MODULE 2

National Income Accounting

Exequiel M Perez 2/7/22 Economic Development

 MODULE II

NATIONAL OUTPUT/NATIONAL INCOME

ACCOUNTING

1 INTRODUCTION

There are two main branches of economics: microeconomics and

macroeconomics. Microeconomics deals with the analysis of individual parts of the
economy. It concerns factors determining the behavior of a consumer, the behavior of
a firm, the demand for a good, the supply of a good, the price of a good, the quantity
of a good, the performance of a market, etc. Thus far, we have been dealing with
microeconomics. Macroeconomics deals with the analysis of the whole economy. It
concerns factors determining aggregate variables such as aggregate demand,
aggregate supply, national output, national income, unemployment, inflation, the
balance of payments, etc. As opposed to microeconomics which focuses on the
individual parts of the economy, macroeconomics looks at the big picture of the
economy. In order to understand macroeconomics, we first need to understand the
concepts of national output and national income which are used for many purposes
such as measuring the standard of living. This chapter provides an exposition of the
concepts of national output and national income.

2 MEASUREMENT OF NATIONAL OUTPUT, NATIONAL INCOME AND

NATIONAL EXPENDITURE

National output is the market value of all the final goods and services produced in
the economy over a period of time. National income is the total income earned by the
nation over a period of time. National expenditure is the total expenditure made on the
final goods and services produced in the economy over a period of time. National
output, national income and national expenditure are different economic variables.
However, they have the same value.

When firms increase production which will lead to an increase in national output,
they will employ more factor inputs from households and hence will pay them more
factor income which will lead to an increase in national income. Therefore, an
increase in national output will lead to an increase in national income. Furthermore, as
the factors of production in the economy which include labor, land, capital and
enterprise are owned by households, the increase in national income will be equal to
the increase in national output.

Although it is easy to see why national income is equal to national output, it is

less obvious why national expenditure is equal to national output. If all the final goods
produced in the economy are purchased by households, firms, the government or
foreigners, then it is obvious why national expenditure is equal to national output.
However, even if some of the final goods produced in the economy are not purchased
by households, firms, the government or foreigners, national expenditure is still equal
to national output. This is because the final goods produced in the economy which are

29
not purchased by households, firms, the government or foreigners are considered to be
purchased by firms themselves. The value of these unsold goods, which is called
stock in accounting, is known as inventory investment in economics.

As national output, national income and national expenditure have the same
value, there are three ways to measure national output: the output approach, the
income approach and the expenditure approach.

Output Approach (Direct Approach)

Adding up the values of all the final goods and services produced in the economy
and indirect taxes net of subsidies yields national output. Final goods and services are
goods and services that are consumed by the end-users. They include consumer goods
such as ice creams and cookies and capital goods such as factories and machinery.
When measuring national output, the values of intermediate goods and services are
excluded as they are already included in the values of final goods and services.
Intermediate goods and services are goods and services that are used as inputs in the
production of other goods and services. They include raw materials and semi-finished
goods.

Income Approach (Indirect Approach)

Adding up the factor incomes (i.e. wages, rent, interest and profits) received by
households from firms for the provision of factors of production and indirect taxes net
of subsidies and depreciation yields national income which is equal to national output.

Expenditure Approach (Indirect Approach)

Adding up the expenditures made on all the final goods and services produced in
the economy yields national expenditure which is equal to national output. In an open
economy, this involves adding up consumption expenditure, investment expenditure,
government expenditure on goods and services and net exports. The expenditure
approach will be explained in greater detail in Chapter 3.

Industrial-Origin Approach (Only used in the Philippines)

Adding up the values or income earned of the three sectors in the economy,
namely; Agriculture Sector, Industry Sector and Services Sector.

Gross Domestic Product versus Gross National Product

Gross Domestic Product (GDP) is the market value of all the final goods and
services produced in the economy over a period of time. Gross Domestic Product is
commonly simply referred to as national output. In contrast, Gross National Product
(GNP) is the market value of all the final goods and services produced by factors of
production owned by the residents of the economy over a period of time. To put it
somewhat differently, although Gross Domestic Product focuses on the location of
factors of production, Gross National Product focuses on the ownership. Some of the
goods and services produced in the economy are produced by factors of production
owned by foreigners. When these foreigners earn wages, rent, interest and profit, they

30
remit the income to their home countries. This income is called ‘factor income to
abroad’. Similarly, some of the income earned by domestic residents comes from the
ownership of factors of production located overseas. This income is called ‘factor
income from abroad’. Gross National Product can be obtained by adding factor
income from abroad and subtracting factor income to abroad from Gross Domestic
Product.

