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Notes on A-Level Macroeconomics: Introduction to Macroeconomics and National Income Accounting

Introduction to Macroeconomics and National Income Accounting

(A) Introduction to Macroeconomics


Microeconomics is the study of the market behavior of individual economic units (e.g. firms
and individual consumers) and it tries to explain price and quantity of a particular good.
Macroeconomics, on the other hand, is the study of aggregate economic behavior and it tries
to explain aggregate economic variables, e.g. aggregate output (GNP), general price level (inflation),
unemployment, etc.

(B) Introduction to National Income Accounting


National income accounting aims at measuring the aggregate output (or national income) of an
economy in a specified period. In addition to GDP, the Census and Statistics Department has started
to compile Gross National Product (GNP) since the reference year of 1993 to meet a growing
demand for such data to analyze the Hong Kong economy.

1. National Income Accounting in Hong Kong


1.1. Definition of GDP
GDP is an aggregate measure of the total value of final products (goods and services) of all
resident producing units in an economy, which production activities are carried out within the
economy in a specified period.
1.2. Definition of GNP
GNP, on the other hand, is a measure of the total value of final products (goods and services)
of residents of an economy from engaging in various economic activities, irrespective of whether
the economic activities are carried out within the economic territory or outside.

1.3. Relationship between GNP and GDP


Adding to GDP the total income earned by residents of the economy from the Rest of the
World, and deducting income earned by non-residents within the economy, gives the Gross
National Product (GNP). GNP is estimated by the following formula:
GNP= GDP + Factor income earned by residents from outside the economic territory
- Factor income carried by non-residents from within the economic territory
(Note: Factor income earned by residents from outside the economic territory - Factor income
carried by non-residents from within the economic territory = External Factor Income Flows)
1.4. Concept of ‘Residents’ of an economy
The concept of ‘residents’ is crucial to the compilation of both GDP and GNP. Practically,
residents of all economy include individuals and organizations.
According to international statistical standards, for individuals, residents refer to, those who
normally stay in the economic territory of the economy for at least 12 months or longer, or intend
to do so, irrespective of their nationality.
For organizations, residents refer to those whic h ordinarily operate in the economic territory.
The economic territory of an economy consists of the geographic territory administered by the
government of the economy within which persons, goods and capital circulate freely.
Conceptually, the residence status of individuals and organizations depends on their centre
of economic interest.

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Notes on A-Level Macroeconomics: Introduction to Macroeconomics and National Income Accounting

Examples
Example 1: Foreign Domestic Helper
A foreign domestic helper working in Hong Kong is regarded as a resident of Hong Kong.
Example 2: Branch of a Foreign Bank
A branch of a foreign bank operating in Hong Kong is defined as a resident organization.
Example 3: Short-term Contract Solicitor
A solicitor coming to Hong Kong to work on a short-term 3-term contract for a local
company is NOT regarded as a resident. The income earned by him is external factor income
outflow from Hong Kong to other economies in the form of compensation of employees (CE).
Example 4: Guest performer from an overseas TV station
A TV station in Hong Kong getting a guest performer from an overseas TV station to
perform in Hong Kong, the guest performer is NOT regarded as a resident. It is regarded as
purchases a service from overseas TV station, which is the employer of the performer. Here, an
‘import of service’is involved.

1.5. Net External Factor Income Flows


As mentioned above, GNP estimates at current market prices are obtained by adding to GDP
at current market prices the net External Factor Income Flows (EFIF).
GNP estimates at constant market prices are obtained by adding to GDP at constant market
prices the real net External Factor Income Flows (EFIF). Real net EFIF is obtained by deflating
nominal EFIF using the implicit price deflator of domestic demand.
On 1 July 1997, Hong Kong became a Special Administrative Region of the People’s
Repub lic of China. Data on transactions and assets and liabilities vis-à-vis the mainland of China
are treated as international transactions and external positions respectively. Hence, factor income
flows between Hong Kong and the mainland are treated as external factor income flows and are
covered in Hong Kong’s GNP estimates.

