1. Chapter 2Chapter 2
Measuring National EconomicMeasuring National Economic
ActivityActivity

2. The concept of national
accounts
• National income refers to the total income of the
nation in a particular period of time.
• National income data reveals the aggregate
economic performance of the economy as a whole.
• National income represents a receipts total, an
expenditure total, and the total value of
production
• Since one man’s income is another man’s
expenditure and each commodity is sold at its
market price, national income accounting is based
on the fundamental three fold identity: the value
received equals, the value paid equals, the value of
goods and services given in exchange
• Thus, National income=National expenditure
=National product

3. National accounts: What do
economists say
“ The labor and capital of a country acting on natural
resources, produce annually a certain net aggregate of
commodities, material and immaterial including services
of all kinds…. This is the true net annual income or
revenue of the country or national dividend.” Alfred
Marshall
Features:
• All outputs whether they come to market or not, and
• Income from abroad should be added in the national
income
Limitations:
• Difficult to have correct estimate
• Possibility of double counting

4. National accounts: What do
economists say
“ National income is that part of objective income of the
community, including of course income derived from
abroad, which can be measured in money.” A.C. Pigou
Features:
• Includes only goods and services measured in money
• Income received on investment from abroad included
• Precise, convenient and workable
Limitations:
• Makes an artificial distinction between outputs
measured for money and not measured on that
• Difficult to apply in countries dominating barter system

5. National accounts: What do
economists say
“ The national dividend/income consists solely of services
as received by ultimate consumers, whether from their
material or from their human environments. Thus, a
piano, or an overcoat made for me this year not a part
of this years income, but in addition to the capital. Only
the services rendered to me during this year by these
things are income.” Irving Fisher
Features:
• Emphasizes on welfare
Limitations:
• Difficult to have an estimate of net consumption than
of net production
• Difficult to measure the value of services rendered by
durables

6. National accounts: Concepts
• The national income accounting refers to the
measurement of aggregate economic activity,
particularly national income and its
components such as Gross Domestic Product
(GDP), Net Domestic Product (NDP), Gross
National Income (GNI), Net National Income
(NNI), Personal Income (PI), and Disposable
Income (DI).
• National income accounting was first
developed by Simon Kuznet during the great
depression of 1930s.

7. Gross Domestic Product
• GDP is the total value of all final goods
and services-bread, rice, wheat,
healthcare, concert etc-produced in a
country during a period, usually a year.
• Hence, GDP is the total value of goods
and services produced within the
territorial boundary of the nation
irrespective of who owns the factors of
production.

8. Gross Domestic Product:
Expenditure and Income
• Two definitions:
– Total expenditure on domestically-produced
final goods and services.
– Total income earned by domestically-
located
factors of production.
Expenditure equals income because
every dollar spent by a buyer
becomes income to the seller.
Expenditure equals income because
every dollar spent by a buyer
becomes income to the seller.

9. The Circular
Flow
Households Firms
Goods
Labor
Expenditure
($)
Income ($)

10. Residents/Nonresidents
• Residents means: Center or territory of
economic interest.
• Nepalese citizens performing economic
activities in Nepal,
• Firm, company, and partners registered in
Nepal
• Foreign citizens and firms involved in
economic activities for more than one year
in Nepal
• Nepalese citizens, firm, company,
partnership, and institutions operating for
less than one year in foreign land.

11. Residents/Nonresidents
• Non-resident means:
• Foreign citizens, firm, company,
partnership firm, and institutions
operating in Nepal for less than one year.
• Nepalese citizens, firm, company,
partnership, and institutions operating for
more than one year in foreign land.
• Diplomatic missions, foreign military
offices, and their employees even if they
are operating for more than one year in
Nepal.

12. Residents/Nonresidents
• This classification of resident and non-
resident is usually helpful in figuring out
the net factor income from abroad
(NFIA):
• Income earned by residents and
domestically owned capital is added to the
GDP and income earned by non-residents
and capital owned by foreigners is
deducted. This gives NFIA.

13. Sectors of the economy
• Households:
• Enterprises
• Government
• External

14. Sectors of the economy
• Households: sell land, labor, and capital on various
factor markets and buy goods and services in the
market for products, but they may also work as
producers by forming or owning enterprises.
Households make decisions about how much to
spend on consumer goods and services, how much
to save, and how to allocate their savings as
holdings of alternative financial and real assets
(cash on hand, bank saving deposits, bonds, home
ownership, and so forth).

