Block 1 - National Income and Accounts

M.A. FINAL ECONOMICS

PAPER I

MICRO ECONOMIC ANALYSIS

BLOCK 1 - NATIONAL INCOME AND ACCOUNTS

Unit - I-National income and accounts

UNIT – II- Flow of funds and Balance of payments

WRITTEN BY

SEHBA HUSSAIN

EDITED BY

PROF.SHAKOOR KHAN

BLOCK 1 NATIONAL INCOME AND ACCOUNTS

The block opens with introduction to national income and accounts. The first unit deals with the explanation of what actually term National income accounts stand for. Circular flow of income is explained and its two sector model, three sector model, four sector models and five sector models are discussed in detail. The income and output approach of national income accounting is dealt in later section followed by the concepts of social accounting.

The second unit covers flow of fund approach to national income accounting and balance of payments. Flow of funds approach is introduced with its methods and applications. Cash flow activities and methods of making cash flow statement are discussed. Balance of Payments concept and history of Balance of Payments issues has been explained. Make up of Balance of Payment sheet is the final concern of the unit.

UNIT 1

NATIONAL INCOME AND ACCOUNTS

Objectives

After studying this unit, you should be able to understand and appreciate:

The concept national income accounting
The meaning of circular flow of income.
Circular flow of income in two, three, four and five sector model
Input and output method and social accounting approach of national income accounting

Structure

1.1 Introduction

1.2 Circular flow of income

1.3 Two sector model

1.4 Three sector model

1.5 Four sector model

1.6 Five sector model

1.7 National income accounting

1.8 The income and output approach

1.9 Social accounting

1.10 Summary

1.11 Further readings

1.1 INTRODUCTION

National income accounting deals with the aggregate measure of the outcome of economic activities. The most common measure of the aggregate production in an economy is Gross Domestic Product (GDP). It is the market value of all final goods and services produced in an economy within a given period of time (typically a year), whether or not those goods are sold to the final consumer. It does not matter who owns the resources as long as it is contained within the geographical border of a country. What is happening to the GDP of a country over time is an important indicator of how well the economy is performing.
Calculating GDP involves adding together trillions of different goods and services produced by the economy. Computation of GDP focuses on transactions involving final output of goods and services produced in the current year.
Transactions involving intermediate goods are not included since their values are reflected in the values of the final goods in whose production the intermediate goods were employed. For example, if there is a firm that sells tires to a car manufacturer, GDP does not include the values of the tires and the full cars separately for this will unnecessarily count the tires twice. We either include the net value added by each firm or just add the value of only the final goods.Toillustrate this concept further, consider the tires and the cars that were sold.The tires cost $100each to manufacture thus totaling $400 for a car. The manufacturer sold the tires to Dodge who used them to make a car. A dealership then sold the car for $10,000. Would the GDP equal $10,400 thus including the tires and the car? No, it would not, because the tires are an intermediate good used to produce the car. In this case, the value added of the tire manufacturer is $400. The value added of the dealership in selling the car is $10,000 - $400 which $9,600 is. The total value added would then be $400 + $9,600 which is $10,000. Basically, the total of the value added must equal the total of the final goods and services.

1.2 CIRCULAR FLOW OF INCOME

In economics, the term circular flow of income or circular flow refers to a simple economic model which describes the reciprocal circulation of income between producers and consumers. In the circular flow model, the inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively and provide each other with factors in order to facilitate the flow of income. Firms provide consumers with goods and services in exchange for consumer expenditure and "factors of production" from households.

The circle of money flowing through the economy is as follows: total income is spent (with the exception of "leakages" such as consumer saving), while that expenditure allows the sale of goods and services, which in turn allows the payment of income (such as wages and salaries). Expenditure based on borrowings and existing wealth – i.e., "injections" such as fixed investment – can add to total spending.

In equilibrium (Preston), leakages equal injections and the circular flow stays the same size. If injections exceed leakages, the circular flow grows (i.e., there is economic prosperity), while if they are less than leakages, the circular flow shrinks (i.e., there is a recession).

More complete and realistic circular flow models are more complex. They would explicitly include the roles of government and financial markets, along with imports and exports.