1.6. Major components of External Factor Income Flows


The classification of EFIF is basically similar to the classification of standard components of
the Income Account of the Balance of Payments Manual (BPM) published by the international
Monetary Fund in 1993.
These income components are:
(a) Direct investment Income (DII) refers to earnings of residents from direct investment in
territory, in which they have a lasting interest and a degree of influence or control over the
management. These earnings are in the form of net interest receipts on intercompany debts, receipts
of distributed dividends, share of undistributed profits and gross rentals.
External investment in real estate, as specified by BPM, is also a form of direct investment.
By statistical convention, land and other immovable structures and objects (e.g. building) in an
economy can only be owned by residents of that economy. If a Hong Kong resident owns real estate
outside the economic territory of Hong Kong, he should be regarded as owning a nominal company
in the economy in question which in turn owns the real estate. The relationship between such
nominal company and legal owner of the land and structures is then treated as a direct investment
relationship.

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Notes on A-Level Macroeconomics: Introduction to Macroeconomics and National Income Accounting

In general, if a Hong Kong company creates a business entity outside the economic territory
of Hong Kong for the purpose of holding some assets in Hong Kong, the income generated by those
assets will be compiled as income out flow to the business entity, and then as income inflow from
the entity back to the final owner(s) of the investment.

(b) Portfolio investment income (PII) refers to earnings of residents from investment in
non-resident equities (i.e. stocks and shares), debt securities (e.g. negotiable certificates of deposits,
bonds and bills) and financial derivatives (e.g. interest rate swaps and forward rate agreements).
Compared with investors making direct investment, portfolio investors in equity and debt securities
of non-resident business enterprises have no lasting interest or influence in the management of the
companies they invest. A holding of less than l0% equity in a company is regarded as portfolio
investment.
The residence status of securities is determined by the legal domicile and place of
productive operation or the issuing company, irrespective of the place of listing. Therefore, shares
that are issued by resident companies are regarded as resident shares. In a Stock Exchange in an
economy, there may be both listings of resident and non-resident shares

(c) Other investment income (OII) refers to external flows of interest incomes derived from other
financial claims on and liabilities to non-residents that are not classified as DII or PII. Examples of
these claims and liabilities include short-term and long-term non- marketable loans, deposits,
financial leases and trade credit.

(d) Compensation of employees (CE) refers to labour income earned by non-residents from their
short-term employment within the economic territory of Hong Kong and labour income earned by
residents from their short-tern employment outside the economic territory of Hong Kong. It
comprises wages, salaries and other remuneration whether paid in cash or in kind.
For Hong Kong people who frequently travel to and from the mainland of China in their
work, they are regarded as Hong Kong residents, and their salaries are normally paid by companies
in Hong Kong. Therefore, the labour income they earn is not included in CE inflow. Also, those
employees who come from other economies to work in Hong Kong under the Importation of
Labour Scheme, or who have an employment contract of more than 12 months, are regarded as
Hong Kong residents according to international standards, and their labour income is accordingly
not included in CE outflow.
Some Hong Kong people work outside the economic territory of Hong Kong in the capacity
of freelance specialists (e.g. singers, lawyers, doctors). Usually they work as employees of Hong
Kong companies owned by themselves which are created for signing legal binding contracts with
non-residents and for receiving earnings. The earnings of these freelance specialists from outside
the economic territory of Hong Kong are treated as trade in services and are already covered in
GDP.

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Notes on A-Level Macroeconomics: Introduction to Macroeconomics and National Income Accounting

2. Different Approaches of Measuring GDP


2.1 Expenditure Approach
GDP = C + I + G + (X - M), where C = private consumption expenditure
I = gross investment expenditure
G = government expenditure
X = value of export
M = value of import
2.1.1 Private consumption expenditure
Private consumption expenditure refers to the consumption expenditure on final goods and
services (by households and non-profit bodies serving households). It should be noted that
expenditure on properties belongs to investment expenditure instead of consumption expenditure.

