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Lecture-2
From circular flow diagrams, it is clear how productive activities by the business sector in the
economy generate income and how these income is spent by the household sector on those final
goods by the households. They are all ‘flow’ concepts and can, therefore, be measured with
reference to a ‘period’ say, an year. There are three alternative methods of measuring the flow:
I. Product or Value-Added Method: Under this method, the values of all final goods and
services produced in the economy in a particular year are added together.
II. Income Method: Income method consists of adding together all the income that accrue to the
factors of production by way of payment of rent, wages, interest and profit.
III. Expenditure Method: Expenditure method consists of adding up of all expenditures – both
public and private- on consumption and investment goods (and services).
Now we proceed to measure national income of a country.

I. Product or Value-Added Method: Given the assumption of well-defined market prices (and
by imputing prices as accounting conventions whenever necessary) for all the commodities
produced and used in production, we can define the value added during a period by a capitalist
enterprise or industry j as:
Value added (VAj) = Value of production (VPj) -- Value of total intermediate inputs(Uj)
= Sales(Vj)+Inventory changes(Aj)--Value of total intermediate inputs (Uj) (1)
But total intermediate inputs (Uj) consist of purchased intermediate inputs as raw materials (Zj) as
well as the 'wear and tear' of durable items used in production i.e. Uj = Zj + Dj. When no allowance
is made to cover this latter element of depreciation (Dj), we have gross value added including
depreciation as,
Gross value added (GVAj)= Value of production(VPj)--Purchase of intermediate raw materials(Zj)
= Sales (Vj) + Inventory changes(Aj)-- Purchase of intermediate raw
materials (Zj) (2)
If we exclude depreciation from gross value added we get net value added as:

Net value added (NVAj) = Gross value added (GVAj) — Depreciation (Dj) (3)
The capitalist economy consists of several productive sectors. A 'sector' could normally be a
collection of industries. If we sum up the value added by all the productive sectors in the economy,
the total value added avoids double counting to estimate the total economic contribution by all the
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sectors in the economy. This summation of all the sectoral gross value added defined by (2)
measures the gross domestic product (GDP) by the product method. Since depreciation is not
deducted from gross value added, GDP includes depreciation. When depreciation {Dj) is deducted
as an input cost from each sector's gross value added, the resulting figures is net value added by the
sector, as already stated in (3); summing over the net value added (NVAj) of all the sectors, we arrive
at net domestic product (NDP) which excludes depreciation. The product method of macroeconomic
accounting can then be represented as,
Gross domestic product (GDP) = ∑j Gross value added (GVAj) (4)
GDP = ∑j Net value added (NVAj) +∑j Depreciation (Dj) (5)
= Net domestic product (NDP) + Total depreciation (D) (6)

II. Income Method:

GDP can also be estimated by another method which consists of finding how the gross value
added is distributed among various types of income like rent, wages, interest and profit. As we know
the gross value added during a period by an enterprise or industry j as:
Gross value added (GVAj) = Value of Production (VPj) -- Purchase of intermediate
raw materials (Zj)
The industry ‘j’ having this gross value added has the following liabilities:
(i) Rent (Rj) to the landowner as payment for utilizing landing in the production process;
(ii) Wages and Salaries (Wj) to the labour as reward for their labour services;
(iii) Interest (Ij) to the supplier of capital,
(iv) Profits and Dividends (Pj) to the entrepreneurs as reward for their risk-taking.
Thus, gross value added during a period by a capitalist enterprise or industry j can be written as:
Gross value added (GVAj) = Rent (Rj) + Wages and Salaries (Wj) +Interest (Ij) +
Profits and Dividends (Pj)
= Rj + Wj + Ij + Pj
As before, summing up the gross value added of all the industries/sectors, we obtain an estimate of
gross domestic product (GDP) by the income method:
Gross Domestic Product (GDP) = ∑Rj + ∑Wj + ∑Ij + ∑Pj
= R+ W + I + P
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It follows that GDP by the income method is the sum total of factor earnings. This is also called GDP
at factor cost, which is considered to be the National Income of a country.
III. Expenditure Method: We could also use the alternative definition of gross value added in (2)
to estimate gross domestic product (GDP) by another route. This leads to an equivalent but
alternative accounting by the expenditure method.
To see this more explicitly, we use definition (2) in (4) to obtain,
Gross domestic product (GDP) = ∑j Sales {Vj) + ∑j Inventory changes (Aj)
--∑j Purchase of intermediate raw materials (Zj)
i.e., GDP = Total sales (V) + Total inventory changes (A)
-- Total purchase of intermediate raw materials (Z) (7)
Total sales (V) in an open economy with international trade equals sales to foreign customers
as exports as well as sales to domestic customers. However, a part of the total expenditure by
domestic customers is on the import of goods and only the remaining part is spent on the purchase
of domestically produced goods. Thus, for total sales of domestically produced say, final
consumption goods (Vc), we may write,
Final sales of domestically produced consumption goods (Vc) =
Export of consumption goods (Xc)
+ Total expenditure by domestic customers on consumption goods (C)
+ Total expenditure by domestic government on consumption goods (GC)
-- Import of consumption goods (Mc)
i.e., Vc = Xc + (C+GC –Mc) (8)
Similarly, for final sales of domestically produced investment goods, we write,
Vi = Xi + (I + GI –Mi) (9)
where Xi and Mi, stand for export and import of final investment goods and I is the total expenditure
by domestic customers on investment goods.
Total sales of raw materials (Vz) consist of raw materials exported (Xz) and raw materials
domestically sold (Zds), i.e.,
Vz = Xz +Zds (10)
On the other hand, total purchase of raw materials (Z) is simply, import of raw materials (Mz)
plus their domestic purchases (Zdp)i.e.
Z = Mz +Zdp (11)
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It should also be added here that all inventory changes (A) being only book-keeping valuation
without actual market transactions, need not be broken down into final sales and purchases in the
manner described by equations (8) to (11).
Now total sales (V) in the economy must equal sales of final consumption goods (Vc),
investment goods {Vi) as well as sales of raw materials (Vz), i.e.
Total sales (V) = Vc + Vi + Vz (12)
Now by substituting relations (8) to (12) in the definition of gross domestic product as the sum of
gross value added by all sectors in (7) and by rearranging we obtain,
GDP = C + I + A +(GC + GI) + (Xc + Xi + Xz) -- (Mc + Mi + Mz) + (Zds -- Zdp) (13)
Clearly (Xc + Xi + Xz) represents the total export (X) and (Mc + Mi + Mz) represents the total

