Topic 7: National Income

What is national income?

1.1

National income is the value of all goods and services that are produced by an
economy in a year. It is a measure of a countrys economic performance.

1.2

A countrys economic performance can be measured in different ways. Three

common measures are:
Gross Domestic Product
Gross National Product
Net National Product.
Gross Domestic Product (GDP) is the output of goods and services produced
within the UK in a year.
Gross National Product (GNP) is the output produced by UK-owned
resources. This differs from GDP in that some output produced within the
country is produced by foreign-owned resources and some of the output from
UK-owned businesses is produced overseas. GNP is GDP plus the value of
output produced overseas by UK-owned resources minus the value of output
produced in the UK by foreign-owned resources.
Net National Product is GNP less depreciation, i.e. the loss in value of
capital goods during the year. NNP is new output, i.e. the addition to the
countrys stock of goods (i.e. its wealth). Net National Product is the true
measure of national income but you will find that commentators may use any
of these three measures as national income.

National income and inflation: nominal income and real income

All of the above measures of economic performance may be expressed in
nominal terms or real terms.

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Unit 7 Summary (National Income)

2.1

Nominal or money terms. When national income is expressed in nominal

terms (sometimes called money terms), this means that its value has been
calculated by using the prices of the time, i.e. current prices. Measuring
value in money terms makes it difficult to compare one years output with
another years since an increase in national income could have been caused by
inflation, i.e. the value may have gone up because of a rise in prices and not
by an increase in output. To measure changes in output, it is necessary to
convert figures to real terms.

2.2

Real terms. Expressing national income in real terms means measuring output
as if there had been no inflation, i.e. at constant prices. It means that value
has been adjusted to remove the inflation element. So an increase in real
national income means that there has been an increase in the quantity of goods
and services produced.

2.3

Method of adjustment
Real national income =
Nominal national income
Price index of base year

1
Price index of current year
Example
Year 1
Money value of national income
Index of prices

Year 2
10,000m
100

12,000m
105

Calculation:
10,000m
100

= 10,000m
1
100
12,000m
100

= 11,429m
Real national income for Year 2 =
1
105
Real national income for Year 1 =

Nominal income increased by 20%.

Real income increased by 14%.
3

National income may be calculated in three different ways

3.1

The output method. This method adds the value of goods and services
produced by all firms in both the private and public sectors.

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Unit 7 Summary (National Income)

Care must be taken to avoid double counting, i.e. counting the same output
more than once, e.g. when the output of one firm, steel, becomes the input of
another, cars. Only the value added to each stage of production, i.e. the value
of work done by each producer, should be included.
3.2

The income method. The incomes earned by the owners of all resources used
in production are added up, i.e. the total amount of rent, wages, interest and
profit earned.
Transfer incomes such as pensions and benefits should not be included as
those who receive them are not involved in producing output.

3.3

The expenditure method. This method totals the spending of individuals,

firms, government and foreign buyers on goods and services.
Spending on imports is deducted as it represents output created by other
countries.

Uses of national income statistics

National income is a measure of economic activity in an economy. The figures
have a number of uses. They can be used:
(a)

to measure economic growth and changes in the standard of living in a

country

(b)

to help government assess the state of the economy and plan future
policy

(c)

to compare the economic performance and standards of living of

different countries

(d)

to identify countries that are in need of aid

(e)

to calculate the contributions which countries should make to

international organisations, e.g. the World Bank and the EU.

Bannerman High School

Higher Grade Economics
Unit 7 Summary (National Income)

Problems of measuring national income

If national income figures are to be used for measuring and comparing
economic activity then they need to be accurate. However there are a number
of reasons why the statistics may be inaccurate:

(a)

Errors and omissions occur in collecting and calculating the statistics.

(b)

People deliberately hide what they earn or what they produce in order to
avoid tax or claim benefit this is known as the black economy.

(c)

Under-recording of output where the production of some goods and

services is not recorded because they are not exchanged for money, e.g.
housework, barter trade and DIY activities.

(d)

Over-recording of output where double counting occurs (see 3.1).

(e)

Over-recording of income when transfer incomes are included (see 3.2).

Difficulties in using national income statistics for making comparisons

over time or between countries
National income figures are used to compare changes in standards of living but
there are difficulties:
(a)

Methods of calculating national income may differ over time or between

countries.

(b)

Levels of self-sufficiency may differ the more self-sufficient people

are, the more output will be under-recorded.

(c)

Standard of living is measured by income per person (per capita) so

population changes must also be measured. Accuracy of comparisons
between years or between countries therefore also depends on the
accuracy of population figures.

