National income accounting (NIA)

1. National income accounting (NIA) • is the measurement of indicators of national output/income; .e.g. GDP, GNP

2. Circular flow diagram • summarizes the transactions between the different economic agents • agents: households, firms (business), government, and foreigners (rest of the world)

3. Circular flow diagram • Assumption: The economy composed of households and firms only • Households: own factors of production, consume goods and service • Firms: hire factors of production to produce goods and services

4. payments for goods and services goods and services FIRMS HOUSEHOLDS factor services factor payments (wages, interest, rent, profit) FIGURE 8.1. Circular flow diagram. The diagram above represents the transactions between firms and households in a simple economy. In the upper loop, the arrow emanating from firms to households represents the sale by firms of goods and services to households. On the other hand, the arrow from households to firms represents the payments. n the lower loop, the arrow originating from the households to the firms shows that firms hire labor and capital from households in order to produce goods and services. The arrow emanating from the firms indicates their payments for the use of the factors of production.

5. Revenue (=GDP) Spending (=GDP) MARKETS FOR GOODS AND SERVICES Good and services sold Good and services bought HOUSEHOLDS FIRMS Land, labor and capital Inputs for Production MARKETS FOR FACTORS OF PRODUCTION Income (=GDP) Wages, rent, interest and profit (=GDP) Flow of goods & services Flow of money: pesos THE CIRCULAR FLOW DIAGRAM

6. Circular flow diagram • Assumption: The economy composed of households and firms only • Households: own factors of production, consume goods and service • Firms: hire factors of production to produce goods and services

7. Circular flow diagram • Upper loop of the circular flow diagram: transactions in the goods and services markets • Lower loop: transactions in the factor markets

8. With government and foreign agents • Need to account for : • Government purchases of goods and services. • Government payments for factor services (wages, rent, interest). • Transfer payments between different agents. • Firms and households pay taxes to government. • Taxes paid on income, property, goods and services. • Transactions with the foreign sector.

9. Transfer payments • Transfer payments – are transactions wherein one party is not obliged to deliver a good or service in return for the payment. • Examples: retirement benefits, unemployment benefits, scholarships, and donations.

10. Transactions with foreign sector • Includes sales of goods and services, assets, and transfers • Exports - sales of domestically produced goods to other countries • Imports - goods bought from other countries

11. Measurement of economy’s output:The Gross Domestic Product (GDP) • The GDP measures the market value of all final goods and services produced within an economy in a given period. • GDP only measures current production. Transfer payments and transactions involving goods produced in other periods are not included in the calculation of GDP. • GDP is usually expressed in the currency of a particular country, e.g., Philippine peso….indicates the market value of the goods and services

12. Definition of GDP • The market value of good i (Vi) is equal to PiQi • GDP = sum of the market values of all final goods and services produced within the year.

13. GDP includes final goods and services only • Final goods - goods and services that are not purchased for the purpose of producing other goods and services or for resale • Eg. Rice (final) and palay or unhusked rice (intermediate product) • Including intermediate goods and final goods will result in “double counting”.

14. 3 Approaches for measuring GDP • Expenditure Approach (upper loop) – measures GDP as the sum of expenditures on final goods and services. • Income Approach (lower loop) – measures GDP as the sum of incomes of factors of production (wages, rent, interest and profit. • Value-added Approach – measures GDP as the sum of value added at each stage of production (from initial to final stage)

15. Expenditure Approach • Uses the upper loop of the circular flow diagram. • Example: Suppose the economy has only one product, namely, rice.

16. Income Approach Uses the lower loop of the circular flow diagram: sum of payments to the various factors of production. Suppose that in the production of rice the sales and expenses are as follows:

17. Suppose that rice is the only final product of an economy: It goes through several (3) stages of production. Value Added Approach

18. Notes of the 3 approaches • The expenditure approach, income approach, and the value-added approach all come up with the same estimate of the GDP. They are equivalent approaches. • In the income approach, profit is also considered a payment to the entrepreneur. So the incomes are (1) wages, (2) rent, (3) interest, and (4) profit. Profit adjusts to make the sum equal to the final value of the good. • In the value added approach, only the value added in each stage of production are included. If we add the value of intermediate product with the value of the final product, we commit the sin of “double-counting.” • At each stage of production, the value-added is equal to wages, interest, rent, and profit. Therefore the value of the final product is likewise the same of all payments to the factors of production.