Labor and other "factors of production" are sold on resource markets. These resources, purchased by firms, are then used to produce goods and services. The latter are sold on product markets, ending up in the hands of the households, helping them to supply resources.

In fact, the circular flow model is a fundamental representation of macroeconomic activity among the major players in the economy--consumers, producers, government, and the rest of the world. Different versions of the model sequentially combined the four sectors--household, business, government, and foreign--and the three markets--product, resource, and financial--into increasingly more comprehensive representations of the economy.

Assumptions

The basic circular flow of income model consists of six assumptions:

The economy consists of two sectors: households and firms.
Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S).
All output (O) produced by firms is purchased by households through their expenditure (E).
There is no financial sector.
There is no government sector.
There is no overseas sector.

1.3 Two Sector Model

In the simple two sector circular flow of income model the state of equilibrium is defined as a situation in which there is no tendency for the levels of income (Y), expenditure (E) and output (O) to change, that is:

Y = E = O

This means that the expenditure of buyers (households) becomes income for sellers (firms). The firms then spend this income on factors of production such as labour, capital and raw materials, "transferring" their income to the factor owners. The factor owners spend this income on goods which leads to a circular flow of income.

The basic model illustrates the interaction between the household and business sectors through the product and resource markets. However, more realistic circular flow models include saving, investment, and investment borrowing enabled by the financial markets; taxes and expenditures of the government sector; and imports and exports of the foreign sector.

The prime conclusion of the circular flow model is that the overall volume of the circular flow is largely unaffected by the path taken. In particular, household income can be used for consumption, saving, or taxes. The income diverting away from consumption and to saving or taxes does not disappear, but is used to finance investment by business sector and purchases by the government sector.

1.4 Three sector model

The three-sector, three-market circular flowmodel highlights the key role that the government sector plays in the macroeconomy. It expands the circular flow model by illustrating how taxes are diverted from consumption expenditures to the government sector and then used for government purchases. It illustrates that taxes do not vanish from the economy, but are merely diverted.

1.4.1 Three Sectors, Three Markets

The three macroeconomic sectors included in this model are:

Household Sector: This includes everyone, all people, seeking to satisfy unlimited wants and needs. This sector is responsible for consumption expenditures. It also owns all productive resources.
Business Sector: This includes the institutions (especially proprietorships, partnerships, and corporations) that undertake the task of combining resources to produce goods and services. This sector does the production. It also buys capital goods with investment expenditures.
Government sector: This includes the ruling bodies of the federal, state, and local governments. Regulation is the prime function of the government sector, especially passing laws, collecting taxes, and forcing the other sectors to do what they would not do voluntary. It buys a portion of gross domestic product as government purchases.

The three macroeconomic markets in this version of the circular flow are:

Product markets: This is the combination of all markets in the economy that exchange final goods and services. It is the mechanism that exchanges gross domestic product. The full name is aggregate product markets, which is also shortened to the aggregate market.
Resource markets: This is the combination of all markets that exchange the services of the economy's resources, or factors of production--including, labor, capital, land, and entrepreneurship. Another name for this is factor markets.
Financial Markets: The commodity exchanged through financial markets is legal claims. Legal claims represent ownership of physical assets (capital and other goods). Because the exchange of legal claims involves the counter flow of income, those seeking to save income buy legal claims and those wanting to borrow income sell legal claims.

1.4.2 Spotlight on the Government Sector

The three-sector, three-market circular flow model highlights the role played by the government sector. The government sector buys a portion of gross domestic product flowing through the product markets to pursue its assorted tasks and functions, such as national defense, education, and judicial system. These expenditures are primarily financed from taxes collected from the household sector. However, when tax revenue falls short of expenditures, the government sector is also prone to borrow through the financial markets.

The government sector, as such, adds three key flows to the model--taxes, government purchases, and government borrowing. These flows divert, but do not destroy, a portion of the core flow of production, income, and consumption.