2.1.2 Gross investment expenditure


Gross investment expenditure has two main components. They are:

(i) Gross domestic fixed capital formation / Gross fixed investment


This refers to the spending on machinery and equipment, properties (including residential
building) and public investment. Production units (private firms and government departments)
purchase many goods and services but most of them are intermediate products. Only fixed capital
(e.g. machinery and equipment) is finally consumed by them.
(ii) Change in stock
This refers to the change in value of the stocks of raw materials, work in progress and unsold
finished products. Because semi- finished and unsold finished products are currently produced, they
are included in GNP.
Gross investment = Gross fixed investment + Change in stock
= Depreciation + Net fixed investment + Change in stock
= Depreciation + Net investment

2.1.3 Government expenditure


This refers to the expenditure on final goods and services by the government. Because most
goods and services provided by the government are not bought and sold in the market, they are
valued at their costs, rather than market prices.
Transfer payments are excluded because they are government payments of which no
corresponding goods and services are exchanged. When transfer payment are spent by receivers on
final goods would be counted as private consumption expenditure.

2.1.4 Net export (X – M)


Exports (X) includes both domestic exports and re-exports. Exports are included in GNP
because they are produced by the country. Imports of goods and services are deducted because they
are not part of domestic output but have been included in various items of expenditure (such as
private and gove rnment consumption, and gross domestic fixed capital formation). They are
deducted to avoid double counting.

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Notes on A-Level Macroeconomics: Introduction to Macroeconomics and National Income Accounting

2.2 Income Approach


GNP = r + w + i + π(net of depreciation) + depreciation + indirect taxes – subsidies
National Income (NI) = r + w + i + π(net of depreciation)
GNP = NI + depreciation + indirect taxes – subsidies
, where r = rent, w = wage, i = interest and π = profits

2.2.1 Rent
Rent refers to the income earned by the owner of natural resources (e.g. land) and properties. It
also includes royalties paid for patents and copyrights. For owner-occupied properties and their
rental values are estimated (imputed rental value) and included in GNP.

2.2.2 Wage
Wage refers to wage and salary supplements (including contributions to pension fund,
commissions, bonuses, housing allowances, rental value of staff quarters, etc.) earned by labour.
2.2.3 Interest
Interest refers to income earned by capital and equipment.
2.2.4 Profits
Profits can be divided into three parts: (i) dividends (i.e. profits distributed to shareholders), (ii)
retained earnings (i.e. undistributed corporate profits) and (iii) corporate profits tax.

2.3 Output Approach (Value added approach)


Using the output approach, we calculate the total value of final goods and services produced
by the economy. To avoid double counting the value of intermediate goods, the value-added
approach is adopted.
Value-added measures the actual contribution of all factors employed by production units. (i.e.
Value-added of all economic sectors = National income (NI) + depreciation)
GNP = Value-added of all economic sectors + indirect taxes – subsidies

3. Different National Income Statistics


! GNP = GDP + net external factor income flow (EEIF)

! GNP at factor cost = GNP (at market prices) – indirect taxes + subsidies

GDP at factor cost = GDP (at market prices) – indirect taxes + subsidies
! Net National Product (NNP) = GNP – depreciation

! NNP at factor cost = NNP – indirect taxes + subsidies


= GNP – depreciation – indirect taxes + subsidies
= r + w + i + π(net of depreciation)
= Nation Income (NI)
! Personal income (PI) = NI – Social security contributions

– Corporate profits tax


– Undistributed corporate profits
+ Transfer payments from the government
[Note: Personal income is the total income received by citizens.]

