.

Chapter 2

Circular Flow
and National
Income
Accounting
by
Ooi Soon Beng
 After studying this chapter, you should be able
to understand:
 Definition and Measurement of National Income
 The Output Method
 The Income Method
 The Expenditure Method
 Uses of National Income
 Problems of Measuring National Income
 Limitations of the GDP Measure
Macroeconomics
The systematic keeping of national accounts only
began in the 1930s in the United States.

The 1930s Great Depression and the rise of Keynesian

economics prescribed a greater role for the
government in managing an economy.

Hence, governments need to obtain accurate

information, so that their interventions into the
economy could proceed as much as possible from a
basis of fact.
Macroeconomics
The national income was first
measured by Simon Kuznets, a
Russian American economist
from Wharton School of
Business, University of
Pennsylvania.
Began in the 1930s, Kuznets
computed U.S. national income
back to 1869.
Kuznets’s measures helped
advance the Keynesian
revolution and the study of
A Jew, Simon Kuznets (1901-1983)
econometrics. won Nobel Prize in 1971.
National income can be measured in three ways.
Aggregate Aggregate Aggregate
output is the expenditure is the income is the
value of the total expenditure income paid out
output of final on final goods and for the use of
goods and services. resources.
services.
C + I + G + (X – M). (wages, interest,
rent, and profit).

Macroeconomics
The three approaches used for measuring national
income give the same result.

Output = Expenditure = Income

The reason is that the market value of goods and
services produced must be equal to the amount that
buyers must spend to purchase them.

At the same time, the buyers’ income must equal what

the buyers spend.
Macroeconomics
The equality of output, expenditure and income can
be represented by the circular flow diagram.
The factors of production flow from households to
producers. In exchange, money income flows in the
opposite direction.
Goods and services flow from producers to
households. In exchange, money expenditure flows in
the opposite direction.

Macroeconomics
A closed economy without any government intervention.
However, in the real world, it is more complicated.
We have to add two more components: government
sector and foreign sector.
Government spending on goods and services is
injected into the circular flow, while taxation will leak
from it.
The value of exports sold overseas is injected into the
circular flow, while spending on imported products will
leak from the flow.
The output approach measures GDP as the market value
of all final goods and services, produced in a country, in a
given time period.
We have to exclude intermediate goods and services to
avoid double counting.

 A final good is an item bought by final users.

 An intermediate good is an item that is produced by one
firm, bought by another firm, and used as a component
of a final good or service.
Macroeconomics
 Intermediate Value Added
Seed $1000 $1000 - $0 = $1000
Wheat $2500 $2500-$1000 = $1500
Flour $3500 $3500 - $2500 = $1000
Bread $5000 $5000-$3500 = $1500
$12,000 (wrong) $5000 (correct)
We can also sum up the value added by each industry.
 Malaysia’s Share of GDP by Sectors (in %)
1993 1997 2007 2017
Agriculture 15.9 11.9 7.7 8.2
Mining and Quarrying 8.0 6.7 8.6 8.4
Manufacturing 30.1 35.7 30.3 23.0
Construction 4.0 5.8 3.0 4.6
Services 44.4 46.5 53.2 54.4

Source: Bank Negara

1) Double counting: When we add up the value of output
of various sectors, we should avoid intermediate goods
to avoid double counting.
2) Value addition in particular year: GDP includes only
goods and services that are newly produced within the
current period. The values which had previously been
included have to be ignored.
3) Production for self consumption: The production of
goods for self consumption should be counted at the
prevailing market prices.
The expenditure approach
measures GDP as the sum of
household consumption, Consumption by
Households
business investment,
government purchases and
+
Investment by
net exports. Businesses
+
Expenditure approach Government
measures GDP at market Purchases
prices. +
Net Exports
Household consumption is
usually the largest component
=
National Income at Market Prices
in the GDP.
1) Expenditure on transfer payments such as unemployment
benefit, old age pensions, interest on public debt should not
be included because no productive service is rendered.

2) Expenditure on second
hand goods should not
be included because they
do not contribute to the
current year's production
of goods.

3) Expenditure on purchase of old shares and bonds

should not be included as these do not represent
expenditure on currently produced goods and services.
The income approach
measures GDP by Wages
summing the incomes +
that firms pay households Rents
for the factors of +
production they hire. Interest
Because this method +
seeks to measure national Proprietors’ Income
income at the phase of +
distribution, it yields Corporate Profits
national income at factor
cost.
=
National Income at Factor Cost
 Wages
To bring it in line with +
Rents
output method and
expenditure method,
+
Interest
we have to convert +
Proprietors’ Income
national income at +
factor cost to market Corporate Profits
=
prices, by adding National Income at Factor Cost
indirect taxes and +
Indirect Taxes
subtracting subsidies. -
Subsidies
=
National Income at Market Prices
1) Transfer payments such as gifts, donations,
scholarships, indirect taxes should not be included.
2) Illegal money earned through smuggling and
gambling should not be included.
3) Windfall gains such as prizes won, lotteries etc.
should not be included.
4) Receipts from the sale of financial assets such as
shares, bonds should not be included.
Macroeconomics
In practice, the three approaches yield
slightly different results due to statistical
discrepancy.

