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NATIONAL INCOME CONCEPTS

The Economic Health of a country is measured in terms of its National Income.


Concepts of National Income:
1. Gross Domestic Product or GDP:
GDP is the aggregate market value of all final goods and services in an economy in one
accounting year. It includes total expenditure on Consumption by households, Gross
Investment by Firms, Government expenditure, and Net import earnings.
GDP = C + IG + G + (X M)
GDP includes all incomes earned within the country, regardless of who earns it. Thus it
includes incomes of foreigners within the country, but not of Indians earning abroad.
C = all consumption expenditure of households, except on housing, which is considered to
be part of investment.
IG = Gross private domestic investment is made of 1) new construction, 2) new capital
(machines, trucks and equipment), and 3) changes in inventory. It excludes investment
made by government and investment made outside the country. By convention, a private
house is considered an investment. The reason is that a private house may later be rented
and it is not possible to know for which purpose, rental or private use, a house is built in
the first place.
G = Government purchases combine all goods and services bought by all forms of
government public sector, utilities and public services.
(X M) = X stands for export earnings, and M for import payments. If X and M are not
included, then the economy is a closed economy. If they are included, the economy is
an open one. If X > M, the economy experiences surplus B of P, while if X < M, then
there is deficit B of P.
2. Gross National Income or GNP:
GNP includes incomes earned by Indians outside the country, and excludes incomes paid to
foreigners within the country. This is known as Net Factor incomes from abroad FA.
GNP = GDP + FA
If a country is earning more income from Indians outside the country, then its GNP > GDP.
If it is paying more to foreigners in the country, who send their income back to their home
countries, its GNP < GDP.
3. Net National Product or NNP at market prices:
All machines and equipment used to produce other goods are subject to some wear and
tear. Part of capital goods production must be devoted to replace this wear and tear.
Otherwise, the productive capacity of a nation would be depleted. This replacement of the
capital used is called capital consumption allowance of CCA.
GNP includes gross investments, i.e. expenditure on wear and tear of fixed capital in the
economy i.e. depreciation. These expenditures are not part of additions to new capital, but
only for repairing old ones. Expenditure on repairs and replacements of old capital is known
as Capital consumption allowance. This has to be deducted from GNP to arrive at net
national product.
NNP = GNP Depreciation

NNP, as well as GNP and GDP are measured in terms of present prices, i.e. market prices.
But market prices do not represent the true value of output produced, because it includes
indirect taxes and subsidies.
4. National Income or NY at factor cost:
Indirect taxes, such as sales tax, excise duties, import duties all increase the market price
of commodities, over and above their cost of production. This gives a false estimate of the
true value of production in the country. Similarly, subsidies given by Governments reduce
the market prices. Hence they have to be added to arrive at the actual cost of production.
NY at factor cost = NNP at market prices indirect costs + subsidies
NY is given in terms of factor costs and is equal to
NY = C + I
Where I is equal to net investment, and C = consumption expenditure of all sectors.
5. Personal Income: PY
The entire National income does not accrue to the households. Some current earnings are
not available to them (e.g. provident fund payments, insurance premiums) called social
security payments, while some money inflows are not currently earned (e.g. insurance, or
pensions) known as transfer payments. They include scholarships, pensions, gifts, etc.
Similarly firms pay corporate profit tax, and do not distribute their entire profits to
shareholders. These are also current earnings, but not available to the households. Therefore
these adjustments have to be made to arrive at the correct figure of the income of the
households sector.
PY = NY at factor cost (corporate taxes + undistributed profits + social security
payments) + transfer payments
6. Disposable Income: DY:
All the income accruing to households are not available to them to use. The households also
have to pay direct income taxes and other personal direct taxes. The income available after
these payments is known as Personal disposable income for consumption and savings.
DY = PY personal direct taxes
DY = C + S
7. Per capita income: PCY:
The average income of the country is given by the PCY. This is total NY divided by
population. PCY is usually taken as an indicator of economic welfare of a country.
PCY = NY/Population
Current prices and Constant Prices:
NY is estimated in different years at the current prices of that particular year. However the
price level does not remain constant, but fluctuates over time. This gives a wrong picture of
the state of the economy. For instance, if prices have increased in a particular year, without
increase in output, GNP will still rise. But this is due to rise in prices not output. Therefore
GNP, GDP and NY have to be adjusted for inflationary impacts. By dividing the present or
current year values of say NY by the Price Index, we arrive at NY at constant prices.
NY (at constant prices) = NY (at current prices) / Price Index

NY at current prices is also known as nominal NY, while NY at constant prices is called
real NY. The Price Index is also known as the national income deflator.
Growth of NY:
Since NY is estimated each year, we can find out the growth of NY over time to see if the
economy is progressing or not.
GY =

(NYT NY T 1) 100
NYT 1

International Comparisons:
To compare the relative status and growth of different economies, their NY figures are
compared and their relative rankings are made. However, the difficulty arises in that each
countrys NY is given in term of its own currency. To ensure uniformity, it is necessary to
have a common currency for evaluation. Usually the NY figures of all countries are
converted into US dollars for the sake of international comparisons.
The level of GDP in different countries may be compared by converting their value in
national currency according to either the current currency exchange rate, or the purchase
power parity exchange rate.

