Measurement of National Income

Question 1

National Income

Answer 1

Refers to total monetary value of all final goods and services produced by various firms in an economy within a period of one year.

Question 2

Gross Domestic Product (GDP)

Answer 2

• This refers to total monetary value of all final good and services within the boundaries of a country irrespective of who is producing it.
  Net Domestic Product = GDP-Depreciation

Question 3

Gross National Product (GNP)

Answer 3

• Refers to total monetary value of all goods and services produced by nationals/citizens of a country irrespective of where they are producing it. This included net factor income from abroad.
• GNP=GDP + Net factor incomes from abroad is the difference between income accruing to domestic residents arising from activities abroad less income earned within the country by non-residents

Question 4

Net National Product (NNP)

Answer 4

• Allows for capital consumption which is the replacement value (wear and tear) of capital used in production process.
  NNP at factor cost - is the actual national income.
  NNP at factor cost = NNP (at Market price) – indirect taxes + subsides
  Net National Product (NNP) = GNP – Depreciation allowance (capital consumption)

Question 5

National disposable income

Answer 5

National income +(-) net transfer payments or receipts. The National disposable income measures aggregate resources available to nations for saving or consumption

Question 6

Per capita income

Answer 6

The income per head i.e. total national income divided by population

Question 7

Nominal National output

Answer 7

Measurement of total output in current prices

Question 8

Real national output

Answer 8

The value of total output measured in constant prices ( base year prices)

Question 9

Importance/ uses of National income statistics

Answer 9

• Measure economic welfare or standard of living. The bigger the national income in a country, the more its citizens will be earning on average.
• Growth in national income is an economic policy objective of most governments; Government uses national income for its planning.
• The business community uses national income estimates to plan their investments.
• National income figures can be used for making international comparisons i.e. to compare the standard of living of different countries

Question 10

Methods/Approaches to the measurement of national income

Answer 10

National Income
National Product/value added
National Expenditure

Question 11

National Product or Output Approach

Answer 11

• The market value of all final goods and services produced by all the firms during the year.
• Found by adding up the values of all final goods and services produced by firms during a year.
• If we merely added up the market value of all firms’ output, the total obtained would be in excess of the value of the economy’s actual output. The error that would occur is called double counting error which is avoided by working with value added.
• Value added is the value of a firm’s production minus the value of intermediate purchases from other firms.
  The sum of all values added in an economy is a measure of the economy’s total output. It is called gross domestic product (GDP).
• GDP using value added method is valued at factor cost.

Question 12

GDP at factor cost

Answer 12

Agriculture + Manufacturing+ Transport and communication + public, administration and defense + education admin and health + other services

Question 13

Problems associated with Product/output approach

Answer 13

Problem of product boundary – what goods and services to include of exclude, for example whether to include housewives services and other employment output values
Problem of valuation of subsistence goods because o inaccurate statistics of volume of production and decision on what prices to use considering seasonal and regional price vitiations
Rates of inflation
Problem of valuation of government output e.g., education
Valuation of illegal activities which might be entered into the production process for example drugs

Question 14

National expenditure Approach

Answer 14

This is calculated by adding up all the expenditure on the final output produced in that year.
Total expenditure on final output is the sum of four broad categories of expenditure: consumption (C investment (I) government (G) and net exports (= exports minus imports i.e. (X-M).

Question 15

National expenditure components

Answer 15

• Consumption Expenditure (C): includes expenditure on all goods and services produced and sold to their final users (households) during the year.
• Investment Expenditure: refers to expenditure by firms on production of goods not for present consumption. Divided into three categories namely:
  i) expenditure on capital equipment and buildings;
  ii) construction of residential houses and
  iii) stocks of goods currently held by firms for future production or for sale (raw materials or finished products).
  The total investment expenditure is called gross investment or gross capital formation.
  Net investment= gross investment - depreciation (capital consumption allowance).
• Government Expenditure: refers to the purchases of goods and services by all levels of government. It includes the cost of providing national defense, law and order, street lighting, refuse collection, health care, education and services of judges etc..
• Exports (X) : Refers to all goods and services that are domestically produced but sold abroad. Exports are not included as part of C, I, or G since they are not purchased by the domestic residents.
• Imports (M) : Imports are the goods that are produced abroad but purchased for use in the domestic economy by households, firms and government.
• Net Exports (X-M). The value of total exports of goods and services minus the value total imports of goods and services (X – M).
• When the value of exports exceed the value of imports, the net export term will be positive. When the value of imports exceed exports, the value of net export term will be negative.

