Class 12 Macroeconomics Chapter 2 National Income Accounting Notes

CBSE Class 12 Macroeconomics Chapter 2 National Income Accounting Notes. This Chapter of Class 12 Macroeconomics is very important as it carries a hugh weightage in Class 12 Board Exams. With our Notes on National Income Accounting, you will be quickly able to review all the concepts of the Chapter. 

Class 12 Macroeconomics Chapter 2 National Income Accounting Notes

The following revision notes are divided into three phases to make your learning easier and more comfortable.

The three main concepts you will be learning in this chapter are:
  • Some Basic Concepts of Macroeconomics
  • National Income and Related Aggregates
  • Methods of calculating National Income

Some Basic Concepts of Macroeconomics

1. Classification of Goods: Based on their characteristics goods are broadly described as:-

(a) Final Goods: These are the goods that are ready for use by their final users and have crossed all the stages of production or transformation. Example- 
  • Wheat used for cooking
  • Tractor used in the fields
(b) Intermediate Goods: These are the goods that are not ready for their final users and are still in the stages of production. These goods are opposite to final goods. Such goods are either used as raw material by the producers or for resale purposes. Example-
  • Paper used for making books
  • Plastic used to make tables
(c) Consumption or Consumer Goods: These are the goods that are directly used to satisfy human wants. Example- Milk and oil.
Consumer goods can also be classified as:-
  1. Durable Goods: These goods are of high value and can be used for a long period. Ex- Television.
  2. Semi-durable Goods: These goods are generally of lower value compared to durable goods and cannot be used for years. Ex- Clothes.
  3. Non-durable Goods: These goods end up in a single act of consumption. Ex- Milk, Oil.
  4. Services: These are the non-material goods consumed for self-satisfaction. Ex- Warehouse facility.
(d) Capital Goods: These goods are the fixed assets of the producers and are used in the production process. It is important to note that these goods are of high value(monetary value) and used for several years by the producer. Example-
  • Sewing machine with tailor
  • Power saws with carpenter
2. Investment: It refers to change in the stock of capital or the process that increases the stock of capital. It is also known as Capital formation.

Therefore, Investment = Change in capital stock during the year

3. Components of Investment: The following are the components of Investment:-
  • Fixed Investment
  • Inventory Investment
(a) Fixed Investment: It refers to the change in fixed assets of a producer during an accounting year.

(b) Inventory Investment: It refers to the change in inventory stock during an accounting year. ‘Inventory Stock’ include the following goods:-
  • Unsold Finished Goods
  • Semi- Finished Goods
  • Raw Material
4. Gross Investment: It refers to the gross production of capital goods during an accounting year. It includes Capital goods used for both-
  • As the replacement of existing capital goods(depreciation)
  • As Net addition to the existing capital goods(Net investment)
Therefore, Gross Investment = Net Investment + Depreciation

5. Net Investment: It refers to the expenditure incurred by the producer only on the purchase of new assets. It excludes the expenditure incurred on the replacement of old assets.

Net Investment = Gross Investment – Depreciation

6. Depreciation: It is the decrease in the value of fixed assets that are used by the producers with the account of:-
  • Normal wear and tear
  • Accidental damages
  • Expected obsolescence
Expected obsolescence: It is the loss in the asset’s value as they become outdated due to the change in technology and change in demand.

Unexpected obsolescence: It is the loss of assets’ value due to natural calamities or during a period of economic recession.
It results in ‘Capital Loss’.

7. Concept of Stock: It is a quantity or value of a variable that is measured at a point of time/period. It is not based on a specified period.
  • Capital
  • Fixed Deposits
  • Water in the tank
8. Concept of Flow: It is a quantity or the value of a variable during a specified period. Unlike stock, it is not measured at a point of time.
  • Investment
  • Interest
  • Leakage of water
9. Sectors of the Economy: The economy is divided into the following four sectors at the macro level-
  • Household Sector- Owners of factors of production
  • Producer Sector- Production units
  • Government Sector- Government as a producer and welfare functionality
  • External Sector- Flow of goods and capital between different national boundaries

10. Intersectoral flows: Intersectoral flow is the flow formed due to the interdependence between various sectors in the economy. These sectors can be household, producer, and government sector. The flow can be either money or goods and services.