import (M) of the economy. (GC + GI = G) is the expenditure of government on consumption and
investment goods. It now needs to be noted that total domestic sales of raw materials (Zds) must
equal total domestic purchase of raw materials (Zdp) by definition, i.e.
Raw materials domestically sold (Zds) = Raw materials domestically purchased (Zdp) (14)
Hence, using (14) in (13), gross domestic product (GDP) by the expenditure method in an open
economy reduces to:
GDP = Consumption expenditure (C) + Investment expenditure
+ Inventory change (A) + Government Expenditure (G) + Exports (X) —
Imports (M) (15)
where, all domestic purchases and sales of raw materials have cancelled out in aggregate economy-
wide accounting. Therefore,.
GDP = Consumption (C) + Gross Investment expenditure (I) + Government
Expenditure (G) + Exports (X) — Imports (M) (16)

The conceptual distinction between 'domestic' and 'national' magnitudes in macroeconomic

accounting is based on a simple idea: 'domestic' is used as a geographical or locational concept.
Thus gross domestic product (GDP) is the aggregate gross value added of various productive sectors
located within the given geographical boundaries of a country. 'National', on the other hand is more
of a politico-legal concept: it relates to the aggregate product or income which accrues to the
normal residents in a country from their economic activity anywhere in the world. Consider, for
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example, an American business corporation owning some factories in India. The domestic product
of India will include the entire value added by those factories because they are located in India.
However, for estimating the national product of India, we must exclude the various types of
incomes in the forms of wages, profits and rents accruing to non-residents (Americans and others)
in those factories. For instance, in so far as those Americans are normal residents of the United
States, their incomes as profit, wage and rent will be added to the national (but not domestic)
product of the United States. On the other hand, normal residents of India working elsewhere in
the world will be contributing to the national (but not domestic) product of India. Thus we define:
Net factor income from abroad = Total factor incomes earned by normal residents
(or citizens) of the country from foreign sources
-- Total factor incomes paid to non-residents
(or foreigners) by domestically located firms.
Gross national product {GNP) of a country can now be defined simply as,
Gross National Product (GNP) = Gross Domestic Product (GDP)
+ Net Factor Income from Abroad (NFIA)
 The difference between GNP and GDP is therefore NFIA.
 GNP > GDP => NFIA >0; GNP < GDP => NFIA < 0.

Gross value added of an industry ‘j’ is the difference between value of output of the ‘j’th
industry and value of raw materials used in the production. Apart from raw materials which are of
single use, there may be some multiple-use(durable) fixed capitals such as machineries, buildings,
factory shades etc whose services are also necessary in production. Fixed capitals have their own
life-time and depreciates in value every period of time after their participation in the productive
process. Depreciation of fixed capital takes place because of their normal ‘wear and tear’. This
depreciation can be treated as the value of fixed capital used up in the production. Hence for getting
‘net’ estimate of value added, we have to deduct this value of depreciation from ‘gross’ value added
i.e.
Net value added (NVAj) = Gross value added (GVAj) — Depreciation (Dj)
Summing over for all industries, we get:
∑j Net value added (NVAj) = ∑j Gross value added (GVAj) -- ∑j Depreciation (Dj)
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Therefore, we can write