15. Sectors of the economy
• Enterprises: employ factors of
production such as land, labor and
capital to produce goods and services
for the products market. They make
production, pricing, hiring, and
investment decisions with a view to
maximizing their profits.

16. Sectors of the economy
• Government: The government's
economic role involves creating an
effective regulatory and legal
framework, providing certain public
goods such as education,
infrastructure, and a social safety
net; overseeing the tax system, and
managing government expenditures.

17. Sectors of the economy
• Financial Sector: provides financial
intermediation services for the economy.
It includes all entities whose main activity
involves supplying assets to savers (such as
households) while lending at a different
maturity to borrowers (such as
enterprise). The financial sector includes
commercial banks, credit unions, savings
and loan associations, investment banks,
pension funds, and insurance companies.

18. Sectors of the economy
• External: Nonresidents make up the
external sector of economy, also
referred to as the rest of the world.

19. Circular flow of
income

20. Final goods, value added,
and GDP
• GDP = value of final goods produced
= sum of value added at all stages
of production.
• The value of the final goods already includes
the value of the intermediate goods,
so including intermediate and final goods in
GDP would be double-counting.

21. The expenditure
components of GDP
• consumption
• investment
• government spending
• net exports

22. Consumption (C)
– durable goods
last a long time
ex: cars, home
appliances
– nondurable goods
last a short time
ex: food, clothing
– services
work done for
consumers
ex: dry cleaning,
air travel.
definition: The value of all
goods and services bought
by households. Includes:

23. Investment (I)
Definition 1: Spending on [the factor of
production] capital.
Definition 2: Spending on goods bought for
future use
Includes:
– business fixed investment
Spending on plant and equipment that firms will
use to produce other goods & services.
– residential fixed investment
Spending on housing units by consumers and
landlords.
– inventory investment
The change in the value of all firms’ inventories.

24. Investment vs. Capital
Note: Investment is spending on new
capital.
Example (assumes no depreciation):
– 1/1/2006:
economy has $500b worth of capital
– during 2006:
investment = $60b
– 1/1/2007:
economy will have $560b worth of capital

25. Government spending (G)• G includes all government spending on
goods and services. Includes such items as
national defense, expenditures, cost of
road-paving by state and local governments,
and salaries of government employees.
• G excludes transfer payments
(e.g., unemployment insurance payments),
because they do not represent spending on
goods and services.

26. Net exports= Exports-
Imports• Exports represent foreign spending on
our country’s output, so we include
exports.
• Imports represent the portion of
domestic spending (C, I, and G) that
goes to foreign goods and services, so
we subtract off imports.
• NX, therefore, equals net spending by
the foreign sector on domestically
produced goods & services.

27. Net exports: NX = EX
– IM
def: The value of total exports (EX)
minus the value of total imports
(IM).U.S. Net Exports, 1950-2006
-800
-600
-400
-200
0
200
1950 1960 1970 1980 1990 2000
billionsofdollars
-8%
-6%
-4%
-2%
0%
2%
percentofGDP
NX ($ billions) NX (% of GDP)

28. An important identity
Y = C + I + G + NX
aggregate
expenditurevalue of
total output

29. A question for you:
Suppose a firm
• produces $10 million worth of final
goods
• but only sells $9 million worth.
Does this violate the
expenditure = output identity?

30. Why output =
expenditure
• Unsold output goes into inventory,
and is counted as “inventory
investment”…
…whether or not the inventory
buildup was intentional.
• In effect, we are assuming that
firms purchase their unsold output.