1.4.3 Taxing and Spending and Borrowing

This diagram presents the three-sector, three-market circular flow. At the far left is the household sector, which contains people seeking consumption. At the far right is the business sector that does the production. At the top is the product markets that exchange final goods and services. At the bottom is the resource markets that exchange the services of the scarce resources. Just above the resource markets are the financial markets that divert saving to investment expenditures. In the very center is the government sector.

Taxes: With the government sector in place, the next step in the construction of the three-sector, three-market circular flow is taxes. Taxes are household sector income that is diverted to the government sector. The household sector is forced to divert part of income away from consumption and saving because the government sector mandates that they must. Click the [Taxes] button to reveal the flow of taxes from the household sector to the government sector.
Government Purchases: The primary reason that the government sector collects taxes from the household sector is to pay for government purchases. Government purchases by the government sector then become the third basic expenditure on gross domestic product that flows through the product markets. Click the [Purchases] button to highlight this flow from the business sector to the product markets.
Government Borrowing: Taxes are not the only source of income used to finance government purchases (which often happens). When taxes fall short of government purchases, the difference is made up with government borrowing. The government sector, like the business sector, often sells legal claims as a means of borrowing the income that can used for government purchases. Click the [Borrowing] button to highlight this flow from the financial markets to the government sector.

Combining all three flows indicates the key role played by the government sector. Taxes flow from the household sector to the government sector. This flow then heads to the product markets as government purchases where it is supplemented with borrowing from financial markets. Income diverted away from consumption expenditures by the household sector as taxes finds its way back to the product markets as government purchases by the government sector.

The key to the addition of the government sector to the circular flow is that taxes do NOT disappear as they move from sector to sector, they are merely diverted. In other words, taxes do not remain in the government sector, but merely pass through on the way to the product markets.

Figure 1 taxing and borrowings

1.4.4 What It All Means

What happens when the government sector is included in the circular flow model?

First, the government diverts a portion of the circular flow. But this diversion that does not necessarily change the total amount of gross domestic product, factor payments, or national income. It merely diverts income from consumption and saving to taxes. And it diverts gross domestic product from consumption and investment to government purchases.
Second, the total flow of government purchases is as important, if not more so, than the source of financing. If the government sector spends a trillion on government purchases, this must be paid for with national income, either through taxes or saving. If borrowing declines and purchases remain unchanged, then taxes must rise. If taxes decline and purchases remain unchanged, then borrowing must rise.
Third, although the total flow is unchanged, shifting income between taxes, consumption, and saving can and does affect the economy. If the tax flow increases, then less remains for consumption and saving. Either the household sector satisfies fewer wants and needs or the business sector borrows less to invest in growth-promoting capital goods. Diverting income to government purchases and away from investment is termed the crowding-out effect, and worries people concerned about big government.
Fourth, while the size of government is important, so too are specific government purchases. Government spending can be wasteful and unneeded, or it can provide valued goods, including national defense, education, transportation systems, police and fire protection, the judicial system, and environmental quality. In some cases, household consumption and business investment are more valuable than government purchases. In other cases, government purchases are more valuable.

1.5 Four sector model

The four-sector, three-market circular flowmodel highlights the key role that the foreign sector plays in the economy. It expands the circular flow model by illustrating how exports add to, and imports subtract from, the domestic flow of production and income. This is the "complete" model containing all four sectors and all three markets.

1.5.1 Four Sectors, Three Markets

The four macroeconomics sectors included in this model are:

Household Sector: This includes everyone, all people, seeking to satisfy unlimited wants and needs. This sector is responsible for consumption expenditures. It also owns all productive resources.
Business Sector: This includes the institutions (especially proprietorships, partnerships, and corporations) that undertake the task of combining resources to produce goods and services. This sector does the production. It also buys capital goods with investment expenditures.
Government sector: This includes the ruling bodies of the federal, state, and local governments. Regulation is the prime function of the government sector, especially passing laws, collecting taxes, and forcing the other sectors to do what they would not do voluntarily. It buys a portion of gross domestic product as government purchases.
Foreign sector: This includes everyone and everything (households, businesses, and governments) beyond the boundaries of the domestic economy. It buys exports produced by the domestic economy and produces imports purchased by the domestic economy, which are commonly combined as net exports.

The three macroeconomic markets in this version of the circular flow are: