Written by: Edmund Quek

CHAPTER 12
NATIONAL INCOME ACCOUNTING

LECTURE OUTLINE
1

DEFINITION OF NATIONAL INCOME

2

CIRCU...
Written by: Edmund Quek

1

DEFINITION OF NATIONAL INCOME

National income is the total income earned by the nation over a...
Written by: Edmund Quek

Alternatively, we can sum up the values added at all the stages of production. Every good
goes th...
Written by: Edmund Quek

Some of the goods and services produced in the economy are produced by factor inputs
owned by for...
Written by: Edmund Quek

5

BUSINESS CYCLE

The business cycle shows the changes in national income over time and involves...
Written by: Edmund Quek

6

NOMINAL NATIONAL INCOME AND REAL NATIONAL INCOME

Nominal national income is national output m...
Written by: Edmund Quek

7

NATIONAL INCOME AND THE STANDARD OF LIVING

Although there is no standard measure of the stand...
Written by: Edmund Quek

evasion. For instance, people smuggle tobacco and alcohol to evade tax. The omission
of the value...
Written by: Edmund Quek

1) The amount of goods and services available for consumption in economy A may not be
higher by 1...
Written by: Edmund Quek

river pollution, acid rain and global warming, overstates the standard of living as
measured by n...
Written by: Edmund Quek

The Human Development Index (HDI) is a composite index made up of three indices: an
index for rea...
Upcoming SlideShare
Loading in...5
×

Chapter 12-national-income-accounting

406

Published on

Published in: Business, Technology
1 Comment
1 Like
Statistics
Notes
No Downloads
Views
Total Views
406
On Slideshare
0
From Embeds
0
Number of Embeds
0
Actions
Shares
0
Downloads
21
Comments
1
Likes
1
Embeds 0
No embeds

