Study Notes on National Income (With Diagram)

Study Notes on National Income: Definition, Measurement Problems and Estimate (With Diagram)!

Definition of National Income:

National income of a country means the sum total of incomes earned by the citizens of that country during a given period, say a year.

It should be noted that national income is not the sum of all incomes earned by all citizens, but only those incomes which accrue due to participation in the production process.

Individuals participate in the production process by supplying factors of production which they possess.

There are four factors of production: natural resources or land; human resources or labour; produced means of production or capital; and entrepreneurs or organisation.

The payment for the use of land is called rent. Payment for the use of labour is known as wages and payment for the use of capital is known as interest. The factors of production — land, labour and capital are primary factors of production and their contractual payments are called factor incomes. The surplus—what is left after the payment of these primary factors — is called the profit. This residual income is paid to the organiser of production as profit.

Thus, income for the participation in the production process may take four forms: rent, wages, interest and profit. By national income we mean the sum-total of all rent, wages, interest and profit earned in the production process during a given period by all the citizens, which is known as the factor payments total.

From this definition of national income, we exclude two types of personal income. The first is transfer payments and the second is capital gains. When a citizen receives a certain sum of money without participating in the production process it is called transfer payments. For example, the unemployment benefit, income of a beggar, etc. are personal incomes but not national income because they provide no services against their receipts.

Again, when we sell out assets which has appreciated in value, and realise a gain it is known as capital gain which is excluded from the calculation of national income because it renders no productive service for reaping this gain.

Measurement Problems of National Income:

Problems arise in aggregation largely because of the difficulty of finding an appropriate unit of measurement. In adding up the total output of a country, there is no single physical unit of measurement that can be used: the millions of different types of goods and services are all measured in different units, for example, steel is measured in tonnes and cloth is measured in metres and it is, of course, impossible to add tonnes to metres!

The problem is partially overcome by using money as the unit of measurement — this greatly simplifies the adding up, but it gives rise to the problem of distinguishing between real and nominal values.

In addition, there are many problems of measuring national income of an economy. These problems may be stated as follows: Firstly, there is the problem of which goods and services should be included. We know that gross domestic product (GDP) is the money value of all goods and services currently produced within an economy involving economic activity which means trans­forming scarce resources to satisfy human wants.

We normally include those activities which generate goods and services to be sold in the market for money. Thus, we exclude from national income accounting all personal and household services which do not pass through the market. This way of measuring is not correct because this excludes all goods that are not sold in the market. In a developing economy a substantial part of the national income (or output) is not marketed and, hence, these products are not included in the national income account.

The second problem is to exclude transfer payments and capital gains from national income accounts. Receipts from illegal activities should also be excluded from the national income calculation.

The third problem is associated with the valuation of inventories. The general rule is that when a firm increases its inventory of goods, this investment in inventory is counted both as past expenditure and as part of income. Thus, production of inventory increases GDP just as production for final sale does.

There are mainly two methods of valuation of inventories: the market price method and the cost price method. In the market price method imputed profits are included which are unlikely to be realised in the same year. However, the cost price method does not include imputed profit. Another problem of inventory valuation is that the total quantity may remain the same, but this may not mean that each individual item remains unchanged during the year.

Now, if prices are rising, the value of the new items are likely to rise faster than the value of the old items. Similarly, if prices are falling, the value of the new items are likely to fall less than that of the old items. Moreover, even if the size of the inventories remains unchanged its value is likely to change, an adjustment may be necessary to take account of the effect of price change. The adjustment is called the inventory valuation adjustment.

The fourth problem is imputed values of the non-market goods, and services. Although most goods and services are valued at their market prices when computing GDP, some are not sold in the marketplace and, therefore, do not have market prices. If GDP is to include the value of these goods and services, we must use an estimate of their value. Such an estimate is called an imputed value. One in which imputations are important is housing.

A person who rents a house is buying housing services and is providing income for the landlord; the rent is part of GDP, both as expenditure by the renter and as income of the landlord. However, many people live in their own homes. Although they do not pay rent to a landlord, they are enjoying housing services similar to those of renters.

