CHAPTER 2

NATIONAL INCOME ACCOUNTING

I Choose the correct answer

1. The study of National income is related to

a) Micro economics c) Both Micro & Macro
b) Macro Economics d) None of the above
Ans: (b) Macro Economics.
2. NNP = GNP –
a) Deduction c) Investment
b) Depreciation d) None of the above
Ans: (b) Depreciation
3. The value of GDP at the current prevailing prices is
a) Real GDP c) Nominal GDP
b) GDP at factor cost d) NDP
Ans: (c) Nominal GDP
4. By deducting undistributed profit from national income, we get
a) Personal Disposable income c) Private income
b) Personal income d) Subsidies.
Ans: (b) Personal Income
5. Measuring the sum total of all factor payments will be called
a) Product method c) Income method
b) Expenditure method d) None of the above
Ans: (c) Income Method

II Fill in the blanks

1. …………..are defined at a particular point of time

Ans: Stocks
2. ………….. goods will not pass through any more stages of production.
Ans: Final Good
3. …………..is an annual allowance for wear and tear of a capital good.
Ans: Depreciation
4. ……………is a stock variable.
Ans: Inventory
5. Pollution is an example for …………..externalities
Ans: Negative
6. The net contribution made by a firm is called its………
Ans: value added.

III Match the following:

 A B

1. Labour a) Non-monetary exchange

2. GDP b) Personal disposable income
3. Inventory c) Gross domestic product
4. PDI d) Stock variable
5. Domestic service e) Wages
Ans: 1 – e; 2 – c; 3 – d; 4 – b; 5 – a;

IV Answer the following questions in a sentence or word.

1. What do you mean by final goods?

Ans: These are the goods which are meant for final use and will not pass through any
more stages of production or transformations.
2. Expand CPI.
Ans: Consumer Price Index.
3. Expand GNPMP
Ans: Gross National Product at Market Prices.
4. How do you get net value added?
Ans: We obtain net value added by deducting the value of depreciation from Gross
value added.
5. Give the meaning of GDP.
Ans: GDP (Gross Domestic Product) is the market value of all final goods and
services produced within a domestic territory of a country measured in a year.
6. Give the meaning of intermediate goods.
Ans: These are the goods used by other producers as material inputs. These are used
as raw material for production of other commodities. These are not final goods.
7. What is depreciation?
Ans: It is a deduction made from the value of gross investment in order to
accommodate regular wear and tear of capital goods.
8. How do we get personal disposable income?
Ans: The personal Disposable Income is obtained by deducting personal tax paymens
and non tax payments from Personal Income.
9. Write the equation of GVA at market prices.
Ans: GVA at Market prices = GVA at basic prices + Net product taxes.
10. What is GDP deflator?
Ans: It is the ratio of nominal GDP to real GDP i.e., GDP deflator = GDP/gdp; where
GDP is nominal Gross Domestic Product and ‘gdp’ stands for real Gross Domestic
Product.

V Answer the following questions in 4 sentences.

1. What are the four factors of production? Mention their rewards.

 Ans: The four factors of production are Land, Labour, Capital and Organisation. The
rewards of these factors of production are as follows:
 Land gets Rent
 Labour gets wages
 Capital gets Interest.
 Organisation gets profit.
2. Distinguish between stock and flow. Give example.
Ans:
Stock Flow

 It is that quantity of economic  It refers to that quantity of economic

variable which is measured at a variable measured over a period of
particular point of time. time.
 Example capital, inventory, wealth,  Example net investment, salary,
foreign exchange reserves etc. National Income etc.
3. What is the difference between consumer goods and capital goods?
Ans:
Consumer Goods Capital Goods

 These are the goods which are  These are the durable goods
purchased for consumption by which are used in the production
ultimate consumers. process.
 Example food, clothes, services like  Examples are machinery, tools,
recreation. implements etc.

4. Mention 3 methods of measuring GDP (national income).

Ans:
The three methods of measuring GDP are
a) Product or Value Added Method
b) Expenditure Method and
c) Income Method.
5. What do you mean by externalities? Mention its two types.
Ans: Externalities refer to the benefits or harms a firm or an individual causes to
another for which they are not paid or penalized. They do not have any market in
which they can be bought and sold.
The two types of externalities are Positive Externalities and Negative
Externalities.
6. Write the equation of GDPMP and GDPFC
Ans: The equations of GDP and Market prices (GDPMP) and GDP at Factor cost
(GDPFC) are as follows:
GDPMP = C + I + G + X – M. where, C-Consumption Expenditure, I-Investment
Expenditure; G – Government’s Consumption and Investment Expenditure; X –
Exports and M- Imports.
GDPFC = GDPMP – NIT. ( NIT is Net Indirect Taxes).
7. Write the difference between nominal and real GDP.
 Ans:
Nominal GDP Real GDP

 It is the value of GDP at current  It is evaluated at constant set of prices

prevailing prices. i.e., by keeping base year’s price
 It is not reliable index.
 It does not give real picture of  It is reliable.
economic development of a country.  It gives real picture of economic
development of a country.