No notes for slide

Chapter 12-national-income-accounting

  1. 1. Written by: Edmund Quek CHAPTER 12 NATIONAL INCOME ACCOUNTING LECTURE OUTLINE 1 DEFINITION OF NATIONAL INCOME 2 CIRCULAR FLOW OF INCOME AND EXPENDITURE 3 MEASURING NATIONAL OUTPUT 4 CONCEPTS OF NATIONAL INCOME 5 BUSINESS CYCLE 6 NOMINAL NATIONAL INCOME AND REAL NATIONAL INCOME 7 NATIONAL INCOME AND THE STANDARD OF LIVING 8 ALTERNATIVE MEASURES OF THE STANDARD OF LIVING References John Sloman, Economics William A. McEachern, Economics Richard G. Lipsey and K. Alec Chrystal, Positive Economics G. F. Stanlake and Susan Grant, Introductory Economics Michael Parkin, Economics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics © 2011 Economics Cafe All rights reserved. Page 1
  2. 2. Written by: Edmund Quek 1 DEFINITION OF NATIONAL INCOME National income is the total income earned by the nation over a period of time. 2 CIRCULAR FLOW OF INCOME AND EXPENDITURE The circular flow of income and expenditure shows the flow of income and expenditure between the different sectors in the economy. Households provide factor inputs which include labour, land, capital and entrepreneurship to firms and in return, they receive factor income in the form of wages, rent, interest and profits. Firms provide goods and services to households and in return, they receive payments known as consumption expenditure. In the above diagram, it can be seen that national income, national output and national expenditure are equal. 3 MEASURING NATIONAL OUTPUT From the circular flow of income and expenditure, one can see that there are three approaches of measuring national output: the output approach, the expenditure approach and the income approach. Output/Production approach (direct approach) Adding the market values of all the final goods and services produced in the economy and indirect taxes net of subsidies yields national output. However, the output of some firms is the factor inputs of others. Therefore, to avoid double or multiple counting, care must be taken to add the market values of final goods and services only. © 2011 Economics Cafe All rights reserved. Page 2
  3. 3. Written by: Edmund Quek Alternatively, we can sum up the values added at all the stages of production. Every good goes through several stages of production and at each stage, value is added to the good. Value added  Value of output  Value of factor inputs Example (Output of bread in a year) Stage Industry Output Value of output 1 2 3 4 Farming Milling Baking Retailing Wheat Flour Bread Selling Bread $1000 $1300 $2000 $2500 Value of factor inputs $0 $1000 $1300 $2000 Sum of values added Value added $1000 $300 $700 $500 $2500 Expenditure approach (indirect approach) Adding the expenditures made on all the final goods and services produced in the economy yields national output. In an open economy, this involves adding consumption expenditure, investment expenditure, government expenditure and net exports. Income approach (indirect approach) Adding the factor incomes (i.e. wages, rent, interest and profits) received by households from firms for the provision of factor inputs and indirect taxes net of subsidies yields national output. Note: Final goods include consumer goods such as cookies and ice-cream and capital goods such as factories and machinery. Raw materials and semi-finished goods that are used to produce final goods are known as intermediate goods. 4 CONCEPTS OF NATIONAL INCOME Officially, national income is defined as Net National Product at factor cost. More commonly, national income is used to refer to Gross Domestic Product or Gross National Product at market price. Gross Domestic Product (GDP) Gross Domestic Product is the market value of all the final goods and services produced in the economy over a period of time. Gross National Product (GNP) Gross National Product is the market value of all the final goods and services produced by factor inputs owned by the residents of the economy over a period of time. Unlike GDP which focuses on the location of factor inputs, GNP focuses on the ownership of factor inputs. © 2011 Economics Cafe All rights reserved. Page 3
  4. 4. Written by: Edmund Quek Some of the goods and services produced in the economy are produced by factor inputs owned by foreigners. When these foreigners earn wages, rent, interest and profit, they remit the income to their home countries. This income is called “income to abroad”. On the other hand, some of the income earned by the residents of the economy will come from the ownership of factor inputs located overseas. This income is called “income from abroad”. Although this income is earned abroad, it forms part of the income of the residents of the economy. GNP  GDP  income from abroad – income to abroad Indirect taxes are taxes imposed on goods and services. In the absence of indirect taxes, market price will be equal to factor cost. In reality, the government does impose indirect taxes. Therefore, market price is higher than factor cost by the amount of the indirect taxes. The converse is true for subsidies. GNP (factor cost)  GNP – indirect taxes  subsidies Net National Product (NNP) One shortcoming of GDP/GNP is that they ignore the fact that some of the capital stock wears out over time. In other words, they ignore depreciation, which is also known as capital consumption. If we subtract depreciation from gross investment, we get net investment. NNP (factor cost)/ National income  GNP (factor cost) – Depreciation (Personal) disposable income Finally, we come to a measure that is useful for analysing consumer behaviour. If we need to examine how consumption expenditure responds to a change in income, the measure we require is called (personal) disposable income. To get from NNP (factor cost) to disposable income, we must add transfer payments, subtract corporate income tax, other direct taxes, undistributed corporate profit and personal income tax. Disposable income  National income  Transfer payments – Corporate income tax – Other direct taxes – Undistributed corporate profit – Personal income tax Note: Some textbooks use the term “property income from/to abroad” instead of “income from/to abroad”. However, students must take note that property income in this context includes non-property income. Transfer payments are payments made by the government to the recipients not in exchange for any goods or services and they include social security benefits, unemployment benefits and interest payments on national debt. © 2011 Economics Cafe All rights reserved. Page 4