To take account of the housing services enjoyed by homeowners, GDP includes (he rent that these homeowners pay to them­selves. Of course, homeowners do not in fact pay themselves this rent but the market rent for a house could be imputed to be included in GDP. This imputed rent is included both in the house-owner’s expenditure and in the homeowner’s income.

Another area in which imputations arise is in valuing the services provided by the government. For example, law and order, fire fighters, defence, etc. provide services to the public. Measuring the value of these services is difficult because they are not sold in the marketplace and, therefore, do not have a market price. GDP includes these services by valuing them at their cost. Thus, the wages of these public servants are used as a measure of the value of their output.

In many circumstances, an imputation is called for in principle but is not made in practice. Since GDP includes the imputed rent on owner-occupied houses, one might expect it also to include the imputed rent on car, jewellery, and other durable goods owned by households. Yet the value of these services is left out of GDP.

In addition, some of the output of the economy is produced and consumed at home and never enters the marketplace. For example, meals cooked at home arc similar to meals cooked at a restaurant, yet the value- added in meals at home is left out of GDP.

Finally, no imputation is made for the value of goods and services sold in the underground economy. The underground economy is that part of the economy that people hide from the government either because they wish to evade taxation or because the activity is illegal. Since the imputations necessary for computing GDP are only approximations, and since the value of many goods and services is left out altogether, GDP is an imperfect measure of economic activity.

These imperfections arc most problematic when comparing standards of living across countries. The size of underground or black economy varies from country to country. So long as the magnitude of these imperfections remains fairly constant overtime, GDP is useful for comparing economic activity from year to year.

Total Output, National Product, National Income and National Expenditure:

The value of the economy’s total output can be measured in three ways which can be seen by examining Fig. 3.1. The figure shows the flows of income and expenditure in this simple model. The two main economic agents are households and firms.

The households are the owners of factors of production, the services of which they sell to firms in exchange for income (such as rent + wages + interest + profit). We assume for simplicity that all profits to be distributed to households and not retained by the firms.

The firms use the factors of production to produce many different goods and services which they sell to households, foreigners, the government and other firms and receive in return the values of goods and services they produced. The figure also shows that the part of household income which is not spent on consumption is either saved, spent on imports or is taken in taxes by the government.

The government itself uses its tax revenue (as well as money from other sources) to finance government spending, including transfer payments (such as pension, unemployment benefit and student grants and loans). Before pro­ceeding further we want to define the terms consumption (C), investment (I) and savings (S).

Definition:

Consumption (C):

It is regarded as total expenditure by households on goods and services which yield utility in the current period.

Savings (S) are that part of the disposable income which is not spent in the current period. It follows that disposable income (Y -T) minus saving equals consumption.

Investment (I) is the production of or expenditure by firms on goods and services which arc not for current consumption: that is, real capital goods, like factors-machines, bridges and motorways, all goods which yield a flow of consumer goods and services in future period.

There are three ways of measuring the annual value of total output in an economy — are by calculating its national product, national expenditure and national income.

National Product:

This is found by adding up the value of all final goods and services produced by firms during the year. It is to be noted that all final goods and services produced must be included, whether they are to be sold to consumers or to the government, whether they are to be sold to foreigners as exports, or whether they are capital goods to be sold to other firms.

It is important to include only final goods and services: all intermediate goods must be excluded so that double-counting is avoided. For example; in production of a woollen coat, only the value of the final cost should be counted. The value of the raw wool and woollen cloth are included in the value of the coat.

If we were to count them as well we should be guilty of double-counting. If all intermediate goods were included in the calculation of the national product, we would seriously overestimate the value of the country’s total output.

National Expenditure:

This is found by adding up all the spending on the final goods and services produced by firms. Such an aggregate will only equal the value of total output if those goods which are produced but not sold are also included—this item, which is called ‘net changes in stocks and work in progress’, is normally counted as part of firms’ investment spending.

National expenditure is the sum of consumption of domestically produced goods, investment, government expenditure and exports (C + I + G + X). It must be noted that, in order to avoid double-counting, only spending on final goods and services is included.

