Measuring National Income

Measuring National Income

2.1 INTRODUCTION

Keynesians argue that aggregate demand determines the level of

economic activity in the economy. In other words, the country's
production and employment depend on the amount of spending.
Too little spending will lead to unemployment while too much
spending will lead to inflation.

2.2 STOCKS AND FLOWS

An important distinction that helps us keeps track of economics activity-

both for the country and for ourselves - is between a stock and flow. A
stock is a variable measured at a point of time. Examples of
macroeconomic stocks are the total amount of money in the economy or
the total amount of buildings, plants and capital equipment in operation
at a given point of time. A flow is a variable that measures a rate per unit
of time. Examples of macroeconomic flows are income and expenditure.
These flows are expressed as Ringgit per unit time or number of hours
worked per week.

2.3 LINKS BETWEEN FLOWS AND STOCKS

Macroeconomic flows are divided into four categories.

i. Income
It is the total payment for the services of factors of production employed
in the economy. It is the sum of wages paid to labor, interest paid to
suppliers of capital, rent paid to suppliers of land, and profit.

ii. Expenditure
It is the purchase of final goods and services. Final goods and services
are goods and services bought by households, firms, and net increases
in firms' inventories; and import. Expenditure is another measure of
aggregate economic activity based on the value of all final goods and
services bought by households, firms, governments and foreigners.

iii. Product
The value of final goods and services is called product. This is the third
measure of aggregate economic activity based on the value of all the
final goods and services produced in the economy.
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iv. Intermediate Transactions

This is the purchase of goods and services by firms in later stages of the
production of final goods and services. Intermediate transactions do not
measure aggregate economic activity.

2.4 THE CIRCULAR FLOW OF INCOME AND EXPENDITURE

IN TWO, THREE, AND FOUR SECTOR ECONOMY.

This is much simpler than the one we live in.

1. A Case of Two Sector Economy ( The Simple Economy )

The economy consists of just two kinds of economic agents.

Household
 own all factors of production
 spend all income by buying all final goods and services

Firms
 hire factors of production from household
 sell goods and services to households
 pay any profits made to households

Figure 2.1: Real Flow and Money Flow In Two Sector Economy

Income

factor of production

HOUSEHOLDS FIRMS

goods and services

Consumer expenditure

To make the model more realistic, we assume that households do not

spend all income. In another words, households save some money.
Figure 2.2 show money flows in a two sector economy with savings and
investment.
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Figure 2.2: Flow of Saving and Investment In Two Sector Economy

Income

HOUSEHOLDS FIRMS

consumer expenditure

savings Investment

2. A Case of a Three Sector Economy ( Closed Economy )

A third sector with government is introduced here. The government

undertakes three important macroeconomic activities in the economy.
They are:
 purchase goods and services
 collection of taxes
 payments of benefits and subsidies

Figure 2.3: Circular Flow of Income In Three Sector Economy

Factors of Production
(Wages, Rent, Capital, Profit)
Income

HOUSEHOLDS FIRMS

Government expenditure tax Government expenditure tax

GOVERNMENT

Consumer expenditure
Goods and Services
Saving
Investment

MONEY MARKET
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3. A Four Sector Economy ( Opened Economy )

The country now does trading with other countries. There is now export
and import. Export is an injection while import is a leakage.

Figure 2.4: Circular Flow of Income In The Four Sector Economy

Factors of Production
(Wages, Rent, Capital, Profit)
Income

HOUSEHOLDS FIRMS

Government expenditure tax Government expenditure tax

GOVERNMENT

Consumer expenditure
Goods and Services
Saving Investment
Import Export Import Export

FOREIGN SECTOR

MONEY MARKET

APPROACHES TO NATIONAL INCOME MEASUREMENT

INCOME – EXPENDITURE – OUTPUT IDENTITY

National income accounting is thus a measure of the value of the

output of the goods and services produced by an economy over a
period of time. It measures the nation’s aggregate economic
performance.
The key concept in national income accounting is gross domestic
product (GDP). GDP refers to the market value of output produced within
the country over a twelve-month period.
There are three ways to calculate national income. This three identity
can be clearly seen when we discuss the circular flow of income.
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Thus from the circular flow, we derived the following:

i. Factor incomes must equal to household spending since we

assume that all income is spend.

ii. The value of production or output must equal to total

spending on goods and services since we assume that all
goods are sold.
iii. The value of output must equal to the value of household
incomes.

Expenditure = Income
= Output

Whichever approach used, we must get the same estimates of total

economic activity.

