for 2000 and 2001 with GDP in rupees on the vertical axis. In 2000, the base year, nominal and real GDP are both Rs 1,000. In 2001, nominal GDP is Rs 1,650 and real GDP Rs 1,100.

What is the GDP deflator?

Nominal and real GDP of the current year use the same volume of output, so their ratio shows only the price change. This ratio is the GDP deflator, sometimes expressed in percentage terms by multiplying by 100. A GNP deflator is found the same way.

GDP deflator = Nominal GDP ÷ Real GDP

How do the CPI and WPI differ from the deflator?

The Consumer Price Index (CPI) is the cost of a representative consumer's basket in the current year as a percentage of its base-year cost. The index of wholesale prices, at which goods are traded in bulk, is the Wholesale Price Index (WPI).

Worked example 8: CPI. A consumer buys 90 kg of rice and 5 pieces of cloth. Prices were Rs 10 and Rs 100 in 2000, and Rs 15 and Rs 120 in 2005.

Answer: the basket costs Rs 1,400 in 2000 and Rs 1,950 in 2005, so CPI = 1,950 ÷ 1,400 × 100 = 139.29, approximately.

Can GDP be taken as an index of welfare?

More income lets a person buy more goods, so a higher real GDP may seem to mean greater well-being. There are at least three reasons why this may not be correct.

Does the distribution of GDP matter?

A rise in GDP may go to very few people while others' incomes fall.

Worked example 9: rising GDP, falling incomes. In 2000, 100 people each earn Rs 10. In 2001, 90 earn Rs 9 and 10 earn Rs 20, with prices unchanged.

Answer: GDP rises from Rs 1,000 to 810 + 200 = Rs 1,010, yet 90 per cent of people are worse off, their income down 10 per cent.

Draw one pair of bars for GDP, Rs 1,000 in 2000 and Rs 1,010 in 2001. Beside them, draw income per person: Rs 10 for all 100 people in 2000; Rs 9 for 90 people and Rs 20 for 10 people in 2001.

What do non-monetary exchanges and externalities do?

Domestic services women perform at home are not paid for, and barter exchanges in the informal sector use no money. They are generally not counted, so GDP is underestimated.

Externalities are benefits or harms one causes to others without being paid or penalised. An oil refinery's value added is counted in GDP, but its pollution of a river may harm water users and fishermen. Ignoring this negative externality overestimates welfare; with positive externalities, GDP underestimates it.

Glossary

• Macroeconomics — The branch of economics that studies aggregate variables of the whole economy and the interlinkages between its sectors.
• Final good — A good meant for final use that will not pass through any more stages of production or transformation by a producer.
• Intermediate goods — Goods used by producers as material inputs, such as steel sheets for automobiles or copper for utensils.
• Capital goods — Durable final goods, such as tools, implements and machines, that make production possible without being transformed in it.
• Consumer durables — Consumption goods with a relatively long life, such as television sets, automobiles and home computers.
• Stock — A variable defined at a particular point of time, such as capital or the water in a tank.
• Flow — A variable defined over a period of time, such as income, output, profits or water entering a tank per minute.
• Depreciation — The annual allowance for wear and tear of a capital good; also called consumption of fixed capital.
• Value added — The value of a firm's production minus the value of the intermediate goods it uses.
• Inventory — The stock of unsold finished goods, semi-finished goods or raw materials a firm carries from one year to the next.
• Net factor income from abroad — Factor income earned by domestic factors employed abroad minus factor income earned by foreign factors employed at home.
• National Income — Net National Product at factor cost, that is, NNP at market prices minus net indirect taxes.
• Real GDP — GDP valued at the constant prices of a base year, so that it changes only with the volume of production.
• GDP deflator — The ratio of nominal GDP to real GDP, an index of price change from the base year.
• Externalities — Benefits or harms a firm or individual causes to others, for which they are not paid or penalised.

Common errors and misconceptions

• Misconception: Buying shares is investment in economics. Correct: Investment in economics is capital formation, an addition to the capital stock; buying shares or property is not.
• Misconception: Whether a good is final depends on what it is. Correct: It depends on its use. Tea leaves bought for home are final goods; tea leaves bought by a restaurant are inputs.
• Misconception: GDP is the sum of every firm's output. Correct: That double counts intermediate goods. GDP is the sum of gross value added, or the value of final goods only.
• Misconception: Depreciation covers losses from accidents. Correct: It allows only for normal wear and tear, not unexpected destruction by accidents or natural calamities.
• Misconception: GDP and GNP are the same. Correct: GNP adds net factor income from abroad to GDP, so they differ unless NFIA is zero.
• Misconception: A doubling of nominal GDP means production has doubled. Correct: Prices alone may have doubled; real GDP, valued at constant base-year prices, shows the change in volume.
• Misconception: A higher GDP always means higher welfare. Correct: GDP may rise while most people are worse off, and it misses non-monetary exchanges and externalities.

Exam-style questions with model answers

Q1. What are the four factors of production, and what is the remuneration of each called? [2 marks]

1. Labour earns wages and capital earns interest.
2. Entrepreneurship earns profit, and land, meaning fixed natural resources, earns rent.