19. Additional Topics • GDP vs GNP • Real vs current GDP • Inter-country comparisons of GDP • Convert to international currency like US dollars • Convert to per capita measures

20. THE NATIONAL ACCOUNTS OF THE PHILIPPINES • same principles as above but need to make adjustments in order to accommodate the realities in modern economies • Expenditure approach • GDP = C + G + I + X –M+ SD

21. Table. Expenditures on GDP, 2002 in million pesos.

22. Expenditure Approach • C - spending of households and private non-profit institutions on goods and services • Non-durables - goods and services that are consumed rapidly • Durable goods - that last for a longer period of time • I - investment spending of domestic agents. Its major components are “changes in” Fixed Capital and Changes in Stocks • G - government’s payments for the salaries of its workforce as well as purchases of goods and services  used for the government’s day to day operations and projects. • X - the spending of the rest of the world on goods and non-factor services produced in the country • M - the country’s purchases of goods and non-factor services from the rest of the world. • SD - accounts for accounting and reporting errors in the accounts. Needed to ensure that GDP value from all approaches are the same

23. Income Approach

24. Income Approach • GDP = COE + NOS + D + IBTS • In a simple world, GDP = COE + NOS. In practice, require two adjustments (D and IBTS) • D - accounts for the wear and tear of physical capital • “D” is treated as a business cost  not included in NOS. However, “D” is part of “I” in the expenditure side of the national accounts • IBTS - includes taxes on the use or purchase goods and services and grants from government to firms. E. g sales taxes, value added tax • Not included in NOS but is part of the market prices, of which the items in the expenditure accounts are quoted

25. Value added or Industrial Origin approach • GDP = value added of different activities (sectors)

26. The distinction between GDP and GNP • GNP = GDP + Net Factor Income from the Rest of the World (NFIRW) • NFIRW - measures the difference between the earnings of Philippine residents in other countries and foreign residents in the Philippines

27. The distinction between GDP and GNP

28. Nominal and Real GDP • GDP at current prices or nominal GDP -GDP measured using the prices of the year for which it is calculated • Nominal GDP can be a misleading indicator of changes in output or income because it also embodies changes in the prices of goods and services. • Real GDP or GDP at constant prices  measures the total value of output using the prices of a selected year (the base year). • Real GDP better for analysis overtime because it eliminates the effects of price changes

29. Table 8.5

30. GDPyear 1 = (100) (50) + (100) (100) = 15,000 • GDPyear 2 = (100) (50) + (100) (100) = 15,000 • In practice, calculating real GDP using the previous approach is a tedious process because there are so many goods and services are produced in an economy. Can simplify the calculation process by using the GDP deflator. • GDP deflator - a price index that allows us to convert nominal GDP into real GDP. (note: price index to be defined later)

31. Real GDP

32. Calculation of Real GDP

34. GNP for cross country comparisons • Convert a country’s GNP to US dollars, or some common currency, by using the country’s exchange rate • When comparing income across countries, it also makes sense to use per capita estimates  eliminates differences in population size. E.g. (data is for 1998)

35. Personal Disposable Income • Personal disposable incomerepresents the income that households are free to spend or save. • It excludes the components of national income that do not accrue directly to households. • It also includes a few items that are not part of national income but nonetheless influence the amount of income that households can spend.

36. Some Limitations of GDP or GNP as measures of growth • Ignores income distribution • Ignores environmental degradation • Does not include activities that do not go through the formal markets sectors • Does not include “illegal” activities like drug trafficking, prostitution, moonlighting