National Income is the outcome or the end result of all economic activities

National Income is the outcome or the end result of all economic activities. Economic activities generate two kinds of flows (i) money flows- these are in exchange for services of factors of production in the form of flows- these are in exchange for services of factors of production in the form of wages, rent, interest and profits (i.e factor earnings) (ii) Product flows, are flows of consumer goods and services and productive assets. All human activities which create goods and services that can be valued at market price are broadly the economic activities. Macroeconomics deals with a number of large totals or aggregates, which are used to conceptualize and measure key components of the economy. The most fundamental of these is the total output of goods and services, conventionally referred to as the national income. (Official data in most countries is now actually reported on a domestic rather than a national basis. The distinction, which is unimportant for most purposes, relates to the treatment of investment income received from non-residents and paid to non-residents. Domestic income is that produced within a country by all producers operating there, whether foreign or not. National income is that produced only by nationals of that country, whether they are producing it there or elsewhere.) There is nothing inconsistent in referring to total output as income. Although what is earned as income can be measured separately from what is produced, the two aggregates are necessarily the same in amount. Before going on to see why, note that in either case such large totals can be expressed only in terms of money, not physical products as such. It is impractical to try to measure output or income in real, physical terms, simply because it is impossible to sum apples and oranges or any of the millions of goods and services which are produced and received as income in a modern economy. Instead, physical quantities must be converted to a common measure and the measure used for this purpose is the national unit of account, the dollar, pound, or other currency. The value of total output or income in an economy during some accounting period, usually a year or quarter of a year, is a significant statistic. It is generally used as an indicator of the economys performance. Because a larger output or income is equated with a rise in the economic well being of a countrys population, a higher output or income is considered desirable and a lower one undesirable. The economys overall performance is tracked by the changing value of the total output or income statistic. Similarly, comparisons of relative well-being among different countries are based on these statistics and a host of political and social as well as economic implications flow from their behaviour over time. The Circular Flow A modern economy can be simply modeled in the aggregate by thinking of it as comprising two key sectors, households which consume produced goods and services and which supply labour and other productive services to firms, which use the labour and other productive services supplied by households to produce the goods and services the households consume. Households supply the services of productive factors (land, labour, capital, etc.) and the firms convert these inputs into produced goods and services which return to the households. Owners of firms are, of course, also part of the household sector where they function in their other capacity as consumers of goods and services. The real flows of productive services and produced outputs have corresponding flows of money payments associated with them. Firms pay out wages and salaries in return for labour services, rents to owners of land and other natural resource inputs, and interest and profits to suppliers of capital and entrepreneurial inputs. Householders consequently have money income with which to pay for the produced goods and services that flow to them from firms. Thus, there are HYPERLINK http//www.chass.utoronto.ca/reak/eco100/circular.swf money flows corresponding to the real flows, but they move, of course, in the opposite direction. Circular Flow of Income Services of factors of Production Goods and services Spending Incomes Because the flows of payments for produced goods and services and payments for factor inputs are continuous, aggregate income/output in this simple model could be measured at any point, metering the flow anywhere in the circuit. If measured in terms of spending on produced goods and services, it would be natural to call this a measure of total spending or total expenditure. If measured in terms of outlays made for the services of productive factor inputs, it would be total income (from the point of view of the owners of those factor inputs). Obviously the two totals would have to be the same. Circular Flow of Income Services of factors of Production Goods and services Spending Incomes LEAKAGES/WITHDRAWALS INJECTIONS Savings Investments Taxation Government Expenditure Imports Exports From the diagram Y C I G (X-M) C S T THE NATIONAL ACCOUNTS All the economies today measure the volume of aggregate income, usually defined as Gross Domestic Product, in much the same way. Gross Domestic Product (GDP) Refers to the total monetary value of all goods and services produced within the geographic boundaries of a nation during a given year. The word domestic implies that only the income produced in that country is accounted for. The income that arises from investments and possessions owned abroad is thus not included in the GDP estimates. Calculation of GDP -calculated simply by valuing the outputs of all final goods and services at market prices ( i.e. actual prices at which they are bought and sold) and then adding the