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Macro 1: National Income and Accounting

Macro 1: National Income and Accounting

At the end of this set of notes, you should be able to explain:


1. The circular flow of income ............................................................................. 2
2. National income statistics ............................................................................... 4
3. Uses of national income statistics ................................................................. 6
4. Concept of Standard of Living ........................................................................ 7
5. Problems of using national income to measure standard of living ............. 7
6. Problems of using national income to measure standard of living between
countries ..................................................................................................................... 9

Note: This set of notes is meant to concise with just enough information for “A” level
students. It is best used as a cheat sheet, complementary with official school notes.

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Macro 1: National Income and Accounting

1. The circular flow of income

1.1 The circular flow of income shows the flow of goods, services, and their
payments around the economy.

1.2 The following illustrates a 2-sector economy where there are only producers and
consumers:

1. Factor Services >> Households supply the factors of production (land, labour,
capital and entrepreneurship) which they own.
2. Factor Income >> Households receive payment (rent, wages, interest and
profits) from firms for their services.
3. Goods and Services >> Households purchase goods and services in the
product market, supplied by firms.
4. Consumption Expenditure >> Households pay for these goods and services
with the income they have earned.

1.3 The 2-sector economy is often referred to as a “simple economy”.

1.4 In the absence of “leakages”, based on the circular flow of income for a simple
economy (refer to the flow in red), we can may assume that:

National Expenditure = National Income = National Output

1.5 Key definitions:


1. National Expenditure >> Total value of spending by households on goods
and services produced by firms.
2. National Income >> Total value of income paid by firms to households in
return for services of land, labour and capital.

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Macro 1: National Income and Accounting

3. National Output >> Total value of the flow of goods and services from firms
to households.

1.6 In reality, consumers save (withdraws money from the circular flow of income),
and firms receive investments (injects money into the circular flow of income).

1.7 Key definitions:


1. Injection >> An addition to the circular flow which does not come from
the expenditure of domestic households.
2. Withdrawal >> Any part of income that is not passed on within the circular
flow of income.

1.8 Therefore a more complete 2-sector economy model would look like this:

1.9 A 3-sector economy adds an additional agent to the model: Government

1.10 The key differences to the circular flow of income due to the addition of the
Government are:
1. Additional injection: Government Expenditure
2. Additional withdrawal: Tax

1.11 A 3-sector economy model would look like this:

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Macro 1: National Income and Accounting

1.12 Finally, a 4-sector economy adds yet another component to the model: Foreign
Sector

1.13 The key differences to the circular flow of income due to the addition of the Foreign
Sector are:
1. Additional injection: Exports
2. Additional withdrawal: Imports

1.14 Even in the presence of injections and withdrawals, we may still assume the
identity:

National Expenditure = National Income = National Output

1.15 This is because at equilibrium, injections will equal withdrawals.

1.16 The economy tends to equilibrium because:


1. When injections > withdrawals: Income generally increases, usually resulting
in increase in S, T and M (withdrawals).
2. When withdrawals > injections: Income generally decreases, usually resulting
in decrease in S, T and M (withdrawals).

2. National income statistics

2.1 Measuring national income allows us to determine the material well-being of a


country’s citizens.

2.2 The Gross Domestic Product (GDP) is the total money value of all final goods
and services produced within the geographical boundary of a country, regardless
of whether the resources are owned by its residents or foreigners, before deduction
for depreciation, in a year.

2.3 GDP does not make allowances for income received from abroad as well as
income paid abroad. (e.g. foreign companies may produce and earn profits that
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Macro 1: National Income and Accounting

ultimately leaves the country, or domestic producers may produce overseas and
bring profit to the home country).

2.4 Therefore it is not an accurate measure of the true value of the output produced
by the resources owned by the residents of the country.

2.5 A more accurate measurement of national income earned by citizens would be the
Gross National Product (GNP).

2.6 GNP measures the total money value of all final goods and services produced by
resources owned by residents of a country, irrespective of whether these
resources are located within the country or abroad, before deduction for
depreciation, in a year.

GNP = GDP - net property income from abroad

2.7 GNP however does not represent the net flow of goods and services in a country
in a given year. This is because it does not make allowance for depreciation.

2.8 Every year, capital goods are produced. The total production of capital goods is
known as gross investment.

2.9 Part of the gross investment is used to replace depreciated capital (i.e. capital that
has been worn out or become obsolete – a process known as depreciation).

2.10 Depreciation needs to be excluded from national income statistics as capital


renewal does not directly add to the national income and over-states the true
material well-being of citizens.

2.11 Removing depreciation from GNP will yield us Net National Product (NNP).

NNP = GNP - depreciation

2.12 NNP measures the total money value of all final goods and services produced by
resources owned by residents of the country, irrespective of whether these
resources are located within the country or abroad, after deduction for depreciation,
in a year.

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Macro 1: National Income and Accounting

3. Uses of national income statistics

3.1 Indicate material welfare

3.1.1 Material welfare refers to the quantity of goods and services that are available to
an individual in a particular year.

3.1.2 Therefore higher national income statistic => higher material welfare => higher
availability of goods and services for the individual.

3.1.3 NNP > GNP > GDP when it comes to measuring material welfare usually.

3.1.4 To better utilize NNP as a measure of material welfare over time, we should take
into consideration the following:

1. Inflation rate: The increase in NNP might be due to prices rather than actual
increase in output.
Real NNP = Nominal NNP X ( CPI base year / CPI current year )
2. Population growth: Overall NNP may have grown, but population growth
can mean less to go around for the individual.
Real NNP per capita = Real NNP / Population

3.2 Measure relative contribution of each sector to the economy

3.2.1 Breaking down the NNP statistic into output from each sector will indicate the
relative sector size in the economy.

