Class 12 Economics Notes Chapter 2 (National Income Accounting) – Introduction MacroEconomics Book

Alright, let's get straight into the crucial concepts of National Income Accounting from Chapter 2 of your Macroeconomics textbook. This chapter forms the bedrock for understanding macroeconomics and is extremely important for your government exam preparations. Pay close attention to the definitions, distinctions, and methods.

Chapter 2: National Income Accounting - Detailed Notes

1. Introduction:

• Macroeconomics: Study of the economy as a whole, dealing with aggregate economic variables like aggregate demand, aggregate supply, national income, inflation, unemployment, etc.
• National Income: The sum total of factor incomes (rent, wages, interest, profit) earned by the normal residents of a country during an accounting year. It essentially measures the monetary value of all final goods and services produced.
• Why Measure National Income? To understand the economy's performance, compare growth over time, compare with other economies, formulate policies, and understand the contribution of different sectors.

2. Basic Concepts:

• Goods:
  • Final Goods: Goods used either for final consumption by consumers (e.g., bread, butter) or for investment by producers (e.g., machinery). They have crossed the boundary line of production and are ready for final use. Their value is included in National Income.
  • Intermediate Goods: Goods used up in the production process of other goods (e.g., flour used by a bakery to make bread) or purchased for resale in the same year. They are not included in National Income calculation to avoid the problem of double counting.
• Consumption Goods (Consumer Goods): Goods directly satisfying human wants (e.g., food, clothing, TV).
• Capital Goods: Fixed assets of producers which are repeatedly used in the production process for several years and are of high value (e.g., plant, machinery). Note: All capital goods are producer goods, but not all producer goods are capital goods (raw material is a producer good but not a capital good).
• Stock vs. Flow:
  • Stock: A variable measured at a particular point in time (e.g., wealth, capital, inventory on Dec 31st).
  • Flow: A variable measured over a period of time (e.g., income, investment, production during a year). National Income is a flow concept.
• Investment: Addition to the stock of capital. Also called Capital Formation.
  • Gross Investment: Total addition to capital stock in an economy during a period, including replacement for depreciation.
  • Net Investment: Gross Investment minus Depreciation. It represents the net addition to the existing capital stock.
• Depreciation (Consumption of Fixed Capital): The expected fall in the value of fixed capital goods due to normal wear and tear, and foreseen obsolescence. It represents the capital 'consumed' during the production process.

3. Circular Flow of Income:

• Illustrates the flow of goods, services, factor payments, and consumption expenditure between different sectors of the economy.
• Simple Two-Sector Model (Households & Firms):
  • Households supply factor services (land, labour, capital, enterprise) to firms.
  • Firms make factor payments (rent, wages, interest, profit) to households.
  • Firms produce goods and services and sell them to households.
  • Households spend their income (consumption expenditure) on these goods and services.
  • Real Flow: Flow of factor services and goods/services.
  • Money Flow: Flow of factor payments and consumption expenditure.
• Assumptions: No government, no external sector (closed economy), no savings (all income is spent).
• Leakages: Withdrawals from the circular flow (e.g., savings, taxes, imports).
• Injections: Additions to the circular flow (e.g., investment, government spending, exports).
• In equilibrium, Leakages = Injections.

