National Income and Related Aggregates Class 12 Notes

The economy is a closed loop of production, income and expenditure. Households supply factors to firms, firms pay factor incomes, households spend that income on the firms' output, and the firms use the receipts to continue production. What is produced becomes income, and income becomes expenditure, so the three sides must measure one and the same total.The two-sector circular flow, households to firms and back, is the model that explains the equality of the product, income and expenditure approaches to national income.

• Real flow: the movement of factors from households to firms and of goods and services from firms to households.
• Money flow: the payment of factor incomes to households and the payment for goods to firms.
• The circular flow assumes two sectors and no leakages; governments, trade and savings appear later as injections and leakages.
• The identity that follows: since every rupee of output is received as income and finally spent, Product = Income = Expenditure.

Two binary pairs organise national income accounting. A stock is a variable measured at a point in time, a flow is measured over a period. A final good is one that is not used up in making another good; an intermediate good is used up in production or resold. Consumption and investment goods complete the classification.

• Stock: wealth, capital, the money supply, inventory, population — a quantity at an instant.
• Flow: income, investment, saving, exports — a quantity per period.
• Intermediate goods: bought for resale or for further production, and the fear of double counting is why only final goods enter the national income.
• Final goods: consumption goods bought by households and capital goods bought by firms, telephones installed and wheat bought by the bakery's customer (not the bakery's wheat).
• Current and capital transactions: the distinction that separates the national income from the change in wealth.

The aggregates are built by two operations: the choice between domestic and national, which introduces net factor income from abroad, and the choice between gross and net, which introduces depreciation. Crossing the two gives the four central measures.GDP is the domestic aggregate; GNP adds NFIA, the net income of Indian residents from abroad. Net measures subtract depreciation, the wear and tear of capital, because a part of every year's output merely replaces the capital used up.

• GDP: the market value of all final goods and services produced within domestic territory in a year.
• GNP: GDP plus net factor income from abroad.
• NDP: GDP less depreciation — the net production of the year.
• NNP: GNP less depreciation.
• NFIA: factor income earned by residents abroad less factor income paid to non-residents within the country.
• Depreciation: the loss of value of capital due to wear and tear, obsolescence and passage of time during the year.

The properly named 'national income' is NNP at factor cost: the sum of the factor earnings — wages, rent, interest and profit — of the residents of the country. The market price of a good includes indirect taxes and excludes subsidies, so the bridge between market price and factor cost runs through net indirect taxes.National income at factor cost is the income earned by the factors, while NNP at market price is what they pay for the final goods.

The same national income can be measured from the production side, the income side or the spending side. The product method sums value added by each producing unit; the income method sums all factor incomes; the expenditure method sums all final expenditures. The three give the same figure because the circular flow ties production, income and expenditure together.

• Product (value-added) method: sum of value added — sales less intermediate purchases — across all producing enterprises in a year.
• Income (factor) method: sum of compensation of employees, operating surplus (rent, interest, profit) and mixed income, plus net factor income from abroad.
• Expenditure method: sum of private final consumption expenditure, government final consumption expenditure, gross domestic capital formation and net exports.
• Precautions: count only final goods, avoid transfer payments, count income earned (not received) and include legal services provided free in national income but not sale of second-hand goods.
• Output equality: three methods, one national income.

The national income at current prices is the nominal income; at constant (base-year) prices it is the real income. The comparison of the two yields the GDP deflator, the broadest price index of the economy. Real income is what says whether the country actually produced more, and the deflator says whether the change was price or volume.

• Nominal GDP: output at current year's prices — a mix of volume and price change.
• Real GDP: output at base-year prices — volume change alone.
• GDP deflator: nominal GDP divided by real GDP, times 100, the price index of the whole economy regardless of the basket.
• GDP as a welfare measure: the national income undercounts welfare because it leaves out the non-monetary services, leisure, the quality of the environment and the unequal distribution of income.
• Green measures and well-being indices address the gap between the GDP and the actual welfare, but the national income record itself stays the base.

The unit is examined through the definitions of the aggregates, the numerical methods, and the adjustment steps between market price and factor cost. The definitions must be word-perfect because the one-marker is a definition, and the numerical questions mark on the formula and the substitution.

• Define GDP, GNP, NDP, NNP, NFIA, depreciation, final and intermediate goods, stock, flow, real and nominal income.
• Distinguish GDP from GNP, market price from factor cost, and nominal from real income, each in two parallel steps.
• Measure national income by the value-added, income and expenditure methods with the precautions.
• Convert the aggregates: GDP to NNP at factor cost by subtracting depreciation and net indirect taxes and adding NFIA.
• Compute real income and the GDP deflator from the given price and volume data.
• Evaluate GDP as a measure of welfare and list what it leaves out.