Net National Product at Factor Cost

By equating national income to national output, I am effectively equating national

income to Gross Domestic Product. However, it is important to note that some
economists do not equate national income to Gross Domestic Product. Instead, they
equate national income to Net National Product at factor cost. In the absence of
indirect taxes and subsidies, market prices will be equal to the factor cost. In reality,
the government imposes indirect taxes which make market prices higher than the
factor cost, and gives subsidies which make market prices lower than the factor cost.
When capital goods are used to produce goods and services, they wear out over time
and this is called depreciation or capital consumption. Subtracting depreciation from
gross investment yields net investment. Net National Product at factor cost can be
obtained from Gross Domestic Product in three steps; add factor income from abroad
and subtract factor income to abroad, subtract depreciation and subtract indirect taxes
and add subsidies.

Disposable Income

Economists are interested to find out how consumption expenditure varies with
income. For this purpose, instead of national income, disposable income is used.
Disposable income is the income that households have available to spend or save after
paying direct taxes and receiving transfer payments. To get disposable income from
national income, we subtract undistributed corporate profits and direct taxes and add
transfer payments.

Note: The Philippine government measures national output which include the output
approach, the income approach and the expenditure approach and the Industrial-
Origin Approach which is only use in the Philippines to measure GDP. However, as
the data are obtained from diverse sources, the three approaches yield slightly
different results. To overcome the problem, a statistical discrepancy is included in the
income approach and the expenditure approach to yield the same result as the output
approach.

Transfer payments are payments made by the government to the recipients not in
exchange for any goods or services. They include social security benefits,
unemployment benefits and interest payments on national debt. The Singapore
government provides limited social security benefits and does not provide
unemployment benefits.

31
3 THE BUSINESS CYCLE

The business cycle, or the trade cycle, refers to the periodic fluctuations of
national output and hence national income around its long-term trend. It involves two
phases: economic expansion and economic contraction. An economic expansion is a
period of time during which national output and hence national income is rising. An
economic contraction is a period of time during which national output and hence
national income is falling.

The Business Cycle

In the above diagram, the upward sloping portions of the business cycle are
economic expansions and the downward sloping portions are economic contractions.
On average, an economic expansion is longer than an economic contraction.
Therefore, national output and hence national income rises over time. Due to several
factors such as globalization, the business cycle is getting shorter. Although the
duration between a trough and the next peak was between 10 and 15 years, it is now
between 5 and 7 years. In other words, economic contraction is occurring more
frequently. Nevertheless, expansion remains the normal state of the economy.

4 NOMINAL NATIONAL OUTPUT AND REAL NATIONAL OUTPUT

Economists distinguish between two types of national output: nominal national

output and real national output. Nominal national output is national output measured
at current prices. Real national output is national output measured at base-year prices.
Similarly, economists distinguish between two types of national income: nominal
national income and real national income. Nominal national income is national
income derived from the production of national output measured at current prices.
Real national income is national income derived from the production of national
output measured at base-year prices.

The size of an economy is measured by the amount of goods and services

produced in the economy. Therefore, an economy grows when it produces a larger

32
amount of goods and services. For the purpose of measuring economic growth,
economists prefer the use of real national output to the use of nominal national output.
As nominal national output is national output measured at current prices, an increase
in nominal national output can be due to an increase in the amount of goods and
services produced in the economy or a rise in the prices of goods and services.
Therefore, when nominal national output rises, the economy may not necessarily be
producing a larger amount of goods and services as the increase in nominal national
output may be due to a rise in the prices of goods and services. However, as real
national output is national output measured at base-year prices, an increase in real
national output can only be due to an increase in the amount of goods and services
produced in the economy as base-year prices do not change unless the government
changes the base year. Therefore, when real national output rises, the economy is
producing a larger amount of goods and services, which is known as economic
growth.