4. Methods of Calculating National Income:

• There are three methods, and all ideally give the same result:
  • Product (Value Added) Method:
    • Measures national income by estimating the contribution of each producing enterprise in the domestic territory of the country.
    • Gross Value Added (GVA_MP): Value of Output - Intermediate Consumption.
    • Value of Output: Sales + Change in Stock (Closing Stock - Opening Stock).
    • GDP_MP = Sum of GVA_MP of all producing units in the domestic economy.
    • National Income (NNP_FC) = GDP_MP - Depreciation - Net Indirect Taxes + Net Factor Income from Abroad (NFIA).
    • Precautions: Avoid double counting (take only value added), include imputed value of owner-occupied houses and production for self-consumption, do not include sale of second-hand goods (already counted), intermediate goods.
  • Income Method:
    • Measures national income by summing up all factor incomes earned by normal residents within the domestic territory.
    • Components:
      1. Compensation of Employees (COE): Wages & Salaries (in cash & kind), Employers' contribution to social security.
      2. Operating Surplus (OS): Income from property and entrepreneurship (Rent & Royalty, Interest, Profit). Profit further includes dividends, corporate profit tax, and retained earnings (undistributed profits).
      3. Mixed Income of Self-Employed (MI): Income of own-account workers (like doctors, shopkeepers) where income cannot be separated into wages, rent, interest, profit.
    • NDP_FC (Domestic Income) = COE + OS + MI.
    • National Income (NNP_FC) = NDP_FC + NFIA.
    • Precautions: Avoid transfer incomes (pensions, scholarships), illegal income, windfall gains (lotteries), income from sale of second-hand goods, income from sale of financial assets (shares, bonds - unless commission is earned). Include imputed rent of owner-occupied houses.
  • Expenditure Method:
    • Measures national income by summing up final expenditures incurred in the economy.
    • Components:
      1. Private Final Consumption Expenditure (PFCE): Expenditure by households and private non-profit institutions serving households.
      2. Government Final Consumption Expenditure (GFCE): Expenditure by government on various administrative services, defence, education, etc.
      3. Gross Domestic Capital Formation (GDCF): Investment expenditure. (GDCF = Gross Fixed Capital Formation + Change in Stocks).
      4. Net Exports (X-M): Exports minus Imports.
    • GDP_MP = PFCE + GFCE + GDCF + (X-M).
    • National Income (NNP_FC) = GDP_MP - Depreciation - Net Indirect Taxes + NFIA.
    • Precautions: Avoid expenditure on intermediate goods, transfer payments, purchase of second-hand goods, purchase of financial assets. Include imputed expenditure on self-consumed output.

5. Aggregates Related to National Income:

• Key Terms:
  • Gross vs. Net: Gross includes depreciation; Net excludes depreciation. Net = Gross - Depreciation.
  • Domestic vs. National: Domestic refers to income generated within the geographical boundary; National refers to income accruing to normal residents (including from abroad). National = Domestic + Net Factor Income from Abroad (NFIA).
  • Market Price (MP) vs. Factor Cost (FC): MP includes the effect of indirect taxes and subsidies; FC represents the cost in terms of factors of production. FC = MP - Net Indirect Taxes (NIT).
  • Net Factor Income from Abroad (NFIA): Factor income earned by our residents from abroad - Factor income earned by non-residents in our country.
  • Net Indirect Taxes (NIT): Indirect Taxes - Subsidies.
• Main Aggregates:
  • GDP_MP (Gross Domestic Product at Market Price): Market value of final goods and services produced within the domestic territory during a year.
  • GDP_FC (Gross Domestic Product at Factor Cost): GDP_MP - NIT.
  • NDP_MP (Net Domestic Product at Market Price): GDP_MP - Depreciation.
  • NDP_FC (Net Domestic Product at Factor Cost / Domestic Income): NDP_MP - NIT OR GDP_FC - Depreciation.
  • GNP_MP (Gross National Product at Market Price): GDP_MP + NFIA. Market value of final goods and services produced by normal residents during a year.
  • GNP_FC (Gross National Product at Factor Cost): GNP_MP - NIT OR GDP_FC + NFIA.
  • NNP_MP (Net National Product at Market Price): GNP_MP - Depreciation OR NDP_MP + NFIA.
  • NNP_FC (Net National Product at Factor Cost / National Income): NNP_MP - NIT OR NDP_FC + NFIA OR GNP_FC - Depreciation. This is the National Income.