Current currency exchange rate is the exchange rate in the international currency
market. The current exchange rate method converts the value of goods and services
using global currency exchange rates. The method can offer better indications of a
country's international purchasing power and relative economic strength. For instance,
if 10% of GDP is being spent on buying hi-tech foreign arms, the number of weapons
purchased is entirely governed by current exchange rates, since arms are a traded
product bought on the international market. There is no meaningful 'local' price distinct
from the international price for high technology goods.

Purchasing power parity exchange rate is the exchange rate based on the purchasing
power parity (PPP) of a currency relative to a selected standard (usually the United
States dollar). The purchasing power parity method accounts for the relative effective
domestic purchasing power of the average producer or consumer within an economy.
The method can provide a better indicator of the living standards of less developed
countries, because it compensates for the weakness of local currencies in the
international markets. For example, India ranks 12th by nominal GDP, but fourth by
PPP. The PPP method of GDP conversion is more relevant to non-traded goods and
services.
There is a clear pattern of the purchasing power parity method decreasing the disparity
in GDP between high and low income (GDP) countries, as compared to the current
exchange rate method. This finding is called the Penn effect.

The ranking of countries may differ significantly based on which method is used.
Limitations:
GDP is widely used by economists to gauge the health of an economy, as its variations are
relatively quickly identified.

Wealth distribution GDP does not take disparity in incomes between the rich and
poor into account within a country.

Non-market transactions GDP excludes activities that are not provided through the
market, such as household production and volunteer or unpaid services.

Underground economy Official GDP estimates may not take into account the
underground economy, in which transactions contributing to production, such as illegal
trade and tax-avoiding activities, are unreported, causing GDP to be underestimated.

Non-monetary economy GDP omits economies where no money comes into play at
all, resulting in inaccurate or abnormally low GDP figures. Bartering may be more
prominent than the use of money, even extending to services.

GDP also ignores subsistence production.

Quality improvements and lower prices reduces GDP, though efficiency increases.

Externalities GDP ignores externalities or economic bads such as damage to the


environment. Some environmental costs, such as cleaning up oil spills are included in
GDP, but show negative welfare.

Sustainability of growth GDP does not measure the sustainability of growth. A


country may achieve a temporarily high GDP by over-exploiting natural resources or
by misallocating investment.

Cross-border comparisons of GDP can be inaccurate as they do not take into account
local differences in the quality of goods, even when adjusted for purchasing power
parity. This type of adjustment to an exchange rate is controversial because of the
difficulties of finding comparable baskets of goods to compare purchasing power
across countries.
I.

Multiple Choice Questions:

1. Which of the following is not included in Gross Domestic Product:


a. Depreciation
b. Net factor incomes from abroad
c. Net exports
d. Social security payments

2. NNP is equal to:


a. GDP Depreciation
c. GNP Depreciation

4. Personal income includes which of the following:


a. Scholarships
b. Pensions
c. Undistributed profits
d. (a and b)

5. Disposable income is equal to:


a. PY personal income tax
c. PY indirect tax

3. NY at factor costs is equal to:


a. GDP direct taxes + subsidies
c. NNP indirect taxes + subsidies

6. Per capita income is equal to:


a. Average income of the economy

b. GNP social security payments


d. GDP + FA
b. GDP Population
d. NNP + indirect taxes subsidies

b. NY personal income tax


d. GNP Depreciation
b. NY Population

d. GNP Population

c. (a and b)
7. Real GNP is measured by:
a. GNP Population
c. NNP Price index

b. GNP Price Index


d. GNP Depreciation

8. Investment includes which of the following?


a. Sale of securities
b. Plant and machinery
c. Fixed deposits
d. Sales taxes

9. If X < M in GDP accounts then the country faces:


a. Balance of Payment deficit
b. Balance of Payment surplus
c. Fiscal Deficit
d. Fiscal Surplus

10. Insurance payments by households is part of:


a. Personal income taxb. Indirect tax
c. Transfer payment
d. Social Security Payment

II.
1.

Fill in the Blanks:

The formula for GDP is given by __________________________________________

2.

If Indians in other countries earn more than foreigners in India, then GNP will be
______________________________ GDP.

3.

Given that NNP is RS. 10000, indirect taxes are Rs.500, subsidies are Rs.250, then NY
at factor cost will be equal to___________________________________.

4.

Average annual growth rate of an economy for two years is given by the formula
_________________________________.

5.

Purchasing power parity (PPP) is the exchange rate based on of a currency relative to a
selected standard such as the US ______________________.
III.
Short Notes:
1. Definition of GNP and GDP:
2. Difference between NY at factor cost and NY at market prices
3. If the NY of a country is Rs.84,000 Crores in 2009, and increased to Rs. 93,000
Crores in 2010, what is its growth rate?
4. Definition of Personal income
5. Per capita real income