Example: The Republic of Coconuts

Assume that

Output (2015) = 20 coconuts

Price (2015) = $3

Output (2010) = 15 coconuts

Price (2010) = $2

The base year is 2010

Therefore,

Nominal GDP (2015) = Output (2015) x Price (2015) = 20 x $3 = $60

Real GDP (2015) = Output (2015) x Price (2010) = 20 x $2 = $40

Nominal GDP (2010) = Output (2010) x Price (2010) = 15 x $2 = $30

Real GDP (2010) = Output (2010) x Price (2010) = 15 x $2 = $30

In the above example, the nominal GDP in 2015 was $60 and the nominal GDP
in 2010 was $30. Therefore, the nominal GDP grew by 100% [($60 – $30)/$30 x
100%] from 2010 to 2015. However, much of the increase in the nominal GDP from
2010 to 2015 was due to an increase in the general price level. The real GDP in 2015
was $40 and the real GDP in 2010 was $30. Therefore, the real GDP grew by only
33% [($40 – $30)/$30 x 100%] from 2010 to 2015, which was lower than the 100%
increase in the nominal GDP.

33
GDP Deflator

With nominal GDP and real GDP, we can measure the GDP deflator. The GDP
deflator is an index of the average price of all the final goods and services produced in
the economy over a period of time. It is used by economists to monitor the general
price level. The GDP deflator measures the general price level in the current year
relative to the general price level in the base year chosen by the government.

Nominal GDP (t)

GDP Deflator (t) = ————————— × 100

Real GDP (t)

From the above example, GDP deflator2015 = (Nominal GDP2015/Real

GDP2015) x 100 = $60/$40 × 100 = 150, which means that the general price level
rose by 50% from 2010 to 2015.

Inflation is a sustained rise in the general price level. The inflation rate is the
percentage increase in the general price level. In theory, it can be calculated as the
percentage increase in the GDP deflator.

GDP Deflator (t) – GDP Deflator (t–1)

Inflation Rate (t) = —————————————————— × 100

GDP Deflator (t–1)

Note: The base year currently used to measure real GDP in Singapore is 2010.

Although the inflation rate can be calculated as the percentage increase in the GDP
deflator, it is calculated as the percentage increase in the consumer price index (CPI)
in reality.

5 NATIONAL INCOME AND THE STANDARD OF LIVING

Economists often use real national income to compare the standards of living
over time (intertemporal comparison) and across space (international comparison).
The standard of living refers to the material and non-material welfare of the people.

An increase in national income may lead to a rise in the standard of living. When
firms increase production which will lead to an increase in national output, they will
employ more factor inputs from households and hence will pay them more factor
income which will lead to an increase in national income. Therefore, an increase in
national income indicates an increase in national output. An increase in national
output may lead to an increase in the amount of goods and services available for
consumption. If this happens, the material standard of living will rise. Furthermore,
when national output rises, the demand for labour in the economy will rise which will

34
lead to a fall in unemployment. When this happens, the morale and self-confidence of
the workers who were previously unemployed but have found a job may rise which
may improve their mental health and this may lead to a rise in their non-material
standards of living. In addition, the mental health of the workers who were previously
employed and have remained employed may improve as they may experience a higher
sense of job security and this may lead to a rise in their non-material standards of
living.

However, due to several reasons, this is not necessarily true. Therefore, problems
arise when national income is used to compare the standard of living over time and
across space.

Intertemporal Comparison (Comparison Over Time)

An increase in national output may not lead to a rise in the standard of living
because it may not lead to an increase in the amount of goods and services available
for consumption due to several reasons.

First, the amount of goods and services available for consumption may not
increase because the amount of non-marketed goods and services may decrease. The
value of non-marketed goods and services is not included in national output. For
example, when a baker bakes a pie, the value of the pie is included in national output.
However, when a housewife bakes a pie, it is not. When unemployment falls due to an
increase in national output, people will have less time to engage in the production of
goods and services in the household economy which will lead to a decrease in the
amount of non-marketed goods and services.

More examples:

In developing economies, many households engage in subsistence farming where

they produce food to feed themselves. However, the value of food that these
households produce is not included in national output. In this case, the omission of the
value of non-marketed goods and services from national output understates the
material standard of living as measured by national output. Over the last few decades,
the national output of Singapore has increased dramatically partly due to an increase
in the women labour force participation rate. Although the increase in the value of the
goods and services that women produce in the market is included in the national
output of Singapore, the decrease in the value of goods and services they produce at
home is not subtracted. In this case, the omission of the value of non-marketed goods
and services from national output overstates the material standard of living as
measured by national output.