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(d)

Statistics have to be adjusted for inflation accuracy depends on

accuracy of inflation figures.

(e)

Statistics do not show differences in the range, design and quality of

goods and services.

(f)

Statistics do not show differences in working conditions, hours and

leisure time.

(g)

Statistics do not show differences in income distribution distribution of

an increase in national income amongst citizens may be inequitable, so
although the average per capita income rises, the standard of living of all
citizens may not.

(h)

Social costs are not taken into account, e.g. the output of cars is recorded
but their associated social costs of pollution and congestion are not.

(i)

Spending on defence or space may account for an increase but may do

little for the standard of living of the people.

Circular Flow of National Income

Introduction
In its simplest form an economy consists of firms and households (a twosector economy). Households own factors of production which they provide to
firms. In return for land, labour, capital and enterprise to firms they receive
income in the form of rent, wages, interest and

Bannerman High School

Higher Grade Economics
Unit 7 Summary (National Income)

profit. These incomes are spent in buying the output of goods and services
made by firms and this expenditure becomes incomes for firms which in turn
is used to pay incomes to households and so on. Thus a circular flow of
income is created. Therefore the total value of output should equal the total
expenditure on goods and services and should equal the total income of
households.
National output = National expenditure = National income.
2

Consumer spending (C)

This is the value of consumer goods and services demanded in a particular
period of time. Consumer spending is a function of income. This means that as
income changes then so does consumer spending.
The average propensity to consume (APC) is the proportion of total income
which is spent.
APC =

Consumption
Income

An APC of 1 means that 100% of income is spent. An APC of 0.9 means that
90% of income is spent. People on low incomes are likely to have an APC of
1. As income rises, average propensity to consume tends to fall as consumers
increase the proportion of their income which they save. (Note that although
the proportion of income spent on consumption falls, the amount spent rises.)
It follows that if a consumer has an APC of 1 there is no saving, i.e. average
propensity to save (APS) = 0, and if APC = 0.9 then APS = 0.1.
APC + APS = 1
The marginal propensity to consume (MPC) is the proportion of any increase
in income which consumers would spend on consumption.
MPC =

Increase in Consumption
Increase in Income

A MPC of 0.8 means that 80% of any increase in income would be spent on
consumption. It follows that the marginal propensity to save (MPS) would be
0.2
MPC + MPS = 1

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Injections and leakages from the circular flow

Injections
An injection is any spending in the economy which is not consumer spending.
Investment, export buying and government spending are injections into the
circular flow of national income. Note that their size is not determined by the
size of national income. Injections are said to be autonomous of national
income.

Leakages
A leakage is a withdrawal of funds from the circular flow of income between
firms and households. Savings, imports and taxation are leakages from the
circular flow of income. Note that the size of each depends on the size of
national income. Leakages are said to be a function of national income.

Investment spending (I)

This is the value of capital goods demanded in a particular period. This is
mainly determined by producers expectation of profit which in turn depends
on:
potential sales revenue
the interest rate on the loans to buy the capital goods.

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Export buying (X)

This is the value of goods demanded by overseas firms and individuals. This is
mainly determined by the size of national incomes in foreign countries. Other
determining factors include:
the prices and quality of exports compared to those of competing countries
delivery times and quality of after-sales service.

Government spending (G)

This is the value of spending by the public sector. This includes the demand
for goods and services by central and local government departments; social
benefits; and grants to the private sector. The level of government spending is
mainly determined by political decisions taken by government.

Savings (S)
These are the amount of money saved by individuals in a particular period of
time. The main determinant is the level of income the higher the level of
income, the greater the proportion of income saved.
The proportion of income saved is called the propensity to save.
At very low levels of income consumption is greater than income, and dissaving occurs, i.e. savings from a previous period are used, or the savings of
others are borrowed to finance spending. Other influences on savings are:
interest rates
habit and attitude to saving
extent of the precautionary motive.

Import spending (M)

This is the amount spent by the resident firms and individuals of a country on
overseas goods and services. The main determinant is the level of income.
Other influences are:
the prices of imports relative to home-produced goods
their quality and after-sales service.

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Taxation (T)
This is the amount of revenue collected by central and local government from
taxation. The amount of revenue collected depends on the level of income and
spending in the economy.

This section (to page 19) is for Higher only

The Determination of National Income
There are two schools of thought about how national income is determined. Some
economists believe that aggregate demand is the main determinant whilst others
believe that it is aggregate supply. Others believe that both aggregate demand and
supply are relevant. Economists who believe in the demand side of the economy as
being the more important are called Keynesians, named after the economist John
Maynard Keynes who developed the theory in the 1930s.