VI Answer the following questions in 12 sentences.

1. Write a short note on the concept of final good.
Ans: The final goods are those goods which are meant for final use and will not pass through
any more stages of production or transformations. They are called final goods because, once
they have been sold they pass out of the active economic flow. However, they may undergo
transformation by the action of the ultimate purchaser.
In fact, many final goods are transformed during their consumption. For instance, Tea
leaves purchased by the consumer are not consumed in that form – they are used to make
drinkable tea, which is consumed. Similarly most of the items that enter our kitchen are
transformed through the process of cooking. But cooking at home is not an economic activity,
even though the product involved undergoes transformation. Home cooked food is not sold to
the market. However, if the same cooking or tea was done in hotel where the cooked product
would be sold to customers, then the same items are not considered as final goods and would
be counted as inputs to which economic value addition can take place.
Thus, it is not in the nature of the good but in the economic nature of its usage that a
good becomes a final good.

2. Explain the circular flow of income of an economy.

Ans: The circular flow of income of an economy can be explained with the help of
following assumptions:
a) Existence of two sectors viz., household sector and producers.
b) Households are the owners of the factors of production.
c) Households receive income by selling the factor services.
d) There are no savings.
e) The firms produce goods to the households.
f) The economy is a closed economic system( where no Government or external
trade or savings)
The circular flow of income in a simple economy can be illustrated with the help of
following chart.

A Spending

Goods and Services

B
 Firms Households

C
Factor payments

Factor services

In the above chart, the uppermost arrow, going from the households to the firms, represents
the spending by the households to buy goods and services produced by the firms. The second
arrow going from the firms to the households is the counterpart of the arrow above. It stands
for the goods and services which are flowing from the firms to the households. Thus the two
arrows on the top represent the goods and services market – the arrow above represents the
flow of payments for the goods and services, the arrow below represents the flow of goods
and services.
The two arrows at the bottom of the diagram similarly represent the factors of the
production market. The lower most arrow going from the households to the firms symbolizes
the services that the households re rendering to the firms. Using these services the firms are
producing the output. The arrow above this, going from the firms to the households,
represents the payments made by the firms to the households for the services provided by the
households.
Thus, When the income is spent on the goods and services produced by the firms, it
takes the form of aggregate expenditure received by the firms. Since the value of expenditure
must be equal to the value of goods and services, we can measure the aggregate income by
calculating the aggregate value of goods and services produced by the firms. This is clearly
shown above in the form of circular flow of income.

3. Write a note on externalities.

Ans: An externality is a cost or benefit conferred upon second or third parties as a result
of acts of individual production and consumption. But the cost or benefit of an externality
cannot be measured in money terms because it is not included in market activities.
In other words, Externalities refer to the benefits or harms a firm or an individual causes to
another for which they are not paid or penalized. They do not have any market in which they
can be bought and sold.
There are two types of externalities viz.,
 Positive Externalities and
 Negative Externalities.
For example, let us imagine that there is chemical fertilizer industry. It produces the chemical
fertilizers required for agriculture. The output of the industry is taken for counting GDP of an
economy. This is positive externality.
While carrying out the production the chemical fertilizer industry may also be
polluting the nearby river. This may cause harm to the people who use the water of the river.
Hence their health will be affected. Pollution also may kill fish and other organisms of the
river. As a result, the fishermen of the river may lose their livelihood. Such harmful effects
that the industry is inflicting on others, for which it will not bear any cost are called negative
externalities.

4. Illustrate unplanned accumulation and decumulation with an example

Ans: Change in inventories may be planned or unplanned. In case of unexpected fall in sales,
the firm will have unsold stock of goods which it had not anticipated. Hence there will be
unplanned accumulation of inventories. If there is unexpected increase in the sales there will
be unplanned decumulation of inventories.
This can be explained with the help of following illustration:
Suppose a firm produces T Shirts. It starts the production year with an inventory of
200 T Shirts. During the coming year it expects to sell 2000 T shirts. Hence, it produces 2000
T shirts, expecting to keep an inventory of 200 T Shirts at the end of the year. However,
during the year, the sales of T Shirts became low unexpectedly. The firm is able to sell only
1200 T Shirts. This means that the firm is left with 800 unsold T Shirts. The firm ends the
production year with 800 + 200=1000 T shirts. The unexpected increase of inventories by
800 T shirts is an example for unplanned accumulation of inventories.
On the other hand, if the sales had been more than 2000 we would have unplanned
decumulation of inventories. For instance, if the sales had been 2100, then not only the
production of 2000 T shirts will be sold, the firm will have to sell 100 T shirts out of the
inventory. This 100 (T shirts) unexpected reduction in inventories is an example of
unexpected decumulation of inventories.