National Income:

It is because goods and services are produced by factors of production that income is created in the economy, so another way of calculating the value of total output is to add up all the incomes paid out to the owners of the factors of production. Moreover, it comes to the same thing to add the values- added by all firms at the different stages of production.

This may be illustrated by a simple example in which production of woollen coat involves the following three stages of production:

(a) A sheep farmer produces raw wool and sells it to a mill for £100. This represents an income of £100.00 for the farmer. Value-added = £100.00.

(b) The mill uses the raw wool to produce cloth which it sells to a coat factory for £210. This represents income of £110 for the mill — remember that £100.00 has had to be paid for the raw wool. Value-added = £110.00.

(c) The coat factory produces the coat and sells it for £400. This includes £210 to cover the cost of cloth and £190 to pay incomes including profits. Value-added = £190.

The total value-added in this example (£400.00) is just equal to the value of the final coat; it is also equal to the sum of all incomes paid at each stage of production. The value of a country’s total output can be found either by adding the values-added by all firms or by adding up the incomes (that is, wages + rents + interest + profits) of all factors of production, those producing intermediate goods as well as those producing final goods.

In either case, double- counting will be avoided. It is important to exclude all transfer payments as these represent nothing more than a redistribution of income from taxpayers to the transfer recipients, including them would involve double counting.

Assuming:

(a) that all measures are calculated accurately; (b) that only final goods and services are counted in the national expenditure and national product figures; (c) that any change in unsold stocks are included in the national income figures; (d) that all incomes (including profits but excluding transfer payments) are counted in the national income figures, then it must follow that all three measures will provide an identical figure for the value of national income and output. That is

National Income = National Expenditure = National Product In principle, these three aggregates simply represent different ways of measuring the flow of output or income being created in an economy over a period of time.

Components of Expenditure:

Economists and policymakers care not only about the economy’s total output of goods and services but also about the allocation of this output among alternative uses. National income accounts allocate GDP among four broad categories: Consumption (C). Investment (I), Government expenditure (G), and Net exports (X – M) or (NX).

Thus, let Y stand for GDP. Y=C + I + G + X- M or Y = C+ I + G + NX. Each pound of GDP is placed in one of these categories. This equation is an identity. It is called the national income accounts identity.

We have already defined almost all of the components of GDP except NX, net exports, that is, trade with other countries in an open economy. Here we will give the definition of NX and explain in detail about open economy later on. Net exports are the value of goods and services exported to other countries minus the value of goods and services imported from other countries. It represents the net expenditure from abroad for our goods and services, which provides income for domestic producers.

Other Measures of Income:

The national income accounts include other measures of income that differ slightly from GDP and GNP. It is important to be aware of various measures because economists and the press often refer to them.

We like to see how the alternative measures of income relate to one another by starting with GNP and subtracting various quantities. To get net national product (NNP), we subtract the depreciation of capital — the amount of capital depreciates during the year: NNP = GNP – Depreciation.

Depreciation is called the consumption of fixed capital. It is about 10 per cent of GNP in many economies. Since the depreciation of capital is a cost of producing the output of the economy, subtracting depreciation shows the net result of economic activity. For this reason, some economists believe that NNP is a better measure of economic well-being.

Market Price and Factor Cost:

The next adjustment in the national income accounts is for indirect taxes. Market prices are very often distorted by indirect taxes and subsidies: indirect taxes have the effect of raising the prices of goods above its costs, while subsidies lower such prices. National income and national product are both measured at ‘factor costs’.

To ensure that national expenditure is also the same as the national income and national product, it is necessary to convert market prices to factor cost by adding subsidies and subtracting indirect taxes. Thus, we get national expenditure at market price, minus indirect taxes plus subsidies = Net National Expenditure at factor cost.

It is preferable to measure the value of total output at factor cost rather than in Market prices so as to remove the influence of indirect taxes and subsidies

Stock Appreciation:

We know that all three measures of total output include the value of the net change in stocks of unsold goods. If prices are rising, the value of firms’ stocks well rise too. To take account of this so-called “stock appreciation’. It is necessary to subtract that amount in computing the national income.