Question 16

Expenditures not included in GDP

Answer 16

• Intermediate goods or producer goods or semi-finished products. These are partly finished goods which may be used as inputs for production of other goods including final goods.
• Second-hand goods. Expenditure on second hand goods is not part of GDP because these goods were counted in the period in which they were produced.
• Financial securities. Firms often sell financial securities such as bonds and stocks to finance purchase of newly produced capital goods.
• Transfer payments such as payments to old age pensioners, unemployment benefits welfare etc. are excluded because the government receives no goods or services in exchange.

Question 17

GDP at market prices (expenditure)

Answer 17

GDP = C + I + G + ( X – M)

Question 18

Problems associated with Expenditure approach

Answer 18

• No accurate records are kept, especially in the private sector
• Imputing or estimating the value of the subsistence sector on the output is difficult
• Distinguishing between expenditure on final goods and intermediate goods
• Double counting on: student allowance, bursaries, interest on public debt, second hand cloth goods, financial assets neither which involve fresh out put.
• The problem of valuation of imports and exports in the economy- caused by fluctuating exchange rates.

Question 19

National Income Approach

Answer 19

• Found by adding together all incomes paid by firms to households for the services of factors of production they hire i.e. by adding wages, interest rent for land and profits together.
• Divided into the following categories:
  Income from employment which consists of wages and salaries (normally referred to as wages).
  Income from self employment that covers those people who are earning a living by selling their services or output but who are not employed any one organization.
  Rent. Rent is the payment for the services of land and other factors that are rented.
  Profits. Profits are net business incomes after payment has been made to hired labor and for material inputs. Profits are divided into distributed (dividends) and undistributed profits (called retained earnings).
  Interest . The net interest category includes interest payments by domestic businesses and the rest of the world to households and firms who have lent to them.

Question 20

GDP at factor cost (income approach)

Answer 20

Income from employment (salaries and wages) + income from self employment + gross profits + rent + interest

Question 21

Problems associated with income approach

Answer 21

• Problem with imputing Transfer payment especially when there are no records
• Unavailability of accurate data on income earned – profits from private firms which may want to evade tax - - Rates of inflation
• Estimating the value of the subsistence sector
• Problem of valuation of illegal activities which might be entered into the production process for example drugs

Question 22

Adjustments from factor cost to market price

Answer 22

• The sum of all the final expenditures on goods and services gives us GDP at market price. But income approach gives GDP at factor cost.
• The presence of government (that subsidizes and taxes production) means that that the two methods of valuation will give two different values of GDP.
• Taxes levied on transactions on goods and services are known as indirect taxes. The effect of an indirect tax is to make the market price of a product greater than the sum received by the factors of production.
• The existence of a subsidy means that the market price may be less than the total reward to factors.

GDP at factor cost + indirect taxes - subsidies = GDP at market prices
GDP at market price - indirect taxes + subsidies = GDP at factor cost
- Net Factor Income from Abroad: GDP at market prices measures total output produced in the economy and total income generated as a result of that production.
However, some of the output produced within the country is actually produced by firms are owned by non residents while some output produced outside the country is actually produced by firms owned by domestic residents abroad. Net property or factor income is income received by domestic residents from assets owned abroad minus income paid out to non resident who own assets in the domestic economy.
GDP + net property = GNP
- Depreciation refers to the value of wear and tear on the existing capital stock. Depreciation (or capital consumption allowance) is measure of the part of GDP or GNP that has to be set aside to maintain the productive capacity of the economy.
GDP - Depreciation = NDP (Net Domestic Product)
GNP - Depreciation = NNP (Net National Product)

Question 23

Reconciling GDP with GNP from Expenditure based

Answer 23

Consumption xxx
Government expenditure xxx
Investment expenditure xxx
Net exports xxx
GDP at market prices xxx
Less: indirect taxes (xxx)
Subsidies xxx
GDP at factor cost xxx
Add Net factor income from abroad xxx
GNP at factor cost xxx
Less Depreciation (xxx)

National income (NNP at factor cost) xxxx

Question 24

Personal income

Answer 24

• Income that is earned by or paid to individuals before allowing for personal income taxes on that income.
• National income is either larger or smaller than personal income.
• Thus we add to national income (NI), the income received but not earned and subtract the income earned but not received, to convert national income into personal income.