Net Domestic Product (NDP) = Gross Domestic Product (GDP)
-- Total Depreciation (D)
Similarly, Net National Product (NNP) is simply obtained as gross national product (GNP) minus
depreciation (D) i.e.
Net National Product (NNP) = Gross National Product (NDP)
-- Total Depreciation (D)

While deriving GDP of a country we estimate value added at the market prices. The estimate
of GDP obtained this way is known as GDP at market price. Market prices normally include indirect
taxes net of subsidies. Market price of product of ‘j’th industry is obtained by adding indirect taxes
net of subsidies on the product of industry ‘j’ to factor cost of production per unit of output of
industry ’j’ i.e.
Market Price(MPj) = Factor Cost(FCj) + Indirect Taxes(ITj) – Subsidies(Sj)
= Factor Cost(FCj) + Net Indirect Taxes(Net ITj)
Alternatively, we can write:
Factor Cost(FCj) = Market Price(MPj) -- Net Indirect Taxes(Net ITj)
It is the factor cost which is finally distributed among the factors of production as their income. In
macroeconomic accounting, we therefore use another concept called GDP at factor cost:
GDP at Factor Cost = GDP at Market Price – Net Indirect Taxes (Net IT)
GDPFC = GDPMP – Net IT
Note that the amount of net indirect taxes (Net IT) equals the total collection of indirect taxes minus
total subsidies paid by the government.
Thus, Gross national product at factor cost {GNPFC) is simply, Gross national product at
market price (GNPMP) minus net indirect taxes (Net IT), i.e.
Gross national product at factor cost = Gross national product at market prices - Net indirect taxes
or, GNPFC = GNPMP – Net IT
Similarly, Net national product at factor cost {NNPFC) is simply, Net national product at market
price (NNPMP) minus net indirect taxes (Net IT), i.e,
NNPFC = NNPMP – Net IT
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Expanding the above equation, we can write:

NNPFC = NNPMP – Net IT
= (GNPMP –D) – Net IT
= GDPMP + NFIA – D –Net IT
This net national product at factor cost is equivalent to the notion of national income {NI), which the
accrual of income to all normal residents in a country due to their participation in production
anywhere in the world.

Therefore, National Income(NI) = NNPFC

To arrive at aggregate personal income (PI) from NI we have to deduct those parts of NI that
are earned by the corporate sector and add net transfer payments to the personal sector. Two
items are deducted from NI:
(i) Pre-tax Corporate Profit;
(ii) Contribution for social insurance;
Three items are added then:
(i) Transfer Receipts such as employee’s social security benefit, state
unemployment insurance benefit along with business transfer such as
charitable contribution of corporate sector;
(ii) Dividends which are distributed corporate profits after tax;
(iii) Interest Adjustment
Note:
(i) Interest adjustment refers to net interest earned on financial assets. The interest adjustment
is equivalent to subtracting ‘net interest’ and adding ‘personal interest income’. Net interest
is that part of interest that is included as non-transfer interest income in national income;
personal interest income is the amount of interest income available to households for
spending, and thus part of the household members’ personal income.
(ii) Transfer are those payments that do not arise out of current productive activity. Thus,
pensions, welfare payments and unemployment benefits are examples of transfer payments.
(iii) Personal income includes all types of income, be it productive income or transfer income,
accrued to the household sector,
Therefore,
P I = N I – C o r p o r a t e p r o f i t s – So c i a l In s u r a n c e C o n t r i b u t i o n s
+ T r a n s f e r R e c e i p t s + In t e r e s t A d j u s t m e n t
+ D i vi d e n d s
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Disposable personal income(DPI) is obtained by deducting personal tax and non-tax

payments from Personal Income i.e.
D PI = P I – Pe r s o n a l T a x a n d N o n - t a x Pa y m e n t s
Not all personal income is available for spending by households. The amount available for spending
is disposable personal income(DPI). Households can either consume or save this amount.
Therefore, we can write:

DPI ≡ Personal Consumption Expenditure + Personal Savings

Yd ≡ C + S
where Y d stands for DPI.

To estimate the income of the private sector before tax i.e. private income(PRI), we only add
the undistributed profits of the normally resident private business sector(UP) to personal income
(PI)
PRI = PI + Undistributed profits of the private business sector (UP)
National Income can also be estimated by adding to this private income, the undistributed profit of
publicly owned enterprises {UPG) and subtracting all income transfers in the form of gifts, grants and
benefits which are in the nature of income redistribution and hence not received by the general
public from their participation in production,
National income {Nl) = Personal Income before tax (PI)
+ Undistributed profits of private enterprises (UP)
+ undistributed profits of public enterprises (UPG)
-- net income transfer from the government to the public
= PRI + undistributed profits of public enterprises (UPG)
-- net income transfer from the government to the public

Suggested Readings:

1. Branson,W.: Macroeconomic Theory and Policy

2. Froyen, T R.: Macroeconomics
3. Mankiw,G.N.: Macroeconomics