National = National = Product

Income Product
Expenditure

Gross domestic product ( GDP ) and gross national product

(GNP )

GDP is the market value of all final goods and services produced by
factors of production located within a country like Malaysia. It excludes
intermediate goods as well as output produced by Malaysians' abroad.
This would therefore include output produced by non-residents (foreign
workers) residing or working in the country.

GNP on the other hand refers to final goods and services produced by
Malaysians' regardless where they are. This will automatically exclude all
output produced by foreign workers and would include the output of
Malaysians working overseas.

2.7 CALCULATING GROSS DOMESTIC PRODUCT

There are three ways of calculating:

1. Add up all the values of all the goods and services produced in
the country, industry by industry. Here we focus on firms and
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add up all their production. This is the product approach.

2. The production of goods and services generated income for

households in the form of wages and salaries, profits, rent and
interest. Adding up all these incomes brings us to the income
approach.

3. This focus on the expenditures necessary to purchase the

countries production. Whatever produced is sold. Therefore no
injections or withdrawals. The value of what is sold must
therefore be the value of what is produced. The expenditure
method measures this value of sales.

2.7.2 INCOME APPROACH

As we have discussed in the circular flow, when the household supplies

the factors of production needed by the firms for production, the firms will
pay in terms of wages, rent, interest and dividend. The household will
then spend this income on the goods and services provided by the firms.

GDP (Gross Domestic Product) = GDI (Gross Domestic Income)

GDI is the aggregate income earned annually from production.

Aggregate expenditure on final goods becomes the aggregate income of
the nation.

2.7.3 THE PRODUCT OR OUTPUT APPROACH

This involves adding up the value of everything produced in the

country during the year. One problem faced in this approach is double
counting. To avoid double counting which exaggerates national
income, we use the concept of value added. Value added refers to the
increase in the value of goods as a result of the production process.
This is calculated by deducting from the value of the firms ‘ output the
cost of the inputs goods used up in the producing that output.

Final goods and intermediate goods

Final goods are goods purchased by the ultimate user..

Intermediate goods are partly finished goods, which form inputs to
another firms’ production process and are used up in that process.
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An illustration to show the process of value added.

Figure 2.7: Process of Value Added

Cotton

Thread
Cloth

T-shirt

RM 3.00 RM 7.00 RM 15.00 RM 21.00

 The prices showed for one unit each. For example, to produce one T-shirt, we need
cotton as the basic material, which cost RM3. Cotton is then process to form thread,
which cost RM7. Thread is then woven to form cloth worth RM15. Cloth is then cut to
make the T-shirt, which is sold, for RM21.00.

 If we add all the prices (RM3+RM7+RM15+RM21), and conclude that this is the
value of national income, we are doing double counting. RM46 is not the value of
national income. National income is only RM21, which is the price of T-shirt, the final
product.

 To get the correct figure, we must only add the value added for each input as they go
for one process to another. Cotton to thread, the value added is only RM4 (7-3),
thread to cloth is only RM8 (15-7) an from cloth to T-shirt is RM6 (21-15).

 Thus, if we add up the price of cotton plus all the value added, we will get the
national income (3 +4+8+6=21).
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2.8 USES OF NATIONAL INCOME

1. To measure the standard of living.

Countries with national income such as USA, UK, Canada, Japan and
others also have high standard of living.

2. Comparison over time

From national income figures, we are able to state whether the
economy is progressing or not. If national income increases over the
years, we can safely say that the economy is growing.

3. Comparisons between countries.

It is through national income that we can differentiate between the
developed and developing countries.

4. Sectorial contributions
There are three main sectors in the economy, the primary, for
example agriculture, fishing and mining; secondary, for example,
manufacturing and construction: and tertiary, that is services like
banking, shipping, aviation and other sectors. By analyzing the
contribution of each sector, we will be able to know which sector
makes the most contribution to the country’s economic growth.

5. Taxable capacity
Generally, the richer the population, the higher the national income
would be. If national income is high, then the income tax rates and
other tax rates can be high. This means that the government can
collect lots of taxes.

6. National planning
National income estimates help the government in formulating their
economic policies. Forecasting future developments is made easier
when national income estimates are collected.

2.9 PROBLEMS IN MEASUREMENT.

Higher national income does not necessarily mean higher living

standard. There are a lot of factors to be considered. Furthermore, per
capita income among different countries does give an accurate picture of
which country is having a higher standard of living. For example, country
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A has a national income of 10 million while country B has 40 million. This

does not mean that country B is better off than country A. There is a lot
of factors to be considered. Two main problems in using national income
are:

i. COMPARISONS OVER TIME.

ii. COMPARISONS BETWEEN COUNTRIES

i. COMPARISONS OVERTIME

1. General price level

National income may increases due to nominal increase in GNP
and not due to real GNP. Thus, there is no physical increase in
goods and services to be enjoyed by the people. When nominal
GNP increases, to find the actual increase of goods and
services, we have to deflate the general price level of the
current year. This is called the GNP deflator.