total. N.B. The market value of all intermediate products- those used to produce the final output is excluded from the calculation of GDP since the values of intermediate goods are already implicitly included in the market prices of the final goods. Gross implies not all output was available for private/public consumption and investment, part went to replace or maintain worn out capital equipment. Nominal and Real GDP Two measures of GDP are given nominal GDP (also called current dollar GDP) and real (constant dollar) GDP. Nominal GDP measures the value of output at the prices prevailing at the time of production, while real GDP measures the output produced in any one period at the prices of some base year. The growth rate of the economy is usually taken to be the rate at which real GDP is increasing. GROSS NATIONAL PRODUCT (GNP) This is the most important and widely used measure of national income. It is the most comprehensive measure of a nations productive activities. It is defined as the value of all final goods and services produced during a specific period, usually one year (Dwivedi, 1996). In other words it refers to that part of the GDP that is actually produced and earned by or transferred to resident nationals of that country. Earnings of foreigners which arise out of their domestic economic activities are thus excluded. For Zimbabweans working abroad their income is included in the GNP of Zimbabwe. Where there is substantial foreign participation in the economy and a large part of total domestic income is earned and repatriated by foreigners and foreign companies as in many LDCs, GDP will be much larger than GNP. As a result statistics of GDP growth may give a false impression of the economic performance of a particular developing nation. GNP is therefore a more appropriate measure of national income. NET NATIONAL PRODUCT (NET NATIONAL PRODUCT) Net National Product Gross National Product Depreciation. Net National Product (NNP) is calculated by deducting from GNP the depreciation of existing capital stock over the course of the period. The production of GNP causes wear and tear to the existing capital stock, for example, machines wear out as they are used. It is a more accurate measure of national product but in real life GNP is mostly because net investment (Gross Investment Depreciation) is difficult to measure especially as rate of depreciation is not known (straight line, declining or reducing balance) or may be quite inaccurate. Depreciation estimates may also not be quickly available. MEASUREMENT OF NATIONAL INCOME There are three methods or approaches for measuring total output, namely 1). Expenditure 2). Income method 3). Value Added or Output approach A. The Expenditure Approach Measuring total output by the expenditure method involves breaking down total spending on all goods and services produced into four categories (a) Expenditures by consumers on goods and services (abbreviated simply to the letter C) (b)Expenditures by businesses on capital goods (total investment spending, I) (c) Expenditure by government on goods and services, G) and (d) Net exports (the total value of exports minus the total value of imports, X-M). Because all spending done in the country falls into one or other of these four categories, we can say that total expenditure is the sum of CIG(X-M). We now examine each of these four main components of total spending. Consumption (C) Consumption spending is the total of all outlays made by households on final goods and services. In all countries it is by far the largest component of total spending. It covers spending on an enormous range of items, including durable goods like television sets and cars, non-durable goods like food and clothing, and personal services such as legal advice, hairdressing, and dental care. But it usually excludes spending on houses, which is customarily (and arbitrarily) treated as investment expenditure. C also excludes purchases of second-hand goods that were produced in some earlier accounting period so as not to double count the value of such output. Government Expenditure on Goods and Services (G) All governments payments to factors of production in return for factor services rendered are counted as part of the GDP. Much of the spending done by governments in the developed countries today takes the form of simple transfers of income from taxpayers to those eligible for the wide range of income supplements available to assist the elderly, the sick and the unemployed, or as payments of interest to holders of the public debt. Such transfer payments do not represent spending on current production and consequently, are not counted in national income determination. What is counted is government spending on goods and services, many of which are bought by the government on behalf of the public and which are ultimately consumed by households education, health care services, national defence, roads, water and sewage systems, postal services. Because so many of these goods and services are provided free or in other ways that bypass markets, it is difficult to determine their value in the same way that the value of the other items entering into C would be determined. Consequently, national income accountants value government spending on the basis of what the government pays for the goods and services it requires. Another complication with government spending on goods and services is that such spending is often done on things like highways which are themselves capable of being used to assist in the production of other goods. Logically, such spending should be thought of as investment spending and included in the next category to be discussed. Some countries produce their accounts in such a form that government spending can be separated into two categories, current spending on