Chapter 2
National Income Accounting
In this chapter we will introduce the fundamental functioning of a
simple economy. In section 2.1 we describe some primary ideas
we shall work with. In section 2.2 we describe how we can view
the aggregate income of the entire economy going through the
sectors of the economy in a circular way. The same section also
deals with the three ways to calculate the national income; namely
product method, expenditure method and income method. The
last section 2.3 describes the various sub-categories of national
income. It also defines different price indices like GDP deflator,
Consumer Price Index, Wholesale Price Indices and discusses the
problems associated with taking GDP of a country as an indicator
of the aggregate welfare of the people of the country.
2.1 SOME BASIC CONCEPTS OF MACROECONOMICS
One of the pioneers of the subject we call economics today, Adam
Smith, named his most influential work – An Enquiry into the
Nature and Cause of the Wealth of Nations. What generates the
economic wealth of a nation? What makes countries rich or poor?
These are some of the central questions of economics. It is not
that countries which are endowed with a bounty of natural wealth
– minerals or forests or the most fertile lands – are naturally the
richest countries. In fact the resource rich Africa and Latin
America have some of the poorest countries in the world, whereas
many prosperous countries have scarcely any natural wealth.
There was a time when possession of natural resources was the
most important consideration but even then the resource had to
be transformed through a production process.
The economic wealth, or well-being, of a country thus does
not necessarily depend on the mere possession of resources; the
point is how these resources are used in generating a flow of
production and how, as a consequence, income and wealth are
generated from that process.
Let us now dwell upon this flow of production. How does this
flow of production arise? People combine their energies with
natural and manmade environment within a certain social and
technological structure to generate a flow of production.
In our modern economic setting this flow of production arises
out of production of commodities – goods and services by millions
of enterprises large and small. These enterprises range from giant
,corporations employing a large number of people to single entrepreneur
enterprises. But what happens to these commodities after being produced? Each
producer of commodities intends to sell her output. So from the smallest items
like pins or buttons to the largest ones like aeroplanes, automobiles, giant
machinery or any saleable service like that of the doctor, the lawyer or the financial
consultant – the goods and services produced are to be sold to the
consumers. The consumer may, in turn, be an individual or an enterprise and
the good or service purchased by that entity might be for final use or for use in
further production. When it is used in further production it often loses its
characteristic as that specific good and is transformed through a productive
process into another good. Thus a farmer producing cotton sells it to a spinning
mill where the raw cotton undergoes transformation to yarn; the yarn is, in
turn, sold to a textile mill where, through the productive process, it is transformed
into cloth; the cloth is, in turn, transformed through another productive process
into an article of clothing which is then ready to be sold finally to the consumers
for final use. Such an item that is meant for final use and will not pass through
any more stages of production or transformations is called a final good.
Why do we call this a final good? Because once it has been sold it passes out
of the active economic flow. It will not undergo any further transformation at the
hands of any producer. It may, however, undergo transformation by the action
of the ultimate purchaser. In fact many such final goods are transformed during
their consumption. Thus the tea leaves purchased by the consumer are not
consumed in that form – they are used to make drinkable tea, which is consumed.
Similarly most of the items that enter our kitchen are transformed through the
process of cooking. But cooking at home is not an economic activity, even though
the product involved undergoes transformation. Home cooked food is not sold
to the market. However, if the same cooking or tea brewing was done in a
restaurant where the cooked product would be sold to customers, then the
same items, such as tea leaves, would cease to be final goods and would be
counted as inputs to which economic value addition can take place. Thus it is 9
not in the nature of the good but in the economic nature of its use that a good
National Income Accounting
becomes a final good.
Of the final goods, we can distinguish between consumption goods and
capital goods. Goods like food and clothing, and services like recreation that
are consumed when purchased by their ultimate consumers are called
consumption goods or consumer goods. (This also includes services which are
consumed but for convenience we may refer to them as consumer goods.)
Then there are other goods that are of durable character which are used in
the production process. These are tools, implements and machines. While they
make production of other commodities feasible, they themselves don’t get
transformed in the production process. They are also final goods yet they are
not final goods to be ultimately consumed. Unlike the final goods that we have
considered above, they are the crucial backbone of any production process, in
aiding and enabling the production to take place. These goods form a part of
capital, one of the crucial factors of production in which a productive enterprise
has invested, and they continue to enable the production process to go on for
continuous cycles of production. These are capital goods and they gradually
undergo wear and tear, and thus are repaired or gradually replaced over time.
The stock of capital that an economy possesses is thus preserved, maintained
and renewed partially or wholly over time and this is of some importance in the
discussion that will follow.
, We may note here that some commodities like television sets, automobiles
or home computers, although they are for ultimate consumption, have one
characteristic in common with capital goods – they are also durable. That is,
they are not extinguished by immediate or even short period consumption;
they have a relatively long life as compared to articles such as food or even
clothing. They also undergo wear and tear with gradual use and often need
repairs and replacements of parts, i.e., like machines they also need to be
preserved, maintained and renewed. That is why we call these goods
consumer durables.