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Notes on A-Level Macroeconomics: Introduction to Macroeconomics and National Income Accounting

! Disposable (personal) income (DPI) = PI – income taxes (except corporate profit tax)
[Note: Disposable income is the total income that can be spent by citizens.]
! Per capita GNP = GNP ÷ Size of population
Per capita GDP = GDP ÷ Size of population

base year price index


! Real GNP = Nominal GNP ×
current year price index

Real GNP = Nominal GNP ÷ GNP deflator × 100

base year price index


Real GDP = Nominal GDP ×
current year price index

Real GDP = Nominal GDP ÷ GDP deflator × 100

[Note: Real GDP is also known as GDP at constant price. Nominal GDP is also known as
GDP at current market price. GDP deflator is the weighted average of the price relatives
of all commodities comprising GDP. GDP deflator can also be found by dividing Nominal
GDP by Real GDP (i.e. GDP deflator = Nominal GDP ÷ Real GDP)]

4. Items Excluded from GNP


4.1 Intermediate products
Intermediate products are excluded in the calculation of GNP because only the value of final
goods and services is counted. It is because the value of intermediate products has been included in
the value of final products as a part of the production cost. If the value of intermediate products is
included in GNP, the error of double counting will be committed.
4.2 Receipts from sale of products not currently produced
The sale of second- hand goods and inventories accumulated in the past are not included in
GNP. The value of second- hand goods has already been counted in the GNP when these goods were
sold in the market for the first time. On the other hand, though past inventories were not sold in the
year they were produced, their value had been included in the items “change in stock”.
However, the commission obtained from the sale of second- hand goods should be included in
GNP because the services are currently provided.

4.3 Non-marketed goods


Non-marketed goods (e.g. services provided by housewives and voluntary workers) are not
included in GNP because it is difficult for the government to collect data and estimate their value.
4.4 Illegal transactions
Although illegal trades generate incomes to the econo my, they are not included in GNP for
various reasons (including moral and political reasons).

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Notes on A-Level Macroeconomics: Introduction to Macroeconomics and National Income Accounting

5. Uses of National Income Statistics


There are numerous uses of national income statistics. Here are some of them:
Q To estimate the economic performance of a country.
Q To reflect the economic welfare or the standard of living of citizens in a country as compared
with other countries.
Q To measure the economic development or the rate of growth of a country by comparing GNP of
a country in different years.

6. Limitations of National Income Statistics


6.1 Limitations of GNP or GDP as an indicator of welfare
Q Nominal GNP may increase due to an increase in general price level instead of an increase in
real output. Thus real GNP would be a more reliable measure of welfare.
Q A country with a high real GNP may not imply a high living standard if the aggregate output is
shared among a large population. Thus per capita real GNP would be a more reliable measure.

6.2 Limitations of National Income Statistics as an indicator of welfare


Q The welfare of citizens depends mainly on the size of consumption. Thus per capita real
consumption would be a more reliable measure.
Q Transaction of some goods and services are unrecorded or unreported (e.g. private tutoring) and
hence national income statistics would underestimate the output of a country. Developing
countries would have more unrecorded or unreported activities.
Q The value of non- marketed goods and services (e.g. services of housewives and voluntary work)
are not included in national income statistics and hence national income statistics would
underestimate the output of a country. Developing countries would have more non-marketed
activities.
Q Although illegal trades generate incomes to the economy, they are not included in GNP for
various reasons (including moral and political reasons).
Q National income statistics place no value on leisure and environmental aspects (e.g. fresh air).
People in developing countries may enjoy more leisure and better living environment (due to a
lower level of pollution). Hence national income statistics tends to underestimate the welfare of
developing countries.
Q Different countries use different currencies (usually their own currency) to measure national
income. In order to compare the welfare of two different countries, national incomes of the
countries should be expressed in terms of a single currency. If the exchange rates do not reflect
differences in the domestic purchasing powers of currencies (as countries fix or manage their
exchange rate arbitrarily), national income statistics would be misleading.

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