Second, the amount of goods and services available for consumption may not
increase because the amount of undeclared goods and services in the underground
economy may decrease. The value of undeclared goods and services in the
underground economy is not included in national output. These goods and services
are not declared because they may be illegal, such as drugs and prostitution, or for the
purpose of tax evasion. For example, people smuggle tobacco and alcohol to evade
tax. When unemployment falls due to an increase in national output, less people will

35
engage in the production of goods and services in the underground economy which
will lead to a decrease in the amount of undeclared goods and services.

Even if the amount of goods and services available for consumption increases, the
standard of living may not rise due to several reasons.

First, the amount of goods and services available to domestic residents for
consumption may not increase because the increase in national output may be due to
an increase in exports. This is particularly true if the economy is highly dependent on
external demand. If this happens, the increase in the amount of goods and services
produced will lead to an increase in the amount of goods and services available to
foreigners rather than domestic residents for consumption. Similarly, if the increase in
national output is due to an increase in the amount of capital goods produced rather
than an increase in the amount of consumer goods and services produced, the material
standard of living may not rise.

Second, the amount of goods and services available to the average person for
consumption may not increase because the population may have increased. In the
event that the population has increased by a larger proportion, the amount of goods
and services available to the average person for consumption will fall.

Third, an increase in national income may worsen income inequity. When

national income rises, the incomes of high income individuals may rise by a larger
proportion than those of low income individuals and this may be due to several
reasons such as high income workers receiving larger wage raises than low income
workers. If this happens, although low income individuals will be better off in
absolute terms, the wider income gap will make them worse off in relative terms
which will lead to a fall in their non-material standards of living.

Fourth, an increase in national output and hence production of goods and services
may lead to an increase in the amount of negative externalities such as carbon
emissions which will result in a more polluted environment and hence a fall in the
non-material standard of living.

Fifth, an increase in national output and hence the demand for labour in the
economy may result in people working longer hours which will cause them to have a
smaller amount of leisure time and hence experience a fall in their non-material
standards of living.

Contrary to what is discussed above, an increase in national output could mean a

larger increase in the standard of living. First, the quality of goods and services
produced may have improved. Second, the variety of goods and services produced
may have increased.

International Comparison (Comparison Across Space)

If the national output of economy A is higher than that of economy B, the

standard of living in economy A may not be higher because the amount of goods and
services available for consumption may not be larger due to several reasons.

36
 First, the amount of goods and services available for consumption in economy A
may not be larger than that in economy B because the amount of non-marketed goods
and services in economy A may be smaller. The value of non-marketed goods and
services is not included in national output. For example, when a baker bakes a pie, the
value of the pie is included in national output. However, when a housewife bakes a
pie, it is not. The omission of the value of non-marketed goods and services from
national output understates the material standard of living as measured by national
output.

Second, the amount of goods and services available for consumption in economy
A may not be larger than that in economy B because the amount of undeclared goods
and services in the underground economy in economy A may be smaller. The value of
undeclared goods and services in the underground economy is not included in national
output. These goods and services are not declared because they may be illegal, such as
drugs and prostitution, or for the purpose of tax evasion. For example, people smuggle
tobacco and alcohol to evade tax. The omission of the value of undeclared goods and
services in the underground economy from national output understates the material
standard of living as measured by national output.

Even if the amount of goods and services available for consumption in economy
A is larger than that in economy B, the standard of living in economy A may not be
higher due to several reasons.

First, the amount of goods and services available to domestic residents for
consumption in economy A may not be larger than that in economy B because the
higher national output in economy A may be due to higher exports. This is
particularly true if economy A is more dependent on external demand compared to
economy B. If this happens, the larger amount of goods and services produced in
economy A could mean a larger amount of goods and services available to foreigners
rather than domestic residents for consumption relative to economy B. Similarly, if
the higher national output of economy A is due to a larger amount of capital goods
produced rather than a larger amount of consumer goods and services produced
relative to economy B, the material standard of living in economy A may not be
higher.

Second, the amount of goods and services available to the average person for
consumption in economy A may not be larger than that in economy B because the
population of economy A may be larger.

Third, the distribution of income in economy A may be less equitable than that in
economy B. If this happens, the incomes of low income individuals in economy A
may be lower than those of low income individuals in economy B which could mean
a lower material standard of living in economy A.

Fourth, the amount of negative externalities such as carbon emissions which is

produced in economy A may be larger than that is produced in economy B resulting
in a more polluted environment in economy A and hence a lower non-material
standard of living.

37
 Fifth, the people in economy A may be working longer hours than those in
economy B which means that the people in economy A may have a smaller amount of
leisure time and hence a lower non-material standard of living.