The national income accounts further divide national income into five components, depending on the way income is earned. The five categories of national income are: Compensation of employees — the wages and fringe benefits earned by workers. Proprietors’ income — the income of non-corporate business, such as small firms. Rental income — the income that landlords receive, including the imputed rent that homeowners ‘pay’ to themselves, less expenses, such as depreciation. Corporate profits—the income of corporations after payments to their workers and creditors. Net interest — the interest domestic business pay minus the interest they receive, plus interest earned from foreigners.

A series of adjustments takes us from national income to personal income, the amount that households and non-corporate business receive. Three of these adjustments are important. First, we reduce national income by the amount corporations earn but do not pay out, either because corporations are retaining earnings or because they are paying taxes to the government. This adjustment is made by subtracting corporate profits and adding back dividends.

Second, we increase the national income by the net amount the government pays out in transfer payments. This adjustment equals government transfers to individuals minus social insurance contributions paid to the government.

Third, we adjust national income to include the interest that households earn rather than the interest the businesses pay. This adjustment is made by adding personal interest income and subtracting net interest. Thus, personal income is: Personal Income = National Income – Corporate Profits – Net Interest + Dividends + Government transfers to Individuals + Personal Interest Income – Social Insurance contributions.

If we subtract personal tax payments and certain non-tax payments to the government (such as parking tickets), we obtain disposable personal income.

Personal Disposable Income = Personal Income – Personal Tax and Non-tax payments. Personal disposable income is the amount households and non-corporate business have available to spend after satisfying their tax ob­ligations to the government.

GDP Deflator:

From nominal GDP and real GDP we can compute the GDP deflector. The GDP deflator is defined as: GDP deflator = Nominal GDP/Real GDP. The GDP deflator is the ratio of nominal GDP to real GDP.

To understand better nominal GDP, real GDP, and the GDP deflator, consider an economy with only one good, bread. In any year, nominal GDP is the amount of sterling spent on bread in that year. Real GDP is the number of loaves of bread produced in that year times the price of bread in some base year. The GDP deflator is the price of bread in that year relative to the price of bread in the base year.

Actual economies produce many goods. Nominal GDP, Real GDP, and the GDP deflator aggregate the many different prices and quantities. For simplicity, consider an economy with two goods — apples and oranges. Let P denote the price of a good.

Q the quantity, and a superscript “92” the base year 1992; then the GDP deflator would be:

The numerator is nominal GDP, and the denominator is real GDP. Both nominal GDP and real GDP can be viewed as the price of a basket of goods; in this case, the basket consists of the quantities of apples and oranges. The GDP deflator compares the current price of this basket to the price of the same basket in the base year.

The definition of the GDP deflator allows us to separate nominal GDP in two parts: one part measures quantities and the other measures prices. That is, Nominal GDP – Real GDP x GDP Deflator.

Nominal GDP measures the pound value of the output of the economy. Real GDP measures the amount of output — that is output valued at constant (base-year) prices. The GDP deflator measures the price of the typical unit of output relative to its price in the base year.

Measuring the Cost of Living: Consumer Price Index:

A pound today does not buy as much as it did 20 years ago. The cost of almost everything has gone up. This increase in the overall level of prices is called inflation.

Consumer Price Index (C.P.I.):

The most commonly used measure of the level of prices is the consumer price index (CPI). The Department of Employment has the job of computing the CPI or Retail Price index (RPI). It begins lay collecting the prices of thousands of goods and services. Just as GDP turns the quantities of many goods and services into a single number measuring the value of production, the CPI or RPI turns the prices of many goods and services into a single index measuring the overall level of prices.

How should we aggregate the many prices in the economy into a single index that reliably measures the price level? We could compute an average of all prices. Yet this approach would treat all goods and services equally. Since people consume more bread then chicken, the price of bread should have a greater weight in the CPI or RPI than the price of chicken.