Macroeconomics
Which of the following are included and which are excluded
in calculating this year’s GDP? Explain in each instance.
 A monthly scholarship check received by an economics
student.
 The purchase of a new truck by a trucking company.
 Government purchase of missiles from a private business
 The purchase of a used tractor by a farmer.
 The value of the purchase of shares of Microsoft by an
individual.
Macroeconomics
Which of the following transactions would be included
in GDP?
A. Mary buys a used book for $5 at a garage sale.
B. Nick buys $5000 worth of stock in Microsoft.
C. Olivia receives a tax refund of $500.
D. Peter buys a newly constructed house.

Macroeconomics
Suppose Smith pays $100 to Jones.
A. We can say with certainty that the GDP has increased by
$100.
B. We can say with certainty that the GDP has increased,
but we cannot determine the amount.
C. We can say with certainty that the nominal GDP has
increased, but we can't say whether real GDP has
increased or decreased.
D. We need more information to determine whether GDP
has changed.
Macroeconomics
By summing the dollar value of all market
transactions in the economy we would:
A. be determining the market value of all
resources used in the production process.
B. obtain a sum substantially larger than the
GDP.
C. be determining value added for the economy.
D. be measuring GDP.
Macroeconomics
GDP is a measure of goods and services produced within
the country, whether by citizens or foreigners.
GNP is a measure of goods and services produced by
citizens of a country, regardless of where they live.
GNP = GDP + [ income earned by citizens from their
work and investments abroad - income earned by
foreigners from their work and investments within the
country ].

Macroeconomics
Net Domestic Gross Domestic Product
Product is obtained (GDP)
after accounting for Less: Consumption of Fixed
the depreciation of Capital
capital. Equals: Net Domestic
Product (NDP)

Macroeconomics
National income (NI) is income earned by citizens
of a country, whether in the country or abroad.
Per capita income (per head income) is measured
by dividing national income with the total
population of the country.

Macroeconomics
1 Luxembourg 114,234 11 Luxembourg 114,234
2 Switzerland 82,950 12 Netherlands 53,106
— Macau 82,388 13 Austria 51,509
3 Norway 81,695 14 Finland 49,845
4 Ireland 76,099 15 San Marino 48,946
5 Iceland 74,278 — Hong Kong 48,517
6 Qatar 70,780 16 Germany 48,264
7 Singapore 64,041 17 Belgium 46,724
8 USA 62,606 18 Canada 46,261
9 Denmark 60,692 19 France 42,878
10 Australia 56,352 20 UK 42,558
63 Malaysia 10,942
Personal income is NI National Income (NI)
minus social security Less: Social Security Contributions
contributions, minus Less: Corporate Taxes
corporate taxes, minus
Less: Undistributed Corporate
undistributed corporate
Profits
profits, minus taxes on
Less :Taxes on production and
production and imports
imports
and add transfer
payments. Plus: Transfer Payments
Equals: Personal Income (PI)
Disposable income is
personal income less Less: Personal Taxes
personal taxes. Equals: Disposable Income (DI)
Macroeconomics
Gross Domestic Product (GDP) $ 13,841
Less: Consumption of Fixed Capital 1687
Equals: Net Domestic Product (NDP) $ 12,154
Less: Statistical Discrepancy 29
Plus: Net Foreign Factor Income 96
Equals: National Income (NI) $ 12,221
Less: Taxes on Production and Imports 1009
Less: Social Security Contributions 979
Less: Corporate Income Taxes 467
Less: Undistributed Corporate Profits 344
Plus: Transfer Payments 2237
Equals: Personal Income (PI) $ 11,659
Less: Personal Taxes 1482
Equals: Disposable Income (DI) $ 10,177
GDP is:
A. the monetary value of all goods and services (final,
intermediate, and non-market) produced in a given year.
B. total resource income less taxes, saving, and spending
on exports.
C. the economic value of all economic resources used in the
production of a year's output.
D. the monetary value of all final goods and services
produced within a nation in a specific year.
Macroeconomics
Personal income will equal disposable income
when:
A. Corporate profits are zero
B. Personal taxes are zero
C. Transfer payments are zero
D. Social Security contributions are zero

Macroeconomics
GDP exceeds NDP by:
A. Taxes on production and imports
B. The consumption of fixed capital
C. Transfer payments
D. Personal taxes

Macroeconomics
Nominal GDP is the value of goods and services
produced during a given year valued at the current
prices.
Real GDP is the value of final goods and services
produced in a given year when valued at constant
prices.