goods and services, and investment spending, but if the main concern is to understand the causes of year-to-year cyclical fluctuations in the level of national income rather than the causes of its longer term growth (which may be strongly affected by the level of investment as opposed to current spending) it is convenient to stick with the traditional categories of spending which emphasize the different motivations driving the spending decisions of ordinary consumers, private investors and governments. Here, investment spending refers to private investment spending unless otherwise stated. Investment (I) Investment is the production of goods that are not for immediate consumption. The goods are called investment goods (inventories and capital goods including residential housing) The total investment in an economy is called Gross Investment. We count the construction of new houses as part of GDP, but we do not add trade in existing houses. We do however, count the value of the estate agents commission in the sale of existing houses as part of GDP. The estate agent provides a current service in bringing buyer and seller together, and that is appropriately part of current output. Total or gross investment Expenditure may be divided into two main categories Expenditure on capital goodspurchases of plant and equipment either to replace existing capacity that is wearing out or to increase capacity. This is often called fixed capital formation. Expenditure on inventories. Many businesses find it convenient or necessary to hold certain supplies of goods on hand, in which case investment in inventories may be considered voluntary. But business conditions are uncertain and so firms may also find themselves holding stocks because they miscalculated demand. In either case, firms are considered to be investing when they accumulate inventories. On the other hand, if their inventories decrease they are disinvesting. Inventory investment is highly volatile, changing greatly in amount and composition from year to year. Gross investment, then, is the total amount of (usually private) spending during the accounting period on capital goods (defined as structures, machinery and equipment, and inventories). Because capital by its nature consists of things that are used in the production of other goods and services, it is inevitable that it will wear out or depreciate. The amount necessary for replacement is called Depreciation or capital consumption allowance. Gross Investment Depreciation Net Investment. Unless it is continually renewed, the stock of capital in the economy will gradually be depleted. Handling depreciation is one of the more difficult parts of national income accounting. Again, the best treatment depends on what the data are meant to be used for. If the concern is with the long-term growth of the economy, net investment (total investment during the accounting period minus depreciation) is the important concept because it measures the growth of the economys capital stock over time. But if the purpose is to understand short term, annual fluctuations in the level of total spending it is better to work with gross investment. Net Exports (X-M) A significant part of total spending in most countries goes toward the purchase of goods produced abroad rather than domestically. As noted in discussing the circular flow, such outlays represent spending which leaks from the domestic economy to the rest of the world and is consequently treated as a negative entry in measures of total domestic spending. But it is offset to a greater or lesser degree by the spending of non-residents on goods produced and exported to international markets. It is often convenient, therefore, to take domestic spending on imports and foreign spending on exports as a combined value, usually called net exports, a value which may be positive or negative in any accounting period depending on which component, exports or imports, is larger. Summing these four expenditure components, CIG(X-M), gives a single figure, the total amount of spending done in the economy during the accounting period. It should be possible to arrive at exactly the same figure by summing all income received in the economy during the accounting period. (GDP Y CIG(X-M), B. Measuring Total Output by the Income Method As seen in discussing the circular flow, what the firms producing the national output see as costs of production, owners of productive factors see as income. Factor costs and factor incomes are consequently the same thing viewed from different perspectives. GDP wages rents interest non-income charges Quantitatively, by far the most important and certainly the simplest factor costs to measure are the payments made by employers for labour services. These payments are usually reported in the official statistics under a heading such as Wages, salaries, and supplementary labour income, with the latter term referring to employee benefits such as pensions, workers compensation benefits, and employer contributions to unemployment insurance funds or other worker social security schemes. Most other factor payments, however, are much more difficult to track. Consider a farming operation. How should any net income derived from farming be classified Part of it must be a return to the services of land the farmer is using ( rent). Part must be a return to the farmers own input of labour (wages). Part might be considered a return to setting up and operating the business(profit). These are difficult to separate. Because of such problems, the national accounts typically use definitions of factor payments which owe more to convenience than to the logic of factor classification net income of farm operators, corporation profits, net income of unincorporated business, and interest and other investment income. Summing