National income accounting is the branch of macro economics that measures the level of aggregate economic activity in an economy. It provides a comprehensive framework for measuring the total value of goods and services produced in a country during a given year, the income generated in the process of production, and the expenditure made on the final output. The national income accounts summarise the economic transactions of an economy in the form of tables showing the flows of production, income, and expenditure.
National income aggregates are of immense importance. They provide a measure of the overall economic performance of a country, enable comparisons of the standard of living over time and across countries, and serve as the basis for formulating economic policies. The measures commonly used are Gross Domestic Product (GDP), Gross National Product (GNP), Net National Product (NNP), and National Income (NI), each of which is defined from a specific viewpoint such as domestic territory versus normal residents, and market price versus factor cost.
The three methods of measuring national income are the product (value added) method, the income method, and the expenditure method. Each method approaches the circular flow from a different side: production, distribution, and disposition respectively. Since the total value of output equals the total factor incomes earned in producing it, which in turn equals the total expenditure on that output, all three methods give the same result.
GDP at market price is the market value of all final goods and services produced within the domestic territory of a country during an accounting year. It is obtained by the expenditure method as:
$$\text{GDP} = C + I + G + (X - M)$$
GNP at market price is GDP plus net factor income from abroad (NFIA). It includes the income earned by normal residents of the country from abroad and excludes the income earned by non-residents within the domestic territory.
$$\text{GNP} = \text{GDP} + \text{NFIA}$$
$$\text{NFIA} = \text{Factor income earned from abroad} - \text{Factor income paid to abroad}$$
NNP at market price is obtained by deducting depreciation (consumption of fixed capital) from GNP at market price.
$$\text{NNP} = \text{GNP} - \text{Depreciation}$$
National income is the sum of incomes earned by normal residents of a country in the form of wages, rent, interest, profit, and mixed income during a year. It equals NNP at factor cost.
$$\text{NI} = \text{NNP at MP} - \text{Net Indirect Taxes}$$
$$\text{Net Indirect Taxes} = \text{Indirect Taxes} - \text{Subsidies}$$
The domestic territory of a country extends beyond its geographical boundaries to include the territorial waters and ships, aircraft, and fishing vessels operated by the residents of the country, plus embassies, military establishments, and offices of the country located abroad. A normal resident is a person or institution whose centre of economic interest lies in the domestic territory of the country and who ordinarily resides there for more than a year.
The distinction between the two concepts is essential. GDP is the income produced within the domestic territory regardless of who produces it, while GNP is the income earned by the normal residents of the country regardless of where it is earned. Net factor income from abroad bridges the gap between the two.
Goods and services can be valued at market price (including indirect taxes and excluding subsidies), at factor cost (cost of factors of production, excluding indirect taxes and subsidies), or at basic price (excluding indirect taxes but including subsidies). The relationship is:
$$\text{Value at Factor Cost} = \text{Value at Market Price} - \text{Net Indirect Taxes}$$
$$\text{Value at Basic Price} = \text{Value at Market Price} - \text{Product Taxes} + \text{Product Subsidies}$$
Under this method, the gross value added of each producing unit is calculated by subtracting intermediate consumption from the value of output. Summing the value added of all producing units within the domestic territory gives GDP at market price.
$$\text{GVA} = \text{Value of Output} - \text{Intermediate Consumption}$$
$$\text{GDP at MP} = \sum \text{GVA at MP}$$
To avoid double counting, only final goods and services are included, or alternatively the value added at each stage is summed.
Under the income method, national income is obtained by summing all factor incomes earned by normal residents: compensation of employees, operating surplus (rent, interest, and profit), and mixed income of self-employed.
$$\text{NI} = \text{Compensation of Employees} + \text{Operating Surplus} + \text{Mixed Income} + \text{Net Factor Income from Abroad}$$
Under the expenditure method, national income is estimated by adding the final expenditures on goods and services by households, firms, government, and the rest of the world, and deducting imports.
$$\text{GDP at MP} = C + I + G + (X - M)$$
$$\text{NI} = C + I + G + (X - M) - \text{Depreciation} - \text{Net Indirect Taxes} + \text{NFIA}$$
Transfer payments such as old-age pensions, scholarships, and unemployment allowance are not included in national income because they are received without contributing to production. Income from sale of second-hand goods and financial assets like shares and bonds is excluded, as it involves transfer of ownership of already-produced assets. Services of housewives, own-account production of durable goods by households, and free services of nature are excluded due to problems of measurement. Imputed rent of owner-occupied houses, however, is included because a productive service is rendered.
Nominal GDP is the market value of final goods and services produced in the economy at current prices, whereas real GDP is measured at base year (constant) prices. Real GDP eliminates the effect of price changes and therefore reflects the actual change in physical output.
$$\text{Real GDP} = \frac{\text{Nominal GDP}}{\text{GDP Deflator}} \times 100$$
$$\text{GDP Deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100$$
| Aggregate | Formula |
|---|---|
| GDP at MP | C + I + G + (X - M) |
| GNP at MP | GDP + NFIA |
| NNP at MP | GNP - Depreciation |
| National Income (NNP at FC) | NNP at MP - Net Indirect Taxes |
| NDP at FC | GDP at MP - Depreciation - Net Indirect Taxes |
| Method | Coverage | Key Items |
|---|---|---|
| Product method | Value added by all producing units | Value of output - intermediate consumption |
| Income method | Factor incomes of residents | Wages + rent + interest + profit + mixed income |
| Expenditure method | Final expenditure on output | C + I + G + (X - M) |
| Included in NI | Excluded from NI |
|---|---|
| Imputed rent of owner-occupied houses | Transfer payments (pensions, scholarships) |
| Income of self-employed | Sale of second-hand goods |
| Own-account production of fixed assets | Sale of shares and bonds |
| Commissions and fees | Household services without monetary payment |
National income accounting converts the abstract idea of economic welfare into measurable aggregates. By defining GDP, GNP, NNP, and national income, and by linking them through depreciation, net indirect taxes, and net factor income from abroad, the chapter provides the tools to measure an economy's performance from the production, income, and expenditure sides. The distinction between market price and factor cost, the treatment of included and excluded items, and the difference between nominal and real GDP complete the analytical toolkit. Mastery of these concepts is essential, as national income forms the foundation for understanding money, banking, fiscal policy, and the determination of income and employment in the chapters that follow.