Question 25

Personal disposable income

Answer 25

National Income xxx
Add: income received but not earned
Government and business transfer xxx
Net interest paid by government xxx
Less income earned but not received:
Undistributed corporate profits (xxx)
Corporate income taxes (xxx)
Contributions for social insurance (xxx)
Personal income xxx
Less: personal income tax (xxx)

Personal disposable income xxx

Question 26

Disposable personal income

Answer 26

GNP at factor cost XXX
Less: depreciation (XXX)
NNP at factor cost XXX
National income XXX
Less: corporate profits (XXX)
Undistributed profits (XXX)
Contributions for social insurance (XXX)
Add: government transfer pay- XXX
Personal income XXX
Less: personal income tax (XXX)

Disposable personal income XXX

Question 27

Using income approach

Answer 27

Salaries and wages 				XXX
Profits 					                XXX
Rents					                XXX
Interest 					                XXX
GDP at factor cost				        XXX
Net property income from above		XXX
GNP at factor cost				        XXX
Less: depreciation 			       (XXX)

National income XXX

Question 28

Circular flow of income model

Answer 28

• This is an economic model illustrating the flow of payments and receipts between domestic firms and domestic households.
• It rests on the basic principle that one sector’s or person’s expenditure becomes another’s income and also the premise that commodities and factors of production do exchange for money.
• It is assumed that an economy comprise of households (owners of the factors of production) needed by the firms to produce goods and services and firms which produces goods and services needed by the households for consumption.
• The firms acquire the factors of production from the households at a payment (rent, wages, interest & profit) which becomes the income of the households.
• The households in turn acquire the goods and services from the firm at a payment which becomes the firms’ income.
• Therefore incomes keep on moving from households to the firm and then back to the households in kind of a circle hence this movement is referred to as circular flow of income

Question 29

Assumptions of circular flow of income

Answer 29

1. There are only two players/sectors i.e. households and firm
2. The household spend all their income received on the purchase of goods and services i.e. no saving
3. The firms spend all their incomes on payment of factors of production provided by the households
4. There is no government intervention
5. The economy is closed i.e. no foreign trade

Question 30

Factors affecting the flow of income

Answer 30

The factors that increase the income and expenditure are referred to as injections while those that reduce the flow are referred to withdrawals/leakages.
Savings, Investments, Foreign trade and government

Question 31

Savings (withdrawals)

Answer 31

• This is the part of income that is not consumed but kept aside for future use.
• Savings by households reduce income received by the firms since they are withdrawn from the circular flow. This implies that the firms will not have enough funds to pay for the factors of production.
• Savings are therefore withdrawal

Question 32

Investment (injections)

Answer 32

• This addition to the stock of capital into the economy. - Firms may make use of the funds that households have saved in financial institutions to invest. This lead to higher incomes to the households as firms utilizes more factors to increase production.
• Investments are therefore injections

Question 33

Foreign trade (injections and withdrawals)

Answer 33

Export earns a country foreign income which is an addition to the income flow hence they are injections. Countries pay to foreigners for imported goods and services thus they constitute leakages

Question 34

Government (withdrawal and injections)

Answer 34

• The government can affect the flow either by taxation or government expenditure
• Taxation reduces the amount available for spending hence it’s a leakage or withdrawal from the circular flow.
• Government expenditure- government can buy goods and services from firms or pay wages and salaries to the households hence constituting the injections

Question 35

Factors that Influence the Size of a Country’s National Income

Answer 35

• The nature and size of natural resources (e.g. mineral deposits, fertility of the soil)
• The nature of the labor force (e.g. in relation to the total population, its energy, skills and ability).
• The amount of capital investment. Some countries attract capital investment more easily than others.
• The efficiency with which the factors of production like land, labor and capital are combined.
• The ability of the country to produce innovative ideas (e.g. new technologies)
• Political stability.
• The availability of foreign loans.
• The terms of trade i.e. the amount of goods and services of another country which can be obtained for specific quantity of home produced goods and services.

Question 36

Real and Nominal output (GDP)

Answer 36

• The total money value of national output is often called nominal national income.
• Changes in nominal or money (GDP) can be brought about by a change in either the physical quantities (amount) of goods and services produced or the prices on which the output is based.
• Real GDP refers to GDP valued at a common set of base - period prices. Thus when real income is measured over different periods using a common set of base – period prices, changes in real income only reflect changes in real output (amount of goods and services).
• When we add up money values of outputs, expenditure or incomes, we get nominal GDP.
• Nominal GDP measures GDP at the prices currently prevailing when those goods and services are produced (i.e. GDP at current year prices).
• Real GDP adjust for inflation by measuring GDP in different years at prices prevailing at some particular calendar date (year) known as the base year.

Question 37

The GNP Deflator

Answer 37

• To convert the nominal GDP to real GDP, we need to use an index that reflects what is happening to the price of all goods and services. This index is called the GDP deflator.
• The GDP deflator is the ratio of nominal GDP to real GDP expressed as an index.
• Expressing the deflator as an index means that the ratio of nominal to real GDP is multiplied by 100.