31. GDP:
An important and versatile
concept
We have now seen that GDP measures
– total income
– total output
– total expenditure
– the sum of value-added at all stages
in the production of final goods

32. GNP vs. GDP
• Gross National Product (GNP):
Total income earned by the nation’s factors
of production, regardless of where located.
• Gross Domestic Product (GDP):
Total income earned by domestically-located
factors of production, regardless of
nationality.
(GNP – GDP) = (factor payments from
abroad)
– (factor payments to abroad)

33. GNP vs. GDP
• Emphasize that the difference b/w GDP and GNP boils
down to two things:
• location of the economic activity, and ownership
(domestic vs. foreign) of the factors of production.
• If you take the example of the US
• From the perspective of the U.S., factor payments
from abroad includes things like:
wages earned by U.S. citizens working abroad
profits earned by U.S.-owned businesses located
abroad
income (interest, dividends, rent, etc) generated from
the foreign assets owned by U.S. citizens

34. GNP vs. GDP
• If you take the example of the US
• Factor payments to abroad includes things
like:
wages earned by foreign workers in the U.S.
profits earned by foreign-owned businesses
located in the U.S.
income (interest, dividends, rent, etc) that
foreigners earn on U.S. assets
• Remember, factor payments are simply
payments to the factors of production, for
example, the wages earned by labor.

35. Discussion question:
Which would you want
to be bigger, GDP, or GNP?
Why?

36. GDP
selected countries, 2002
U.S.A. 1.0%
Angola -13.6
Brazil -4.0
Canada -1.9
Hong Kong 2.2
Kazakhstan -4.2
Kuwait 9.5
Mexico -1.9
Philippines 6.7
U.K. 1.6

37. Real vs. nominal GDP
• GDP is the value of all final goods and
services produced.
• nominal GDP measures these values
using current prices.
• real GDP measure these values using
the prices of a base year.

38. Practice problem, part 1
• Compute nominal GDP in each year.
• Compute real GDP in each year
using 2006 as the base year.
2006 2007 2008
P Q P Q P Q
good A $30 900 $31 1,000 $36 1,050
good B $100 192 $102 200 $100 205

39. Answers to practice
problem, part 1nominal GDP multiply Ps & Qs from same year
2006: $46,200 = $30 × 900 + $100 × 192
2007: $51,400
2008: $58,300
real GDP multiply each year’s Qs by 2006 Ps
2006: $46,200
2007: $50,000
2008: $52,000 = $30 × 1050 + $100 × 205

40. Real GDP controls for
inflation
Changes in nominal GDP can be due to:
– changes in prices.
– changes in quantities of output
produced.
Changes in real GDP can only be due
to changes in quantities, because real
GDP is constructed using constant
base-year prices.

41. Real GDP controls for
inflation
•Suppose from 2006 to 2007, nominal GDP rises by
10%. Some of this growth could be due to price
increases, because an increase in the price of
output causes an increase in the value of output,
even if the real quantity remains the same.
•Hence, to control for inflation, we use real GDP.
Remember, real GDP is the value of output using
constant base-year prices. If real GDP grows by
6% from 2006 to 2007, we can be sure that all of
this growth is due to an increase in the economy’s
actual production of goods and services, because
the same prices are used to construct real GDP in
2006 and 2007.

42. GDP Deflator
• The inflation rate is the percentage
increase in the overall level of prices.
• One measure of the price level is
the GDP deflator, defined as
×
Nominal GDP
GDP deflator = 100
Real GDP

43. GDP Deflator
• the GDP deflator.
• The GDP deflator is so named because it is used
to “deflate” (remove the effects of inflation
from) GDP and other economic variables.
• Nominal = Pt * Qt
• Real = Pb*Qt
• Nominal/Real = Pt/Pb in base year = 100.

44. Practice problem, part 2
• Use your previous answers to compute
the GDP deflator in each year.
• Use GDP deflator to compute the
inflation rate from 2006 to 2007, and
from 2007 to 2008.
Nom. GDP Real GDP
GDP
deflator
Inflation
rate
2006 $46,200 $46,200 n.a.
2007 51,400 50,000
2008 58,300 52,000

45. Answers to practice
problem, part 2
Nominal GDP Real GDP
GDP
deflator
Inflation
rate
2006 $46,200 $46,200 100.0 n.a.
2007 51,400 50,000 102.8 2.8%
2008 58,300 52,000 112.1 9.1%

46. Some frequently used
terminologies
National income concepts at market price
• GDP at market price: Value of all final goods and
services produced within the domestic territory
of a country in one fiscal year.
• Gross National Product (GNP) at market price:
GDP at mkt price+ Net factor income from abroad
• Net National Product (NNP) at market price:
GNP at mkt. price- Depreciation
• National income/Net National Product at factor
cost: NNP-Indirect taxes +subsidies

47. Some frequently used
terminologies
What is indirect tax?
• The incidence and burden of taxes shifted are
called indirect taxes. These are levied on the
sellers but shifted on the buyers by the sellers.
Sales taxes/VAT, customs, excises are indirect
taxes. It is to be subtracted to avoid a
discrepancy between market prices and prices
received by producers. If not deducted, market
price becomes higher than producers’ price.
• Subsidies: These are the financial help given by
the govt. to encourage the production in some
sectors of the economy. These understate the
value of national income. So, these should be
added to get NI.