The Department of Employment Statistics weighs different items by computing the price of a basket of goods and services purchased by a typical consumer. The CPI or RPI is the price of this basket of goods and services relative to the price of the same basket in some base year.

For example, suppose that the typical consumer buys 5 apples and 2 oranges every month. That is, the basket of goods consists of 5 apples and 2 oranges.

The CPI or RPI is:

In this CPI or RPI, 1992 is the base year. The index tells us how much it costs now to buy 5 apples and 2 oranges relative to how much it cost to buy the same basket in 1992.

The CPI or RPI is the most closely watched index of prices, but it is not the only index. Another is the producer price index, which measures the price of a typical basket of goods bought by firms rather than consumers. In addition to these overall price indexes, the Department of Employment computes price indexes for specific types of goods, such as food, housing and energy.

Estimation of National Income in the Presence of Government Activities:

The government is undertakes several economics activities in a mixed economy. The government is engaged in mainly four types of economic activities which should be constituted while calculating the national income of a country. Firstly, the government may be engaged in the production of goods and services which are sold in a market like private firms. For example, transport, utility services, etc.

Secondly, the government provides certain services free of charge to the public which are not sold in the market. For example, law and order, defence, education, etc.

Thirdly, the government imposes taxes and grants subsidies. The taxes may be direct tuxes and indirect taxes. Direct taxes are those taxes which are imposed on personal and corporate incomes. On the other hand, indirect taxes are taxes imposed on commodities.

Fourthly, the government also makes transfer payments to the public and grants subsidies to firms. Transfer payments are those payments against which no services are rendered. For example, pensions, unemployment benefit, child benefit, etc.

Let us now examine how these activities can be incorporated in the national income account. The first type of activity poses no problem because the public sector firms can be treated as a private firm. The ownership of an enterprise is irrelevant when considering its contribution to the national product.

Thus, a public enterprise could be treated in the same way as a private enterprise. Therefore, the final product produced by public enterprises or the values-added by them should be included in the national product. Or, factor incomes generated in public sector undertakings should be included in the national income total.

The second type of activity by the government creates two problems when calculating national income accounting. One problem is the conceptual problem regarding whether or not these services should be treated as final products or as intermediate products. The other problem is the problem of valuation — since these services are not sold ‘in the market, they have no market price.

The conceptual problem can be dealt with as follows:

Now the question is whether these services — the maintenance of law and order and defence — are to be regarded as services which satisfy the wants of the consumers directly, or are they to be regarded as facilitating the production of other goods and services? If we accept the first proposition then it becomes a final product and should be included in the national production.

On the other hand, if we accept the second proposition then it becomes an intermediate goods and should not be included in the national product to avoid double counting. Now there are reasons to believe that such services are to be regarded as partly satisfying one and partly the other. It is true that part of the services provided by the government are directed to protect the life and liberty of individuals while part of them are directed towards the protection of the productive process.

However, it is impossible to make a dividing line between these two and, hence, the entire common services are to be treated as final products. Thus, the value of these services should be included in the national product. How can the value of such services be determined? This brings us to the valuation problem. These services are not offered for sale in the market.

Therefore, there is no market price for such services. Hence, such services cannot be valued on the basis of market prices. To solve the valuation problem of such services, we must take into account the cost of providing these services and include items in the national product.

Alternatively, the factor incomes paid to the persons who provide these services should be included in the national income total. The value of the government services can be obtained by subtracting transfer payments from the total government expenditure.

Thus taking into consideration the government activity we get the following identities:

GDP ≡ Gross value of output of the private sector + Gross value added by private enterprises + value of public sector’s common services.

GDE ≡ Consumption expenditure on domestically produced good + investment expenditure + public sector expenditure on common services.

GDI ≡ (wage bill of public and private sectors) + (rents paid by public sector and private sector) + (gross profit of private enterprises and gross profit of public sector enterprises) + (interest received by both sectors).

Let us examine other two items and the problems arise as a result of transfer payments and imposition of taxes. Taxes are of two types: direct taxes and indirect taxes. Direct taxes are imposed on personal and corporate incomes while indirect taxes are imposed on commodities. In the case of transfer payments people receive income from the government without rendering any service.