6. Nominal vs. Real GDP:

• Nominal GDP (GDP at Current Prices): Value of final goods and services produced in a year, measured using the prices of the same current year. It can increase due to an increase in either output or price level, or both.
• Real GDP (GDP at Constant Prices): Value of final goods and services produced in a year, measured using the prices of a base year. It reflects the change in the volume of production only. Real GDP is a better indicator of economic growth.
• GDP Deflator (Price Index): Measures the average level of prices of all goods and services that make up GDP.
  • GDP Deflator = (Nominal GDP / Real GDP) * 100.
  • It is used to convert Nominal GDP into Real GDP: Real GDP = (Nominal GDP / GDP Deflator) * 100.

7. GDP and Welfare:

• GDP is often used as an indicator of economic welfare, but it has limitations:
  • Distribution of GDP: A high GDP with high inequality may not mean high welfare for all.
  • Composition of GDP: GDP may rise due to increased production of harmful goods (like defence goods, liquor), which doesn't necessarily increase welfare.
  • Non-Monetary Exchanges: Many activities (e.g., services of a housewife, barter system) are not included in GDP calculation but contribute to welfare.
  • Externalities: Benefits (positive externality, e.g., a public park) or harms (negative externality, e.g., pollution) caused by economic activities for which no price is paid or received. GDP doesn't account for these. Negative externalities reduce welfare, while positive ones increase it, but GDP remains unaffected.
  • Rate of Population Growth: High GDP growth might be offset by high population growth, leading to low or stagnant per capita GDP.

Multiple Choice Questions (MCQs):

1. Which of the following is a flow concept?
   (a) Wealth
   (b) Capital
   (c) National Income
   (d) Foreign exchange reserves

2. The difference between Gross Value Added (GVA) and Net Value Added (NVA) is:
   (a) Net Indirect Taxes
   (b) Depreciation
   (c) Net Factor Income from Abroad
   (d) Intermediate Consumption

3. Which method of calculating National Income adds up Rent, Wages, Interest, and Profits?
   (a) Expenditure Method
   (b) Product Method
   (c) Income Method
   (d) Value Added Method

4. National Income (NNP_FC) is equal to:
   (a) GDP_MP - Depreciation + NFIA - NIT
   (b) NDP_FC + NFIA
   (c) GNP_MP - Depreciation - NIT
   (d) All of the above

5. Which of the following is NOT included while calculating National Income using the Income Method?
   (a) Compensation of Employees
   (b) Operating Surplus
   (c) Transfer Payments like pensions
   (d) Mixed Income of Self-employed

6. Real GDP is calculated using:
   (a) Current year prices
   (b) Base year prices
   (c) Average prices of past 10 years
   (d) Future expected prices

7. Net Factor Income from Abroad (NFIA) is:
   (a) Exports - Imports
   (b) Factor income received from abroad - Factor income paid abroad
   (c) Indirect Taxes - Subsidies
   (d) Gross Investment - Net Investment

8. Which of the following represents an injection into the circular flow of income?
   (a) Savings
   (b) Imports
   (c) Taxes
   (d) Exports

9. GDP Deflator is calculated as:
   (a) (Real GDP / Nominal GDP) * 100
   (b) (Nominal GDP / Real GDP) * 100
   (c) (Nominal GDP - Real GDP) / Real GDP * 100
   (d) (Change in Price Level / Base Year Price Level) * 100

10. Which of the following is a limitation of using GDP as an index of welfare?
    (a) It accounts for non-monetary exchanges perfectly.
    (b) It ignores externalities like pollution.
    (c) It reflects the income distribution accurately.
    (d) It only measures production in the current year.

Answer Key for MCQs:

1. (c)
2. (b)
3. (c)
4. (d)
5. (c)
6. (b)
7. (b)
8. (d)
9. (b)
10. (b)

Make sure you thoroughly understand these concepts, especially the differences between the aggregates (Gross/Net, Domestic/National, MP/FC) and the components of the three calculation methods. These are frequently tested areas. Good luck with your preparation!