48. Some frequently used
terminologies
National income concepts at factor cost (FC)
• Net Domestic Product (NDP) at factor cost:
Wages + Interest + Profits+ Rents
• Gross Domestic Product (GDP) at factor cost:
NDP at factor cost + Depreciation
• GNP at factor cost: GDP at FC +Net factor
income from abroad
• National Income/Net National Product at
factor cost: GNP at FC-Depreciation

49. Some frequently used
terminologies
Personal Income and Disposable Income
• Personal Income: is the money income received
by households before they pay their personal
taxes. PI= NI-pre tax corporate profits-social
security taxes+ transfer payments + Net interest
(including dividend)
• Disposable personal income: is the income that
households can choose to consume or save after
subtracting income taxes from personal income.
Personal income- direct personal taxes
• Disposable personal income is the sum of
consumption and saving i.e. DPI=C+S

50. Three approaches to
measure GDP
• The expenditure approach to GDP
• The Value added approach to GDP
• The income approach to GDP

51. The Expenditure Approach
to GDP• Expenditure approach divides output into four
categories according to which group in the
economy purchases it as final users
– Consumption goods and services (C)—
purchased by households
– Private investment goods and services (I)—
purchased by businesses
– Government goods and services (G)—
purchased by government agencies
– Net exports (NX)—purchased by foreigners

52. The Expenditure Approach
to GDP• Consumer spending, C, is the sum of expenditures by households on
durable goods, nondurable goods, and services. Examples include
clothing, food, and health care.
• Investment, I, is the sum of expenditures on capital equipment,
inventories, and structures. Examples include machinery, unsold
products, and housing.
• Government spending, G, is the sum of expenditures by all
government bodies on goods and services. Examples include naval
ships and salaries to government employees.
• Net exports, NX, equals the difference between spending on
domestic goods by foreigners and spending on foreign goods by
domestic residents. In other words, net exports describes the
difference between exports and imports.

53. The Expenditure Approach
to GDP• Everyone who purchases a good or service included in
the GDP of a country must be either a
– Household of that country
– business entity/firm
– government agency (including state and local
government)
– Or else is part of the foreign sector
• When we add up the purchases of all four groups we
get GDP
• GDP = C + I + G + NX

54. Consumption Spending
• Consumption is the part of GDP purchased by
households as final users
– Almost everything households buy during the year
is included as part of consumption spending when
we calculate GDP
– One exception is construction of new homes
• Counted as private investment
– Some quirky exceptions to the definition of
consumption
• Total value of all food products that farm families
produce and consume themselves
• Total value of the housing services provided by
owner-occupied homes

55. Private Investment
• Private investment has three components
– Business Purchases of Plant, Equipment, and
Software
• A firm’s plant, equipment, and software are
intended to last for many years—only a small
part of them is used up to make the current
year’s output
• Are regarded as final goods, and firms that buy
them as final users of those goods
– New Home Construction
• Residential housing is an important part of
nation’s capital stock
• House will continue to provide services into the
future

56. Private Investment
– Changes in Inventories
• We count the charge in firms’ inventories as part
of investment in measuring GDP
• Why?
– When goods are produced but not sold during
the year, they end up in some firm’s inventory
stocks
– Part of the nation’s capital stock
– Will provide services in the future, when they
are finally sold and used

57. Government Purchases
• Purchases by state, local governments and federal
government are included
• Government purchases include
– Goods
• Fighter jets, police cars, school buildings, spy
satellites, etc.
– Services
• Such as those performed by police, legislators,
and military personnel
• Government is considered to be a purchaser even if
it actually produces the goods or services itself

58. Government Purchases• Important to distinguish between
– Government purchases
• Which are counted in GDP
– Government outlays
• As measured by local, state, and federal budgets
and reported in the media (include transfer
payments.