Again, direct taxes are paid by people to the government without receiving any service in return. Thus, direct taxes and transfer payments are similar in nature and transfer payments can be regarded as negative direct taxes. Both these items do not affect the computation of national income.

However, transfer payments and direct taxes cause personal incomes and personal disposable incomes to differ from national income: Personal income ≡ national income + transfer receipts while personal disposable income ≡ personal income – direct taxes ≡ national income + transfer receipts – direct taxes.

However, indirect taxes and subsidies do pose some problems. Indirect taxes and subsidies given on commodities create distortion on market price and cost price. Thus, we get the following relations: Market price ≡ factor cost + (indirect taxes – subsidies) ≡ factor cost + net indirect taxes.

The government also borrows money from the public by issuing bonds and the government makes interest payments to the bond-holders. Interest on public debt is considered as a transfer payment and, hence, is not included in national income total.

National Income Estimate in an Open Economy:

As in a closed economy, in an open economy also we can look at the national income from three sides — the production side, the income side and the expenditure side. Let us first consider the expenditure side of the national income account. Gross National Expenditure (GNE) at market prices ≡ Consumption (C) + Gross Investment + government expenditure on goods and services ≡ C + I + G.

Now expenditure on home produced goods and services by foreigners must also be included in gross national expenditure. If X stands for exports, then the value of X must be added to C + I + G. Again, some part of C + I + G is not spent on domestically produced goods and services but on goods and services produced by foreigners. Such expenditure is equal to the value of imports (M).

Hence the value of imports must be deducted from C + I + G. If M stands for the value of imports then we have GNE ≡ C + I + G + X- M or C + I + G + NX where NX means net exports. Now let us consider the output side of the national income. On the output side the value of the national product is equal to the sum total of values added by all the productive units of the economy.

We know that production takes place only in firms. For a single firm, value added = total sales (including exports) minus purchases from other firms (including imports). If we take the sum of the value added by all firms we get total value added by all firms ≡ sales to households + sales to enterprises + sales to government + sales to foreigners – purchase from foreigners. Thus we get GNP ≡ C + I + G + X-M.

Let us now consider the income side. By income we mean income originated as a result of participation in the production process. Now in an open economy foreigners participate in the domestic production process. Foreign capital is also employed in the domestic production process. Similarly, domestic residents may participate in the production .process outside the country and domestic capital may be employed in the foreign production process.

In this way a part of the income produced within the economy is earned by foreigners and a part of the income produced outside the country is earned by domestic residents. Taking these two items we get net income from abroad. Thus, net income from abroad ≡ income receipts from abroad ≡ income paid to foreigners. This is a part of the national income, though this part does not arise out of production within the domestic economy.

In an open economy a distinction is made between gross domestic product and gross national product. In a close economy, gross domestic product (GDP) is equal to gross national product (GNP). But in an open economy some adjustments are necessary for conversion of the gross domestic product into gross national product.

In an open economy, gross national product (GNP) is equal to gross domestic product (GDP) plus net income from abroad. Moreover, in an open economy net domestic product is equal to gross domestic product minus depreciation. Net national income in an open economy is equal to net domestic produces plus net income from abroad.

GNP ≡ GNI ≡ GNE. These identity between them is preserved even in an open economy.

National Income Identities:

It can be seen from national income accounting that actual saving (S) of an economy is equal to actual investment (I) during a given period of time. This is called the accounting identity between saving (S) and investment (I).

We denote the value of output (GDP) in a simple economy, without a government and foreign trade, by Y. Consumption expenditure is denoted by C and investment spending as I. The first key identity is that output produced and output sold. Output sold can be written as the sum of consumption and investment spending. Thus, we can write the identity of output produced and output sold: Y ≡ C + I………… (1)

It is an identity because all output produced is either consumed or invested including the accumulation of inventories as part of investment.