3.2.2 Such information is useful for planning economic policies (e.g. identification of
which sectors to grow).

3.3 Calculate labour productivity

3.3.1 Labour productivity can indicate the country’s labour force competitiveness:
Average labour productivity = NNP/ Total labour force
3.3.2 A low labour productivity will result in higher labour cost per unit output, and reduce
the export competitiveness of the country.

3.3.3 Restructuring of the economy may then be required (e.g. retraining workers) to
rectify the issue.

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Macro 1: National Income and Accounting

3.4 Determine subscription rate to international organisations, trade


agreements or aid amount.

3.4.1 The NNP can be used to measure the relative affluence of a country, and is often
used as a basis for determining the subscription amount to international
organisations (e.g. UN).

3.4.2 NNP can be also be used as a basis for determining the appropriate trade
agreements (e.g. less-developed countries can argue for preferential tariffs or
quotas for sectors specific to their economy).

3.4.3 Less developed countries (as measured by NNP) are also more likely to receive
larger aid or grant amounts, by virtue of need.

4. Concept of Standard of Living

4.1 Material well-being

4.1.1 The higher the quantity of goods and services available for consumption by the
individual, the higher his material well-being will be.

4.2 Non-material well-being

4.2.1 Refers to the quality of life in general, such as life expectancy, healthcare
availability, crime rates and leisure time.

5. Problems of using national income to measure standard of living

5.1 In general, any statistical metric suffers from the following class of problems:
1. Conceptual
2. Measurement
3. Usage

5.2 Conceptual

5.2.1 Conceptual problems arise from fundamental problems in the concept behind the
derivation of the statistic.

5.2.2 In this case, the nominal NNP ignores price and population changes. It needs
to be adjusted by calculating its real value (refer to point 3.1.4 for further
elaboration).

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Macro 1: National Income and Accounting

5.2.3 NNP, as a measure of material standard of living, does not measure non-
material well-being (e.g. social stability, environment, leisure time). For example,
a blind pursuit for high NNP growth may result in environmental degradation that
negatively impacts the standard of living as a whole.

5.2.4 Using composite welfare indices (e.g. NEW1 and HDI2) gives a better picture as
they include both national income and non-material welfare measurements.
5.3 Measurement

5.3.1 NNP does not include non-market goods and services 3 (e.g. housework,
voluntary work, gardening).

5.3.2 NNP does not include undeclared economic activities (e.g. illegal activities, odd
jobs not reported to tax authorities).

5.3.3 Both above often understate the true NNP.

5.3.4 In addition, the data gathered may not be accurate (e.g. survey sampling issues,
inaccurate filling out of tax filings).

5.4 Usage

5.4.1 A growth in NNP may overstate the increase in material well-being at the national
level due to income inequality. In the worst case, the growth in NNP is enjoyed
only by the wealthy, and not felt by the rest.

5.4.2 We need to know also the composition of the NNP growth. For example, if the
growth in output is attributable to the production of capital goods only (e.g.
machinery, factories), the material well-being of the citizens will not increase
directly as these goods are not directly consumable.

5.4.3 The NNP growth rate says nothing about changes to the quality of output. It is
possible for welfare to increase even if NNP remains the same, if the quality of
output improves over time.

1
Net Economic Welfare – positive factors that improve standard of living are added to NNP and vice vera for
negative factors.
2
Human Development Index – A composite index that considers GDP per head (PPP adjusted), life expectancy,
literacy and education. Ranges between 0 to 1 (best score).
3
Goods and services that do not have a price attached.
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Macro 1: National Income and Accounting

6. Problems of using national income to measure standard of living between


countries

6.1 In general, any statistical metric suffers from the following class of problems:
4. Conceptual
5. Measurement
6. Usage

6.2 When comparing between countries, it is often necessary to convert the NNP
figures to a common currency (most commonly USD), to allow consistent
comparisons.

6.3 Conceptual

6.3.1 Differences in cost of living may mean the true material well-being may not be
accurately reflected in the NNP figure. For example, 2 countries may have the
same NNP, but one may have a lower cost of living and can purchase more
products on that national income (NNP under-states true material well-being).

6.3.2 One way to solve this problem is to adjust for purchasing power parity4. The NNP
of a country whose cost of living is lower, should be adjusted upwards, and vice
versa.

6.3.3 Differences in non-material well-being can mean differing standards of living


even for similar NNP figures between countries.

6.4 Measurement

6.4.1 Differences in the size of the hidden economy (undeclared economic activity)
can cause the true material well-being of a country to be understated relative to
other countries.

6.4.2 Differences in the size of the non-market economy (undeclared economic


activity) can cause the true material well-being of a country to be understated
relative to other countries.

6.4.3 Differences in the quality of data collection methods can also cause
inconsistencies in the NNP figures when compared.

6.4.4 These above measurement problems are especially apparent when comparing
between developed and developing countries, where the “unofficial” economy
tends to be significant and data collection means are weak.

4
This is an exchange rate based on solely on the differences in cost of living between 2 countries.
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Macro 1: National Income and Accounting

6.5 Usage

6.5.1 Differences in the income distribution can mean different impacts to similar
individuals across countries even when the NNP growth rate is the same.

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