Thus if we consider all the final goods and services produced in an economy
in a given period of time they are either in the form of consumption goods (both
durable and non-durable) or capital goods. As final goods they do not undergo
any further transformation in the economic process.
Of the total production taking place in the economy a large number of
products don’t end up in final consumption and are not capital goods either.
Such goods may be used by other producers as material inputs. Examples are
steel sheets used for making automobiles and copper used for making utensils.
These are intermediate goods, mostly used as raw material or inputs for
production of other commodities. These are not final goods.
Now, to have a comprehensive idea of the total flow of production in the
economy, we need to have a quantitative measure of the aggregate level of final
goods produced in the economy. However, in order to get a quantitative
assessment – a measure of the total final goods and services produced in the
economy – it is obvious that we need a common measuring rod. We cannot
add metres of cloth produced to tonnes of rice or number of automobiles or
machines. Our common measuring rod is money. Since each of these
commodities is produced for sale, the sum total of the monetary value of
these diverse commodities gives us a measure of final output. But why are
we to measure final goods only? Surely intermediate goods are crucial inputs
to any production process and a significant part of our manpower and capital
10 stock are engaged in production of these goods. However, since we are dealing
with value of output, we should realise that the value of the final goods already
Introductory Macroeconomics
includes the value of the intermediate goods that have entered into their
production as inputs. Counting them separately will lead to the error of double
counting. Whereas considering intermediate goods may give a fuller description
of total economic activity, counting them will highly exaggerate the final value
of our economic activity.
At this stage it is important to introduce the concepts of stocks and flows.
Often we hear statements like the average salary of someone is Rs 10,000 or the
output of the steel industry is so many tonnes or so many rupees in value. But
these are incomplete statements because it is not clear whether the income which
is being referred to is yearly or monthly or daily income and surely that makes
a huge difference. Sometimes, when the context is familiar, we assume that the
time period is known and therefore do not mention it. But inherent in all such
statements is a definite period of time. Otherwise such statements are
meaningless. Thus income, or output, or profits are concepts that make sense
only when a time period is specified. These are called flows because they occur
in a period of time. Therefore we need to delineate a time period to get a
quantitative measure of these. Since a lot of accounting is done annually in an
economy, many of these are expressed annually like annual profits or production.
Flows are defined over a period of time.
National Income Accounting
In this chapter we will introduce the fundamental functioning of a
simple economy. In section 2.1 we describe some primary ideas
we shall work with. In section 2.2 we describe how we can view
the aggregate income of the entire economy going through the
sectors of the economy in a circular way. The same section also
deals with the three ways to calculate the national income; namely
product method, expenditure method and income method. The
last section 2.3 describes the various sub-categories of national
income. It also defines different price indices like GDP deflator,
Consumer Price Index, Wholesale Price Indices and discusses the
problems associated with taking GDP of a country as an indicator
of the aggregate welfare of the people of the country.
2.1 SOME BASIC CONCEPTS OF MACROECONOMICS
One of the pioneers of the subject we call economics today, Adam
Smith, named his most influential work – An Enquiry into the
Nature and Cause of the Wealth of Nations. What generates the
economic wealth of a nation? What makes countries rich or poor?
These are some of the central questions of economics. It is not
that countries which are endowed with a bounty of natural wealth
– minerals or forests or the most fertile lands – are naturally the
richest countries. In fact the resource rich Africa and Latin
America have some of the poorest countries in the world, whereas
many prosperous countries have scarcely any natural wealth.
There was a time when possession of natural resources was the
most important consideration but even then the resource had to
be transformed through a production process.
The economic wealth, or well-being, of a country thus does
not necessarily depend on the mere possession of resources; the
point is how these resources are used in generating a flow of
production and how, as a consequence, income and wealth are
generated from that process.
Let us now dwell upon this flow of production. How does this
flow of production arise? People combine their energies with
natural and manmade environment within a certain social and
technological structure to generate a flow of production.
In our modern economic setting this flow of production arises
out of production of commodities – goods and services by millions
of enterprises large and small. These enterprises range from giant
,corporations employing a large number of people to single entrepreneur
enterprises. But what happens to these commodities after being produced? Each
producer of commodities intends to sell her output. So from the smallest items
like pins or buttons to the largest ones like aeroplanes, automobiles, giant
machinery or any saleable service like that of the doctor, the lawyer or the financial
consultant – the goods and services produced are to be sold to the
consumers. The consumer may, in turn, be an individual or an enterprise and
the good or service purchased by that entity might be for final use or for use in
further production. When it is used in further production it often loses its
characteristic as that specific good and is transformed through a productive
process into another good. Thus a farmer producing cotton sells it to a spinning
mill where the raw cotton undergoes transformation to yarn; the yarn is, in
turn, sold to a textile mill where, through the productive process, it is transformed
into cloth; the cloth is, in turn, transformed through another productive process
into an article of clothing which is then ready to be sold finally to the consumers
for final use. Such an item that is meant for final use and will not pass through
any more stages of production or transformations is called a final good.