Rising nominal GDP is caused by both production

and prices increase, but rising real GDP is caused by
production increase only.
Macroeconomics
 Hence, real GDP is the nominal GDP that has
been adjusted to remove the impact of inflation.

Real GDP = Nominal GDP

Price Index

Price Index = Current Year Price

Base Year Price

Macroeconomics
 Assume Year 2 is the base year.

Year Price Price Index

1 $100 _____
2 $120 _____
3 $132 110

Macroeconomics
 Year Nominal Price Real
GDP Index GDP
2000 $150 83 180.7
2002 $200 100 _____
2003 $575 110 _____

Macroeconomics
 Nominal Price level GDP Growth
Year GDP index Real GDP Rate (%)

1 $117 120 $ 98 -
2 124 104 119 +21.4
3 143 85 168 +41.2
4 149 96 155 -7.7
5 178 112 159 2.6
6 220 143 154 -3.14
In an economy, the total expenditures for a market
basket of goods in year 1 (the base year) was $5,000
billion. In year 2, the total expenditure for the same
market basket of goods was $5,500 billion. What was
the GDP price index for the economy in year 2?
A. 100
B. 110
C. 115
D. 120
Macroeconomics
A GDP index one year was 110, and the next year it
was 115. What is the approximate percentage change
in the price level from one year to the next as
measured by that index?
A. 3.1%
B. 4.5%
C. 5.4%
D. 6.2%
Macroeconomics
One year nominal GDP was $286 billion and the
price index was 88. Real GDP that year was:
A. $252 billion
B. $325 billion
C. $308 billion
D. $262 billion

Macroeconomics
Main uses of national income :
1. It gives us a measure of the state of the
economy at a particular point in time.
2. It permits us to track the condition of the
economy over a period of time to see whether
it has grown or stagnated.
3. Provide the basis for economic policy
decisions.
Macroeconomics
Which is a primary use for national income accounting?
A. To analyze the environmental cost of economic
growth
B. To assess the economic efficiency of specific
industries in the economy
C. To measure changes in the value of goods and
services produced in the economy
D. To determine whether there is a fair and equitable
distribution of income in the economy
Macroeconomics
1) Illiteracy: In developing countries, some
producers do not keep any record of the sale of
the products in the market.
2) Unreliable data: In developing countries, the
statisticians themselves do not feel the
importance of data which they collect. The figures
of national income are, therefore, not up-to-date.

Macroeconomics
3) Self-consumed production: In developing
countries, a significant part of the output is
not exchanged for money in the market. It is
either consumed directly by producers or
bartered for other goods.
4) Errors and Omissions. This is a problem as
people hide what they earn, and firms hide
their output, to avoid paying tax.

Macroeconomics
Singapore’s 2018 per capita income = USD60,041
Malaysia’s 2018 per capita income = USD10,942

Source: IMF
Macroeconomics
 GDP measures do not
reflect
 environmental pollution
 product quality
 leisure time
 nonmarket production
services
 activities in underground
economy
 non-economic well-
being like crimes,
political freedom.
Macroeconomics
GDP is not a perfect measure to compare standard
of living between two countries because of :

1) Differences in inflation 6) Differences in health and

rate life expectancy
2) Differences in income 7) Differences in leisure time
distribution 8) Differences in
3) Differences in non- environmental quality
monetised sector 9) Differences in political
4) Differences in the freedom
composition of GDP
5) Differences in the size of
black economy
GDP tends to underestimate the productive activity in the
economy because it excludes:
A. Spending by the government on military goods
B. Spending by businesses to reduce the level of pollution
C. The work done by construction companies to remodel
homes
D. The personal labor time homeowners spend on home
repairs
Macroeconomics
Some of the production of an economy creates
pollution. As a result:
A. Nominal GDP is greater than real GDP
B. Real GDP is greater than nominal GDP

C. GDP tends to understate social welfare

D. GDP tends to overstate social welfare

Macroeconomics
GDP tends to underestimate the productive activity
in the economy because it excludes the value of
output from:
A. Public transfer payments to households
B. The consumption of fixed capital
C. The underground economy
D. Intermediate goods

Macroeconomics
SOCIALISM: You have two cows. The State takes one and gives it to
someone else.
COMMUNISM: You have two cows. The State takes both of them and
gives you the milk.
FASCISM: You have two cows. The State takes both of them and sells
you the milk.
MILITARY DICTATORSHIP: You have two cows. The State takes both
of them and shoots you.
BUREAUCRACY: You have two cows. The State takes both of them,
accidentally kills one and spills the milk in the sewer.
CAPITALISM: You have two cows. You sell one and buy a bull.
PURE DEMOCRACY: You have two cows. Your neighbours decide who
gets the milk.
REPRESENTATIVE DEMOCRACY: You have two cows. Your
neighbours pick someone to decide who gets the milk.