59. Government Purchases• Transfer payments represent money redistributed
from one group of citizens (taxpayers) to another
(poor, unemployed, elderly). While transfers are
included in government budgets as outlays they are not
purchases of currently produced goods and services
and therefore
• Not included in government purchases or in GDP
• Example? – Social Security payments by Fed,
unemployment insurance and welfare payments by
state gov, money disbursed to homeless shelters
by city gov etc

60. Net Exports
• Once we recognize dealings with the rest of the
world, we must correct an inaccuracy in our
measure of GDP
– Deduct all imports
– Include domestic production that is purchased by
foreigners: total exports
• To properly account for output sold to, and
bought from, foreigners
– Must include net exports—difference between exports
and imports—as part of expenditure in GDP

61. Precautions on Exp. method
• Exp on second hand goods be excluded since that
is not on currently produced goods.
• Exp on purchase of shares and bonds be
excluded since they are not for goods and
services.
• Gov. exp on transfer payments be excluded since
they are not in exchange of goods and services.
• Exp on intermediate goods and services be
excluded. Otherwise it creates the problem of
double counting.

62. Product Approach
• Product approach can be
classified into:
-Final Product Approach
-Value added approach
• Final product approach: Market
value of final goods and services
produced in the economy in a
given period. However, there is
the risk of double counting.

63. The Value-Added Approach
• Value added
– Firm’s contribution to a product as
it is produced or
– Revenue it receives for its output
minus cost of all the intermediate
goods that it buys
– Example: Production of bread, as
discussed in chapter 1

64. The Value-Added Approach
• GDP is sum of values added by all
firms in economy. For example, (Rs.
million)
Sectors Value of
output
Cost of
interme
d.
Value
Added
Agricult. 50 15 35
Mafg. 80 40 40
Service 20 10 10
Total 150 65 85=GDP

65. The Factor Payments
Approach• In any year, value added by a firm is
equal to total factor payments made by
that firm
• Factor payments: payments to the owners
of resources that are used in production.
• GDP equals sum of all firms’ value added
– Each firm’s value added is equal to its
factor payments

66. The Factor Payments
Approach• Each firm’s value added is equal to its factor payments
• Thus, GDP must equal total factor payments made
by all firms in the economy
• Since all of these factor payments are received
by households in the form of wages and salaries,
rent, interest or profit
– GDP is measured by adding up all of the income
—wages and salaries, rent, interest, and profit
—earned by all households in the economy
(Third Method of measuring GDP)
• Gives us an important insight into the macroeconomy
– Total output of economy (GDP) is equal to total
income earned in the economy

67. The Factor Payments
Approach• Factor Payments are generally classified into:
1. Rent, including imputed rent
2. Compensation of employees i.e. wages and
salaries
3. Interest
4. Profits, which include (dividends, Retained
earnings, Corporate taxes, direct taxes,
indirect taxes)
5. Mixed income of the self-employed
Total of these gives NDP at factor cost.
Think, how do you get GDP at factor cost, GNP
at factor cost, NNP at factor cost

68. Precautions in the Factor
Payments Approach
• Transfer payments should not be included because there is no
corresponding production of goods and services.
• Value of production for self consumption should be included.
• Imputed rent is to be included.
• Illegal incomes should not be included
• Windfall gains should not be included
• Corporate tax is a part of profit and therefore be included
• Gift tax, wealth tax, and tax on windfall gains are to be excluded
because they are not paid from current income.
• Money received from selling second hand goods are not to be
included because there is no corresponding production of goods
and services.
• Interest on public debt is transfer payments and therefore
should be excluded while calculating GDP.

69. Measuring GDP: A
Summary• Different ways to calculate GDP
– Expenditure Approach
• GDP = C + I + G + NX
– Value-Added Approach
• GDP = Sum of value added by all firms
– Factor Payments Approach
• GDP = Sum of factor payments made by all
firms
• GDP = Wages and Salaries + interest + rent +
profit
• GDP = Total household income

70. Actual and potential or full
employment GDP
• The output gap measures the gap between
actual output and the output the economy
could produce at the full employment level,
given the existing resources. Output gap=
Potential output- Actual output
• This provides the framework for the analysis
of output (GDP) gap. This leads to the
discussion of trade cycle.
• Remember the graph drawn while making
discussion on business cycle. The output below
and above the trend line reflects the output
gap in an economy.