Why do we call this a final good? Because once it has been sold it passes out
of the active economic flow. It will not undergo any further transformation at the
hands of any producer. It may, however, undergo transformation by the action
of the ultimate purchaser. In fact many such final goods are transformed during
their consumption. Thus the tea leaves purchased by the consumer are not
consumed in that form – they are used to make drinkable tea, which is consumed.
Similarly most of the items that enter our kitchen are transformed through the
process of cooking. But cooking at home is not an economic activity, even though
the product involved undergoes transformation. Home cooked food is not sold
to the market. However, if the same cooking or tea brewing was done in a
restaurant where the cooked product would be sold to customers, then the
same items, such as tea leaves, would cease to be final goods and would be
counted as inputs to which economic value addition can take place. Thus it is 9
not in the nature of the good but in the economic nature of its use that a good
National Income Accounting
becomes a final good.
Of the final goods, we can distinguish between consumption goods and
capital goods. Goods like food and clothing, and services like recreation that
are consumed when purchased by their ultimate consumers are called
consumption goods or consumer goods. (This also includes services which are
consumed but for convenience we may refer to them as consumer goods.)
Then there are other goods that are of durable character which are used in
the production process. These are tools, implements and machines. While they
make production of other commodities feasible, they themselves don’t get
transformed in the production process. They are also final goods yet they are
not final goods to be ultimately consumed. Unlike the final goods that we have
considered above, they are the crucial backbone of any production process, in
aiding and enabling the production to take place. These goods form a part of
capital, one of the crucial factors of production in which a productive enterprise
has invested, and they continue to enable the production process to go on for
continuous cycles of production. These are capital goods and they gradually
undergo wear and tear, and thus are repaired or gradually replaced over time.
The stock of capital that an economy possesses is thus preserved, maintained
and renewed partially or wholly over time and this is of some importance in the
discussion that will follow.
, We may note here that some commodities like television sets, automobiles
or home computers, although they are for ultimate consumption, have one
characteristic in common with capital goods – they are also durable. That is,
they are not extinguished by immediate or even short period consumption;
they have a relatively long life as compared to articles such as food or even
clothing. They also undergo wear and tear with gradual use and often need
repairs and replacements of parts, i.e., like machines they also need to be
preserved, maintained and renewed. That is why we call these goods
consumer durables.
Thus if we consider all the final goods and services produced in an economy
in a given period of time they are either in the form of consumption goods (both
durable and non-durable) or capital goods. As final goods they do not undergo
any further transformation in the economic process.
Of the total production taking place in the economy a large number of
products don’t end up in final consumption and are not capital goods either.
Such goods may be used by other producers as material inputs. Examples are
steel sheets used for making automobiles and copper used for making utensils.
These are intermediate goods, mostly used as raw material or inputs for
production of other commodities. These are not final goods.
Now, to have a comprehensive idea of the total flow of production in the
economy, we need to have a quantitative measure of the aggregate level of final
goods produced in the economy. However, in order to get a quantitative
assessment – a measure of the total final goods and services produced in the
economy – it is obvious that we need a common measuring rod. We cannot
add metres of cloth produced to tonnes of rice or number of automobiles or
machines. Our common measuring rod is money. Since each of these
commodities is produced for sale, the sum total of the monetary value of
these diverse commodities gives us a measure of final output. But why are
we to measure final goods only? Surely intermediate goods are crucial inputs
to any production process and a significant part of our manpower and capital
10 stock are engaged in production of these goods. However, since we are dealing
with value of output, we should realise that the value of the final goods already
Introductory Macroeconomics
includes the value of the intermediate goods that have entered into their
production as inputs. Counting them separately will lead to the error of double
counting. Whereas considering intermediate goods may give a fuller description
of total economic activity, counting them will highly exaggerate the final value
of our economic activity.
At this stage it is important to introduce the concepts of stocks and flows.
Often we hear statements like the average salary of someone is Rs 10,000 or the
output of the steel industry is so many tonnes or so many rupees in value. But
these are incomplete statements because it is not clear whether the income which
is being referred to is yearly or monthly or daily income and surely that makes
a huge difference. Sometimes, when the context is familiar, we assume that the
time period is known and therefore do not mention it. But inherent in all such
statements is a definite period of time. Otherwise such statements are
meaningless. Thus income, or output, or profits are concepts that make sense
only when a time period is specified. These are called flows because they occur
in a period of time. Therefore we need to delineate a time period to get a
quantitative measure of these. Since a lot of accounting is done annually in an
economy, many of these are expressed annually like annual profits or production.
Flows are defined over a period of time.