So, what is Intersectoral interdependence?
  • The Household sector depends on the producer sector for goods and services
  • The producer sector depends on the Household sector for factors of production
  • The Government sector depends upon both for its revenue
Real Flows:-
                     It refers to the circulation of goods and services between different sectors of the economy. It does not include monetary exchanges between different sectors of the economy. Example-

Producer Sector —–> Goods produced by the firm —–> Household Sector

Household Sector ——> *Factor Services ——-> Producer Sector

( *Factor services = Land, Labor, Capital, and Entrepreneurship)

Money Flows:-
                         It is obvious from the name that the flow of money between different sectors of the economy is called money flows. Money flows are opposite to real flows as they are responses to the real flows.

Household Sector ——> Expenditure on the ——-> Producer Sector
 purchase of goods

Producer Sector —–> Payments for  —–> Household Sector 
                               Factor services

11. Circular flow of Income: It involves three different activities-
  • Production of goods and services
  • Generation and Distribution of Income
  • Expenditure

The above activities are unending flow concepts that are linked with one another. In other words, one cannot exist without the others

The circular flow of income is the interdependence of production, Distribution of Income, and Expenditure in a circular path or in an unending flow. The flow will be disturbed if any of the above activities fail to function.

2) National Income and Related Aggregates

1. Concept of National Income: National Income involves two major parts-
  • It involves only factor incomes
  • Factor incomes must be earned by only normal residents of a country
So, the aggregate factor incomes earned by the normal residents of a country in an accounting year is called the National Income.

We cannot learn the concept of national income without learning the concepts of Factor Income and Normal Residents of a country.

Factor Incomes: These are the payments made by the producing units against the factor services offered by the household sector to the producing units. These are-
  • Income of employees (Employee services)
  • Interest (on capital)
  • Profit (for entrepreneur skills)
  • Rent (on use of land)
Normal Residents: Any person can be a normal resident of a country if he satisfies the following two conditions:
  • who *ordinarily resides in that country
  • whose **economic interest lies in that country
* residing in a country for one year or more even if he is not a citizen of that country.

** Committing economic activities(like expenditure) in that country.

2. Domestic Income: It is the total of factor incomes(rent, interest, etc.) generated within the *domestic territory of a country. 
Whereas national income is earned by normal residents of a country, Domestic is earned by both- normal residents and non-residents of a country.

* A territory within which the flow of goods, persons, and capital is freely circulated and administrated by the government.

Thus we can say that,

Domestic Income = National Income – *Net factor income from abroad

3. Net factor income from abroad: This is the part of national income which differs it from the domestic income. In simple words,

Net factor income from abroad = Factor income earned by our normal residents from the outside world – Factor income earned by non-residents from our domestic territory

4. Domestic product: It is simply the sum total of values of products produced in a domestic territory of a country. 
Domestic product is identical to domestic income. This is because the aggregate value addition in production is similar to that of the factor incomes. In simple words, total production is similar to factor incomes.

Domestic product = Domestic Income

5. Gross and Net concepts: Domestic product and national product are further measured as-
  • Gross Domestic Product (GDP)
  • Net Domestic Product (NDP)
  • Gross National Income (GNP)
  • Net National Income (NNP)
Depreciation causes differences between:
  • GDP and NDP
  • GNP and NNP
Let’s check how it happens-

GDP – Depreciation = NDP
GNP – Depreciation = NNP
NDP + Depreciation = GDP
NNP + Depreciation = GNP

6. Concept of Factor Cost: Before learning about factor cost, we should first learn the relationship between the market price of the goods and factor cost. 

There is no difference between domestic product at market price and domestic product at factor cost as long as the following two things from the government sector do not exist-
  • Subsidies
  • Indirect taxes
How does this happen?

Indirect taxes increase the market value of goods which results in –

  • Domestic product at MP > Domestic product at FC
Subsidies decrease the market value of goods which results in –
  • Domestic product at MP < Domestic product at FC
How can they both become equal?