71. Actual and potential or full
employment GDP
• Suppose: potential/full employment GDP=y*,
Actual GDP=y
• GDP Gap =y*-y
• When y‹y*, A recessionary gap/deflationary
gap. Output falls. Unemployment rises.
• When y›y*, An inflationary gap, upward
pressure on prices. The economy is
overheating.
• Both of these situations call for policy actions
in terms of monetary policy and fiscal policy to
stabilize actual output growth around potential
GDP growth.

72. Actual and potential or full
employment GDP
Time
Output Potential
GDP/trend line
Output gap Output
gap
Actual GDP line

73. Importance of the study of National
Income
• Indicator of economic structure
• Indicator of welfare
• Helpful in devising economic policy
• Shows the inflationary or deflationary gap
• Important in international comparison
• Economic analysis
• Basis of measuring standard of living
• Basis of growth accounting

74. Problems in National Income
Computation
• Unreported activities (underground
economy)
• Non market activities
• Economic bads-environmentnal damages
• Double counting
• Transfers
• Non-availability of data
• Non-monetized sector
• Mixed incomes: arises due to lack of
specialization
• Capital gains

75. Problems in National Income
Computation
• Unreported activities (underground economy): NI
does not record activities such as gambling,
prostitution, black marketing, drug dealing etc.
Because of this, NI underestimates the value of
output.
• Non market activities: Activities that take place
within household but do not come in the market are
not included in GDP. A house-wife’s contribution in
cleaning, washing, cooking etc. But if the home maid
is hired for this, his/her wages is included in GDP.
In economies where there are more activities of
non-marketable nature, accurate measurement of
national income is difficult.

76. Problems in National Income
Computation
• Economic bads-environmentnal damages: Ni
counts goods produced but ignores the
bads. No nation is making an account related
to the depletion of natural resources in
terms of mining minerals (oil, gas etc.), soil
erosion, and pollution of water and air. NI
neither measures the possible degradation
of human capital as a result of
environmental pollution (ill health) nor
provides any account of resource depletion.

77. Problems in National Income
Computation
• Double counting: Basic thrust in NIA
to follow value added approach is to
avoid double counting. But again it is
difficult to draw a clear line between
final goods and intermediate goods.
The same goods can be counted as
intermediate goods and final goods.
Rice produced by farmer is final good
if consumed and is intermediate if
sold to the miller.

78. Problems in National Income
Computation
• Transfers: May lead to miscalculation of NI. For
example, social security payments like pension,
unemployment allowances, prize, gifts, charity
payments, awards, scholarships do not reflect the
flow of goods and services. In other words, these
are not in exchange of goods and services. But if
these are not considered properly, there will be
overestimation of NI. For example, if a retired
person gets pension for his past service and salary
for the present job, a clear distinction between his
transfer income and income that he earned in
exchange of his services.

79. Problems in National Income
Computation
• Non-availability of data: Lack of data on various
economic activities has made the NIA a difficult
task in developing countries.
• Non-monetized sector: Imputation is done for
owner occupied housing, wages paid in kinds,
services provided free of cost and government
services. Exclusion of these activities understates
the actual economic activities. To include these,
some type of imputations are needed, which may
lead to subjective valuation.
• Mixed incomes: arises due to lack of specialization

80. Problems in National Income
Computation
• Capital gains: Sometimes there are capital
gains just because of the price rise. For
example, increase in the value of land and
building because of the inflation. Gains
arising from inflationary reasons should not
be included in NI since these are not
against productive services. However, any
gain due to improvements such as planting,
digging the well, leveling represent current
flow of goods and services and should be
included in NI.

81. Assignment for your own
knowledge
• Find which method of NIA is used in
Nepal.
• What are the classification of sectors
of economy in Nepal?
• What is the annual GDP growth in
Nepal over the last five years?
• For necessary information, visit the
website of the Central Bureau of
Statistics, and Ministry of Finance/
Nepal.