Contrary to what is discussed above, a higher national output in economy A than

in economy B could mean an even higher standard of living in economy A. First, the
quality of goods and services produced in economy A may be higher than that in
economy B. Second, the variety of goods and services produced in economy A may
be greater than that in economy B.

Purchasing Power Parity

One problem with the use of national income to compare the standards of living
in different economies is that the national income of an economy is measured in the
local currency. In theory, this problem can be overcome by converting the national
income of each economy in the local currency to a common currency such as the U.S.
dollar using the market exchange rate. However, using the market exchange rate as a
conversion factor will not take into account the differences in the costs of living in
different economies. Although the World Bank does convert the national incomes of
different economies in their local currencies to the U.S. dollar using the market
exchange rate, the purpose is to compare the sizes of the economies rather than the
standards of living.

The World Bank, however, also convert the national incomes of different
economies in their local currencies to the U.S. dollar using the purchasing power
parity (PPP) exchange rate with the purpose of comparing the standards of living. The
purchasing power parity (PPP) exchange rate is the exchange rate which allows the
amount of money that is required to purchase a basket of goods and services in one
economy to purchase the same basket of goods and services in another economy after
exchanging it into the currency of the other economy. Suppose that S$200 is required
to purchase a basket of goods and services in Singapore. Further suppose that US$100
is required to purchase the same basket of goods and services in the United States. In
this case, the purchasing power parity (PPP) exchange rate of the U.S. dollar against
the Singapore dollar will be S$2/US$1. As the purchasing power parity (PPP)
exchange rate takes into account the differences in the costs of living in different
economies, it is a better conversion factor for the purpose of comparing the standards
of living in different economies. Needless to say, we should also take into account the
differences in the sizes of the population and a host of other factors.

Note: In addition to the factors that have been discussed in this section, in reality, the
standard of living is affected by many other factors which include housing conditions,
sanitary conditions, literary rate, life expectancy, etc.

Gini coefficient is a measure of inequality of income distribution. It has a value

between 0 and 1, where 0 corresponds to perfect equality (i.e. everyone has the same
income) and 1 corresponds to perfect inequality (i.e. one person has all the income
and everyone else has zero income). Therefore, a higher Gini coefficient indicates a
wider income gap. The Gini coefficient in Singapore is above the internationally
recognised alarming level of 0.4 and is one of the highest among developed countries.
Even after taking into consideration taxes and transfer payments, the Gini coefficient

38
in Singapore still remains above 0.4 while those of other developed countries all fall
below 0.35.

6 ALTERNATIVE MEASURES OF THE STANDARD OF LIVING

Due to the limitations of the use of national income as a measure of the standard
of living, many economists have turned to alternative measures for this purpose.
Among them, the Measurable Economic Welfare and the Human Development Index
are the commonly used.

Measurable Economic Welfare (MEW)

Measurable Economic Welfare is a measure of the standard of living which is

obtained by adding to national income factors which increase the standard of living
such as leisure hours and subtracting factors which reduce the standard of living such
as negative externalities. It is a better measure of the standard of living than national
income as it takes into consideration a larger number of factors which affect the
standard of living. A higher Measurable Economic Welfare indicates a higher
standard of living and vice versa. Measurable Economic Welfare was developed in
1972 by two American economists, William Nordhaus and James Tobin, which they
called it the Net Economic Welfare.

Human Development Index (HDI)

The Human Development Index is a composite index made up of three indices:

an index for real Gross Domestic Product per capita in purchasing power parity
dollars (PPP$), an index for life expectancy and an index for adult literacy and
average years of schooling. Although it was developed as a measure of economic
development, it is commonly used as a measure of the standard of living. It is a better
measure of the standard of living than national income as it takes into consideration a
larger number of factors which affect the standard of living. A higher Human
Development Index indicates a higher standard of living and vice versa. The Human
Development Index was developed in 1990 by Pakistani economist Mahbub ul Haq
and Indian economist Amartya Sen. It has been published by United Nations since
1990.

Limitations

Although Measurable Economic Welfare and Human Development Index are

better measures of the standard of living than national income, they are subject to
several limitations. For example, it is difficult to measure the values of non-marketed
‘goods’ such as leisure hours and the values of non-marketed ‘bads’ such as negative
externalities to obtain the Measurable Economic Welfare. Although Human
Development Index takes into consideration a larger number of factors which affect
the standard of living than national income, it omits several important factors such as
housing conditions and the level of pollution.

39