To create similarity between domestic product at FC and domestic product at MP, we-
  • Reduce the value of indirect taxes from domestic product at MP
  • Add the value of subsidies to domestic product at MP
In other words, 

Domestic product at MP – *Net Indirect taxes = Domestic product at FC

*Net Indirect taxes =  Indirect taxes – Subsidies

7. Nominal GDP: It is simply the market value of final goods and services produced in the domestic territory of a country at the current prevailing prices. It is also known as GDP at Current Prices

To understand better let us use the following example-

Suppose an economy’s GDP is 1 trillion dollars in a particular year.
Now suppose that the GDP of that country reaches 2 trillion dollars next year.

We know that:  Nominal GDP = Q × P

[Q = number of final goods and services]
[P = prices in the current year]

But, here is the problem. While the economy reached 2 trillion it does not guarantee that rise in the GDP was mostly due to an increase in the production of goods(Q). It can also be due to a hike in the prices of the goods and services compared to the previous year.

Thus, Nominal GDP is not a good measure in terms of welfare measurement as it focuses on both the quantity and prices of the goods and services in that accounting year.

8. Real GDP: It is the market value of goods and services produced in a country and is evaluated at constant prices (prices of the base year). 
Real GDP fulfills the lacking of nominal GDP. This is because the prices of final goods and services are fixed during the calculation of Real GDP.

[Q = number of final goods and services]
[P = prices in the base year]

A base year is a normal year where prices are meant to be stable and no extraordinary event had occurred in that year.

Thus, in Real GDP the emphasis is on the output of goods and services in a country. Therefore it is a better measurement of the welfare of people.

9. GDP Deflator: It is simply the ratio between Nominal GDP and Real GDP. It can also be expressed by percentage.

10. Limitations of GDP: The following are certain limitations of GDP as an index of welfare:-
  • Distribution of GDP
  • Non-monetary exchanges
  • Externalities 

3) Methods of calculating National Income

1. Methods: The following are the methods by which the national income of a country can be calculated-
  • Value Added Method
  • Expenditure Method
  • Income Method
2. Value Added Method: Under this method, the aggregate value added by different sectors in the economy is considered during an accounting year. Then further adjustments are made to find out National Income or NNP at FC.

It is also known as-
  • Product method 
  • Output method
But does Value Added means?

Value Added = Value of Output – Intermediate Consumption

*Value of Output = Sales + Change in stock during the year
** Intermediate Consumption = Value of non-factor inputs (raw material)

GDP at MP = It is found as the result of gross value added by different enterprises in the domestic territory of a country which is equal to the market value of final goods and services.

But this method does not stop here!

We are now required to find NNP at FC-

GDP at MP – Dep. = NDP at MP
NDP at MP – Net indirect taxes = NDP at FC
NDP at FC + Net factor income from abroad = NNP at FC

Therefore, National is found like this in this method.

3. Expenditure method: Under this method, National Income is calculated using expenditure incurred on the purchase of final goods and services in a country. It also requires various adjustments with GDP at MP.

Firstly, GDP at MP is calculated using the expenditure on the purchase of final goods and services in the domestic territory of a country.

Types of Final Expenditure: 
  • Private Final Consumption Expenditure (C)
  • Government Final Consumption Expenditure (G)
  • Investment Expenditure (I)
  • Net Exports (X-M)
a) Private Final Consumption Expenditure (C): It includes expenditure on various consumer services and goods by the household sector.
b) Government Final Consumption Expenditure (G): It includes expenditure on the purchase of goods and services by the government.
c) Investment Expenditure (I): It includes-
  • Fixed Investment
  • Inventory Investment
d) Net Exports (X-M): It refers to the difference between exports and imports of a country during an accounting year.

All of the above types of expenditure are added to find out GDP at MP.

National Income is calculated similarly as calculated under Value Added Method.

4. Income Method: Income method is a method of calculating National Income using factor incomes in a country.

National Income is calculated after deducting net factor income from abroad from the domestic income of a country.

Types of Factor Incomes:

a) Compensation of Employees

  • Wages and salaries
  • Payments in kind
  • Retirement Pension

b) Operating Surplus

  • Rent 
  • Interest 
  • Profit

c) Mixed Income

  • Income from self-employed resources
NNP at FC (National Income) is simply calculated by adding net factor from abroad with Domestic Income (Compensation of employees, Operating Surplus, Mixed Income).

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