all these items yields the total amount received during the accounting period by the owners of productive factors. But if this figure for factor costs or income is compared with the total arrived at by the expenditure method, it falls considerably short of the amount expected. Value Added output of firm – output purchased from other firms. If we follow the course of this process, we will see that the sum of values added at each stage of process is equal to the final value of the item sold. Value added is also the basis for the Value added Tax (VAT). A problem associated with the value added approach is valuation of inventories of goods produced but unsold. Unsold inventories are valued at market prices yet profits ( or losses) have not been realised prices may fall or rise goods may not be sold. This means that a rise in market prices causes a rise in value of the existing inventories. To avoid this distortion a correction is made to eliminate changes in the value of inventories due to price changes that is stock appreciation should be deducted from the value. The table below summarizes the relationships. For example from the third and fourth columns NNP at market prices indirect taxes add subsidies national income at factor cost. Net factorpaymentsDepreciationIndirect taxesGDP at GNPless marketat marketsubsidiespricespricesNNP at marketNational VariouspricesIncomeitemsat factorPersonalPersonalcostIncomeTaxPersonalDisposable income includes income that does not accrue to personal sector e.g. corporate taxation and corporate saving Uses of National Income Accounting Assists government in planning the economy. The accounts will show growth or stagnation in the economy, alerting policymakers to the sort of action which ought to be taken. Since national income accounts break the performance of the economy down into its component parts, they provide policymakers with specific information regarding the formulation and application of economic policy. Permits us to measure the level of production in the economy over a given period of time and to explain the immediate causes of that level of performance. By comparing the national income accounts over a period of time, the long-run course which the economy has been following can be plotted. To compare standards of living of different countries- the problem is the countries being compared use different currencies. The simplest means of dealing with the problem is to use the Exchange rates between countries to convert the GNP of each nation to a common currency e.g. US. Most international comparisons use this method. The second method used is Purchasing Power Parity. (a) Exchange rate conversion- the method is simple and straightforward but this does not meet our needs fully. We are seeking to measure differences in standard of living among areas, but exchange rate reflects purchasing power of currencies for goods traded in international markets. Goods and services not traded on international market may not be correctly taken into account. (b) Purchasing power parity- the method involves determination of the relative purchasing power of each currency by comparing the amount of each currency required to purchase a common bundle of goods and services in the domestic market of the currencys country of origin. This information is then used to convert the GNP of each nation to a common monetary unit. Estimates using Purchasing Power Parity method are a more accurate indicator of international differences in per capita GNP than exchange rate conversion method. As a measure of welfare and national development, GNP per capita may be rising over a period of time implying a rise in economic welfare and economic development. Criticisms include the following- output of weaponry may rise, crime may rise (use of more police), motor vehicle production (more pollution) may also rise (showing increasing GNP) yet in terms the people are not better off or even worse off. Output may also have been of capital goods. GNP per capita gives no indication of how national income is actually distributed and who is benefiting from growth of production. A rising level of absolute and per capita GNP may obscure the reality that the poor are no better off than before. As an index of improved economic welfare GNP growth rates are inadequate for the generality. Despite its shortcomings, GNP provides a useful measure especially if it is accompanied by indicators like life expectancy, infant mortality rates, education, literacy and income distribution. For soliciting international aid from other countries or multilateral organizations. National income and product estimates by sector of origin of national product reveal contributions made by different sectors of the economy. PROBLEMS OF GDP MEASUREMENT GDP data are far from perfect measures of either economic output or welfare. Problems of GDP measurement are Badly measured outputs-some outputs do not go through the market, e.g. government output (such as defence) is not sold in the market. Also there is nothing comparable available that would make it possible to estimate the value of government output. It is therefore valued at cost. Other non-market activities, including do -it- yourself work and volunteer activities, are also excluded from GDP. Unrecorded economy- many transactions that go through the market escape measurement. e.g. payment for a handymans services is not recorded in the GDP data as it is unlikely to be declared, illegal traffic in drugs. The main problem is that the relative importance of such activities may have been changing. If such activities become more important over time , then measured real GDP will understate the rate of growth of total economic activity. Why there might have been an increase in unrecorded transactions (i) rising tax rates (which make