2. Income distribution
Even though national income may have increased, not
everyone benefited from it. Sometimes only a certain class of
people enjoy this increase. Thus, the gap between the rich and
poor will be widening.

3. Composition of goods and services

If the country produces more machinery and factories than
consumer goods and services, then the standard of living has
not increase though producers' goods will benefit the future
generation.

4. Quality of goods and services

Not only should the consumers enjoy more goods and services
but also more quality goods. Only then the standard of living will
improve.

5. Working hours and working condition

If national income increases due to longer working hours,
standard of living has certainly not improved. The more leisure
hours that the consumer can get without reducing the GNP, the
higher the standard of living.

6. Facilities available
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If more facilities are available to the people, the living standard

will be increase. Higher GNP does not necessarily mean that
more facilities will be made available.
7. Population
The increase in national income may be absorbed by the
increase in population as in the case in China, India and others.

ii. COMPARISONS BETWEEN COUNTRIES

1. National income concept

There are two methods in terms of national income accounting.
In the Anglo-Saxon method, all goods and services are included
in the calculation of national income. However, the Soviet
approach will not include services in their calculation of national
income.

2. Different price structures

If country A faces a high inflation compared to country B,
naturally A’s national income is higher. Thus, here too national
income would not show accurately the differences in terms of
living standard.

3. Different treatment of items

a. Some countries include transfer payments such as pensions,
scholarships and other unproductive payments in calculating
national income. The aim is to make the national income
looks bigger.
b. Some countries exclude government activities such as
defense, free education and others while some countries
don’t.

4. Different units of currency

Even though all these countries have the same national income,
USA will have the highest standard of living. This is because US
currency is the strongest of all three in terms of par value. Thus,
to compare standard of living, national income of all countries
should be based on a standard currency.

5. Statistics

Poor countries generally face many problems in collecting data.

Some of the problems are:
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i. Lack of expertise and professionals in the field of

statistical research.
ii. Lack of sophisticated machinery to process data.
iii. Illiteracy and the lack of understanding of the importance
or the need to cooperate when data is collected.
iv. Inaccessibility to certain remote and isolated areas.

All these problems will make the value of national income

inaccurate and unreliable.

2.10 PROBLEMS IN CALCULATING NATIONAL INCOME.

Problems can be classified into two. They are:

I. Practical problems
II. Conceptual problems

I. Practical problems

1. Problems of illiteracy
This is usually the case of poor countries, which make
collection of data difficult. The people here produce their
own goods and do barter trading. Being uneducated, they
fail to give accurate value of their home produced goods.

2. Problem of expertise
Shortage of professionals in developing countries makes
analysis of data unreliable.

3. Lack of sophisticated machinery

This makes analyzing of data difficult

4. Problems of inaccessibility
This causes the collection of data in remote areas
impossible. National income is underestimated.

5. Problems of false information.

This problem is more serious in developing countries
since law enforcement is not fully developed. People will
usually underestimate their earnings to evade paying high
taxes. This will result in underestimation of national
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income.

II. Conceptual Problems

1. Arbitrary definition
The problem here is whether to include or exclude certain
items in national income accounting. For example, the
services of a full time housewife are not included but
wages of maids or baby-sitters are included.

2. Problems of estimation
a. The estimation of depreciation differs in different
countries.
b. The value place on rent especially occupied by owners
differs greatly. Some owners may overestimate while
others underestimate their imputed rent. This will
distort national income.

3. Problems of double counting

When this happens, national income data is distorted.

4. Problem of stock appreciation

During inflation, the value of stocks increases even
though the quantity is the same. Thus, this stock
appreciation must be deducted so that the value of
national income is accurate.

5. Problem of measuring quality.

Even if quantity increases which make national income
increases, quality is still important. There is no
measurement of quality that is reliable.

Real and nominal income

Nominal income measures the value of the output in a given period in

the prices of that period, or, as it is sometimes put in current Ringgit.
Thus 1999 nominal income measures the value of the goods produced
in 1999 at the market prices that prevailed in 1999. Nominal income
changes from year to year for two reasons.

 The physical output of goods changes. In other words, goods

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increase or decrease.
 The market prices changes.

Real income measures changes in physical output in the economy

between different time periods by valuing all goods produced in the two
periods at the same prices, or in constant dollars.