Keynesianism: the Demand Side of the Economy

1

Link between national income and employment

The higher the level of national income (remember this is the same as national
output) then the greater the number of workers who will be needed to produce
it.

Full employment level of national income

This is the potential output of an economy, i.e. the maximum output which
could be produced if all resources are employed in producing those goods and
services which they are best at producing.

Actual national income may be less than the full employment level
Why is this? One suggestion was provided by J M Keynes in an attempt to
answer the massive unemployment of the 1930s when the economy had gone
into a slump. The basis of his theory was that national income may settle at an
equilibrium level which is below the full employment level.

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Unit 7 Summary (National Income)

Equilibrium national income in a two-sector economy

4.1

The two-sector economy assumes that there is no government sector and that
the economy is closed, i.e. there is no foreign trade.

4.2

Equilibrium level of national income is where aggregate demand equals

income/output or where saving = investment. Aggregate demand is total
expenditure. It is equal to consumption plus investment, i.e. the spending of
consumers plus the spending of firms on capital goods.
In the following diagrams, an average propensity to consume of 0.8 and an
average propensity to save of 0.2 are assumed.

Diagram A: Equilibrium

Consumer
Spending
80b

Aggregate demand = C + I = 80b + 20b = 100b

National income/output = 100b
Aggregate demand = National output
Saving (20b) = Investment (20b)

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Diagram B: not equilibrium

Consumer
Spending
72b

Aggregate demand = C + I = 72b + 20b = 92b

National income/output = 90b
Saving 18b < Investment 20b
Demand is greater than output, so producers will increase production and hire more
resources. This in turn will raise incomes and this will continue until equilibrium is
reached.

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Diagram C: not equilibrium

Consumer
Spending
88b

Aggregate demand = C + I = 88b + 20b = 108b

National income/output = 110
Demand < National income/output
Savings 22b > Investment 20b
Demand is less than output, so producers will notice the build-up in stocks and will
cut back production. Workers will be laid off and incomes will fall until equilibrium
is reached.

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Changes in equilibrium

5.1

Change in propensity to save. If consumers wish to save more out of their

incomes, i.e. if the average propensity rises, it follows that they wish to spend
less on consumption. Aggregate demand will fall, output/income will fall and
so will employment. National income will fall until a new equilibrium is
reached, i.e. where saving = investment.

5.2

Change in investment. An increase in investment raises aggregate demand.

National income and employment will rise until equilibrium is restored, i.e.
where savings = investment. A decrease in investment has the opposite effect.
However, national income will change by more than the change in investment.
This is because of the multiplier effect.

The multiplier

6.1

Keynes also developed the idea of the multiplier. He suggested that if there
were any change in demand then national income would change by more. Any
change in any component of aggregate demand would have a multiplier effect
on national income. This can be explained by the investment multiplier.

6.2

The investment multiplier measures the change in national income resulting

from a change in investment.
Change in national income = Change in investment x Multiplier

6.3

How the multiplier process works. Assume that in a two-sector economy

with no government or external trade, consumers have a marginal propensity
to consume of 0.9 and a marginal propensity to save of 0.1.
(a)

If a car manufacturer invests 100m in a new plant then this becomes

100m of income to those households which provide the resources.
These households will spend 90m of their increased incomes on
consumer products and save 10m.

(b)

This 90m of consumer spending becomes 90m of income to those

individuals who provided the resources to produce these consumer
products. These individuals in turn will spend 81m of this 90m of
income on consumer products and save 9m.

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(c)

This 81m of spending becomes income to those individuals who

provided the resources . . . etc.
This process continues until national income is back in equilibrium. At
this point saving will again equal investment. In this example national
income would increase 1000m.
Not only should you be able to describe the process in words, but you
should also be able to show it in a circular flow diagram.

6.4

The size of the multiplier effect depends on the % of income spent on

consumption and the % saved with each round of income. This depends on the
marginal propensity to save.
The marginal propensity to save is the proportion of any change in income
which is saved.

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Change in savings
Change in income
1
1
Multiplier =
or
MPS
1 MPC
MPS =

If the MPS = 0.1, then the multiplier would be 10. National income would
increase by ten times the amount of the increase in investment of 100m to a
new equilibrium level of income which would be 1000m higher than before.
Savings would have increased by 100m which is equal to the increase in
investment.
7

Equilibrium national income in an open economy

7.1

In a two-sector economy it is assumed that the economy is closed and that

there is no government activity. In an open economy, there is government
activity and international trade. This means that, as well as savings
withdrawing income from the circular flow there will also be taxation and
spending on imports. Government spending and the selling of exports will, in
addition to investment, inject income into the circular flow. Aggregate demand
in an open economy is therefore:
Aggregate demand = C + I + G + (X M)