Question 38

Per Capita Real GNP

Answer 38

• Real GNP gives a simple measure of the physical output of an economy and the annual percentage increase gives us an idea of how fast the economy is growing.
• Per capita real GNP is real GNP divided by the total population. It is real GNP per head.
• It gives us an idea of quantities of goods and services available for an average citizen.
• For a given level of real GNP, the larger the population, the smaller will be the quantities of goods and services available to each individual.

Question 39

Problems encountered when measuring national income

Answer 39

1. Unreported activities: The transactions that occur in the underground economy/black economy are perfectly legal in themselves but are not reported for tax purposes hence are omitted in the GDP.
2. Non-marketed activities: These are activities which owners do themselves and hence do not pass through the markets. They include all forms of household chores that people do by themselves.
3. Economic ‘bads’/Harmful Side Effects : Economic ‘bads’ such as pollution, congestion and the destruction of the natural environment that accompany production are not included in the GDP but the values of the goods and services are.
4. Illegal activities such as illegal gambling, drug trade are not included in GDP even though many of them are business activities that produce goods and services sold on the market and that generate factor incomes. The fact that they are excluded means that GDP underestimates the value of a county’s output.
5. Depreciation: GNP does not take depreciation into account. To make this adjustment, depreciation must be deducted from GNP in order to obtain the NNP. However depreciation is not easy to measure and hence NNP estimates contain whatever errors made in estimating depreciation.
6. Lack of appropriate unit of measurement: The problem is partially overcome by using money as the unit of measurement. However, the value of money itself changes over time. To estimate real output, it is necessary to convert nominal output into real output by an appropriate price index. However there is the problem of deciding which price index to use – producer or retail price index which in themselves are difficult to compute.
7. Problem arising from Net factor income from abroad: To compute GNP from GDP, we have to make adjustment for net factor income from abroad. However, it is very difficult to estimate this figure with any level of accuracy.

Question 40

National income as measure economic welfare or standard of living.

Answer 40

To do this we have to convert national income to real national income per head.

i) First national income must be converted to real national income by deflating by an appropriate price index.
ii) the figure is then divided by the total population to convert it to per capita terms.

Question 41

Limitations of using per income to measure standards of living

Answer 41

1. Income Distribution: GNP per capita does not tell us how the output is distributed among the population.
2. Social Costs: GNP does not reflect the social costs arising from the production of goods and services. For example, environmental damage, pollution and congestion not reflected in the GNP estimates hence it overestimates the value of a country’s output.
3. Gainers and Losers: Increases in real output per capita occasioned by technological progress/ advancement often leave some people worse off and others better off.
4. Income in relation to effort: An increase in real output per capita may not even increase economic welfare if it is accompanied by increased number of hours of work and inferior working conditions.
5. Quality Changes: GNP does not take adequate account of changes in the quality of goods and services unless those changes are reflected in the prices of those goods.
6. Composition of goods: GNP does not show the composition of goods and services. For example, a rise in real income per capita may be caused by an expansion of capital goods and public sector expenditure on civil service and defense which do not increase current economic welfare.

Question 42

Limitations of using national income figures to compare standards of living in different countries

Answer 42

1) To use real per capita income to compare the standard of living of different countries, we have to convert them into a common currency using the exchange rate. However the market rate of exchange may not measure the relative amounts of the goods and services consumed in each countries – distortions due of exchange rates.
2) Different countries have got different tastes and needs which may not be taken into account in making comparisons. For example, the need for commuting or heating in extremely cold areas will differ between countries.
3) Real income per capita does not show the distribution of income. For example, a country with a lower income per capita but more evenly distributed income may have a higher standard of living than another with a higher income per capita but unevenly distributed income.
4) Government expenditure; government expenditure forms a major component of the GDP. Differences in expenditure by governments in different countries will make comparison different.
5) Variations in the length of the working week: between different countries. For example, per capita income may be higher in country A than country B but if the average working week is higher in country A than in B, then we can not say that the standard of living is higher in country A than in B.
6) Non Monetary transactions: National income accounts measure monetary transactions hence omits non monetary transactions which are however economically beneficial. Thus it is difficult to compare the standard of living between two countries if one has a substantial amount of subsistence production while the other an insignificant subsistence production.
7) Differing Composition of the final output; Composition of the final output may differ between countries. For example one country may have a higher per capita income but a large amount of capital goods or military goods than another country which may have a large amount of consumer goods and a small amount of capital goods and/or military goods.