  5. 5. Written by: Edmund Quek 5 BUSINESS CYCLE The business cycle shows the changes in national income over time and involves two phases: expansion and contraction. An expansion is a time period during which national income rises and a contraction is a time period during which national income falls. Every economy is subject to the business cycle and the business cycle is getting shorter over time. The duration between a trough and a peak is now about 5 to 7 years. In other words, a recession occurs once in about 5 to 7 years. In the above diagram, the upward-sloping portions of the business cycle are expansions and the downward-sloping portions are contractions. On average, an expansion is longer than a contraction. Therefore, national income rises over time. Note: A recession is defined as a contraction for at least two consecutive quarters. The National Bureau of Economic Research (NBER) in the United States, however, does not define a recession in terms of at least two consecutive quarters of contraction. Rather, it defines a recession as a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. © 2011 Economics Cafe All rights reserved. Page 5
  6. 6. Written by: Edmund Quek 6 NOMINAL NATIONAL INCOME AND REAL NATIONAL INCOME Nominal national income is national output measured at current prices. Real national income is national output measured at base-year prices. Example (The Republic of Coconut) Nominal GDP (2005) Nominal GDP (2012) Real GDP (2012)* Output (2005)= 15 coconuts Output (2012) =20 coconuts Output (2012) = 20 coconuts Price (2005) = $2 Price (2012) = $3 Price (2005) = $2 Nominal GDP (2005) = $30 Nominal GDP (2012) = $60 Real GDP (2012) = $40 * Assume that the base year is 2005 The output and price of coconuts in 2005 and 2012 are shown in the first two columns. The nominal GDP in 2005 and 2012 are $30 and $60 respectively, which is an increase of 100%. However, much of the increase in the nominal GDP is due to an increase in the price. Although nominal GDP in 2012 is $60, real GDP in 2012 is only $40, which is an increase of 33%, far lower than 100%. The GDP Deflator The GDP deflator is one of the measures used by economists to monitor the general price level. It is an index of the average price of all the final goods and services produced in the economy. The GDP deflator measures the general price level in the current year relative to the general price level in the base year selected by the government. GDP deflatort  Nominal GDPt/Real GDPt × 100 From the table above, GDP deflator2012  $60/$40 × 100  150. Basically, what this means is that the general price level rose by 50% from 2005 to 2012. Inflation is a rise in the general price level over a period of time. The inflation rate is the percentage increase in the general price level over a period of time. In principle, the inflation rate can be calculated as the percentage increase in the GDP deflator over a period of time. Inflation ratet  (GDP deflatort – GDP deflatort–1)/GDP deflatort–1 × 100 In reality, the inflation rate is calculated as the percentage increase in the Consumer Price Index over a period of time (which will be explained in Chapter 18). © 2011 Economics Cafe All rights reserved. Page 6
  7. 7. Written by: Edmund Quek 7 NATIONAL INCOME AND THE STANDARD OF LIVING Although there is no standard measure of the standard of living, it is commonly believed that the welfare of the people depends to a large extent on the amount of goods and services available for consumption and this is directly, though not perfectly, related to national output or national income. An increase in national income may lead to an increase in the amount of goods and services available for consumption. If this happens, the standard of living will rise. However, this is not necessarily true. Further, national income does not measure the non-material standard of living. Therefore, problems arise when national income is used to compare the standard of living over time and across space. Comparison of the standard of living over time An increase in national income of, let’s say 100 per cent, may not lead to a 100 per cent rise in the standard of living because it may not lead to a 100 per cent increase in the amount of goods and services available for consumption due to several reasons. 1) The amount of goods and services available for consumption may not have increased by 100 per cent because the general price level may have risen. However, this problem can be overcome by using real national income instead of nominal national income. 2) The amount of goods and services available for consumption may not have increased by 100 per cent because the value of non-marketed goods and services may have decreased. The value of non-marketed goods and services is not included in national income. For instance, when a baker bakes a pie, the value of the pie is included in national income. However, when a housewife bakes a pie, it is not. Similarly, when a nanny is employed by a parent to look after her children, the value of childcare is included in national income. However, when a parent stays at home to look after her children, it is not. In some economies, especially developing ones, many of the households engage in subsistence farming where they produce food to feed themselves. However, the value of food that these households produce is not included in national income. The omission of the value of non-marketed goods and services understates the standard of living as measured by national income. A Singapore example Over the last few decades, the national income of Singapore has increased dramatically partly due to an increase in the women labour force participation rate. Although the increase in the value of the goods and services that women produce in the market is included in the national income of Singapore, the resultant decrease in the value of goods and services they produce at home is not subtracted. 3) The amount of goods and services available for consumption may not have increased by 100 per cent because the value of undeclared goods and services in the underground economy may have decreased. These goods and services are not declared may be because they are illegal, such as drugs and prostitution, or for the purpose of tax © 2011 Economics Cafe All rights reserved. Page 7
  8. 8. Written by: Edmund Quek evasion. For instance, people smuggle tobacco and alcohol to evade tax. The omission of the value of undeclared goods and services in the underground economy understates the standard of living as measured by national income. 4) The amount of goods and services available for consumption may not have increased by 100 per cent because the amount of capital goods as a proportion of national income may have increased. Even if the amount of goods and services available for consumption has increased by 100 per cent, the standard of living may not have risen by 100 per cent due to several reasons. 5) The amount of goods and services available to domestic residents for consumption may not have increased by 100 per cent because exports may have increased. 6) The amount of goods and services available to the average person for consumption may not have increased by 100 per cent because the population may have increased. However, this problem can be overcome by using national income per capita. 7) The increase in national income may lead to an increase in the Gini coefficient. When national income rises, income inequity may worsen, and if this causes the majority of the population to feel relatively poorer and hence worse off, the standard of living may fall. 8) The increase in national income may have caused negative externalities to increase. National income does not take into account negative externalities. The omission of the cost of environmental side effects such as air and river pollution, acid rain and global warming, overstates the standard of living as measured by national income. 