The next step is to find a relation among saving, consumption and output. All output produced in the economy will go to private individuals as income, Y. This income will either be spent on consumption or saved. Thus we can write: Y ≡ C + S…………… (2) when S is private saving. Identity (2) tells us that the whole income is allocated to read: C + I ≡ Y ≡ C + S……….. (3) where the left hand side shows the components of demand, and the right-hand side shows the allocation of income. This identity shows that output produced is equal to output sold. The value of output produced is equal to income received which is spent on goods or saved. Identity (3) can be slightly reformulated to let it look like saving and investment relation. I ≡ Y – C =S……….. (4). This gives the simple economy identity between saving and investment and that some of the investment might well be inventory investment. We now complicate the economy by introducing government and foreign trade. In such an economy, the GNP ≡ Y ≡ C + I + G + X – M……… (5).

Again, from the GNI ≡ C + S + T + T_R…………………… , (6), where T_R is transfer payments and T is tax payment. Since GNP ≡ GNI…………… (7). From identity (7) we get C + I + G + NX ≡ C + S +T + T_R …….. (8)

or, I + G + NX ≡ S + T + T_R

The left-hand side of the identity (8) represents total output not going to consumption expenditure while the right-hand side gives the total income that is not spent. If we identify non-consumed output as investment and income not going to consumption as saving, then the above identity can be regarded- as a saving-investment identity.

If we assume that it is a closed economy, then (X-M) or NX is dropped and the above identity can then be written as: I + G ≡ S + T + T_R……………………….. (9)

or, I ≡ S + ( T – G + T_R) …………………. (10)

This represents another version of saving-investment identity. The left-hand side of identity (10) represents private investment. The first term on the right hand side of the identity (10) represents private saving and the second term, (T – G + T_R) is government saving.

Finally, if there is no government activity then the term (T – G + T_R) will disappear and the above identity becomes I ≡ S. This represents saving- investment identity of the simple one sector model of the economy.

It would be noted that saving-investment identity is a definitional identity which follows from the definition of saving and investment. This identity has nothing to do with the equilibrium in the economy. Whether the level of income is in equilibrium or not, aggregate actual investment is always identically equal to aggregate actual saving.

National Income and Economic Welfare:

The GNP are generally used for two purposes: one is to indicate the level of economic well-being of the people and the other is to measure the level of economic activities of the nation. When GNP (or the output of final goods and services by the country in a year) of a country is taken as an index of economic well-being of the people, it is suggested that the market price of the product should be used as a measure of the benefit derived by the people from the consumption of the product.

If GNP is supposed to indicate the level of utilisation of scarce resources, the cost price should be the basis of evaluation. In a competitive equilibrium, the two evaluations are identical, since the market price happens to be equal to the cost price. In the presence of a monopolistic control over the market, the market price is higher than the cost price.

The GNP measurement for the purpose of evaluating the welfare level should be done at the market price, while an evaluation of the level of economic activity should be done at the cost price. However, there are several reasons for which the GNP cannot be considered as good index of economic welfare.

Firstly, the GNP considers only market transactions, whereas welfare depends on both market and non-market transactions. In less-developed economies, non-market transactions occupy a substantial part, thus, the GNP fails to give a true indicator of the welfare of the people in these countries.

Secondly, the GNP does not consider the social cost associated with production. Some negative externalities are likely to arise as output expands and these factors will tend to offset the effects of any increase in average income. So, although consumers may on average be better-off so far as their spending power is concerned, they may be worse-off overall when environ­mental factors are taken into consideration.

For example, consider the building of a large chemical factory in the heart of the countryside, the extra production may increase real output per capita, but the factory will pollute the air and water and cause severe visual pollution in an area of natural beauty. If these external costs offset the increase in real output per capita, then any overall improvement in economic welfare would only be apparent and not real.

The some argument applies if output has been increased only through the work-force taking fewer hours of leisure and putting more hours of work. Again, the improvement in welfare resulting from increased spending power may be offset by a reduction in welfare resulting from loss of leisure. Overall, there may be no real improvement in welfare.

Thirdly, if the rise in real output per capita is caused by an expansion of investment goods industries and public sector expenditure on civil servants, while at the same time there is a decline in consumer goods industries, the current economic welfare may fall rather than rise. The simple reason for this is that economic welfare stems from the consumption activity.