it more tempting not to declare sales or income,) and the growing importance of the so called informal activities outside the modern sector of the economy. Data revisions- when they first appear, GDP data are not firm estimates. The reason is that many of the data are not measured directly, but are based on surveys and guesses. Considering the GDP is supposed to measure the value of all production of goods and services in the economy, it is not surprising that not all the data are available within a few weeks after the period of production. The data are revised as new figures come in, as the CSO and RBZ improve their data collection methods and estimates. Adjusting National Income Data to Allow for Price Changes One difficulty with using money values to express national accounting magnitudes is that the value of money may change over time. If there is a general rise in all prices, or a fall in all prices, the monetary unit either decreases or increases in value. Trying to measure distance with a ruler that shrank or expanded significantly between measurements would obviously be a frustrating and not very useful activity. Inflation, defined as a general rise in the price level, or deflation, a general fall in the price level, are common enough to make it necessary to adjust national income data to remove the effect of changes in the purchasing power of the dollar or other monetary unit being used to measure the value of total output. This is done by developing indexes which show how the prices of the goods and services produced in any one year have changed relative to the prices of those goods and services in some other year. Setting up these indexes of prices is not difficult in principle, although it can be an expensive, time-consuming task in practice. Consider a simple example in which only a single commodity is the subject of interest, mens shoes. In the following table the price of mens shoes in each year is compared with the price prevailing in one particular year. The base year in the example is year 2000, (this can be written as 2000100) although it could have been any one of the five years. The price in any particular year is then divided by the price in the base year to get the ratio of prices shown in the third column. Because these ratios are usually expressed as percentages, they are then multiplied by 100 to obtain the price index numbers shown in the last column. Year19992000200120022003Price()2040506080Price Ratio20/400.540/40150/401.2560/401.580/402Price Index50100125150200 These index numbers can now be used to adjust the data on the value of mens shoes produced in each year, thereby eliminating the effect of price changes from the series. Suppose the following production information is available. Year19992000200120022003Output in Current 520305090Output in Constant10202433.345 The current dollar values shown in the second column turn out to be quite misleading as an indicator of the real changes in output. Because prices were lower in Year 1999 than in the base year (Year 2000), the output in Year 1999 was understated, whereas, because prices in Years 2000, 2001, and 2003 were higher than in the base year, the current dollar production values overstated the volume of output. The conversion to (Year 2000) constant dollars in the third column was done by dividing the current dollar values of output for each year by the relevant index number (expressed as a percentage). Mens shoes are only one of thousands of commodities which are included in the total national income and, in practice, it is not feasible to develop price indexes for each item in this way. Instead, price indexes are built up for groups of commodities which are often defined in terms of who buys them. For example, a commonly used index measures changes in the amounts households spend on a selected bundle of goods and services. One of the problems with this kind of index is that it is very costly to determine which goods should be included in such a bundle. Surveys must be made of household buying habits to determine which goods households are buying in significant quantities and the relative importance of various goods in typical household budgets. Because of this, years may elapse between redefinitions of the goods which are included in the index which makes the information the index provides of dubious value toward the end of the redefinition cycle. When constructing large price indexes for adjusting national income data, most statistical agencies build up a general index from a large number of specific commodity group indexes, so that changes in expenditure patterns within the component groups will not seriously affect the outcome. This composite index is known as a gross domestic product deflator. It can be used to convert any current dollar value of gross domestic product to a constant dollar basis using the relation Nominal GDP/Real GDP x 100 GDP Deflator GDP price deflator is an index calculated from nominal and real GDP. Thus, if the deflator is known to have a value of 125 and nominal (current dollar) gross domestic income is 50 billion dollars, real gross domestic income is 40 billion. The measurement of per capita income All countries have adopted the conventions (the United Nations Standard National Accounts) for the calculations of Gross National Product (GNP) and Gross Domestic Product (GDP), and GNP or GDP per capita is the commonest indicator of the level of development. Economic growth refers to an increase in either of these indicators. There are however well known problems associated with the calculation of national income in poor countries and its use as an indicator of development The necessary data are often incomplete, unreliable or not available The accounting conventions are not necessarily appropriate the services of women