Q2. Nominal GNP is Rs 2,500 crores and GNP at base-year prices is Rs 3,000 crores. Find the GNP deflator in percentage terms. Has the price level risen? [2 marks]

1. GNP deflator = 2,500 ÷ 3,000 × 100 = 83.33 per cent, approximately.
2. It is below 100, so the price level has fallen, not risen, since the base year.

Q3. Distinguish between stock and flow. Of net investment and capital, which is a stock and which a flow? [3 marks]

1. A stock is defined at a particular point of time; a flow is defined over a period of time.
2. Capital is a stock and net investment is a flow, because net investment is the addition to capital during a period.
3. When a tank is filled from a tap, the water in the tank at a moment is a stock, like capital, and the water entering per minute is a flow, like net investment.

Q4. GDP at market price is Rs 1,100 crores, NFIA is Rs 100 crores, indirect taxes minus subsidies are Rs 150 crores and National Income is Rs 850 crores. Calculate depreciation. [3 marks]

1. NNP at market price = NI + net indirect taxes = 850 + 150 = Rs 1,000 crores.
2. GNP at market price = GDP at market price + NFIA = 1,100 + 100 = Rs 1,200 crores.
3. Depreciation = GNP − NNP = 1,200 − 1,000 = Rs 200 crores.

Q5. Distinguish between planned and unplanned inventory accumulation, and relate the change in inventories to value added. [4 marks]

1. Planned accumulation is a rise the firm intends: a shirt firm with 100 shirts that wants 200 and expects to sell 1,000 produces 1,100.
2. Unplanned accumulation follows an unexpected fall in sales: if it produces 1,000 expecting to sell 1,000 but sells 600, stock rises by 400.
3. Change in inventories ≡ production − sales ≡ value added + intermediate goods used − sales.

Q6. Explain double counting with an example. How does the value added method avoid it? [4 marks]

1. Double counting is counting intermediate goods more than once. Farmers grow Rs 100 of wheat and sell Rs 50 to bakers, who make Rs 200 of bread.
2. Adding outputs gives Rs 300, counting the Rs 50 of wheat twice.
3. The value added method subtracts intermediate goods: farmers add Rs 100 and bakers Rs 150, so aggregate production is Rs 250.

Q7. Write the three identities for calculating GDP, and explain why they give the same value. [6 marks]

1. Product method: GDP ≡ ΣGVAᵢ, the sum of gross value added of all firms.
2. Expenditure method: GDP ≡ C + I + G + X − M, consumption plus investment plus government expenditure plus exports minus imports.
3. Income method: GDP ≡ W + P + In + R, the sum of wages, profits, interest and rent.
4. They agree because income moves in a circular flow. Firms pay factors for their services, factors spend their incomes on firms' output, and firms' revenue is paid out again as factor payments.
5. For example, if firm A sells cotton worth Rs 50 to firm B, which sells cloth to consumers for Rs 200, value added is 50 + 150, final expenditure is 200, and wages of 80 plus profits of 120 also total 200.

Q8. Explain three reasons why GDP may not be a good index of welfare. [6 marks]

1. Distribution: a rise in GDP may go to a few. If 100 people earn Rs 10 each and next year 90 earn Rs 9 and 10 earn Rs 20, GDP rises from Rs 1,000 to Rs 1,010, yet 90 per cent are worse off.
2. Non-monetary exchanges: unpaid domestic services women perform at home and barter exchanges are generally not counted, so GDP is underestimated.
3. Externalities: an oil refinery's value added enters GDP, but its pollution of a river harms water users and fishermen at no cost to it. Ignoring such negative externalities overestimates welfare; positive externalities make GDP underestimate it.

Key takeaways

• Macroeconomics studies the economy as a whole and emerged after Keynes's General Theory of 1936, following the Great Depression of 1929.
• An economy has four sectors, namely households, firms, government and the external sector, and macroeconomics studies the links between them.
• Only final goods are counted in national income, because counting intermediate goods as well would cause double counting.
• Stocks are defined at a point of time and flows over a period; capital is a stock, while net investment is a flow.
• Net investment equals gross investment minus depreciation, the annual allowance for normal wear and tear of capital.
• GDP ≡ ΣGVAᵢ ≡ C + I + G + X − M ≡ W + P + In + R, so all three methods give the same value.
• GNP equals GDP plus NFIA, and National Income is NNP at market prices minus net indirect taxes.
• Real GDP uses base-year prices, and the GDP deflator, nominal GDP divided by real GDP, measures price change.

Test yourself

Who are the macroeconomic decision makers?

The State and statutory bodies such as the RBI and SEBI, which pursue public goals defined by law or the Constitution.

Why are consumer durables not capital goods?

They are for ultimate consumption, not for production; they only share durability and wear and tear with capital goods.

What makes the two-sector circular flow free of leakages?

Households do not save, pay no taxes and buy no imports, so all income returns to firms as sales revenue.

What are the three major categories of investment?

A rise in inventories, fixed business investment in machinery, buildings and equipment, and residential investment in housing.

How do production taxes differ from product taxes?

Production taxes, such as land revenues, are independent of the volume of production; product taxes, such as excise tax, are paid per unit.

Why are the Hyundai factory's profits subtracted to find India's GNP?

The factory is Korean-owned, so its profits are income of foreign factors in India, which GNP deducts.

Give two reasons why the CPI may differ from the GDP deflator.

The CPI includes imported goods and uses constant weights; the GDP deflator excludes imports and its weights vary with production.