Fourthly, the GNP does not include unpaid services rendered by the members of the household but such unpaid services also increase the level of welfare.

Fifthly, welfare also depends on the distribution of income. The Pareto condition of welfare states that economic welfares will increase if at least one consumer is made better-off without at the same time any other being made worse-off. Adopting this condition, we can interpret an increase in real output per capita as an actual improvement in economic welfare if no distributional changes occur which may make any individuals or groups worse-off.

Unfortunately, increases in real output per capita often do leave some people or groups of individuals in society worse off. For example, suppose that there were a big new discovery of a fuel, like oil, whose production will increase a country’s real national income. An unfavourable side-effect of this may be a reduction in demand for some other fuel, like coal. Some coal- workers may lose their jobs or be put on short-time.

These people will have been made worse-off by the oil discovery which, on average, increased real output per capita, making many other people better-off. By applying the Pareto condition, we cannot say that the oil discovery improves actual economic welfare. In cases like this we can apply Hicks-Kaldor condition for a potential improvement.

According to the Hicks-Kaldor criterion, if any change occurs which redistributes income in such a way that the gainers can potentially compensate the losers and still be better-off than they were before, then we can say that potential economic welfare has increased. However, we can interpret the situation as actual improvement if full compensation were actually paid.

From the above analysis it is clear that the GNP cannot be used as an index of actual economic welfare. The GNP should, however, be used to measure changes in the level of economic activity. It should not be used to judge the quality of life or the level of welfare.

Other Uses of National Income Account:

We can conclude from the analysis of the previous section that a change in national income can only be used as an indicator, and not as an accurate measure, of a change in economic welfare. There are other uses of the national income statistics that we wish to mention.

Making International Comparisons:

Care must be taken in using real output per capita figures to compare different countries standard of living. First, a further adjustment is necessary to convert the figures to the same currency using the rate of exchange. This poses problems because the market rate of exchange is not necessarily the ideal measure of the relative values of the goods and services consumed in each country. Secondly, different countries have different needs and tastes which cannot be easily taken into account in making comparisons.

Government Planning:

There is a close connection, at least in the short-run, between real national income and the level of employment in the economy. A rise in the national income with a fairly constant Capital Stock will generally be associated with a fall in unemployment. Since governments have “full employment” as one of their major policy objectives, it is important for them to have an accurate national income statistics.

A rising national income in the long-run is called economic growth and this is another important policy objective of governments. We can, therefore, conclude that the national income figures play an important role in the planning of both short run and long run government policies.

The Equilibrium Level of National Income:

In the microeconomics market for a single good, an equilibrium is said to exist when the demand for the goods is equal to the supply of it. Similarly, in macroeconomics, the equilibrium level of national income has been reached when there are no economic forces operating to change the level of national income. This occurs when the total demand (aggregate demand) is equal to total supply (aggregate supply).

That is, for equilibrium level of income to be achieved, we require that:

(AD) Aggregate Demand = Aggregate Supply (AS)

Only when this condition is satisfied we can say that the total value of goods and services that households and the other economic agents want to buy is equal to the total value that firms want to produce. It may, however, be noted that AS cannot strictly be regarded as being the same as national income. National income is the value of the actual amount produced and is equal to the national product and expenditure.

AS is the amount that firms want to produce given the general level of wages and prices. The two will only be equal: (a) if wages and prices are such that firms plan to product what is currently being produced; and (b) if firms are able to implement their production plans successfully.

Conclusion:

Here we introduce the notion of national income accounting and the equivalent of national product, expenditure and product demonstrated. We highlighted the problems of using national income as an indicator of economic welfare. Finally, we considered the meaning of an equilibrium in macroeconomics.

The determination of the equilibrium level of national income is of crucial importance in macroeconomic analysis because it is this which determines to a large extent the level of employment in the economy. It is the debate about the forces which determine this equilibrium which fundamentally sepa­rates the various schools of thought in macroeconomics.