working in the household are excluded from national statistics yet in many poor countries, especially in sub Saharan Africa, women are often responsible for running the family farm as well as working in the household. In most poor countries, there is a large subsistence sector that is, farmers may well consume all or large proportion of what they produce, rather than sending it to the market where it would be counted for the purposes of calculating national income. Statisticians make an allowance for this non- marketed component of output, and for rural capital formation that may not enter the national accounts house building, irrigation ditches but it is generally accepted that the value of the activities is underestimated, thus biasing downwards the national income figures for poor countries. Income may be overstated for developed economies because a number of items that are included as income might better be seen as costs and hence excluded from income- the cost of travelling to work, for example, or the cost of heating the home in temperate climates. Per capita (average) incomes tell us nothing about the distribution of income. Two countries with similar per capita income distributions, with important implications for the welfare of their populations and the nature and characteristics of the development process. Significant problems arise when international comparisons of income levels are made. Income data measured in national currencies have to be converted into a common currency, usually the US dollar, and an exchange rate must be chosen. If poor countries artificially maintain overvalued exchange rates (that is, the price of foreign currencies in terms of their domestic currency is too low), this will overstate the income of the country expressed in US dollars. Offsetting this, however, is the fact that many goods and services in poor countries are not traded and hence have no impact on the exchange rate. Many of these necessities of life in poor countries basic foodstuffs for example- are very low priced in dollar terms, and a haircut in Zimbabwe will cost less than one in Paris or London. According to World Bank data Mozambique with an estimated GNP per capita of US 60 in 1992 was the poorest country in the world Switzerland, with a GNP per capita of US36080, was the richest Is the average Swiss citizen 600 times better off than the average Mozambican To put that question slightly differently, does it make sense to state that in Mozambique, on average, people live on 16 cents a day Clearly nobody in a developed economy could survive on such a low income. Given that the majority of Mozambicans do survive, it must be the case that the necessities essential for survival cost less in Mozambique than for example in Switzerland, and/ or 60 is not a meaningful estimate of per capita income in Mozambique. This is not to deny that a huge gap exists between the average incomes of very rich and very poor countries, nor should it lessen our concern with such inequalities. But it does mean that the gap on average is not as great as the statistics would suggest and a number of attempts have been made to compute more meaningful comparisons. Measurement of the Standard of Living The value of this years national income is a useful measure of how well-off a country is in material terms. However, inflation increases the money value of national income but does not provide us with any more goods to consume. Real national income is found by applying the equation Real national income Money national income/Retail price index x 100. The standard of living refers to the amount of goods and services consumed by households in one year and is found (i) by applying the equation Standard of living Real national income/ Population national income per capita A high standard of living means households consume a large number of goods and services. Or (ii) by counting the percentage of people owning consumer durables such as cars, televisions, etc. An increase in ownership indicates an improved standard of living. Or (iii) by noting how long an average person has to work to earn enough money to buy certain goods. If people have to work less time to buy goods, then there has been an increase in the standard of living. Interpretation of the Standard of Living An increase in the standard of living may not mean a better life-style for the majority if Only a small minority of wealthy people consume the extra goods. Increased output of certain goods results in more noise, congestion and pollution. Leisure time is reduced to achieve the production increase. There is an increase in the amount of stress and anxiety in society. Common Misunderstanding The various measures of the national product give us a tally of the nations income for a year. However this does not measure the nations wealth .The nation has great stock of capital goods .The stock of national capital is the sum total of everything that has been preserved from all that has been produced throughout our economic history. Interestingly, perhaps the greatest asset of modern economies is the skill and education of the workforce. This is called human capital but is not included in measures of net capital stock owing to difficulty of measurement. 2. If we are assessing someones wealth, one of the first things we would look at is how much money they had and whether they owned stock and shares. However these are excluded from the calculation of national wealth. Why The answer is because we have already counted them in the form of real wealth such as buildings and machines. Money and other financial assets are only claims upon wealth and hence are simply paper certificates of ownership. Similarly, varying the amount of money in the economy does not directly make it any richer or poorer. H/HOLDS FIRMS FIRMS H/HOLDS /