9) The increase in national income may partly be due to people working longer hours which results in less leisure time. Contrary to what is discussed above, a 100 per cent increase in national income could mean that the standard of living has risen by more than 100 per cent because the quality of goods and services produced may have improved. If the variety of goods and services produced has increased, a 100 per cent increase in national income could also mean that the standard of living has risen by more than 100 per cent. Comparison of the standard of living across space If the national income of economy A is higher than that of economy B by, let’s say 100 per cent, the standard of living may not be higher by 100 per cent because the amount of goods and services available for consumption may not be higher by 100 per cent due to several reasons. © 2011 Economics Cafe All rights reserved. Page 8
  9. 9. Written by: Edmund Quek 1) The amount of goods and services available for consumption in economy A may not be higher by 100 per cent because the general price level may be higher. This problem cannot be overcome even if real national income is used for comparison. 2) The amount of goods and services available for consumption in economy A may not be higher by 100 per cent because the value of non-marketed goods and services may be lower. The value of non-marketed goods and services is not included in national income. For instance, when a baker bakes a pie, the value of the pie is included in national income. However, when a housewife bakes a pie, it is not. Similarly, when a nanny is employed by a parent to look after her children, the value of childcare is included in national. However, when a parent stays at home to look after her children, it is not. In some economies, especially developing ones, many of the households engage in subsistence farming where they produce food to feed themselves. However, the value of food that these households produce is not included in national income. The omission of the value of non-marketed goods and services understates the standard of living as measured by national income. 3) The amount of goods and services available for consumption in economy A may not be higher by 100 per cent because the value of undeclared goods and services in the underground economy may be lower. These goods and services are not declared may be because they are illegal, such as drugs and prostitution, or for the purpose of tax evasion. For instance, people smuggle tobacco and alcohol to evade tax. The omission of the value of undeclared goods and services in the underground economy understates the standard of living as measured by national income. 4) The amount of goods and services available for consumption in economy A may not be higher by 100 per cent because the amount of capital goods as a proportion of national income may be larger. Even if the amount of goods and services available for consumption in economy A is higher than that in economy B by 100 per cent, the standard of living may not be higher by 100 per cent due to several reasons. 5) The amount of goods and services available to domestic residents for consumption in economy A may not be higher by 100 per cent because exports may be higher. 6) The amount of goods and services available to the average person for consumption in economy A may not be higher by 100 per cent because the population may be larger. However, this problem can be overcome by using national income per capita. 7) The distribution of income in economy A may be more unequal than that in economy B. In other words, economy A may have a larger Gini coefficient. 8) The amount of negative externalities produced in economy A may be larger than that is produced in economy B. National income does not take into account negative externalities. The omission of the cost of environmental side effects such as air and © 2011 Economics Cafe All rights reserved. Page 9
  10. 10. Written by: Edmund Quek river pollution, acid rain and global warming, overstates the standard of living as measured by national income. 9) The people in economy A may be working longer hours than the people in economy B which means that the people in economy A have less leisure time. 10) The quality of goods and services produced in economy A may be lower than the quality of goods and services produced in economy B. 11) The variety of goods and services produced in economy A may be smaller than the variety of goods and services produced in economy B. Note: One problem with using national income to compare the standards of living in two economies is that the national income of an economy is measured in the local currency. However, this problem can be overcome by converting the national income of each economy to a common currency such as the US dollar using the market exchange rate. An even better conversion factor which takes into account the difference in the cost of living is the purchasing power parity (PPP) exchange rate. The PPP exchange rate is the exchange rate which allows the amount of money that is required to buy a basket of goods and services in one economy to buy the same basket of goods and services in another economy after exchanging it into the currency of the other economy. Thus, the PPP exchange rate is a better indicator of the purchasing power of the currency at home. The OECD publishes PPP exchange rates against the US dollar for all OECD economies. 8 ALTERNATIVE MEASURES OF THE STANDARD OF LIVING Measurable Economic Welfare (MEW) National income can be adjusted to obtain the MEW by adding factors which improve the standard of living such as increased leisure hours and subtracting factors which reduce the standard of living such as negative externalities. This approach gives a fuller picture of the standard of living. However, it involves the difficult task of measuring the values of non-marketed “goods” and “bads”. This measure of economic welfare was developed in 1972 by two American economists, William Nordhaus and James Tobin, which they called it the Net Economic Welfare (NEW). Human Development Index (HDI) Economic development, which has a wide meaning of economic welfare, is sometimes used as a measure of the standard of living. The most well-known measure of economic development is the Human Development Index (HDI), which has been published by United Nations since 1990. © 2011 Economics Cafe All rights reserved. Page 10
  11. 11. Written by: Edmund Quek The Human Development Index (HDI) is a composite index made up of three indices: an index for real GDP per capita in PPP$, an index for life expectancy and an index for adult literacy and average years of schooling. A higher MEW or HDI is commonly taken to indicate a higher standard of living. © 2011 Economics Cafe All rights reserved. Page 11

×