7.2

Equilibrium national income will still be where aggregate demand = national

output/income. Because of the extra leakages and injections, at equilibrium:
S+T+M=I+G+X

7.3

The multiplier in an open economy. A change in any injection, I, G or X will

have a multiplier effect on national income. Remember from para 10.4 that the
size of the multiplier effect depends on the proportion of any change in income
which is consumed. In an open economy the MPC will depend not only on the
MPS but also on the proportion of any change in income which is spent on
imports (the marginal propensity to import) and which is taken in tax (the
marginal rate of tax). Spending on imports and taxation reduce the multiplier
effect. For an open economy:
1
1 MPC
1
or =
MPS + MPM + MRT
Multiplier =

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7.4

The importance of the multiplier

(a)

An increase in any injection into the circular flow of income will

increase national income by more than the increase in the injection.

(b)

A decrease in any injection will decrease national income by more than

the decrease in the injection.

(c)

If government is planning to increase national income, e.g. to full

employment level by increasing government spending then the increase
does not have to be so large as the shortfall in national income.

The importance of Keynesianism

Keynes not only explained how national income was determined but also how
it could be managed. The 1930s, when he published his theory, was a time of
great depression in the worlds major economies. He suggested that
governments should intervene to increase aggregate demand in their
economies by lowering taxes and increasing government spending. Many
governments adopted this policy and were able to reduce their unemployment.
Governments continued to use demand-management policies after the Second
World War until the late 1970s but when they found it difficult to control
inflation there was a dramatic switch to monetarist policy.

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Monetarism The Supply Side of the Economy

1

Introduction
While Keynesians believe that demand is the main determinant of national
income, in contrast, monetarists believe that it is aggregate supply. They
believe that national output is determined by the quantity of resources
available to an economy and their productivity. If resources are plentiful,
easily available and cheap then producers will put them to work and this will
create income for their owners which in turn will finance the demand for the
output produced.
Note the contrast in views:
Keynesians believe that demand creates supply, whereas
Monetarists believe that supply creates demand.

Quantity and efficiency

Monetarists believe that an economy can increase the quantity and efficiency
of its resources if it has the following characteristics:
(a)

Private enterprise, operating in competitive markets, with minimum

government intervention. The desire to make profit encourages producers
to make as much output as possible as efficiently as possible.

(b)

Low taxes on incomes. High income taxes discourage firms from

earning high profits and discourage workers from earning high incomes.

(c)

A flexible labour market. It should be easy for firms, facing falling

demand for their products, to lower wages and shed labour; conversely,
firms facing rising demand should find it easy to recruit labour and raise
wages. Unemployment benefit should be low.

(d)

Government should keep to a minimum regulations which add to

firms costs, e.g. Health and Safety, minimum wage legislation, limits to
working hours.

(e)

Government should concentrate its efforts on improving the quality

and efficiency of the workforce through education and training.

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Business/Trade Cycles
1

Introduction
It has long been observed in economics that income and employment tend to
fluctuate regularly over time. These fluctuations are known as business cycles
or trade cycles. The figure below shows the various stages of a business cycle.

Time in years
2

Peak or boom
When the economy is in a boom, some or all of the following characteristics
are likely:

Income and employment will be high.

Wages and profits will be rising.
Consumption and investment spending will be high.
There will be inflationary pressures.
Demand for imports will be high.
Tax revenues will be high.

Recession
A recession is said to exist when there have been two successive quarters (3month periods) of negative growth of real GDP (i.e. falling real GDP).

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Some or all of the following may happen:

Income and employment fall. Note that unemployment is a lagging
indicator it tends to rise some months after the recession starts but
continues to rise even after a recovery starts.
Wage demands moderate as unemployment rises.
Consumption falls and investment spending falls as firms lose confidence in
the future.
Inflationary pressures moderate.
Imports decline.
Tax revenues begin to fall and government expenditure on benefits begin to
rise.
4

Slump
In a slump, economic activity is low compared with surrounding years.

Mass unemployment exists.

Consumption and investment is low. Aggregate demand is low.
There are few inflationary pressures.
Demand for imports is low.
Tax revenues are low and there is a large demand for state benefit.

Recovery
Income and output begin to increase and so does employment.
Consumption and investment begin to rise.
Inflationary pressures begin to mount as workers feel more confident about
demanding wage increases.
Import spending begins to rise.
Tax revenues start to rise and government spending on benefit starts to fall.

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Higher Grade Economics
Unit 7 Summary (National Income)

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Bannerman High School

Higher Grade Economics
Unit 7 Summary (National Income)

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