5. Explain the examples of planned accumulation and decumulation of

inventories.
Ans: Inventories are the unsold goods, unused raw materials or semi-finished goods which a
firm a firm carries from a year to the next year. Change in inventories may be planned or
unplanned. A planned change in inventories is the change in the stock of inventories which
has occurred in a planned way. The planned accumulation and decumulation of inventories
are explained with example as follows:
Suppose a firm wants to increase the inventories from 200 T shirts to 400 T shirts
during the year. Expecting sales of 2000 T shirts during the year, the firm produces 2000 +
200 = 2200 T shirts. If the sales are actually 2000 T shirts, the firm ends up with a rise of
inventories. The new stock of inventories is 400 T shirts, which was planned by the firm.
This is planned accumulation of inventories.
On the other hand, if the firm had wanted to reduce the inventories from 200 to 50,
the it would produce 2000 – 150 = 1850 T shirts. This is because it plans to sell 150 T shirts
out of the inventory of 200 T shirts it started with. Then the inventory at the end of the year
becomes 200 – 150 = 50 T shirts, which the firm wants. If the sales turn out to be 2000 T
shirts as expected by the firm, the firm will be left with the planned reduced inventory
(decumulation) of 50 T Shirts.
These are the two instances of planned accumulation and planned decumulation of
inventories.

VII Answer the following questions in 20 sentences.

 1. Explain the macro economic identities.
Ans: The macroeconomic identities are as follows:
a) Gross Domestic Product (GDP): Gross Domestic Product measures the aggregate
production of final goods and services taking place within the domestic economy during a
year. But the whole of it may not accrue to the citizens of the country. It includes GDP at
Market prices and GDP at Factor cost.
GDP at market price is the market value of all final goods and services produced
within a domestic territory of a country measured in a year. Here everything is valued at
market prices. It is obtained as follows:
GDPMP = C + I + G + X – M
GDP at factor cost is gross domestic product at market prices minus net indirect taxes.
It measures money value of output produced by the firms within the domestic boundaries
of a country in a year.
GDPFC = GDPMP – NIT.
b) Gross National Product: It refers to all the economic output produced by a nation’s
normal residents, whether they are located within the national boundary or abroad. It is
defined as GDP plus factor income earned by the domestic factors of production
employed in the rest of the world minus factor income earned by the factors of production
of the rest of the world employed in the domestic economy. Therefore,
GNP = GDP + Net factor income from abroad
c) Net National Product (NNP): A part of the capital gets consumed during the year due to
wear and tear. This wear and tear is called depreciation. If we deduct depreciation from
GNP the measure of aggregate income that we obtain is called Net National Product. We
get the value of NNP evaluated at market prices. So,
NNP = GNP – Depreciation
d) Net National Product (NNP) at factor cost: The NNP at factor is the sum of income
earned by all factors in the production in the form of wages, profits, rent and interest etc.,
belong to a country during a year. It is also known as National income. We need to add
subsidies to NNP and deduct indirect taxes from NNP to obtain NNP at factor cost.
NNPFC = NNP at market prices – indirect taxes + subsidies.
e) Personal Income (PI): It refers to the part of National income (NI) which is received by
households. It is obtained as follows:
PI = NI – Undistributed Profits – Net interest payments made by the households –
Corporate tax + Transfer payments to the households from the Government and firms.
f) Personal Disposable Income (PDI): If we deduct the personal tax payments (income
tax) and Non-tax payments (fines, fees) from Personal Income, we get PDI. Therefore,
PDI = PI – Personal tax payments – Non-tax payments.
2. Briefly explain the expenditure method of measuring GDP.
Ans: Expenditure method is the alternative way to calculate the GDP by looking at the
demand side of the products. Here the aggregate value of the output in the economy by
expenditure method will be calculated in the following way.
In this method we add the final expenditures that each firm makes. Final expenditure
is that part of expenditure which is undertaken not for intermediate purposes. If the baker
buys Rs.50 worth of wheat from the farmers is considered as intermediate good and the final
expenditure received by the baker is 200. Then the aggregate value of output of the economy
is Rs.200 + Rs.50 = Rs.250.
Let us assume that firm i makes the final expenditure on the following accounts:
 Final consumption expenditures on the goods and services by households, denoted as
Ci
 Final investment expenditure incurred by the firms on capital goods, denoted as I i
 The expenditure that the Government makes on the final goods and services produced
by the firm, denoted as Gi
 The export revenues that firm i earns by selling its goods and services abroad, denoted
as Xi.
Now the total final consumption, investment, government and export expenditures
received by the firm i. Now GDP according to the expenditure method is expressed as
follows:
GDP = ∑Ni-1 RVi = C + I + G + X – M
∑Ni-1 RVi is the sum of final consumption -C, investment -I, government - G and exports -X
expenditures (M-imports) received by all the firms in the economy.

3. Explain a numerical example to show that all the three methods of estimating GDP
gives us the same answer.
Ans: The three methods of calculating GDP viz., Product or Value Added Method,
Expenditure method and Income Method, give us the same answer. This can be explained
with the help of numerical example as follows:
Let us imagine, there are two firms X and Y. Suppose X use no raw material and
produces cotton worth Rs.50. X sell its cotton to firm Y, who uses it to produce cloth. Y sells
the cloth produced to consumers for Rs.200.
 GDP in the phase of product or the value added method: Here the value added =
Sales – Intermediate goods.
Thus VA X = 50 – 0
VA Y = 200 – 50 = 150.
Thus GDP = VA X + VA Y = 50 + 150 = 200 .
GDP distribution for firms X and Y
Particulars Firm X Firm Y

Sales 50 200

Intermediate consumption 0 50

Value added 50 150

 GDP in the phase of Expenditure Method: Under this method, GDP is the sum of
final expenditure/s on goods and services for end use. In the above case, final
expenditure is expenditure by consumers on cloth. Therefore, GDP = 200.
 GDP in the phase of Income Method: Under this method, GDP is obtained by
adding factor payments. Let us imagine firm X, from Rs.50 received gives Rs.30 as
 wages and keeps the remaining Rs.20 as its profits. Similarly, firm Y gives Rs.100 as
wages and keeps Rs.50 as profits. It can be stated in the following table:
Particulars Firm X Firm Y Total

Wages 30 100 130

profits 20 50 70

Now the GDP by income method = total of factor payments (incomes) which is equal
to total wages received (workers of Firms X and Y) and total profits earned (by Firms
X and Y). Thus GDP = Wages + Profits i.e., GDP = 130 + 70 = 200.
Thus all the three methods of estimating GDP give us the same answer.

4. Write down some of the limitations of using GDP as an index of welfare of a

country.
Ans: Gross Domestic Product (GDP) is the sum total of value of goods and services created
within the geographical boundary of a country in a particular year. It gets distributed among
the people as incomes except retained earnings. So we consider that higher level of GDP of a
country is an index of greater well being of the people of that country. Welfare of a country
means well being of entire population of the country. But there are certain limitations of
suing GDP as an index of welfare of a country. They are as follows:
a) Distribution of Gross Domestic Product (GDP): Generally, the rise in GDP will not
represent increase in the welfare of the country. If the GDP of the country is rising, the
welfare may not rise as a consequence. This is because the rise in Gross Domestic Product
may be concentrated in the hands of very few individuals or firms. For the remaining, the
income may in fact might have decreased. In such a situation the welfare of the entire country
cannot be said to have improved.
b) Non-monetary exchanges: Some of the activities in a country are not evaluated in terms of
money. For instance, the domestic services of housewife are not paid for. The exchanges
which take place in the informal sector without the help of money are called barter
exchanges. In barter exchanges goods are directly exchanged against each other. As money is
not used here, these exchanges are not registered as part of economic activity. In India,
because of many remote areas, these kinds of exchanges still take place and they are
generally not counted in the GDP. Therefore, Gross Domestic Product calculated in the
standard manner may not give us a clear indication of welfare of a country.
c) Externalities: An externality is a cost or benefit conferred upon second or third parties as a
result of acts of individual production and consumption. In other words, externalities refer to
the benefits or harms, a firm or an individual causes to another for which they are not paid or
penalized. These do not have any market in which they can be bought and sold. But the cost
or benefit of an externality cannot be measured in money terms because it is not included in
market activities. For example, the pleasure one gets from his neighbour’s garden is an
external benefit and external cost is environmental pollution caused by industries. Both are
excluded from national income estimates.
d) Leisure and work: One of the important things that affect the welfare of a society is leisure.
But is not included in GDP. For example, longer working hours may make people unhappy
 because their leisure is reduced. On the contrary, shorter working hours per week may
increase leisure and make people happy.
e) Manner of production: The economic welfare also depends on the manner of production of
goods and services. If goods are produced by child labour or by exploitation of workers, then
the economic welfare cannot increase.

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